contribution issue 2011/13 europe's growth emergency€¦ · issue 2011/13 october 2011...

ISSUE 2011/13 OCTOBER 2011 EUROPE'S GROWTH

EMERGENCY

ZSOLT DARVAS AND JEAN PISANI-FERRY

Highlights

• The European Union growth agenda has become even more pressing because growthis needed to support public and private sector deleveraging, reduce the fragility of thebanking sector, counter the falling behind of southern European countries and provethat Europe is still a worthwhile place to invest.

• The crisis has had a similar impact on most European countries and the US: a persis-tent drop in output level and a growth slowdown. This contrasts sharply with theexperience of the emerging countries of Asia and Latin America.

• Productivity improvement was immediate in the US, but Europe hoarded labour andproductivity improvements were in general delayed. Southern European countrieshave hardly adjusted so far.

• There is a negative feedback loop between the crisis and growth, and without effec-tive solutions to deal with the crisis, growth is unlikely to resume. National and EU-level policies should aim to foster reforms and adjustment and should not riskmedium-term objectives under the pressure of events. A more hands-on approach,including industrial policies, should be considered.

Earlier versions of this Policy Contribution were presented at the Bruegel-PIIE conferenceon Transatlantic economic challenges in an era of growing multipolarity, Berlin, 27September 2011, and at the BEPA-Polish Presidency conference on Sources of growth inEurope, Brussels, 6 October 2011. We are grateful to Dana Andreicut and Silvia Merler forexcellent research assistance, and to several colleagues for useful comments andsuggestions. Zsolt Darvas ([email protected]) is a Research Fellow at Bruegel.Jean Pisani-Ferry ([email protected]) is Director of Bruegel.

Telephone+32 2 227 4210 [email protected]

www.bruegel.org

BRU EGE LPOLICYCONTRIBUTION

EUROPE’S GROWTH EMERGENCY

ZSOLT DARVAS AND JEAN PISANI-FERRY, OCTOBER 2011

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1 INTRODUCTION

In the twentieth century it was common to jokethat ‘Brazil is a country of the future, and alwayswill be’. In the same way it is tempting to say thatgrowth is Europe’s agenda for the future, andalways will be. This goal has been emphasised asa priority at least since the 1980s, and it seemsthat each decade makes it even more elusive.

It was therefore bold for the Polish presidency ofthe EU Council to put economic growth at the coreof its agenda (Polish Presidency, 2011), and itwas brave for the World Bank to undertake an in-depth examination of the 'lustre' of Europeangrowth (Gill and Raiser, 2011). Both should becongratulated on their initiatives, because growthin Europe is both more important and more diffi-cult to achieve than at any point in recentdecades.

The reasons why restoring growth has becomeparamount are not hard to grasp. Until the globalcrisis, Europe’s disappointing growth performancecould be seen as a merely relative concern vis-à-vis more successful countries. It meant that thecontinent would not reach the US level of GDP percapita, but it enjoyed already high living stan-dards, and benefited from longer holidays and ear-lier retirement. As Olivier Blanchard (2004) put itin a (controversial) paper, Europe’s lower incomeper head was perhaps the result of a social choice.Furthermore, as pointed out in the World Bankreport, Europe was successful in fostering thecatching up of its least developed areas, wherethere was the most pressing need for growth.

The global crisis has however altered this benign

‘Without growth, Europe is at risk of struggling permanently with debt sustainability and it is at

the mercy of stagnation and a debt overhang. Without growth the sustainability of the (already

precarious) European social model would be further brought into question.’

landscape in three fundamental ways:

• First, growth is of utmost importance for bothpublic and private deleveraging and for reduc-ing the fragility of the banking sector. Historyshows that in addition to growth and fiscal con-solidation, previous rounds of financial repres-sion, inflation, and occasional default helpedachieve the deleveraging of the public sector.Europe does not want to have to fall back on thelatter three. Without growth, Europe is at risk ofstruggling permanently with debt sustainabil-ity and it is at the mercy of stagnation and adebt overhang. Without growth the sustainabil-ity of the (already precarious) European socialmodel would be further brought into question.

