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Europe beyond the crises

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In the context of the current crisis, return to growth is for Europe a challenge which is difficult to address because of the mutually reinforcing interaction among several aspects, amongst which: a) the combined effects of the financial and economic crisis; b) the limited productivity of some countries; c) the protracted deleveraging demanding for higher risk premia; d) fragmentation and structural weaknesses of the financial sector, e) distorted relative prices. At the same time, the problems of growth in Europe date back well before the crisis, which mainly unveiled that growing macroeconomic imbalances and low productivity, along with the overall challenges of globalisation (such as ageing populations, increasing limitation of resources, climate change, etc.), were structural problems of the European economy – and that of the Eurozone in particular. Since the beginning, the European strategy against the crisis mainly focused on the priority to promote fiscal consolidation at the national level and structural reforms to increase the competitiveness of national economies. This was considered as the first necessary step to create pre-conditions for sustainable economic growth and job creation, as well as to ensure macroeconomic stability. Moreover, the strategy relied on the belief that, after an initial period of economic correction and contraction, growth would have come as a result of a complete and ambitious implementation of those reforms. Against this backdrop, the Commission launched the ‘Europe 2020 strategy for smart, sustainable and inclusive growth’. This strategy fixes guidelines aiming to address the shortcomings of the European growth model and create the conditions for a smarter, more sustainable and more inclusive growth. The ‘Europe 2020’ strategy indicates five key targets for the EU to achieve by the end of the decade, covering employment, education, research and innovation, social inclusion and poverty reduction, climate change and energy sustainability. Two years later, with Europe still being in the midst of an unprecedented crisis, the full implementation of this strategy by the Member States was lacking. In a political and economic context where attention of some national leaders (in particular the Italian and the French) to the need of boosting growth was growing, the June 2012 European Council agreed on a ‘Compact for Growth and Jobs’. Amongst other things, the ‘Compact’ outlined a EUR 120 billion investment package, providing: – the increase of the capital of the European Investment Bank (EIB) by EUR 10 billion with a view to increase its overall lending capacity by EUR 60 billion, which could unlock up to EUR 180 billion of additional investment across the EU; – the Project Bond pilot phase bringing additional investments of up to EUR 4.5 billion for pilot projects in key transport, energy and broadband infrastructure; – the reallocation of European Structural Funds in support of innovation and research, SMEs and youth unemployment and a further 55 billion devoted to growth measures. One year later, with a further deteriorating economic situation, the European Council (27-28 June 2013) agreed on a comprehensive approach to combat youth unemployment, as well as to boost investments and improve access to credit by calling for the mobilisation of European resources, including that of the EIB, to support SMEs and boost the financing of the economy. Given the need to restore normal lending to the economy and to facilitate the financing of investment as well as the importance of SMEs for the economy, the European Council mainly agreed on: – stepping up efforts by the EIB to support lending to the economy by making full use of the recent increase of EUR 10 billion in its capital. The European Council called on the EIB to implement its plan to increase its lending activity in the EU by at least 40% over 2013-2015. To this effect, the EIB has already identified new lending opportunities of more than EUR 150 billion across a set of critical priorities (such as innovation and skills, SME access to finance, resource efficiency and strategic infrastructures); – the expansion of joint risk-sharing financial instruments between the European Commission and the EIB to leverage private sector and capital market investments in SMEs. The Council, in consultation with the Commission and the EIB, will specify the parameters for the design of such instruments co-financed by the Structural Funds, aiming at high leverage effects. These instruments should begin operating in January 2014; – extending the European Investment Fund’s mandate to increase its credit enhancement capacity; – expanding the EIB’s trade finance schemes to favor SME business across the EU; – strengthening cooperation between national developments banks and the EIB to increase opportunities for co-lending and exchanges of best practices; – developing alternative sources of financing in close cooperation with Member States. The impact of these measures on the European economy depends now on how swift and effective the decisions will be implemented. Today, the top priorities of the European strategy for growth are: pursuing differentiated, growth-friendly, fiscal consolidation; restoring normal lending to the economy; promoting growth and competitiveness; tackling unemployment and the social consequences of the crisis; and modernising public administration. In our view, the major drivers at the disposal of the EU are: – the full exploitation of the potential of the Single market, by deepening it and removing the remaining barriers. To this regard, the Commission has recently put forward ambitious