Europe’s Choice: Risk Stagnation or Pursue Integration

IMF Blog, October 11, 2013

Source details

Canonical URL

Europe’s Choice: Risk Stagnation or Pursue Integration

Other formats

• Markdown version
• Structured JSON version
• Bundle manifest

Bibliographic details

• Authors: Nemat Shafik
• Published: October 11, 2013

Context and challenge

• Five years into the crisis, recovery in the euro area remains fragile.
• Important euro-wide and national actions already taken:
  • European Central Bank’s announcement in 2012 that it stands ready to undertake outright monetary transactions in secondary sovereign bond markets.
  • Completion of the European Stability Mechanism, which created a financial firewall around the euro area.
  • Efforts to restore the health of public finances and implement structural reforms.
• Persistent problems: financial markets remain fragmented; unemployment—especially among young people and in the periphery—is at record highs; countries on the euro area periphery are still recovering from recession; there is also weakness in some core countries.
• In the hardest-hit countries, the social fabric has started to fray, reform fatigue is setting in, and politics have become increasingly polarized.

The risk of stagnation (scenario)

• If reform efforts stall, the most likely outcome is a period of prolonged stagnation.
• Mechanism of stagnation described:
  • Financial fragmentation persists and loans remain expensive for companies in the periphery.
  • High private debt and continued uncertainty lead households and firms to remain reluctant to spend and invest.
  • Unemployed workers lose skills and new workers find it difficult to join the labor force, permanently damaging productive capacity and the social fabric.
• Current indicators cited:
  • Economic activity in the euro area today is still below what it was in 2008, before the global financial crisis.
  • In 2012, GDP in the euro area contracted by 0.6 percent of GDP.
  • Despite recent signs of a gradual recovery in the second half of 2013, inflation is expected to remain subdued and unemployment remains elevated.

The path to growth — four key areas requiring immediate attention

• Complete the banking union:
  • Expedite reforms already under way, including a final agreement on the Bank Recovery and Resolution Directive by the European Parliament and progress on the Deposit Guarantee Scheme Directive.
  • Agree on a strong single resolution mechanism based on a centralized authority, supported by a common backstop, with powers to trigger resolution and make decisions on burden-sharing to ensure timely and least-cost resolution.
• Restore the health of bank portfolios:
  • Conduct a credible assessment of the quality of banks’ assets to quantify capital needs.
  • Accompany the assessment with a clear plan on how to meet capital needs.
  • Where private capital is insufficient, credible backstops—in some cases, the ESM—will be essential to preserve banks’ ability to continue lending.
• Take further steps to support demand in the near term:
  • IMF supports the ECB’s commitment to keep the monetary policy stance accommodative for as long as necessary.
  • Further monetary easing is needed to support demand; unconventional measures could help reduce fragmentation.
  • Fiscal adjustment in euro area countries should be focused on structural targets and carefully designed to avoid an excessive drag on growth.
  • In the medium term, the euro area also needs to move toward fiscal union.
• Push ahead with structural reforms:
  • Tackle structural rigidities at both the euro area and national levels to raise potential growth and promote rebalancing within the euro area.
  • Implementation of the Services Directive could encourage cross-border competition and raise productivity.
  • National efforts to address labor market weaknesses would boost competitiveness and employment.
  • A new round of free trade agreements—preferably of the multilateral kind—could help boost productivity.

Political economy and timing

• Structural reforms are politically difficult and often take years to yield results, requiring electorates to accept short-term pain for medium- and long-term gains.
• The challenge is greater at the European level when 17 countries that are members of the euro area—or the 28 countries that make up the European Union—have to agree to deep-reaching reforms.
• Importance of seizing political windows of opportunity and understanding electoral cycles.
• Sometimes the best strategy is to move on many fronts at once because policy actions are mutually reinforcing (for example, improving credit flow in the periphery would boost investment and job creation, restoring competitiveness and raising growth).

Key statistics and projected gains

• "Five years into the crisis" (contextual timeframe).
• "In 2012, GDP in the euro area contracted by 0.6 percent of GDP."
• Political scope: "17 countries that are members of the euro area" and "28 countries that make up the European Union."
• IMF analysis projection: a comprehensive reform effort—tackling financial fragmentation and structural weaknesses at the same time—could raise the level of euro area and global output by about 3 percent and 1 percent respectively within five years.

Nemat Shafik, October 11, 2013