The European Economy: Where Does It Stand and Where Should It Go?
Growth in Europe is still fragile. The euro area exited from recession in spring 2013, following six quarters of declining GDP, but stagnated just one year later. Weak private sector balance sheets, credit constraints, and high unemployment are still undercutting demand while high margins of economic slack together with steeply falling energy prices have pushed inflation down into negative territory. The OECD projects that real GDP growth will rise only slowly this year and next, conditional on improving confidence, a further strengthening of banks’ balance sheets, additional quantitative easing by the European Central Bank (ECB), and the effects of a weaker euro and oil price declines seeping through to support demand.1 Unemployment is projected to decline only gradually. By contrast, growth in the United States is likely to remain buoyant, likely exceeding growth in the euro area by between 1.5 ½ and 2 percentage points.
To some extent the renewed economic weakness in Europe is due to heightened geopolitical risks weighing on business confidence. Strong growth impulses from emerging economies are also missing. On the other hand, crude oil prices fell to about half their 2014 average, providing extra stimulus by lowering cost and raising real incomes. Model simulations suggest that this effect could raise euro area GDP by around 0.2 percentage points this year and next. The GDP impact is likely to be weaker than in the United States due to the lower energy intensity in Europe and the depreciation of the euro against the U.S. dollar. The euro depreciation will also help on its own. A gradual 10 percent depreciation against the dollar over the next two years could raise GDP growth in the euro area on average by around 0.2 and 0.4 percentage points in 2015 and 2016, respectively.
Nonetheless, persistently sluggish growth in Europe shows that overcoming economic imbalances and lifting the economy to a higher growth and employment trajectory is a cumbersome process. Already prior to the crisis, average European employment and productivity performance has been disappointing. For example, annual trend labor productivity growth per worker between 2000 and 2007 averaged 0.8 percent in the euro area, 1.4 percent in the OECD and 1.8 percent in the United States.
Hidden Progress in European Economies
There is progress, however, that the aggregate picture hides. In the run-up to the crisis, large current account deficits had built up in some European countries, often paired with inflated housing investment or high and rising government debt. In several countries this was associated with distortions in relative wages and prices and domestic resource allocation, weighing on external competitiveness and productivity growth. The countries with current account deficits that were hardest hit by the crisis, notably Ireland, Greece, Portugal, and Spain, are now all recording current account surpluses. This swing does not only reflect weak domestic demand depressing imports. External competitiveness has also increased, with relative price adjustment helped by structural reform in labor and product markets. Relative unit labor costs declined significantly, notably in Greece, and more recently relative product prices are also adjusting. This has improved these countries’ exports and export market shares and is likely to have contributed to the trend decline in interest rate spreads seen since the second half of 2012, as cross-border funding needs declined. Net international investment positions of the vulnerable countries remain strongly negative, however, and reducing them significantly will require many years of current account surpluses.
Internal rebalancing in the vulnerable countries is also going on and some countries, notably Greece, Ireland, Portugal, and Spain, have recorded quarterly growth in 2014 significantly above the EU average, although the Greek economy contracted again in the last quarter of the year. Structural reform in the vulnerable countries in recent years has been significant, in particular with respect to labor markets, although competition-friendly product market reform has also commenced. Less rebalancing has occurred in the economies with high surpluses. A stronger contribution of their domestic demand to growth would support the overall adjustment in the EU. Continued structural reforms, by fostering the reallocation of resources and boosting growth, can put the rebalancing process on a more sustainable footing. Labor market reforms can help to better align wages to productivity and active labor market policies can improve workers’ protection against unemployment. In surplus countries, measures to create more favorable conditions for investment and regulatory reform in service sectors could support domestic demand and smooth the overall adjustment in the EU economy.
Accompanying Structural Reform: Fiscal and Monetary Policies
Structural reform needs to go hand in hand with appropriate fiscal and monetary policies. All three pillars are needed for the European economy to durably exit the crisis and generate higher growth and employment. Fiscal balances in the EU have improved considerably since the crisis peaked in 2009/2010, and gross government debt ratios have broadly stabilized, albeit at levels that are still too high, on average 108 percent of GDP in the euro area—94 percent in the definition of the Maastricht treaty. Simulations by the OECD under stylized assumptions about the evolution of growth and interest rates suggest that in all countries the largest part of the fiscal adjustment needed to bring debt levels down to more prudent levels has already been achieved.2 In 2014, the pace of fiscal consolidation has slowed down and on average only minimal fiscal adjustment is projected over the next two years. Given the progress already achieved and the still fragile economy, slower fiscal adjustment in the EU is appropriate as it would give structural reforms and the additional monetary policy easing that has been announced by the ECB a better chance to lift activity.
