The most important area where Europe can contribute positively to growth remains the single market.
Most euro area countries have ageing societies, which means that raising living standards will increasingly depend on higher productivity growth. Productivity growth, however, has been stalling in the euro area for some time. The single market represents one of the most powerful tools we have to unlock the mechanisms that will raise productivity.
Productivity growth takes place through two channels, innovation and diffusion of new technologies. We have innovative firms in Europe and they compare well with their international peers. But innovations do not diffuse quickly enough to other firms, which weighs on productivity in the wider economy.
The top 10% of firms are on average three times more productive than the firms in the bottom 10%. And the sector where the gap is the widest is services.
In this context, advancing the single market agenda can help in two ways.
First, research shows that openness to trade is a key factor in enabling faster technology diffusion. Completing the single market in services can therefore boost productivity by raising trade in services, which should be higher in a fully integrated market. Services make up over 70% of EU GDP, but only 20% of services are traded across borders, representing just 5% of EU GDP.
The second element is building a true single market in capital. Deep financial markets play a critical role in facilitating diffusion, by providing the risk capital for firms to commercialise new technologies. But the opportunities of our large financial market are not being exploited.
In the euro area, only around 30% of debt securities and 20% of equities are held by investors in other countries, and only around 10% of the assets of the banking sector are held by branches and subsidiaries of cross-border banks. Completing banking union and capital markets union are the critical measures to improve this.
Taken together, the gains from this agenda would be sizeable. According to one estimate, removing all barriers to trade could raise the EU’s income by up to 14% over ten years and double intra-EU trade.
This underscores why, especially for countries struggling with low productivity, reversing the direction of European integration would not be a profitable path. Moreover, in an international environment where trade openness can no longer be taken for granted, a broad and deep internal market may become even more important to shield us from external shocks.
Completing the single market would also provide a further benefit.
Integrated markets, and especially financial markets, help share risks within and across countries. Such private risk-sharing plays a vital role in adjustment in well-functioning monetary unions, because individual regions cannot adjust to shocks through exchange rate devaluation. This takes place through two main channels.
The first is integrated capital markets. Typically, a recession causes both consumption and asset prices in a region to fall, which then reinforces the downturn. But when people can diversify their asset holdings across different regions, they can smooth their consumption by drawing on the assets they hold in better performing parts of the union.
The second channel is an integrated banking sector. Because local banks are typically heavily exposed to the local economy, a downturn will lead to large losses and prompt them to cut lending to all sectors. But if there are cross-border banks that operate in the region, they can offset losses there with gains in other regions, and can continue providing credit.
In the US, it is estimated that around 70% of local shocks are absorbed through integrated financial markets. In the euro area, however, only 25% of shocks are absorbed in this way because financial integration is low. As I have explained elsewhere, this is one reason why our crisis was so protracted and why some countries diverged economically.
Risk-sharing, in other words, fosters both stability and convergence within monetary unions. And without that, it becomes much harder to make high rates of growth sustainable.
So, to boost growth and increase private risk-sharing, our priority should be as follows: to re-establish a clear focus on finishing the single market in all its dimensions; and consistent with the strategy that Delors laid out, to buttress this with appropriate tools and institutions.
Today, this buttressing applies most of all to closing the gaps that remain in the institutional architecture of EMU. There are two key areas where actions are necessary.
Buttressing the Monetary Union
First, we need to address the obstacles that are still standing in the way of deeper financial integration.
We have already taken important strides in this direction with the creation of European banking supervision, a harmonised rulebook and the Single Resolution Mechanism. There has also been considerable risk reduction in the banking sector, with bank capital rising, leverage falling and non-performing loans being progressively reduced.
But there is still work to do. This includes finishing the clean up of bank balance sheets, as legacy assets act as a deterrent to cross-border takeovers, and especially removing the remaining supervisory and regulatory barriers that hamper cross-border activity.
For example, despite the banking union, regulation still limits the free flow of capital and liquidity within cross-border banks. This in turn reduces the efficiency gains for banks of operating on a European scale, and keeps retail banking integration low.
Yet levelling the playing field alone is not sufficient for deep financial integration – and this is the second point. Today’s debate is often cast in terms of dichotomies: private risk-sharing versus public risk-sharing, and risk sharing versus risk reduction. But I believe that, to a great extent, these different goals are complements, not substitutes.
Take the example of restrictions on the free flow of liquidity and capital. These barriers exist in part because there is an incomplete framework for bank resolution in the euro area with no public backstop. If there is a residual risk that the costs of bank resolution will end up on one single government’s balance sheet, those national authorities will have the incentive to limit capital and liquidity flows, so as to protect their depositors in the event of a bank failing.
With common public risk-sharing through a backstop for the resolution fund, the incentives at the national level to limit capital and liquidity flows would disappear. That would in turn lead to greater banking integration and private risk-sharing at the euro area level.
Risk-sharing, however, would not be a way to avoid risk reduction. When markets have confidence that banks can be resolved efficiently, it stabilises the system and reduces the costs of crises. In other words, risk sharing actually reduces risks.
A good example of this is the Federal Deposit Insurance Corporation in the US, which is also the resolution authority, and is backstopped by a credit line with the US Treasury. During the crisis, it resolved around 500 banks without triggering financial instability. This was possible because of confidence that the resolution framework was effective and that was backed by the resources it needed to do the job.
The same interaction also applies to fiscal policies.
We saw during the crisis how lack of fiscal space, needed to stabilise the economy, can create a vicious circle of low growth, rising bond spreads and loan-losses in the banking sector. That can in turn produce financial fragmentation.
For as long this risk exists, it is obvious that it will deter deep financial integration. And it also means that private risk-sharing tends to collapse at precisely the moment it is most needed.
To address this, the first priority is to make national fiscal policies more effective by encouraging governments to build up buffers. For that, we need to rekindle faith in our fiscal rules by making them both more countercyclical and more binding.
But we know that even sound domestic policies are not always enough. Markets can at times overreact and penalise sovereigns, over and above what may be needed to restore a sustainable fiscal path. And this overshooting can harm growth and ultimately worsen fiscal sustainability. This is why there is also a role for public risk-sharing, although the more we complete banking union and capital markets union, the smaller this needs to be.
The European Stability Mechanism cannot fully fill the gap, as it typically leads to procyclical fiscal tightening. So, we need an additional fiscal instrument to provide stabilisation. There ought to be an instrument that complements monetary policy in delivering macroeconomic stability both at the euro area level and, crucially, in each of its Member States.
As I have discussed elsewhere, what shape this fiscal instrument should take is still open for discussion. But any proposal should fulfil the following two conditions.
First, it should be adequate, so that it can restore full fiscal stabilisation capacity. And second, it should be properly designed so as to contain moral hazard. With these conditions in place, such an instrument should be seen as a way of reducing risks rather than increasing them. [...]
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