• Second, the convergence machine has brutallystopped in the southern part of the EU – andhas moved into reverse in Greece, Portugal andSpain, with little chance of short-term improve-ment. Italy, meanwhile, has been falling behindsince the early 1990s.

• Third, the euro-area sovereign debt crisis mayput Europe at risk of being seen by investors asa place where there are very few reasons toinvest. This may trigger an accelerated weak-ening of its economic performance.

It is of the highest importance to assess theseriousness of these threats and the possiblepolicy responses. With this goal in mind and witha focus on the medium term, this paper isorganised as follows: in section 2, we explain whywe think growth should now be given higherpriority; in section 3 we investigate if the seeds offuture growth have been sown during therecession; in section 4 we discuss the policyresponses. Section 5 concludes.

EUROPE'S GROWTH EMERGENCY Zsolt Darvas and Jean Pisani-Ferry

To simplify matters, we use throughout this paperfive country groups as the basis for discussion ofthe diverse challenges. The Appendix presents theclassification.

2 WHY GROWTH IS EVEN MORE IMPORTANT

2.1 Overall performance

After the second world war, European countriesembarked on a rapid convergence with the US interms of GDP per capita (Figure 1). This was inpart based on the rebuilding of the capital stocklost during the war, in part on technological catch-ing-up and in part on economic integration efforts. By the late 1970s, however, convergence with theUS has stopped in most countries of 'older' Europe– though with significant exceptions, such as Ire-land. Countries in the North (Denmark, Finland,Sweden, Ireland, United Kingdom; see Appendix)and South (Greece, Italy, Portugal, Spain) groupsin particular had apparently settled for levels cor-responding to 80 percent and 60 percent of USGDP per capita. The central and eastern countriesby contrast were catching up from the mid-1990s,though from a much lower base.

Figure 1 also shows IMF projections up to 2016suggesting that the positions of the West andNorth country groups relative to the US shouldremain broadly stable, while southern Europe isexpected to fall behind and the convergence of theCentral and East groups is projected to continue

1. By 2016, the relativeposition of the East group isforecast to reach only pre-transition level. Note thatdata for the late 1980s andearly 1990s should beinterpreted with cautiongiven the differences instatistical methodology,changes in relative prices,and measurement errors.

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Source: Bruegel using data from the IMF’s World EconomicOutlook September 2011, PENN World Tables and EBRD.Note: median values are shown.

(after the major shock of recent years in the lattercase)1.

Judging from Figure 1 it seems that the potentialfor natural catching-up with the US has beenexhausted in three of the five groups, and the gapremains noteworthy. Only significant economicreforms and/or a change in social preferenceswould lead to a change in this diagnosis.

Europe should not only look at the US but also thenew emerging powers. Figure 1 also underlinesthe extremely rapid development of China, andshows that smaller countries in Asia and LatinAmerica are also converging.

But there is also some good news. As Figure 2shows, western European countries are closer tothe US in terms of GDP per hour worked, with Bel-gium and the Netherlands even at US level. Fromthe North group, Ireland is only three percent below.Therefore, these European countries were able tocatch-up with the US in terms of productivity; lowerper capita output is in part a reflection of socialpreferences (more leisure), and in some caseshigher unemployment. The four South group coun-tries have mixed records in this respect: Spain andItaly are closer to the US than Greece and Portugal.

2.2 Deleveraging

The period in the run-up to the crisis wascharacterised by a rapid increase in private debt inseveral countries, such as the Baltic countries,Ireland, the Netherlands, Spain and the UK, while

West North South Central East0

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Figure 2: GDP per hour worked and per capita atPPP (US = 100), 2010

Source: Bruegel using data from the OECD (all but GDP perhour for four Eastern countries apart from Estonia) andEurostat (GDP per hour for four Eastern countries).

