Making the Euro Area More Resilient Before the Next Recession Hits
IMF Blog, June 17, 2019
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Bibliographic details
- Authors: Shekhar Aiyar, John Bluedorn, Romain Duval
- Published: June 17, 2019
Overview
- Authors: Shekhar Aiyar, John Bluedorn, Romain Duval.
- Date: June 17, 2019.
- Summary: Growth in the euro area rebounded earlier this year, but remains fragile and risks have increased. A new IMF staff paper finds euro area countries experienced more frequent and severe recessions than other advanced economies over the past 20 years, and post-downturn divergences in growth and unemployment widened, especially after the 2008 global financial crisis.
- Central message: National structural reforms—labor market policies, product market regulations, and corporate insolvency regimes—combined with euro area–wide architectural improvements, would strengthen resilience and reduce economic and social costs of adverse shocks.
Key findings
- Euro area countries had more frequent and severe recessions than other advanced economies over the past 20 years.
- Differences between member countries’ growth and unemployment rates after euro area-wide downturns have widened, with the widening most stark following the 2008 global financial crisis.
- Over the past four decades, economies that reformed labor and product market regulations experienced smaller and less persistent output losses after deep recessions than those that did not.
- After the 2008 global financial crisis, resource misallocation across industries rose on average in economies with less efficient and more inflexible insolvency regimes, while it barely budged in economies with better-quality regimes.
Labor and product market regulations — resilience mechanisms
- Objectives:
- Weather temporary shocks (e.g., a credit crunch or supply disruption).
- Reallocate workers and capital swiftly after permanent shocks (e.g., long-lasting loss in external competitiveness).
- Effective elements:
- Wage bargaining and benefit systems that make labor costs—hourly wages or hours worked—more responsive to labor market conditions can reduce job losses in bad times.
- Less cumbersome and more predictable layoff procedures for regular workers facilitate firm adjustment and speed worker reallocation.
- Carefully designed unemployment insurance schemes supplemented by strong job search support and incentives provide necessary worker security.
- Lower administrative barriers and startup costs in product markets enable quicker economic adaptation.
- Importance for monetary unions:
- Getting labor and product market regulations right matters much more for economies that lack independent national monetary policy and nominal exchange rates, such as monetary union member countries.
- Country examples:
- Germany after the 2008 financial crisis: unemployment barely increased; firms adjusted labor costs through wages and—primarily—hours; government “Kurzarbeit” scheme financially compensated employees for lost hours at no cost to firms; Germany recovered quicker than most European peers.
- Portugal and Spain: less flexibility led companies to eliminate large numbers of temporary jobs; unemployment shot up in 2009, amplifying the recession and the subsequent euro area crisis.
- Policy nuance:
- Better labor market policies need not mean across-the-board deregulation or weaker protections. Different packages (e.g., “Anglo Saxon” and “Nordic” approaches) can deliver flexibility while reflecting social preferences. Both feature limited job protection but differ in worker protection and fiscal costs; the “Nordic” approach relies on more generous unemployment benefits paired with strong job search assistance.
Corporate insolvency reforms
- Rationale: Lowering the cost and increasing the flexibility of insolvency procedures allows viable companies to restructure and recover quickly and accelerates elimination of unproductive “zombie firms.”
- Evidence: Countries with better-quality insolvency regimes saw little increase in resource misallocation after the 2008 global financial crisis, while those with less efficient regimes saw resource misallocation rise on average.
- Progress and scope: Some countries (for example, Portugal) have made progress over the past decade, but further improvements are possible in many cases.
- Economic effect: Efficient corporate insolvency laws hasten reallocation of capital and workers toward more productive activities after deep downturns, alleviating misuse of resources and speeding recovery.
Cyclical policies and fiscal space
- Interaction with structural reforms:
- Structural reforms reduce the burden on cyclical policies—national fiscal or common monetary policies—used to stabilize member economies.
- Effectiveness caveat:
- Greater rigidities make economies more sensitive to shocks and can make countercyclical policies more powerful in isolation.
- If a country has limited fiscal space (for example, because of a high debt burden), attempts at fiscal expansion can weaken confidence and undo expansionary effects, raising the debt burden further for no return.
- Implication: Countries should not only undertake reforms but also rebuild fiscal space as insurance against future downturns.
Policy recommendations
- Prioritize structural reforms that improve:
- Labor market flexibility and responsiveness (wage and hours adjustment, predictable layoff procedures, active labor market policies).
- Product market flexibility (lower administrative barriers, reduced startup costs).
- Corporate insolvency regimes (lower cost, greater flexibility).
- Complete euro area–wide architectural improvements where needed (banking and capital markets unions; central fiscal capacity for macroeconomic stabilization), while recognizing these cannot fully substitute for national reforms.
- Rebuild fiscal space to ensure fiscal policy remains an effective stabilization tool during downturns.
- Fostering structural reforms should be a key priority for the next European Commission because such reforms improve productivity, growth, economic convergence, and macroeconomic resilience amid mounting global and domestic risks.
IMF staff blog: "Making the Euro Area More Resilient Before the Next Recession Hits" — Shekhar Aiyar, John Bluedorn, Romain Duval; June 17, 2019.