reform packages (including proposals on EU patent, public procurement, reform of insolvency laws, high-speed broadband infrastructures, etc.) . Even if this would have huge potential benefits for the European economy, until now the commitment of the involved institutions and Member States to quickly put these tools on track, is weak and ambiguous. Tax policy can also contribute to fiscal consolidation and sustainable growth. For this reason, the Commission’s Country-Specific Recommendations for the year 2013 pay lots of attention to the reform of national tax systems. At the same time, closer cooperation between national tax administrations can deepen fiscal integration. The fight against tax fraud and evasion, which is increasingly gaining attention, can be an opportunity in this sense. Trade is another important driver for growth. In addition to ongoing negotiations with a number of key international partners (such as Japan), negotiations has just been launched with the US to establish the so called ‘Transatlantic Trade and Investment Partnership’. This agreement has a huge potential in terms of growth and jobs: it would be the biggest ever negotiated and could add around 0.5% to the EU’s annual economic output. Since stability is a precondition for sustainable growth, strengthening the architecture of the Economic and Monetary Union (EMU) is regarded as essential. The current reform process of the EMU governance aims to a deeper integration of the financial regulation in the short term, and of fiscal and economic policy in the longer term, to be complemented by political integration to provide legitimacy and accountability to the Union. In the context of the current crisis, addressing the weaknesses of the European financial sector is an urgent priority. Financial intermediation, which is of central importance, is centered on banks here in Europe. Bank-based credit growth in the majority of EU countries, which was weak since 2008, worsened in the current crisis (particularly in the south of Europe). In this context, as repeatedly highlighted by the European Central Bank, monetary policy action cannot be properly transmitted to all Eurozone countries. This impairs the provision of credit to the real economy. Today, the objective of a deeper financial integration is mainly pursued through the commitment for the setting up of a European Banking Union (BU). The quick establishment of a genuine BU should aim at separating banks from the sovereigns and reversing the on-going fragmentation of financial markets along national borders by fostering financial integration. This in turn would contribute to restore the proper functioning of the monetary policy transmission mechanism and thus, by improving the financing conditions within the Monetary Union, to boost growth. At the same time, by allowing a better management of the risks of booms and busts in the financial sector, the BU would make them more sustainable and less dangerous for the overall financial stability of the Eurozone, with direct benefits also for the EU. We hope that the boundaries of the BU go beyond the Eurozone, to coincide with the EU boundaries as much as possible . In fact, since the setting up of the BU is a crucial step to increase confidence in the health of the banking sector, then in the overall ability of Europe to address the crisis and its challenges, the more it is extended, the wider are its benefits for Europe and its Single Market. Since the onset of the Euro sovereign debt crisis, unprecedented policy measures have been undertaken at the European level to guarantee the stability of the European Monetary Union and stem contagion. Whereas this has been done at the European level, at the individual country level, Eurozone economies, especially the debt-stricken ones, have committed themselves to a programme of fiscal consolidation. Yet, as growth rates have been further declining and unemployment has been rising, Eurozone has found itself confronted with the specter of a never ending crisis. This brings up important questions: Can fiscal rectitude work alone in helping countries achieve both sustainable finances and lift growth? Or should also countries commit to painful wide-ranging reforms to boost their economic growth potential? And how can fiscal rigor or structural reforms alone be sufficient to sustain growth if investors continue fear the risk of sovereign default? These are questions many Euro Member States will have to answer to fully address their problems. Clearly, individual countries can implement important steps to foster and revive growth. Yet, forgetting that the original design of European Monetary Union was incomplete is to ignore the root cause of the Euro sovereign debt crisis. Not surprisingly, today’s lack of growth is a symptom of a bigger Eurozone malaise but also the tangible result of an unfinished architecture. The Euro sovereign-debt crisis and the lethal interdependence between banking and sovereign crisis are, “as economist Martin Neil Baily has put it, ‘symptoms, not causes’ of a Eurozone unable to achieve convergence”. Over the last ten years, different growth patterns, which resulted in persistent trade imbalances, and divergences in competitiveness across countries led to fall in Eurozone potential growth. Indeed, growth performance was disappointing even in the past decade. The European Central Bank calculates that Germany has been gaining competitiveness against all other members of the Eurozone since 1999. Since 2000, German productivity-adjusted wages have been rising in line with labour productivity so modestly, that their rise amounted to 5% only. This was possible because German unions in coordination with government and employers representatives accepted modest wage increases in exchange