Europe faces a stark choice: risk stagnation or pursue integration. It can continue to muddle through, and hope that growth in the world economy will eventually pick up enough steam to pull its economy out of the doldrums. Or it can make a decisive push to revitalize its economy and complete the reforms needed to achieve a fully integrated economic and monetary union
Five years into the crisis, recovery in the euro area remains fragile. Important actions at both the national and euro-wide levels have tackled the immediate threats to the single currency. These include the European Central Bank’s announcement in 2012 that it stands ready to undertake outright monetary transactions in secondary sovereign bond markets, the completion of the European Stability Mechanism, which created a financial firewall around the euro area, and efforts to restore the health of public finances and implement structural reforms.
But countries on the euro area periphery are still recovering from recession and there is also weakness in some core countries. Financial markets remain fragmented and unemployment, especially among young people, and in the periphery, is at record highs.
In the hardest-hit countries, the social fabric has started to fray, reform fatigue is setting in, and politics have become increasingly polarized.
The risk of stagnation
Against this backdrop, it is not difficult to imagine a scenario in which the euro area enters a period of prolonged stagnation. Suppose that financial fragmentation persists, and loans remain expensive for companies in the periphery. In the face of high private debt and continued uncertainty, households and firms remain reluctant to spend and invest. As unemployed workers lose skills and new workers find it difficult to join the labor force, the productive capacity of the economy is permanently damaged—and so is the social fabric.
Clearly, this would not be a desirable outcome. But if reform efforts stall, it is the most likely one. Economic activity in the euro area today is still below what it was in 2008, before the global financial crisis. In 2012, GDP in the euro area contracted by 0.6 percent of GDP. And despite recent signs of a gradual recovery in the second half of 2013, inflation is expected to remain subdued and unemployment remains elevated.
The path to growth
There is an alternative future—one that is premised on higher growth and a brighter outlook for all of Europe. But reviving growth and creating jobs will not be easy. It will require action on multiple fronts, and at the same time. There are four key areas that require immediate attention.
- Complete the banking union. This would entail expediting reforms already under way, including a final agreement on the Bank Recovery and Resolution Directive by the European Parliament and progress on the Deposit Guarantee Scheme Directive. European partners should agree on a strong single resolution mechanism based on a centralized authority, supported by a common backstop, with powers to trigger resolution and make decisions on burden-sharing to ensure timely and least-cost resolution.
- Restore the health of bank portfolios. To raise confidence, a credible assessment of the quality of banks’ assets is needed. Such an assessment would quantify capital needs and should be accompanied by a clear plan on how to meet these needs. Where private capital is insufficient, credible backstops—in some cases, the ESM—will be essential to preserve banks’ ability to continue lending.
- Take further steps to support demand in the near term. The IMF has supported the ECB’s commitment to keep the monetary policy stance accommodative for as long as necessary. Further monetary easing is needed to support demand, while unconventional measures could help reduce fragmentation. In addition, fiscal adjustment in euro area countries should be focused on structural targets and carefully designed to avoid an excessive drag on growth. In the medium term, the euro area also needs to move toward fiscal union.
- Push ahead with structural reforms. Tackling structural rigidities—at both the euro area and the national levels—would raise potential growth and promote rebalancing within the euro area. Implementation of the Services Directive could encourage cross-border competition and raise productivity, while national efforts to address labor market weaknesses would boost competitiveness and employment. A new round of free trade agreements—preferably of the multilateral kind—could also help boost productivity.
Choosing the right moment
The path to higher growth will not be easy. Reforms such as the ones listed above are extremely difficult for policymakers to address. Structural reforms often take years to yield results, requiring policymakers to convince their electorates to go along with painful measures in the short term for gains in the medium and long term. The challenge becomes even greater at the European level, when the 17 countries that are members of the euro area—or the 28 countries that make up the European Union—have to agree to reforms that reach deep into areas that used to fall exclusively under the prerogative of national sovereignty.
This is where politics come in. Understanding the importance of electoral cycles and being ready to seize the moment when a window of political opportunity opens up is vital for effective economic reform. Sometimes, the best strategy is to move on many fronts at once. The policy actions I have listed above would all be mutually reinforcing. For instance, measures to improve the flow of credit in the periphery would boost investment and job creation, which in turn would help restore competitiveness and raise growth.
While it may appear daunting, the political challenge of achieving greater integration now is probably easier than having to deal over the long term with the political consequences of protracted stagnation. And the payoff could be substantial. The IMF’s analysis suggests that the benefits of a comprehensive reform effort—tackling financial fragmentation and structural weaknesses at the same time—could raise the level of euro area and global output by about 3 percent and 1 percent respectively within five years. Think of the difference that could make to the lives of millions of people in Europe and beyond.