Zsolt Darvas and Jean Pisani-Ferry EUROPE'S GROWTH EMERGENCY

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2. McKinsey (2010)assessed the likelihood of

deleveraging in five EUcountries (among others).Concerning the household

sector, they found highprobability for Spain and the

UK, but low probability forGermany, France and Italy.In the case of the non real-

estate corporate sector thelikelihood of deleveraging is

low in the UK and France,moderate in Germany and

Italy, and mixed in Spain.

3. According to Reinhart,Kirkegaard and Sbrancia

(2011), “financial repres-sion occurs when govern-ments implement policiesto channel to themselves

funds that in a deregulatedmarket environment would

go elsewhere”. At the cur-rent juncture, these authors

and Reinhart and Rogoff(2011) foresee a revival of

financial repression –including more directed

lending to government bycaptive domestic audiences

(such as pension funds),explicit or implicit caps oninterest rates, and tighter

regulation on cross-bordercapital movements.

in many other countries, private debtaccumulation was less pronounced, such as inAustria, the Czech Republic and Germany. In mostof Europe, public debt ratios (as a percent of GDP)were generally stable or slowly declining. Somecountries, such as Ireland, Spain and Bulgaria hadeven achieved sizeable debt reductions.

The post-crisis landscape is very different. Publicdebt ratios in the EU have increased by 20 per-centage points on average, and in some casesthey have reached alarming levels. At the sametime market tolerance of high public debt hasdiminished severely, especially for the membersof the euro area. The challenge of public delever-aging is therefore paramount. At the same time,several European countries face the challenge ofbringing down household or corporate debt2.

Let us start with public debt. Reinhart and Rogoff(2011) summarise five major ways in which highdebt ratios were reduced in past episodes ofdeleveraging:

i Economic growth;ii Substantial fiscal adjustment, such as auster-

ity plans;iii Explicit default or restructuring of public and/or

private sector debt;iv A sudden surprise burst in inflation (which

reduce the real value of the debt);v A steady dose of financial repression3 accom-

panied by an equally steady dose of inflation.

Of these, economic growth is by far the mostbenign. There are three main channels throughwhich it aids deleveraging in both the public andprivate sectors:

• First, higher growth results in higher govern-ment primary balances and higher privatesector incomes – which can be used to pay offthe debt.

• Second, higher growth results in a reduction ofthe relative burden of past debt accumulation.Other things being equal, a one percentagepoint acceleration of the growth rate reducesthe required primary surplus by one-hundredthof the debt ratio. With the debt ratio approach-ing or in certain cases exceeding 100 percentof GDP, this is a meaningful effect.

• Third, by improving sustainability, highergrowth makes future threats to solvency lessprobable and for this reasons it is likely to resultin lower risk premia. It is not by accident thatthe potential growth outlook is often mentionedby market participants and rating agencies asa key factor in their solvency assessments.

Box 1 illustrates the point by decomposing factorsbehind the impressively fast reduction of the UKgeneral government and the US federal debt ratiosin the first three post-war decades. Growth and pri-mary surpluses made sizeable contributions todeleveraging, and primary surpluses were partlythe result of growth. There were several years withnegative real interest rates (and whenever the realinterest rate was positive, it was small) which alsohelped deleveraging. As pointed out by Reinhartand Sbrancia (2011), financial repression wasthe major reason for low real interest rates.

Another reason why public debt deleveraging, andhence growth, is paramount is that without it theEuropean social model is not sustainable. This wasobserved by Sapir et al (2004) and is a majorreason why they advocated an agenda for agrowing Europe.

Turning to the private side, credit developmentsshow that deleveraging has started: as a result ofboth credit demand and supply factors, creditaggregates have started to fall in several EU coun-tries (Figure 3). These credit developments helpprivate sector deleveraging on the one hand. Buton the other hand, the simultaneity of public and

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Source: Bruegel calculation using ECB data. Note: medianvalues.

EUROPE'S GROWTH EMERGENCY Zsolt Darvas and Jean Pisani-Ferry

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BOX 1: DECOMPOSITION OF UK AND US POST SECOND WORLD WAR PUBLIC DEBT REDUCTION

In the UK and the US, the public debt ratio (general government for the UK, federal government in the US) fellrapidly after the second world war. In 1946, the public debt was 257 percent of GDP in the UK and 122 percentin the US. By 1976 it had been brought down to 52 percent and 36 percent, respectively. Table 1 shows aver-age annual growth, interest rates and primary surpluses during these three decades. GDP growth was robustand both countries had primary surpluses (especially sizeable in the UK), but real interest rates were very low– always below the growth rate of GDP and even negative in several years.

