ECMI Annual Conference - Rebalancing Europe, rebuilding the EMU
Many thanks to ECMI, CEPS and the National Bank of Belgium for the invitation. I will give you my take of the economic rebalancing that is going on in Europe and of our policy response to the debt crisis.
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We are today meeting in the aftermath of the IMF annual meetings in Tokyo last week. Discussions in Tokyo reflected overall concern about slower-than-expected global economic recovery. This time the debates were more balanced than at previous similar events over the past couple of years. Risks to global growth were considered to stem not only from weaknesses in the euro area, but also from the U.S. fiscal cliff and from the economic slowdown in China and other emerging economies.
In fact, Europe's efforts to address the crisis were generally appreciated, with the reference to the ESM becoming operational, the ECB's Outright Monetary Transactions scheme at place, the Commission's proposal on the euro area banking supervisor on the table, and a wave of reforms moving forward in euro area Member States.
At the same time, our partners do expect that we maintain the momentum and live up to our commitments by demonstrating that the new instruments can be effectively used, as necessary.
There was also some discussion on fiscal multipliers, but this did not lead the IMF to suggest that the fiscal consolidation paths in the EU should be changed. I will come back to this shortly.
This slide includes two main messages on our growth prospects.
First, the euro-area economy is going through a period of stagnation this year. The latest readings of hard and soft indicators still point to weak developments in the near future. We will return to growth next year 2013, but it will be a slow and subdued recovery.
Second, real GDP in the EU will return only next year to the level of 2008, with major divergences between countries. This is largely the result of unravelling of the excessive macroeconomic imbalances that accumulated in the course of the previous decade within the euro area.
The necessary adjustment process and structural change is weighing on the labour market. Unemployment is expected to remain high at 10% in the EU and 11% in the euro area. Cross-country differences in labour market performance are expected to remain large.
However, some developments give rise to prudent optimism.
First, as regards public finances, the situation is gradually improving. In 2009 and 2010, fiscal deficits in the European Union were above 6% of GDP. This year they are expected to be somewhat above 3% of GDP, which is a welcome improvement.
The outlook for public finances has, however, been affected by the weaker than expected macroeconomic performance.
Yet, public debt in the EU has risen from around 60% before the crisis to almost 90% of GDP. This is very worrying, as the levels of public debt above 90% tend to have a negative impact on economic dynamism. In their 2011 empirical study, Carmen Reinhart and Kenneth Rogoff found a negative correlation between debt above 90% and growth.
The challenge of medium-term fiscal sustainability differs between countries, but it is clear that the necessary debt reduction will require a commitment to substantial primary surpluses over a long period of time.
I have listened carefully to the argument that pursuing fiscal consolidation in times of weak or negative growth is counterproductive – and that, instead, what is needed is fiscal stimulus.
It is correct that fiscal consolidation can have a dampening effect on growth in the short term. Attempts to quantify this effect through the so-called "fiscal multiplier" have been much in the news in recent days. This issue merits analysis. But we should be cautious about drawing conclusions too quickly. Let me make two counter-arguments on this.
On fiscal multipliers and the quantifiable and confidence effects
First, we have to make a distinction between the directly quantifiable fiscal effect and the confidence effect. Fiscal multipliers may be larger on average in this crisis than in normal times, since households are more financially constrained and the room for monetary maneuver is limited.
But this does not mean that no consolidation should be undertaken. Can we attribute worse-than-expected economic situations in some countries just to the effects of fiscal consolidation? We should ask whether worse-than-expected recessions in certain countries can be attributed only, or even mainly, to the effects of fiscal consolidation. Other factors have played a role in each slowdown. In some countries, it has been due to a fall in consumer and investor confidence. In other countries, it has been due to a complete loss of market access of a country. In these cases, the multipliers should not be measured against a business-as-usual scenario, but one in which drastic market reaction would not allow a managed unwinding of the unsustainable policies of the past.
Second, the EU's reformed Stability and Growth pact is not stupid. A casual reader of much recent commentary could be forgiven for believing that EU governments are blindly enacting harsh policies of austerity, under the watchful eye of a European Commission obsessed with enforcing arbitrarily chosen nominal deficit targets. It is time to debunk this damaging myth. In fact, the Stability and Growth Pact can adapt a country's path of fiscal adjustment, if the economic situation calls for it.
Alongside the nominal targets for deficit reduction, each new recommendation issued to a member state specifies the structural fiscal effort to be achieved each year until the excessive deficit is corrected. While the nominal targets may continue to dominate the headlines, the Commission focuses its assessments of member states' actions first and foremost on their compliance with the agreed structural effort.
