Adjustment in the euro area: Impressive, but still incomplete
Speech by Peter Praet, Member of the Executive Board of the ECB,
at the Eurofi Financial Forum,
Genval, Belgium, 27 September 2012
Ladies and Gentlemen,
It is a great pleasure to be speaking here today about essential ingredients to overcome the crisis in Europe. As we all know, there are major adjustment needs in the euro area to improve the workings of the European Monetary Union and to overcome its flaws.
In difficult times it is probably natural for markets, policy makers and observers to focus on short-term issues, such as missed targets or delayed reforms.
But occasionally it is also worthwhile to step back and take a look at the achievements to date, which should not be downplayed.
I will briefly set the scene by discussing the major challenges which Europe is facing at the moment. I will then discuss three areas in which progress is underway: (i) fiscal consolidation by euro area member states, (ii) structural reforms, and (iii) the strengthening of the European governance framework.
Current economic challenges
Several challenges are similar in many advanced economies:
The financial crisis and the subsequent recession have had a strong negative impact on growth. In the euro area, an average annual real GDP growth rate of just 0.5% has been achieved since 2007 and growth prospects remain subdued for the years to come. After several years of very low growth, many advanced economies face challenges in restoring growth prospects and achieving a sustainable and enduring recovery.
This growth weakness is partially related to another major challenge, namely the need to unwind imbalances and adjust excessive leverage. For the euro area as a whole, balance sheet problems are not so obvious. Private sector indebtedness has remained limited overall and the net international investment position of the euro area aggregate is broadly balanced. However, balance sheet problems have been more prominent in individual euro area countries, which exacerbated regional imbalances. In particular, some countries have faced deleveraging pressures following strong credit expansion and a sharp correction of asset prices. The on-going necessary deleveraging in these countries is likely to limit growth in the years to come as the balance sheet adjustment weighs on the investment expenditure of firms and on households’ consumption.
Fiscal deficits and debt are often (too) high, especially where financial sector institutions needed bailout. More generally, fiscal sustainability and financial stability in individual member states have become strongly intertwined.
Other challenges are specific to the euro area:
It has to be recognised that the institutional framework governing the European Monetary Union (EMU) is unique: the EMU is a union of at present 17 sovereign states sharing a common currency. It is a deeply integrated area, in which problems in individual countries have area-wide impact but with major institutional flaws. Despite the obvious strong interdependence, there has been a lack of tools (crisis prevention, management and resolution) to tackle contagion and preserve stability.
Rapid decisions to manage an on-going crisis are difficult to take when so many actors are involved, even more so when there are great differences in economic conditions across countries.
Europe has been acting in response to all of these challenges, both at the level of individual member states and at the EA/EU level.
Fiscal consolidation is required to address the high debt and deficits and reduce funding risks. Moreover, this should be well designed to lay the foundation for sustainable growth in the medium term.
Structural reforms are generally needed to boost growth, but specifically in the context of the euro area, to allow the reduction of imbalances where nominal exchange rate adjustments are not possible.
To address coordination difficulties, essential reforms to the European governance framework are needed.
I will now address these three issues:
On the fiscal consolidation front, we see significant progress. The euro area deficit has fallen from a peak of 6.4% of GDP in 2009 to 3.2% in 2012 according to the European Commission’s (EC) spring forecasts. The deficit is less than half the size observed today in other major advanced economies (US: 8.3% of GDP; UK: 6.7%; Japan: 8.2%).
Deficits in programme countries have been reduced even more significantly. In Ireland the deficit as a share of GDP fell from 31% (in 2010 partly driven by one-off financial transactions) to 8% in 2012, in Greece from 16% (2009) to 7% and in Portugal from 10% (2009) to 5%.
These very strong improvements have been achieved despite strong economic headwinds, including rising interest costs. Primary deficits as a share of GDP thus fell even more, in Ireland from 28% (2010) to 4%, in Greece from 11% (2010) to 1% and in Portugal from 7% (2009) to 0%.
However, reaching the 3% of GDP deficit limit – let alone balanced budgets – requires further efforts. In fact, debt ratios in most euro area countries are still rising. This needs to be reversed as soon as possible.
One risk is the increasing likelihood of consolidation fatigue following the strong adjustment that has already taken place in many countries. To minimise this risk and to maintain social and political cohesion the right composition of measures should be chosen, protecting the most vulnerable members of society.
Policy-makers should do their best to explain the need for further adjustment until medium-term objectives are met. While this may have short-run costs, it will provide the foundation for macroeconomic stability, and ultimately stronger economic growth.
The quality of the fiscal measures – both in spending and taxation – is also crucial. Measures must be well-designed to avoid a self-defeating fiscal policy. As part of growth enhancing structural reforms, they should lay sound foundations for sustainable growth.
