Europe: Toward A More Perfect Union

IMF Blog, February 15, 2013

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Financial integration accelerated after the euro’s introduction, fostering a belief that capital would flow to where it would be best used and promote real convergence.
In practice, lasting convergence in productivity did not materialize across the European Union; a competitiveness divide emerged.
For the 17 euro area members:
- A common currency implied a common monetary policy and, initially, convergence of risk premia that encouraged capital shifts from the richer north to the poorer south (the periphery).
- Differences in sovereign yields across the euro area narrowed quickly during this period.
Recipient countries largely used capital to finance current consumption and real estate investment rather than productive capital, resulting in little absolute real convergence.
Newly accessant countries from emerging Europe performed better, with per capita incomes converging faster to northern Europe levels; these economies benefited from global growth, FDI, and stronger integration in worldwide supply chains, notably via links with Germany.

The crisis in the euro zone largely reflected the unwinding of financial integration in the absence of accompanying productivity improvements.
As growth prospect gaps became evident, markets discriminated among countries that had formerly faced similar borrowing costs, triggering a reversal of capital flows and fragmentation of the financial system in the euro zone.
The fragmentation impaired monetary policy transmission. The Target2 system serves as an indicator of financial fragmentation along national borders.
- In late 2011, Target2 balances increased particularly due to fragmentation affecting markets in Italy and Spain, with surplus countries—particularly Germany—providing the counterbalance.
- The Target2 system acted as an important shock absorber and balances have since stabilized.

Hard-hit countries on the southern periphery implemented tough reforms in the three years following the crisis; these reforms are beginning to yield results, but substantial work remains.
IMF research cited:
- If euro area member states managed to close half the gap with OECD best practice in labor market and pension policies, they could boost GDP by almost 1½ percent on average after five years.
- An additional boost of 2¼ percent could follow if more competition is introduced into markets for products and services.
As reforms improve growth prospects, private capital needs to return to the periphery and be channeled into investment that converts prospects into realized growth.

National reforms are necessary but insufficient; managing the crisis requires “more Europe” to reverse financial fragmentation and prevent sudden stops in intra-union capital flows.
Recent euro area policy actions include measures aimed at strengthening the monetary union’s functioning (actions categorized as helping growth, helping integration, or both).
Two elements identified as necessary for a more viable union:
- A banking union to make the financial sector more robust to future shocks.
- More fiscal integration to address gaps that amplify country-level shocks into zone-wide events.
From the IMF perspective, a banking union additionally requires:
- A common fiscal backstop for resolution of troubled banks.
- A common approach to deposit insurance.
No consensus yet exists on the form of closer fiscal integration. Proposals range from:
- A common euro area treasury with a centralized budget.
- Powers to direct national budgets and common borrowing.
These proposals carry direct monetary implications and substantial consequences for national sovereignty; empirical evidence from various federations suggests multiple models can work.

Immediate focus should be on growth to address very weak economic outlooks and intolerable unemployment in much of the EU.
Priority national reforms include:
- Encouraging labor mobility.
- Implementing product market reforms.
- Investing in infrastructure and education to foster competitiveness.
Eurozone-level actions needed include:
- Central support for market access.
- Mechanisms to support troubled banks.
The path forward requires sustained, difficult work:
- 2012 was characterized as balancing on edges of cliffs and precipices for Europe.
- 2013 should be a year of climbing mountains—restoring competitiveness across economies to restore growth and steadily completing the monetary union’s architecture.

Italic: Europe: Toward A More Perfect Union — Nemat Shafik, February 15, 2013

Staff Discussion Note
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