Europe seems to be turning the corner. Progress in tackling big challenges has been made. Signs of growth have begun to emerge after several years of declining activity, and question marks about the viability of the monetary union have dissipated.
Some countries, hit hard by the crisis, had to undertake a great deal of adjustment, but they appear to be stabilizing. Financial markets are more upbeat and foreign capital that fled Europe is gearing up to return.
There is a palpable sense of optimism in some quarters that the European crisis is over. But can a crisis really be over when 12 percent of the labor force is without a job? When unemployment among the youth is in very high double digits, reaching more than 50 percent in Greece and Spain? And when there is no sign that it is becoming easier for people to pay down their debts?
Indeed, looking past the headlines, there are clearly signs that not all is well.
First and perhaps most important, growth rates and output levels still remain well below where they should be. With unemployment rates as high as they are, this gap between actual and potential growth rates is likely to remain large for the foreseeable future. This keeps a check on price increases, which helps consumers in the short run; but if this were to persist long enough, it could lead to a vicious cycle of low demand and activity as it also affects capital spending and hiring.
Second, growth has not been balanced across Europe and, therefore, may not be sustainable. There are pockets of stronger growth and high employment, for example in Germany, but growth is low or declining elsewhere.
Most of the demand for European goods and services comes from abroad, not from within, leaving the economy at the mercy of the ups and downs of global trade. European demand for European products remains lackluster, despite a small revival in investment in recent months.
Beyond the short term, more fundamentally and much more worryingly, what is at stake is Europe’s potential for growth in the future. One factor at work is that the crisis has taken a severe toll on the young and the vulnerable.
Unemployment at a young age means a lack of on-the-job training, depreciating skills, and possible withdrawal from the labor market. Experience tells us that long spells of unemployment lead to a less productive workforce down the road. Another factor is the dearth of investment—be it private or public—that in many countries erodes the capital stock and depletes the productive capacity of the economy. Thus, a failure to revive investment and employment will not bode well for Europe’s future.
All in all, it is therefore premature to declare victory. The only durable solution lies in jump-starting growth. This means growth not only from stronger exports, but also from a robust recovery in domestic demand, especially investment, that touches all corners of Europe.
History gives hope. Countries have emerged stronger from a crisis before. Sweden is such an example. After a banking crisis devastated the economy in the early 1990s, Sweden adopted wide-ranging reforms, liberalizing product markets, privatizing, and deregulating services. This helped boost productivity and vaulted Sweden to one of Europe’s top performers since 1995 while also safeguarding employment and equality in a strong welfare state. For the euro area, securing growth will be a more complex challenge. It will require comprehensive and multi-layered solutions to unravel the Gordian knot of obstacles that are holding back domestic demand.
I will touch on what we see as the priorities to jump-starting growth, many of which will be discussed in a book on employment and growth in Europe that we will be releasing in January.
First priority: Reviving credit
The experience with financial crises has shown that a robust recovery cannot resume without decisively resolving the problems of an ailing financial sector. Europe has lagged somewhat behind other countries in this regard.
It is critical that the flow of credit on reasonable terms to businesses and households be restored. That means restoring the health of weak banks by resolving the problem of bad loans on their books and making sure they are holding sufficient capital to be viable once again.
Reviving credit growth also entails properly accounting for, and disclosing, how bank assets and liabilities are valued so that investors and depositors may regain confidence.
With these objectives in mind, Europe is now set to undertake a comprehensive, complex, and ambitious exercise to clean up its banks under the aegis of the new European bank supervisor, the European Central Bank. A job well done will set the stage for a return of confidence, credit and growth. In that context, completing all elements of a banking union remains a priority.
A second priority: Supporting demand
In the interim—while banks are being cleaned up and credit flows have yet to resume fully—public policy needs to do as much as it can to support demand.
This means, the ECB needs to keep interest rates low and convince investors that it will do so for as long as is necessary. It must act preemptively to stall further declines in inflation and inflation expectations. It needs to find ways to reduce the cost of lending to small- and medium-sized enterprises, the largest employers within Europe. In contrast, government budgets have less scope to support growth, given large—and, in some cases, growing—debt. But there may be room to relax nominal budget deficit targets if growth forecasts fail to materialize.
And in the event growth is low for a protracted period of time and monetary policy options are depleted, fiscal policy will need to provide more support to domestic demand.
A third priority: Reducing debt
Growth will not pick up substantially unless households, corporates and sovereigns also get their finances in order. Reducing the debt burden will make borrowers more attractive in the eyes of lenders, and revive prospects for credit. It will free up income from the need to service debt toward supporting consumption and investment.
For the private sector, this means that governments need to put in place the structures to facilitate private debt restructuring. This includes effective national insolvency frameworks to reduce the time it takes to restructure debt. We also need to address public sector debt burdens. In many countries, fiscal consolidation is hard to avoid, and our experience suggests that this is best done in the context of a medium-term framework and in a transparent manner. But ultimately, bringing down debt levels in a sustained way requires higher growth.