Moreover, the composition of fiscal policy can and should be adjusted to support growth and employment. Fiscal consolidation has often involved cutting infrastructure investment. This can be harmful for Europe’s future growth prospects and would need to be corrected. A coordinated approach to lift growth-enhancing infrastructure investment, as suggested in the “Juncker Plan” could contribute to achieving this. Some infrastructure, such as more efficient energy networks, can produce substantial positive spill-over effects across the EU, suggesting coordination. Investment spending could also produce stimulatory effects in the short run. More can be done to link fiscal consolidation with structural reform. For example, raising the effective retirement age does not harm growth in the short term and augments potential output growth in the long run. Reforms of the education and health care systems can produce large consolidation gains without compromising equity or service quality.3 There is also scope on the revenues side of public sector budgets, notably with respect to cutting tax expenditures.
The crisis left Europe with high and rising non-performing loans on banks’ balance sheets and fragmented capital markets. There is strong international evidence that the speed of dealing with banks’ balance sheet problems following financial crises matters for economic performance.4 In contrast to the United States in 2008, Europe was late in recognizing balance sheet problems, which has likely hampered efficient reallocation of credit in Europe’s private economy. Meanwhile, bank capitalization has improved, largely in anticipation of the Comprehensive Assessment of banks’ balance sheets by the European Central Bank and the European Banking Authority, whose results were published in October 2014. It is now important to ensure that banks with balance sheet problems will be recapitalized or restructured if necessary, without undue forbearance. Much has been achieved in moving toward a banking union, whose main elements comprise single supervisory and resolution mechanisms, backed up by a single resolution fund, and a common rule book for bank supervision, resolution, and deposit guarantee schemes. Not all of these elements are fully in place yet. Banking union is necessary to better control systemic financial market risks and raise the efficiency of capital allocation.
Barriers to Growth: Benchmarking Europe against the United States
In contrast to the other economies in the OECD area, the EU economy is still subject to various significant barriers affecting key areas such as entrepreneurship, labor mobility, and energy efficiency. Completing a genuine Single Market in the EU could contribute substantially to boost medium-term growth. For example, empirical analysis indicates that the process of resource allocation to innovative firms is slower or less efficient in the EU than in the United States.5 Also, compared to their American peers, firms are more static in Europe: averaged over a longer period, the share of firms that is shrinking is smaller in the EU than in the United States, but the share of firms that is growing is also smaller. In a successful single market, productive factors should be reallocated from non-competitive firms that downsize or close, toward highly competitive firms that grow. Similarly, innovative firms that spend large fixed costs in research and development need a large internal market to amortize these costs.
To give an example, the EU Services Directive, which was to be implemented by 2009, goes some way in lisingliberalizing cross-border provision of services but does not apply the rules of the service providers’ country of origin in a foreign country, which in turn reduces competition from foreign providers. This is important as services are inputs in production processes across all sectors. The OECD’s Product Market Regulation (PMR) indicators show that barriers in services hardly changed between 2008 and 2013, and even seem to have deteriorated in some EU countries, indicating that the directive has had little impact so far in reducing barriers. Thus, a more ambitious approach would be warranted.6
EU-wide integration of energy networks is far from complete as illustrated, for example, by price gaps in electricity across countries.7 Estimates from the European Commission point to considerable investment needs for electricity grids by 2020.8 Renewable energy growth can only occur with additional electrical grid infrastructure, with a special focus on interconnection of national networks. This could be one of the areas that warrant integration into the Juncker Plan mentioned above. At the same time, ownership unbundling of generation, supply, and network activities within vertically-integrated electricity utilities in states where it is not yet alisedrealized so would remove incentives for national incumbents to stifling investment in interconnection capacity to protect their national markets.
Looking Ahead to a Streamlined European Regulatory Framework
There is considerable scope for further onharmonization in regulatory standards that could boost competition and growth and employment in Europe. Establishing a regulatory framework in the EU for the digital economy with technical and legal security and privacy standards is one of them. Others include moving further toward mutual recognition of qualifications, cross-border transportability of pension rights, and harmonization in bankruptcy regulations and tax bases. Unwarranted heterogeneity of regulation itself increases costs and can reduce intra-EU trade(Fournier, 2014).9
Minimizing regulatory and administrative burden that is associated with EU regulation itself is also important to create a growth-friendly environment. In fact, this is one of the declared policy priorities of the new EU Commission. Estimates by national authorities suggest that EU-origin regulations account for 40-50 percent of the total administrative burden imposed on firms. Over the last decade, the EU has launched a number of initiatives to improve the quality of legislation, such as the Regulatory Fitness Performance Program (REFIT). Simplification measures that have been identified by these programs should be considered by policymakers and followed up.