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Restoring growth and employment in the euro area
Why is growth not rebounding more quickly and evenly across the euro area? A key explanation is that the adjustment process has been hindered by adverse feedback loops resulting from the interaction of accumulated fiscal and macro-economic imbalances, weak bank balance sheets and the lack of a genuinely European approach to bank resolution and recapitalisation. To give just one example of such interactions, large fiscal imbalances in a Member State can lead financial markets to drive up yields on its sovereign debt. This in turn creates higher funding costs for its domestic banks and reduces their profitability, thereby hampering credit growth to the real economy. Lower credit growth then contributes to lower nominal GDP, which not only further weakens banks’ balance sheets by increasing non-performing loans, but also increases concerns about the sustainability of sovereign debt through the denominator effect; and thus, the feedback loop restarts again. Without a European approach to banking sector repair, if the sovereign intervenes to break the feedback loop by recapitalising or resolving banks, it may only heighten market concerns about its debt sustainability and aggravate the situation.
Addressing such adverse feedback loops between government finances, credit and growth implies a triple policy response from governments: First, fiscal consolidation and current account rebalancing to secure public debt sustainability and lower external financing needs. Second, structural reforms to increase potential growth and offset the potential negative effects of fiscal consolidation. Third, comprehensive banking sector repair to acknowledge impaired assets and strengthen bank balance sheets. Fortunately, in all three areas the euro area is heading in the right direction.
First, fiscal and macro-economic imbalances have improved significantly: fiscal deficits have declined from their 2009 peaks throughout the euro area based on sizeable consolidation efforts and despite strong economic headwinds, while there has been a pronounced reduction of current account deficits. However, these sizeable flow adjustments have not yet fully translated into improvements in the accumulated stock of imbalances – public debt ratios on the fiscal side, net international investment positions on the macro-economic side – because of depressed nominal GDP growth.
Second, the euro area witnessed a renewed momentum to implement structural reforms. It has been well-understood by euro area countries that restoring fiscal sustainability must rest not only on fiscal adjustment to achieve sizeable primary surpluses, but also on measures to revive growth to avoid adverse snowball effects undoing the debt-stabilising impact of primary surpluses. This requires structural reforms that improve labour market and product market functioning and hence increase potential growth. There are numerous studies, for instance by the OECD and the IMF, showing the significant benefits in terms of employment and growth that could accrue to the euro area from such measures – and not only in the medium-term. A credible commitment by euro area governments to implement structural reforms could already create a permanent upward shift in expectations of future growth, improve labour market performance, and as a welcome side-effect, improve the health of public finances over the medium-term. And to a certain extent, this is what we are seeing in the euro area today.
Third, euro area countries have taken a series of measures to address balance sheet weaknesses in the banking sector. Capital requirements are in the process of being strengthened following the conclusion of the Capital Requirements IV Directive, which transposes the Basel III agreement into EU law. At the same time, a number of banks raised new capital to address balance sheet weaknesses. The greatest progress in financial sector repair has of course taken place in the countries under EU-IMF programmes, where there has been a comprehensive restructuring and recapitalisation of the domestic banking sectors. Spain has also taken decisive measures to address the imbalances of the past via its ESM indirect bank recapitalisation programme.
What remains to be done
While a great deal has already been done by euro area authorities to address these root causes, there are three areas in which more progress still needs to be made.
First, the euro area needs to continue to deepen structural reforms aimed at enhancing competition, flexibility, efficiency, and productivity. The reform process takes time, and so a medium-term, comprehensive approach is crucial to anchor expectations and maximise the positive effects of adjustment in the short-term. The greatest challenge today is to maintain reform momentum and implement fully those changes which have already been announced or even enacted into law. Concretely, this means, for the labour markets, addressing the remaining insider-outsider dualities and enhancing labour mobility, including across borders. For product markets, the key challenge is to open up regulated professions and network industries that are sheltered from competition by government regulations. This requires a simplification and streamlining of regulations, a reduction of barriers to entry and limits to competition, a resolute deepening of the Single Market in Europe. Going forward, structural reforms also need to go into the government sector itself. In several euro area countries, modernisation of public administration is essential to increase efficiency in the provision of public goods, like infrastructure, and essential services, like civil justice. This will also support fiscal consolidation, by reducing the size of the government sector.
Second, the euro area needs to persevere in fiscal consolidation efforts and reduce steadily the government debt ratio. Despite the important progress on fiscal consolidation, debt ratios have yet failed to stabilise in most euro area countries, as improvements in primary balances were outweighed by the debt-rising impact of unfavourable developments in interest-growth differentials and deficit-debt adjustments. The euro area government debt ratio is projected to rise further to above 95 per cent of GDP in 2013 – far above the 60 per cent Maastricht reference value – with debt ratios displaying large differences across countries. Further adjustment is thus inevitable, and unfortunately it must take place in an environment of rising consolidation fatigue. Five years into the crisis this rise in consolidation fatigue is understandable. Going forward, it will be important for policymakers to communicate effectively both on the need for further adjustment and how this adjustment will be distributed in an equitable way across different groups of the population.
Third, the euro area needs to press ahead with constructing a genuine Banking Union. A first and important step has been made with the decision to create the Single Supervisory Mechanism (SSM), the responsibility for which was assigned to the ECB. Political agreement by the ECOFIN Council and the European Parliament was reached on a legislative package in March, and technical agreement is expected very soon, so that national parliamentary proceedings can start, which should be concluded by the summer. The existence of the SSM, by reducing regulatory capture and increasing supervisory consistency and coherence, should play an important role in increasing confidence in the overall euro area banking system, and as a result, reduce fragmentation of interbank and other financial markets.