Finally, it remains important to break the pernicious links between banks and sovereign balance sheets. This can be done by creating the conditions to ensure that the future cost of fixing banks will no longer fall primarily on the public sector. All this would help put debt on a downward trajectory.
A fourth priority: Fostering growth-friendly labor and product markets
The goal of reform is to break down barriers to growth. There is no “silver bullet.” This means taking on entrenched positions and vested interests. It means bringing in more competition and flexibility to spark innovation, boost competitiveness, and enable resources to go where they are most productive. But it also means helping labor markets to support growth and adjustment.
To be clear, reforms are needed across all of Europe.
For example, in countries with large external surpluses, reforms should be targeted to boost investment to ensure that resources are invested where they will maximize returns.
In countries with external deficits, prices must be adjusted through improvements in productivity of workers and firms; this would make the tradable sector more competitive and generate more demand.
Can this really work? Yes, reforms do pay off. There is growing evidence that significant reforms in product and services sectors can lead to sizeable productivity gains, which eventually creates room for higher wages and more job opportunities.
IMF staff has estimated that eliminating just half of the euro area’s gap with the best practices in labor market and pension policies of OECD countries could raise the level of real GDP by almost 1½ percent after 5 years, and by another 1¾ percent through product market reforms that reduce the regulatory burden.
Revenue-neutral tax reforms that shift the tax burden away from labor-based taxes to other taxes, including indirect taxes, would raise GDP by ¾ percent over the same time period. And combining all of these reforms would result in a 4 percent boost. These are big gains!
So what to do exactly? Labor market reforms can strengthen resilience, making economies better placed to absorb future shocks. For example, the German labor market has worked well during this crisis in part because of the Hartz reforms introduced during the early 2000s.
Changes to the labor market need to be done in a manner that respects the legitimate rights of workers and pays due regard to income distribution. Solutions need to be devised through constructive dialogue with all stakeholders, including representatives of workers and business.
There are ways to make the adjustment more job-friendly:
Wage-setting arrangements could be improved. For example, in Spain, government estimates suggest that the labor reform package, which includes liberalizing opt-outs from collective agreements, would increase potential GDP by more than 4 percent.
A lower employment tax wedge—put simply, the difference between before and after tax wages—can increase incentives to hire, boost growth, and shift resources to exporting sectors.
Greater labor mobility across borders could help skilled workers in regions of high unemployment to find jobs in areas with skill shortages. Portable pension and unemployment benefits would help the process.
Beyond the labor market, big payoffs come from opening up product and service markets to competition to unleash new investment and new jobs.
Lower regulatory hurdles for the entry and exit of firms and simpler tax systems, especially in network industries such as transportation and energy, can reduce the cost of business and help create jobs.
For example, electricity prices for Italian industry are about 30 percent higher than the European average and high electricity prices raise the cost of business in Portugal.
In France, for instance, the average size of firms is much smaller than in Germany because firms with more than 50 workers become subject to about 30 additional laws and regulations. This makes it harder for French firms to reach the critical mass needed to access export markets.
A targeted implementation of the EU Services Directive would open up protected professions and increase competition by promoting cross-border provision of services. Right now, about 800 professions and activities are still heavily regulated in many countries—including legal services, architects, accountants, tax advisors, and engineers.
And there is also a financial dimension to long-term growth. It would be useful to develop alternative funding sources for small- and medium-sized enterprises, which are too reliant on bank financing at the moment. Recent proposals by the European Commission and the European Investment Bank to provide credit support to these enterprises through securitization schemes hold promise.
Finally, it makes sense to pursue access to growing markets, including through a new round of Free Trade Agreements. In this connection, let me welcome the breakthrough agreement reached this week-end in Bali by the World Trade Organization and fully support Director General Roberto Azevêdo’s determination to move the broader Doha Development Agenda forward. A deeper integration of markets would provide markets for Europe to export to and help improve productivity. It is also important for countries to plug into global production chains, which several emerging markets in Europe have accomplished successfully. Structural reforms in product and labor markets can help other countries achieve such integration as well.
Let me conclude. Europe is on the right track. The recent improvement in growth and market sentiment is no accident. Looking back to the beginning of the crisis, it is remarkable how far Europe has come in pushing through reforms to tackle deep-seated obstacles to growth.
But there can be no letting up on reforms until growth has recovered sufficiently to arrest the rise in unemployment and debt. In the words of Madiba: “After climbing a great hill, one only finds that there are more hills to climb.”
Although there are no quick fixes or easy answers, the IMF is dedicated to continuing to work with its European member countries, as well as with the European Commission and the ECB, to support the recovery and generate growth and jobs.
We also remain committed to continuing to engage with all our partners—including all of you in this room—to addresses together Europe’s significant challenges.