for job security. These factors increased Germany’s international competitiveness thus leading to big surpluses which in turn made possible for the Country to experience a lower unemployment rate and a growth in real wages. Germany’s competitiveness against non-Eurozone countries was also facilitated by the relatively poor performance of southern Europe, which avoided the appreciation of the Euro against other currencies. In contrast, in other European nations, improved confidence and lower interest rates which were the direct result of the entrance into the Monetary Union, fuelled a jump in domestic demand as foreign capital flowed in. The domestic demand boom induced prices to go up and wages, particularly non-tradable sectors, to rise faster than labour productivity. Since 2000, while productivity-adjusted wages have increased only 5% in Germany, in peripheral Euro countries, they have increased by between 25% and 35%. This resulted in a dramatic loss in competitiveness of those countries against other advanced economies. The strategy of southern Eurozone countries was to boost domestic demand while cheap credit promoted a credit boom and real estate bubbles. Not surprisingly, peripheral countries underwent a shift of 4% of GDP from industry to financial services and real estate from 1997 to 2007, compared to 2 % shift in northern economies. If in the short run this strategy seemed to work, in the longer one, it was false success. These countries started to build up increasing trade deficits, until the global financial crisis brought to an end this growth pattern. As recession started to kick in and tax revenues decreased abruptly, public spending resulted in unsustainable fiscal deficits. Confronted by years of competitiveness decline, peripheral countries were unable to turn to exports to lift their growth prospects. Absent the Euro, to service their debts, weak economies would have been facilitated by a big devaluation, but within the Single Currency this instrument was no longer available. What has come afterwards has been a period of “internal devaluation”: with stagnation and prolonged high unemployment. Because this disappointing performance has a lot to do with different patterns of growth across countries and increasing competitiveness differentials, the implications in terms of policies are straightforward. In other words, the problems of many peripheral economies are so deep that reflect a profound capital misallocation of resources, which to be solved requires the implementation of comprehensive reforms than just deficit reduction. Fiscal austerity is necessary, but it is not something that can compensate for declining competitiveness, price misalignments, rigidities in labour market, lack of reform in product markets, slow productivity growth, excessive regulation to name a few. After all, if not properly addressed in a timely manner, the severe challenges many Eurozone countries are confronted with, will remain obstacles to growth. Addressing structural deficiencies on the other hand can allow economies to grow at their full potential. Italy, for instance, is a striking example for limited competition and inadequate infrastructure in the electricity sector. For Italians, electricity is about 50% more expensive than for the average industrial European consumer. Spain, on the other hand, which notoriously has one of the highest jobless rate of the Eurozone – especially among the young – is another striking example for persistent rigidities in the labour market and significant differentials between wage setting and productivity levels. However, any sensible strategy has to acknowledge that for structural reforms to deliver their potential, time is needed. Product and services market reforms, as well as reforms to the labour market and pension systems, should be put in place immediately. In a recent working paper, the OECD has analysed the impact of some wide-ranging structural reforms implemented over the past thirty years by 30 advances economies. The main finding was that while long-term gains took at least five years to materialise, some short-term benefits appeared sooner. The study also showed that despite concerns about possible transitional short-term costs exist, they seem exaggerated, since “structural reforms seldom involve significant losses and often deliver gains already in the short run.” “A well designed package of labour and product market reforms” – the working paper suggests – “would deliver the largest gains and alleviate the transitional costs of certain individual reforms – for instance, liberalising product markets alongside job protection or unemployment benefit reforms can mitigate possible real wage declines associated with the latter”. According to another working paper by the IMF, longer-term growth-enhancing supply-side policies should be advanced in conjunction with shorter-term demand-sided macroeconomic policies to support demand in the near term. Drawing on numerous data, the IMF estimates that implementing labor, product market, and pension reforms could boost growth in the Euro area by 4.5% over five years. 