Europe is making progress but not all is well- Lagarde

Europe is making progress but not all is well- Lagarde

Posted by Sylvester on Monday, January 13, 2014 0

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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.

Jump-Starting Growth

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.
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