This takes into account the fiscal space and macroecommic conditions of a member state. Accordingly, a member state may receive extra time to correct its excessive deficit. This has occurred twice this year already: in July for Spain, and in October for Portugal. Both now have until 2014 to bring their government deficits back below 3% of GDP.
Of course, there are those who argue that pursuing fiscal consolidation in times of weak or negative growth is counterproductive and that, instead, what is needed is fiscal stimulus. But investors and consumers do not need to be convinced that a country can boost growth by a few decimal points in a given year through higher spending. They need to be reassured that the country's public finances will be sound in the long-term, which means pursuing prudent fiscal policies, ensuring the sustainability of welfare states and enacting structural reforms that can deliver a lasting improvement in growth and employment.
To illustrate the confidence effect, Belgium in between the fall of 2011 and spring 2012 is a case in point: thanks to the return of confidence following the relatively sound (but not exaggerated!) budget for 2012, the spreads of Belgian 10-year bonds narrowed by 270 basis points.
However, the situation of public finances today is a reflection of the economic imbalances built up over the past decade, either directly through irresponsible fiscal policies or by taking over the liabilities from exaggerations in the private sector.
Overall, Europe is undergoing a difficult, but necessary, process of rebalancing and the current divergences in economic growth are to a good extent a reflection of past policies, both at national and at EU-level. In this sense, the current crisis was home made.
The build-up of large current account divergences since 2000 was not sustainable: this we have learned the hard way. They have been gradually narrowing, and the re-balancing is proceeding.
The blue bars reflect the current account as % of GDP of the „surplus countries“ in the euro area, i.e. with current account surplus over the last decade (BE, DE, LU, NL, AT, FI). The orange: the current account „deficit“ countries (all other EAMS).
Countries that have been running current account deficits for a long time need to achieve surpluses to bring their external debt onto a declining path. This requires private sector deleveraging, fiscal consolidation and especially improvements in competitiveness.
The process of rebalancing will inevitably take time, and the rebalancing needs are considerable. But what matters is that this process has already been going on for some time. And what matters even more is that the EU MS and EU institutions will maintain the momentum of reform and stabilisation through decisive policy action.
Competitiveness that was lost during the first decade of EMU is being regained, as the re-convergence of unit labour costs clearly shows. In the euro area in 2011, the largest declines in relative unit labour costs were seen in Ireland, Greece and Spain.
Looking at the development of nominal wages over time, we can see the initial divergences of wage developments. In some countries, this is also due to the housing booms. And we can also see the progress that some countries have made recently.
The surplus countries, for instance Germany and Finland, are moving in the opposite direction, recording increasing wages, which would support domestic demand. In Germany, the pay increases in the union wage agreements concluded in the first half of this year amount to about 5%. As wage contracts last for longer time, we will see these agreements gradually being reflected in actual wage developments.
Internal rebalancing is part of Europe’s comprehensive strategy aimed at restoring sustained growth whilst ensuring financial stability.
Several steps have already been taken to address structural weaknesses and to ensure the conditions for future growth.
Particular efforts have been geared in particular to break the negative loop between sovereign debt and the banking system, so as to create foundations for sustainable growth and job creation.
First, EAMS must maintain the tempo of reform and fiscal consolidation. That is the only way to restore confidence in a lasting way, to boost growth and create the jobs Europe’s citizens need.
Second, the ESM is operational, and the European Central Bank set out its programme for Outright Monetary Transactions. Taken together, these are formidable contributions to underpin investor confidence.
Also last month, the European Commission laid the foundations of a banking union with its proposal for a single supervisory mechanism for euro area banks, paving the way for the possibility of direct bank recapitalisation by the ESM. This is a key step towards breaking the vicious circle linking banks and sovereign risk.
And thirdly, we are rebuilding our Economic and Monetary Union to strengthen its foundations. To that effect, a far-reaching debate on the next step is now getting underway. We have identified four building blocks that must underpin the EMU: as well as the banking union, these are a fiscal union, an economic union and a political union.
The interim report of last Friday will be discussed today at the European Council.
The Commission will make its contribution to this debate later this autumn, when we present our blueprint for what I have called EMU 2.0. This will be our long-term vision for the EMU with a clear roadmap to counter any lingering doubts about the viability of the euro.
Let me conclude by saying that we need simultaneously bold and consistent reforms in the member states and deeper integration in the Eurozone. That is the way to overcome the debt crisis and return to recovery – to sustainable growth and better employment.
Thank you for your attention.