Table 1: Average annual growth, interest rate and primary surplus in the UK and the US

Sources: UK: HM Treasury (debt), Office of National Statistics (budget balance, interest payments, GDP from 1948), andmeasuringworth.com (GDP for 1946-48); US: White House Office of Management and Budget Historical Tables (debt, budgetbalance), Bureau of Economic Analysis, Table 3.1 Government Current Receipts and Expenditures (interest payments),and Bureau of Economic Analysis (GDP). Note. Ex-post real interest rate is calculated with the so called ‘implicit interest rate’(ie interest expenditures in a given year divided by the stock of debt at the end of the previous year) and the change in theGDP deflator.

Our decomposition is based on the well-known, simple accounting identity for the change in the debt ratio:

where dt is the gross public debt (% GDP), rt is the real interest rate (%), gt is the real GDP growth rate (%), πt isthe inflation rate (%), st is primary surplus (% GDP) and sft is a stock-flow adjustment (% GDP). Many of thesevariables are interlinked, for example, faster growth and higher surprise inflation improves the primary bal-ance, which complicates a causal decomposition of the change in the debt ratio. Therefore, we use this simpleaccounting identity to decompose the changes, ie we report (rt/(1 + gt + πt))dt–1 under the heading ‘real ex-postinterest rate’, (–gt/(1 + gt + πt))dt–1 as ‘growth’, –st as ‘primary surplus’ and sft as ‘stock-flow adjustment’. Wecalculate these values for each year and sum them up for each decade we consider, in order to get their cumu-lative impacts over decades. As Table 2 indicates, growth was an important factor in bringing down debt and ithas always more than counterbalanced the impact of the real interest rate, whenever the latter was positive.But the real interest rate was sometimes negative, which is labelled as financial repression by Reinhart andSbrancia (2011).

Table 2: Contributions to UK and US post-war public debt deleveraging (% GDP)

Source: Bruegel calculation based on data sources of Table 1. Note: see the explanation of the methodology and the inter-pretation of the numbers in the main text.

United Kingdom United States

Real GDP growthrate (%)

Real ex-postinterest rate (%)

Primary sur-plus (% GDP)

Real GDP growthrate (%)

Real ex-postinterest rate (%)

Primary sur-plus (% GDP)

1947-56 2.3 -3.0 7.4 3.6 -1.5 2.0

1957-66 2.9 0.2 4.8 4.2 1.7 1.2

1967-76 2.4 -4.6 3.0 3.0 1.0 0.6

Reduction in debtratio

Real ex-postinterest rate

Growth Primary surplusStock/flow

adjustment

United Kingdom

1947-56 -128 -58 -37 -74 41

1957-66 -45 3 -29 -48 30

1967-76 -32 -22 -15 -30 35

United States

1947-56 -58 -15 -28 -20 6

1957-66 -20 9 -21 -12 4

1967-76 -7 4 -11 -6 6

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BR U EGE LPOLICYCONTRIBUTION EUROPE'S GROWTH EMERGENCY Zsolt Darvas and Jean Pisani-Ferry

private deleveraging is a major challenge thatcould hinder economic growth and could even leadto a vicious circle of lower growth and lower credit– even to those companies and households thatare not overly leveraged4. Furthermore, the bank-ing sector in Europe is itself highly leveraged andwill need to undergo sizeable corrections, not leastbecause of the Basel III regulations.

There are therefore major concerns both on thesupply and the demand sides. On the supply sidepotential growth in the coming years couldweaken further post the financial crisis; on thedemand side the combination of public and pri-vate deleveraging may result in slow growth of pri-vate aggregate demand.

