Toward a More Resilient Europe

IMF Blog, July 13, 2020

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Based on updated IMF projections released last month, real GDP in the European Union is expected to:
- contract by 9.3 percent in 2020
- grow by 5.7 percent in 2021
- return to its 2019 level only in 2022
Recovery speed conditional:
- If an effective treatment or vaccine for COVID-19 is found, the recovery could be faster.
- The opposite would hold true if there are large new waves of infection.

Several countries entered the crisis with entrenched product and labor market rigidities, holding back growth potential.
Economies dependent on industries tightly integrated into cross-border supply chains are deeply vulnerable to supply disruptions.
In several large euro area countries, slow growth has coexisted with high public debt and limited fiscal space, constraining shock absorption.
Europe’s high-debt countries will bear the brunt of the social impact:
- Public debt burdens have historically ratcheted up in bad times and stabilized—but not fallen—in good times.
- Outcomes include high unemployment and emigration, especially among the youth, and a trend toward less-progressive taxation, while pensions have largely been protected.
- COVID-19 “calls for protection of the elderly but leaves the young shouldering much of the cost,” complicating demographic challenges.

Immediate and continued fiscal support remains vital to preserve economic capacity and allow prompt bounce-back from short, extreme disruptions.
As dislocations persist and resources become stretched, policymakers should:
- Reposition national fiscal policies for a longer crisis.
- Think ahead and reassess how best to use limited fiscal space without unduly burdening future taxpayers.
- Carefully target support for firms and households in the high-debt countries; “the longer the slump, the greater will be the need to carefully target fiscal support in the high-debt countries.”
Recognize that the post-crisis economy may look very different from 2019 and that permanent change and investment in resilience are required.
Public investment priorities:
- Greening
- Digitalization
- Other aspects of resilience

Public funds must steer needed resource reallocation while protecting the most vulnerable.
Labor and product market guidance:
- Focus on flexibility.
- Ensure short-time work schemes that tie workers to employers are kept temporary.
Corporate sector guidance:
- Support programs must embed incentives that encourage uptake by firms with strong business plans and discourage uptake by firms on a path to failure.
- As liquidity needs become solvency needs, state aid may need to include equity injections; various European initiatives are already moving this way.
Policy clarity:
- Clarity on carbon pricing is important to set the stage for a climate-friendly recovery of private investment.

Strong case for joint EU fiscal action given divergent national conditions.
The “Next Generation EU” package can improve outcomes for the single market by focusing funds on countries:
- hardest hit by the pandemic
- with less fiscal space
- with lower income levels
- with greater environmental damage
Conditions and limits:
- EU funds should act as a catalyst, not a substitute for structural reforms and prudent fiscal policies.
- With fundamental limits to the size of any joint EU assistance, responsibility for ensuring sustainable debt burdens remains at the national level.
- All countries will need to pair upfront stimulus provision with credible medium-term policy plans, even with low borrowing costs.

Monetary policy stance:
- Through the acute crisis phase and beyond, monetary policy must remain strongly accommodative.
- Policy rates must remain at extraordinarily low levels for now, supported by net asset purchases that implicitly look to bond spreads and issuance volumes.
- The European Central Bank’s strategic review remains essential to reflect on missed inflation objectives, demarcation from fiscal policy, the global decline in equilibrium real interest rates, monetary instruments, and more.
Banking and credit supply:
- For now, most European banks have the capital and liquidity needed to expand credit.
- As the crisis wears on, many defaults could erode bank buffers and lending capacity.
- Risks: the longer the pandemic, the greater the credit disruption, and the slower the post-pandemic recovery.
- Supervisory priorities:
- Prepare banks for the coming test.
- Uphold robust lending standards.
- Provision for losses fully and transparently.
- Pursue restructurings of bad assets actively to preserve value.
- Bank recapitalization may prove necessary in some cases.

Transition from broad emergency measures to an increasingly calibrated approach that balances immediate imperatives with longer-term burdens on young taxpayers and new generations.
Continue responsible policymaking while pursuing difficult reforms with renewed determination.
Overarching policy goals (twofold):
- to save lives now
- to ensure that Europe emerges with a greener and safer economy for the long run, where future generations can thrive equitably

Source: Toward a More Resilient Europe — Poul M. Thomsen, July 13, 2020