2¼ % of this gain is expected to derive from product and service market reforms alone, a sign of the importance of addressing vested interests and regulated professions. Another quarter of this gain is on the other hand expected to stem from cross-country reform spillovers, underlining the importance of a simultaneous implementation of such growth-enhancing reforms across countries. When it comes to structural reforms, there is no one-size-fits-all method. Each country must design its own reform agenda, tailoring it to the specific challenges it faces. Even within the group of southern peripheral economies, each country is faced with unique challenges, which require specific policy measures to be properly addressed. Yet, common to them all is the need to tackle long-standing rigidities and improve the competitiveness in the tradable goods sector, especially through labor and product market reforms. Some of the far-reaching structural reforms many countries could implement, include: Labour market reforms. Labor market reforms should address the duality of the labor market, making it more inclusive. Policies should also be aimed at enhancing the workforce participation through incentives to increase the working age and effective measures to facilitate school-to- work transition. Increasing the portability of pensions and healthcare are among the structural measures that could address Europe’s lack of internal labor mobility. Wage-setting systems should also be made more effective at preventing wages from rising steeply. Product market and taxation reforms. In heavily regulated countries, product market reforms aimed at increasing competition in the market for good and services and reducing the barriers to entry created by unnecessarily restrictive regulations can raise the potential for job creation. To this end, Eurozone countries, especially the surplus economies such as Germany should ease barriers to competition in the service sector. This would facilitate investment and domestic activity. Other countries such as France, Italy, Greece, Spain for instance should reduce regulatory barriers to competition. Reducing the costs for companies to start up or close down, and simplifying the fiscal systems, will also promote greater competitiveness. Public sector reforms. For some countries such as Italy, reforming the justice system, would be critical in order to attract foreign direct investment (FDI). Human capital reforms. Strengthening the role of secondary education would be functional to employment, especially in countries whose economies rely on unskilled work force. With regard to macroeconomic policy, other measures could include a better budget composition and “smart fiscal consolidation”. Considering that in many European countries tax revenues are close to 50% of GDP, the concretionary effect of additional tax hikes could be very detrimental to growth prospects. Where financing allows, preference should be given to spending cuts which are less recessionary than adjustments achieved through tax increases. It is undeniable that fiscal consolidation can stifle growth. While fiscal consolidation is necessary for the most debt-stricken economies, advancing at the right pace is crucially important as well, especially considering the current economic outlook of anemic growth and weak employment. Additionally, as suggested by the IMF, “while consolidation will have to proceed rapidly where market pressures remain high [..] consideration should be given to modifying the current pro-cyclical nominal targets for structural deficit objectives”. Against a general backdrop of anemic growth and increasing unemployment rates, southern European countries should aim for higher net exports. Regaining competitiveness for them becomes crucial to boost export driven growth and also sustain and create jobs for the unemployed. This holds equally true for countries, such as France, Italy, Spain to name a few, where reforms should focus on labor market duality, relative price misalignments, reduction in non-wage costs, reform of wage setting mechanisms, deregulation of the services sectors and reallocation of resources – both employment and capital – towards the relatively more productive tradable sector. While countries with current account deficits will have to carry the majority of reforms, reversing competitiveness differentials within the Eurozone requires somehow an increase in domestic demand in countries with current account surpluses. In northern “surplus” economies, such as Germany, where competitiveness is not even a problem, some reforms could help increase the labor force participation while others could increase the productivity in the service sector. Reviving growth is no easy task. Improved European mechanisms , fiscal rigor or structural reforms alone cannot be enough to boost growth if investor’s still fear the risk of sovereign default. Risks that affect growth should be solved at the European level, with a comprehensive approach towards a common view of the Eurozone’s long term economic governance. This means that to take full advantage of reforms implemented at the national level, EU policymakers will have to take further steps toward a more comprehensive fiscal and banking union. Whereas, greater financial integration would serve to complement the efforts made by individual countries and resolve the problematic correlation between banks and sovereigns; deeper fiscal integration would help restore investors confidence in the Eurozone stability. Inevitably, progress in locking in these efforts and restoring growth not only will rest on the ability of the European policymakers to advance with the process of strengthening and completing the Monetary Union, but it will also depend on the ability of each individual country to stay committed to the path of reforms. In this respect, individual countries will have to make important efforts in explaining the rationale of reforms to their public opinion. The danger of a public opinion being seduced by simplistic recipes and Eurosceptic rhetoric, at a time of widespread reform fatigue, is high. Not only this would frustrate the efforts so far accomplished but it would also negate the more than 50 years of European economic, political and social integration and the 14 years of European Monetary Union, something Eurozone countries cannot dare to risk.

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