Significant progress in the unwinding of external imbalances is visible. On the back of strong positive net trade contributions, partly owing to subdued domestic demand, the programme countries in particular have recently achieved considerable improvements in their current account balance, which are also foreseen to continue. According to the EC 2012 Spring Forecast, current account balances have evolved since 2008:
Part of the correction seen thus far reflects countries’ structural measures to correct relative price and cost developments and improve competitiveness in a lasting manner. However, part of the decline in unit labour costs is also explained by increases in productivity, which are the result of labour shedding. With the exception of Ireland, wage moderation has only set in following a significant delay (Portugal in 2010, Spain in 2012). Far-reaching and comprehensive labour and product market reforms could have proved very beneficial in reducing labour shedding and facilitating employment growth in more productive sectors, had they been passed some years ago. Nevertheless, tackling this strong increase in youth unemployment should be a priority.
As there are still substantial needs for rebalancing, many countries need to introduce further measures to increase both price- and non-price competitiveness and to foster job creation and reduce unemployment.
To strengthen price competitiveness, further significant reductions in unit labour costs and excess profit margins are particularly urgent, especially in countries where unemployment is high. To achieve this, wage determination processes have to become more flexible. Furthermore, competitiveness adjustment needs to be strengthened by permanent increases in labour productivity, for example through privatisations, innovations, measures to boost the skills of the labour force and initiatives to create a more favourable business environment and increase competition.
Also, a well-functioning financial sector is needed to foster growth. The financial sector is in a major adjustment process. Deleveraging by banks is progressing as are recapitalization measures.
More generally, courageous policy actions on structural reforms across the board are needed. Countries need to fully implement the 2012 country-specific recommendations issued by the Commission and approved by the Council.
The roots of the crisis in Europe can be traced to an insufficient enforcement of the fiscal governance framework, a lack of attention to private-sector imbalances and the absence of a banking union in complement to the economic and monetary union.
In response to this diagnosis, over the past two years, the economic governance framework has been strengthened by stronger fiscal rules and deeper monitoring of macroeconomic imbalances.
On the fiscal side, the existing rules-based framework has been strengthened through the adoption of the “six pack” on economic governance. In addition, the Fiscal Compact was signed by 25 EU Member States on 2 March 2012. These Member States will be required to introduce balanced budget rules in national legislation, with an automatically triggered correction mechanism in the case of deviations.
On the broader macroeconomic side, the Macroeconomic Imbalance Procedure has been implemented for the first time this year as part of the “six pack”.
Negotiations are on-going on the so-called “two-pack” regulations which would allow the Commission to put countries that are under financial stress under much closer surveillance. It would also allow the Commission to request a revised draft budget in case of non-compliance with budgetary obligations as spelled out in the Stability and Growth Pact.
Those governance reforms fundamentally change the way surveillance is conducted at the EU level which is now broader and more intrusive. However, their success will depend on a stricter enforcement of the rules.
Another aspect of the reform of EMU architecture has been the creation of the European Financial Stability Facility (EFSF), the temporary crisis management facility and, subsequently, of its permanent successor, the European Stability Mechanism (ESM). The ESM will provide support on the basis of a strict conditionality to safeguard the financial stability of the euro area as a whole and of its Member States. The inaugural meeting of the ESM Board of Governors is expected in the margins of the Eurogroup meeting of 8 October 2012 in Luxembourg.
However, the reform of the EMU architecture is far from being complete. The report “Towards a genuine Economic and Monetary Union”, presented to the European Council in June by the four Presidents Herman Van Rompuy, José Manuel Barroso, Jean-Claude Juncker and Mario Draghi, sets out a shared vision for EMU over the next decade. The report outlines four building blocks on which further work is on-going: financial market union, fiscal union, economic union and political union.
Work on financial market union and, in particular, on the establishment of a unified banking supervisor involving the ECB, is proceeding. On 12 September the European Commission unveiled a draft legislation on the single supervisory mechanism, which proposes to confer ultimate responsibility for specific supervisory tasks on the ECB. It is important to note that the legislative process has just started and many details remain to be worked out in the coming months. Yet, it is fair to say that the Commission’s proposal is an important step towards laying the foundations of a financial market union with the view to ensuring financial stability in the euro area and the European Union. An equally important pillar of the financial market union is the establishment of a European banking resolution mechanism.
To sum up: while substantial adjustment needs still remain, there has also been significant progress in various areas and further progress is in the making.
Countries have embarked on major consolidation of their public finances; further progress is needed to meet the requirements of the fiscal framework. This should be well-designed to allow a quick growth recovery.
Structural reforms have been initiated in many countries, but these need to be speeded up and further bold reforms are necessary across the euro area. Delays in this area are particularly costly and have manifested themselves in high unemployment rates, particularly among young people.
The European governance framework, and more generally the EMU architecture, is undergoing fundamental but necessary changes in order to tackle the EMU’s institutional flaws.
Overall, while action has sometimes been insufficient or late, adjustment is occurring in the right direction.
The remaining adjustment needs are significant. But the progress achieved so far is an encouraging sign of the resolve to address the problems. Keeping up the reform momentum is now paramount to completing the adjustment process.
I would like to thank Alexander Klemm, Katrin Forster and Marta Wieczorek for their useful contribution in the preparation of this speech.