28 February 2013

ECFIN Economic Brief: European prosperity reloaded - An optimistic glance at EMU@20

At the  beginning of 2013, with the economy still in recession, unemployment soaring and large disparities across euro area Member States, the prospects for economic growth and prosperity appear to be fairly  bleak, both with respect to the  short-run outlook and over a more medium- to long-term horizon. Historical evidence shows that  economic recoveries after financial  crises tend to be slow and sluggish; typically, the need for financial deleveraging, demands for higher risk premia, inevitable fiscal consolidation to restore sustainable public finances and persistent labour market weaknesses combined to  weigh on growth for a prolonged period of time. But already before the crisis, the euro area had to face sluggish productivity growth, and the overall challenges of globalisation, ageing populations, growing resource limitations and climate change. Against that backdrop, we are now facing a dangerous mix of economic and social tensions, reform fatigue and complacency with respect to the "crisis stabilisation" which risks jeopardising the painful efforts and achievements so far.

Restoring normal lending conditions to the economy is a necessary albeit not sufficient condition for a resumption of growth. There are many positive signs of financial market stabilisation: while still fragile, undeniable improvements have set in, as reflected inter alia in higher stock market evaluations, unwinding convertibility risk premia, across-the-board declines in CDS and corporate bond spreads, stronger interbank lending, and some restoration of downhill capital flows. However, bank lending rates remain stubbornly high in many countries. The incomplete pass-through of monetary policy rates is indicative of ongoing deleveraging needs and balance-sheet-stress, only to be re-enforced by financial market fragmentation, impairing the functioning of the credit channel. And in turn, unsurprisingly, the necessary simultaneous deleveraging of both public and private sectors has translated into severe demand  weaknesses, eventually spilling over from the periphery into the core of the euro area. Against that backdrop,  facilitating orderly balance-sheet adjustment with minimal negative growth impact is at the core of current economic policy efforts.

Pursuing growth-friendly fiscal consolidation is an indispensable element of the overall strategy. Public finances are gradually improving; the fiscal deficit in the euro area has halved over the past two years, and several  countries, including vulnerable ones, have or are about to achieve primary surpluses. With fiscal multipliers higher than in normal times, the consolidation efforts have been costly in terms of output and employment. But they have not been self-defeating; and indeed, some countries had no better option than deep frontloaded fiscal cuts when the alternative was break-away from the euro area with unforeseeable consequences.

Optimism with respect to the future of EMU is presently regarded as politically incorrect in some quarters. Indeed, it must not be naïve, white-washing problems and downplaying the challenges ahead, risking complacency and, eventually, disappointment. But spanning an arc over the first two decades of EMU, it should not be dismissed too easily either. In 2008, EMU had successfully lived through the first 10 years of its existence. Already then, growing intra-area imbalances and governance design gaps were identified which gave reasons for concern. But only very few had foreseen that when these risk factors met with a global financial  crisis in a vicious circle, an almost perfect storm swept the euro area, endangering to sink it altogether as feared by many pessimists. However, the doomsayers have been proven wrong, underestimating the determination to take bold policy action at both the EU and the national level.

The euro area is by no means out of the  danger zone, and damage levels are high in terms of unemployment and social costs. Much remains to be done to repair and improve, but we can set a course to a prosperous EMU@20 on the medium-term horizon, characterised by macro-economic stability, dynamic efficiency, and fairness and solidarity. We are convinced that Europe possesses unique strengths to succeed in the global economy and to retain a quality of life which is envied by much of the rest of the world. This positive vision of Europe is one of a continent comprising 500 million skilled, active citizens in an open, inclusive, prosperous society, living together in a civilised manner, positively engaging with all other parts of the world. We can make it happen, but it will not happen by chance. For such a post-crisis future of EMU@20 to materialise, smart policy action is required to stay on course to exit the crisis and pave the way towards sustainable growth and prosperity.

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