In this context, improving potential growth in thelong run remains of paramount importance but atthe same time policymakers cannot afford toignore the interplay between supply and demandor between short-term and longer-term develop-ments.

3 DEVELOPMENTS DURING THE CRISIS

Growth policies are generally and rightly regardedas medium-term oriented. However the impact ofthe Great Recession of 2009 and the current crisisin the euro area are more than mere cyclical phe-nomena that could be overlooked in a medium-term analysis. In this section we analyse anddiscuss the behaviour of European countries

4. There is a growing litera-ture about ‘creditless’

recoveries (see Abiad, Del-l'Ariccia and Li, 2011, and

references therein), whichfinds that such recoveries

are not rare, but growth andinvestment are lower than

in recoveries with credit;industries more reliant on

external finance seem togrow disproportionately

less during creditless recov-eries; and such recoveriesare typically preceded by

banking crises and sizeableoutput falls. But there are atleast two important caveatsin applying these results to

Europe. First, financing ofEuropean firms is domi-

nantly bank based and thelevel of credit to output ismuch higher than in other

parts of the world. There-fore, lack of new credit oreven a fall in outstandingcredit could drag growth

more in Europe than else-where. Second, the litera-

ture has not paid attentionto real exchange-rate devel-

opments during creditlessrecoveries. But Darvas

(2011) found that credit-less recoveries are typicallyaccompanied by real effec-tive exchange rate depreci-

ations, which can boost thecash-flow from tradable

activities, thereby reducingthe need for bank financing.

But the southern membersof the euro area and the

eastern countries with fixedexchange rate cannot rely

on nominal depreciationand hence this effect

cannot work.

5. Our purpose is not toassess the IMF’s forecast-

ing ability, rather to useforecast changes as indica-

tive of changes to economicperspectives. Comparison

of forecasts by the IMF

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Figure 4: GDP forecasts to 2012: October 2007 versus September 2011 (2007=100)

Source: Bruegel calculation using IMF (2007) and IMF (2011d).

‘There are major concerns both on the supply and the demand sides. Potential growth in the

coming years could weaken further post the financial crisis, while the combination of public and

private deleveraging may result in slow growth of private aggregate demand.’

during this episode and assess implications formedium-term growth.

3.1 Shock and recovery

A telling measure of the economic impact of thecrisis can be obtained by comparing pre-crisis andpost-crisis forecasts. While forecasts certainlycontain errors, they reflect the views about thefuture that are used for economic decisions. InFigure 4, we therefore compare forecasts to 2012made by the IMF in October 2007 and September20115.

Figure 4 shows that the crisis had a moderateimpact on West group countries. There, as in theUS, output fell and recovered at a broadlyunchanged pace, therefore not closing the gapcreated by the recession. The impact on the Northgroup was more significant, owing to the greatertrade openness of the countries of this group, butthe recovery pattern is similar. The situation ismuch worse in the South group where therecession was mild in 2009, but output declinehas continued and is forecast to last at least until2012. This widening gap is very worrying. Finally,central European economies (with the exceptionof Poland) also suffered significantly from thecrisis, and those of the East group suffered a majorshock in 2009, from which they have started torecover but which leaves a major gap amountingto more than 30 percent of the 2007 GDPtrajectory.

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BR U EGE LPOLICYCONTRIBUTIONZsolt Darvas and Jean Pisani-Ferry EUROPE'S GROWTH EMERGENCY

(2007), the European Com-mission (2007) and the

OECD (2007) made in late2007 indicate that the

other two institutions gavebroadly similar forecasts.

6. See Brenke, Rinne andZimmermann (2011).

European developments are similar to those in theUS but contrast sharply with the experience of the14 emerging countries of Asia and Latin America(see Appendix), where the impact was mild. InChina (not shown in the figure), pre- and post-crisis growth trajectories are almost identical.These emerging countries were primarilyimpacted by the global trade shock, but did notsuffer from a financial crisis and started to recoverwhen global trade recovered.

