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Symposium 2013

Proposal - Wanted: structural reform in Europe

The Challenge

Fourteen years after its foundation, the European Monetary Union (EMU) is facing the greatest challenge of its history thus far. High unemployment in a number of member countries, the need for substan ...

Fourteen years after its foundation, the European Monetary Union (EMU) is facing the greatest challenge of its history thus far. High unemployment in a number of member countries, the need for substantial consolidation of the budgets of numerous governments, and distressed banks are symptoms of economic misalignments and economic policy failure that threaten not only economic prosperity in Europe, but the European project as a whole. A series of interrelated fiscal and financial crises in the euro area have provoked a series of extraordinary policy measures. Some of these measures have undermined the fiscal sovereignty of affected countries, and they have circumvented market mechanisms. As social cohesion is called into question in various debtor countries, there is a danger that policy makers cannot or will not solve the existing problems in a way consistent with both monetary stability and the current political integration. The ECB’s announcement to possibly step in via its OMT-program has somewhat calmed down financial markets since mid-2012, but most of the fundamental questions for the future of Europe are either unanswered or answered quite differently by various parties. Policy makers have bought time, but the question remains what this time is used for and where the current policy stance leads to.

Transforming the present encouraging economic news from the euro area into a lasting exit from the crisis and vivid and sustained economic growth requires ambitious policy actions, both at the national and European levels, designed to remove external imbalances, boost the economy’s capacity to generate employment and productivity growth, improve debt sustainability, and reinforce fiscal and financial institutions.

Domestic and external economic imbalances were pivotal for the European economic crisis. Much of the cross-border credit flows that coincided with pre-crisis interest rate convergence to very low levels failed to properly take into account economic risks. At the same time they contributed little to raising the economies’ growth and employment potential but helped financing either high and rising government debt or the leveraging by banks and private households with the funds largely floating into the real estate sector. Low interest rates and booming spending in some external deficit countries caused distortions in relative wages and prices, undermining international competitiveness. A reevaluation of risks, triggered by the sub-prime financial crisis in the United States, finally lead to sudden stops in private sector funding of large current account deficits, producing high losses in output and employment in deficit countries as well as serious adverse spill-over effects into the rest of Europe.

The imbalances underlying the European crisis are to a large extent attributable to regulatory shortcomings and insufficient structural reform. The European regulatory architecture was not sufficiently adapted to meet the requirements of the currency union. In particular, banking regulation remained fragmented across borders and fiscal governance was not well geared towards keeping government finances at prudent levels. At the same time, in many countries structural reforms were not ambitious enough to foster high and sustainable employment and productivity growth. A holistic approach to overcoming the crisis and raising the growth and employment potential of the European economies requires progress in regulatory and institutional reform on all of these fronts.

Stronger growth, higher employment and a larger resilience to external shocks call for full functionality of the banking system. Deleveraging and bank balance-sheet repair have been markedly slower in the euro area than in the United States, which should explain part of the opening growth gap on both sides of the Atlantic. Non-performing loans on banks´ balance sheets need to be fully identified, based on a consistent definition across European countries. Adequate capitalisation needs to be secured for banks to continue their business. The upcoming asset quality reviews and stress tests need to be made a serious base for decisions about bank resolution or recapitalisation. With the single resolution mechanism (SRM) not yet in place, procedures should be announced soon on how to deal with banks that are revealed by the exercises to have inadequate capital. Preparations for setting up the SRM, based on a single rule book for bank resolution and recovery, need to continue without delay. Establishing a banking union – consisting of a single supervisory mechanism, a single resolution mechanism and appropriate fiscal backstops – is necessary to ensure that capital markets can properly assess financial risks, to deal with balance sheet weaknesses, and to relieve monetary policy from crisis interventions.

OECD estimates suggest that the cumulative fiscal consolidation that will have been achieved by 2014 will account for the largest part of the total consolidation required in the euro area to put government debt/GDP ratios on a downward path. But in many countries, debt ratios are still much too high. To reap the benefits from the large efforts already undertaken, consolidation needs to continue, based on credible medium-term plans, while the automatic stabilisers should be allowed to play fully if growth disappoints. The composition of fiscal consolidation can and should be adjusted to support growth and complement employment-enhancing structural reform. Options include raising the effective retirement age, reform in education and health care systems and cuts in tax concessions. National fiscal governance systems need to be adapted to better achieve fiscal targets.

Potential growth in Europe had slowed already prior to the crisis and has fallen further since. Raising the capacity to generate employment and productivity growth requires structural reform. Reform efforts have picked up in recent years, notably in vulnerable countries, with the euro area debt crisis having acted as a catalyst. Reform efforts in the core area have been less ambitious. Overall, more is needed, including further efforts to deepen the EU single market. Country-specific reform needs range from reducing barriers to market entry over competition-enhancing reform in the services sector to reform in employment protection and activation schemes. For example, competition-friendly reform is needed for reductions in unit labour cost to better translate into adjustment of product prices and gains in external competitiveness. Active labour market and training programmes need to be re-designed to adequately cushion the impact of job losses in the short term and to facilitate the return to work before unemployment becomes entrenched. Product market reforms aimed at improving competition in the service and non-tradable goods sectors would support investment and domestic demand in external surplus countries.

    Related Proposals

    Symposium 2013

    The Kiel Policy Package to address the EMU crisis: Restoring prosperity based on fiscal federalism and monetary stability

    Guided by the principles of fiscal federalism (preserving national fiscal sovereignty) and monetary stability (narrow policy mandate for the central bank) the Kiel Policy Package focuses on bridging l ...

    Guided by the principles of fiscal federalism (preserving national fiscal sovereignty) and monetary stability (narrow policy mandate for the central bank) the Kiel Policy Package focuses on bridging longer-term considerations for a workable policy framework and the short-term requirements of resolving European legacy problems by a set of ten integrated measures (addressing fiscal policy, financial market regulations, structural reforms and monetary policy) that come with a clear delegation of authority within the euro area. Regaining sound public finances through national fiscal rules — Overcoming the confidence crisis in sovereign debt markets In order to ensure adequate fiscal consolidation while retaining

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