Europe's Choice: Policies for Growth and Resilience

IMF News, December 16, 2024

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Speech delivered by Mr. Alfred Kammer, Director of the European Department at the IMF, at the Annual Economics Conference: Pillars of Resilience Amid Global Geopolitical Shifts; Vilnius, Lithuania.
Date: December 16, 2024.
Central message: Europe must durably raise growth and build a resilient shock-proof economy through a deeper single market, smarter industrial policy, and domestic structural reforms.

Historical context:
- Europe narrowed the productivity gap with the United States after World War II; by the 1990s advanced European economies were as productive as the US.
- Since the 2000s Europe began falling behind due to structural deficiencies and limited benefits from the ICT revolution.
Current gaps:
- Advanced European economies now lag the US by 15 percent in terms of labor productivity.
- Per capita income in the European Union today is about 30 percent below that of the United States.
Projection:
- Without significant policy action, Europe’s income gap with the United States will remain virtually unchanged through 2030.

Enumerated headwinds:
- Uncertain external and domestic environments (Russia’s war in Ukraine reshaping trade, increased energy costs, heightened geopolitical uncertainty).
- Demographic decline (shrinking labor force).
- Fiscal pressures (high public debt levels may rise further with growing demands for defense, climate action, and aging populations; fiscal consolidation will often be unavoidable).

Assessment of current barriers:
- Intra-EU goods trade barriers might be as high as a tariff equivalent of about 44 percent on average — three times higher than trade barriers between US states.
- For services, barriers are equivalent to a 110 percent tariff.
- The EU’s effective external tariff rate is of around 3 percent.
Potential gains from lowering barriers:
- Lowering intra-EU trade barriers to US levels could raise productivity by nearly 7 percentage points in the long term.
- This would halve the current productivity gap between advanced EU economies and the US.
Policy actions to reduce barriers:
- Investing in cross-border infrastructure.
- Liberalizing protected sectors.
- Pursuing meaningful intra-EU trade liberalization.
- Harmonizing regulations across member states.

Labor mobility:
- Labor movement costs between EU countries are estimated to be eight times higher than between US states.
Capital and venture finance:
- Europe’s venture capital ecosystem has investments at just one-quarter the level seen in the US.
- IMF research: venture capital injections lead recipient firms to double their intangible investments within a year.
Combined effect:
- Lowering barriers to both trade and factor mobility would amplify gains, creating a virtuous cycle of innovation and growth.

Mechanisms of resilience in a fully integrated single market:
- Banks operating seamlessly across borders.
- Households holding equity issued by firms in other member states.
- Greater role for centrally provided public goods.
Risk-sharing comparison:
- Recent ECB research: around 70 percent of an income shock hitting an individual Euro area economy must be borne domestically, compared to just 25 percent in the US.
Example of fragmentation costs:
- Divergence in electricity prices between Southeastern and Western Europe when Ukraine increased its electricity imports following Russia’s attacks on its electricity generation capacity.
IMF advocacy:
- An EU-wide Energy Union supported by an EU Climate and Energy Security Facility to lower energy costs and deliver climate and energy security goals more cost effectively.
Note: Shocks will become more frequent and self-insuring will become increasingly costlier.

Recent trends:
- State aid in EU countries now accounts for approximately 1.5 percent of EU GDP, up one percentage point from a decade ago.
Principles for industrial policy:
- Avoid protecting mature industries.
- Policies must be coordinated, laser-focused on addressing market failures, time bound to contain fiscal costs, and accompanied by a strong governance framework to avoid institutional capture.
Role of EU-level coordination:
- Unilateral industrial policies can be harmful even if targeting national externalities.
- Acting simultaneously in a coordinated way can more than halve losses for the average European country.
- Coordination can cushion adverse regional impacts, including via potential intra-EU fiscal transfers.
- If the EU lowers remaining internal barriers to labor and capital mobility, the losses from industrial policy can be turned into gains.

Key domestic reforms:
- Easing administrative barriers to entry for firms.
- Improving insolvency frameworks to facilitate the exit of unproductive firms.
- Enhancing labor market flexibility while protecting workers (example: Denmark’s flexicurity model combining more flexible layoff procedures with adequate unemployment benefits and strong active labor market policies).
Potential growth dividends:
- EU countries lag global best practices in business regulation by 33 percent. Closing half of this gap to the global frontier could increase GDP by about 2 percent in the medium term for Euro area countries, and by 3 percent for countries in Central, Eastern and Southeastern Europe.
- The gap in labor market regulation to global best practices is 31 percent; slightly larger gains can accrue from labor market reforms.

Summary prescription: a more integrated single market, smarter industrial policy, and bold domestic reforms are the policies for growth and economic resilience.
Closing appeal: The choice is Europe’s to make; seize the moment to build a stronger, more dynamic, and more resilient Europe.

Source: Speech by Alfred Kammer, “Europe's Choice: Policies for Growth and Resilience,” December 16, 2024.