3.2 Adjusting to the shock

At the time of economic hardship, firms relied ondifferent strategies to survive and to sow theseeds of future growth. The strategies depend oninitial conditions (firms that were not competitiveenough before the crisis had no choice but toimprove), credit constraints (liquidity-constrainedfirms had no choice but to cut costs), expecta-tions about future growth (firms looking forwardto recovery had an incentive to hoard labour), eco-

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Bulgaria Netherlands Ireland Poland Slovakia Czech Republic

Panel A: EU groups and the US

Panel B: Best performing EU countries

Figure 5: Output, hours worked, and productivity in the non-construction business sector (2008Q1= 100)

Source: Bruegel using data from Eurostat, OECD and US Bureau of Labor Statistics. Note: median values in Panel A; US data isfor the whole business sector.

nomic policies (such as Kurzarbeit, a schemefinanced by the German government to supportpart-time work and keep workers employed duringthe recession6) and other factors, such asexchange rate changes (countries that experi-enced depreciation faced less pressure to adjust). To get a better picture of productivity develop-ments in the private sector, we exclude construc-tion and the public sector from GDP and comparepatterns of adjustment across countries. Thereason for excluding construction is that it is ahighly labour-intensive and low-productivitysector that suffered heavily in some countries. Theshrinkage of construction may therefore give riseto a misleading improvement in productivity data,whereas it is entirely due to a composition effect. Figure 5 shows output (at constant prices), hoursworked, and the ratio of these two indicators, aver-age productivity.

It is interesting to observe that there was a promptand significant productivity surge in the US – as

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a result of reducing labour input by more than theoutput fall. In western and northern Europe bycontrast productivity initially fell while employ-ment did not, which is evidence of labour-hoard-ing. Only after a lag did productivity start torecover, but only to a level barely above the pre-crisis level. In central Europe productivity startedto improve from mid-2009 and the gains areimpressive. In southern Europe the fall in outputand labour input went broadly hand in hand. Pro-ductivity essentially remained flat for the groupas a whole.

Interpreting these differences is not straightfor-ward. The broad evidence is that the supply sidewas more damaged in Europe than in the US, atleast if one assumes that the largest part of USunemployment is cyclical. Labour hoarding byEuropean firms seems to have resulted in lastingeffects on aggregate output per hour.

There are significant variations within our groupsas well. Panel B of Figure 5 shows data for the sixbest performing EU countries, most of which out-performed the US in terms of the cumulative pro-ductivity increase in the last three years. Thesharp increase in Irish productivity is remarkableand suggests a brighter growth outlook7. Bulgariaranks second, followed by three central Europeancountries (the Czech Republic, Slovakia, andPoland) and the Netherlands.

The worst performers in terms of productivityincrease are from all regional groups. These areGreece from the South group, Romania from theEast group, Hungary from the Central group, theUK from the North group, and Germany from theWest group. Hungary, Romania and the UK havefloating exchange rates that depreciated in 2008-09 and have remained weak since then, whichimproved external competitiveness. However,Poland, another floater that benefited from anexchange rate depreciation, was among the bestperformers in terms of productivity increase.German firms were already highly competitivebefore the crisis and weak productivity develop-ments to date are not necessarily worrying. Whatis much more worrying is the weak performanceof Greece as its real overvaluation would call formajor improvements.

Concerning manufacturing unit labour costs(ULC), there was prior to the crisis a surge in theSouth and the East groups, but not in the otherthree regions (Figure 6). Post-crisis, there isalmost no adjustment in the South group, but theadjustment is impressive in the East group. In theWest and North groups, after a temporary increasein 2008, ULC has fallen. Ireland again is the bestperformer: ULC fell by 25 percent from 2008Q1 to2011Q1.

Finally, another major aspect of the adjustment isthe impact on external accounts. Figure 7 showsthat there was an abrupt adjustment in the Eastgroup, due to a sudden stopping of capital inflows,but that the adjustment in the South group is slow.Private capital also stopped flowing into southernEuropean countries. The main reason for the lackof faster adjustment is the massive European

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Figure 6: Unit labour cost in manufacturing(2000Q1=100), 2000Q1-2011Q1

Source: Bruegel using OECD and Eurostat data. Note:median values.

7. Note that total economyIrish GDP fell by 10 percent

between 2008Q1 and2009/2010, and recovery

started in 2011, but thenon-construction businesssector shown on the figure

fell only by three percentand the recovery started in

2010.

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

-20.0

-15.0

-10.0

-5.0

0.0

5.0

West

NorthSouth

CentralEast

United States

Figure 7: Current account (% of GDP), 1995-2016

Source: Bruegel using IMF data. Note: median values.

09


Central Bank (ECB) support to southern Europeanbanks, which has offset the sudden stop in privatecapital flows and contributed to financial stability.But at the same time, ECB financing has made itpossible for these countries to delay theadjustment, as noted by Sinn (2011).

3.3 The special challenges of southern Europe

The evidence presented thus far confirms thatsouthern European countries face special chal-lenges. Their economic convergence has reversed,their unit labour costs have failed to improve fol-lowing a steady rise in the pre-crisis period, andtheir current account deficits have hardlyimproved. Most southern European countries areunder heavy market pressure and face a viciouscircle of low and even worsening confidence and

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

0

5

10

15

20

25

30

35

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

0

5

10

15

Under 25

From 25-74

West

NorthSouth

CentralEast

United States

West

NorthSouth

CentralEast

United States

Figure 8: Unemployment rate (%), 2000-10

Source: Bruegel using Eurostat data. Note: median values.

‘There was an abrupt current account adjustment in the East group, due to a sudden stopping of

capital inflows, but the adjustment in the South group has been slow. The main reason for this is

the massive European Central Bank support to southern European banks.’

weak economic performance. This and the marketpressure necessitate a greater fiscal adjustment,which again leads to a weaker economy, therebylowering public revenues and resulting in addi-tional fiscal adjustment.

The social consequences of fiscal adjustment andthe weaker economy make it more difficult toimplement the adjustment programmes andescape the vicious circle. Figure 8 shows thatunemployment has increased, especially youthunemployment (which is also very high in theEast group). Such a high youth unemploymentrate is already leading to widespread frustrationand the rise of anti-EU political movements.

It is interesting to contrast South group countrieswith Ireland, because the latter seems to havebeen able to avoid this vicious circle through agreater flexibility to adjust to the shock by improv-ing competitiveness and unit labour costs. Thefundamentals of the Irish economy, which aremuch better than the South group countries (seeDarvas et al, 2011), have likely played importantroles in this development. The Irish programme isbroadly on track (Table 3 on the next page), butthe outcomes and recent forecasts for Greece aresignificantly worse compared to the May 2010assumptions of the initial programme.

4 WHAT SHOULD BE DONE?

The European growth agenda traditionally focuseson horizontal structural reforms that have thepotential to improve potential output growth.Much of this agenda is indisputable, but policy-makers must also reflect on whether it is stillenough. In particular, two issues deserve atten-tion in the policy discussion: the pace and com-position of fiscal adjustments, and the potentialfor more active policies.

4.1 Revisiting the EU2020 agenda

Against the background presented in the previoussections, what can be said of the EU2020

10


Tabl

e 3:

Pro

gram

me

assu

mpt

ions

and

rece

nt fo

reca

sts

for G

reec

e an

d Ire

land

GREE

CEFo

reca

st d

ate

2009

2010

2011

2012

2013

2014

2015

GDP

May

201

0-2

.0-4

.0-2

.61.

12.

12.

12.

7

% ch

ange

Sept

201

1-2

.3-4

.4-5

.0-2

.01.

52.

33.

0

Gros

s pu

blic

deb

tM

ay 2

010

115

133

145

149

149

146

140

% GD

PSe

pt 2

011

127

143

166

189

188

179

165

Budg

et b

alan

ceM

ay 2

010

-13.

6-8

.1-7

.6-6

.5-4

.8-2

.6-2

.0

% GD

PSe

pt 2

011

-15.

5-1

0.4

-8.0

-6.9

-5.2

-2.8

-2.8

IREL

AND

Fore

cast

dat

e20

0920

1020

1120

1220

1320

1420

15

GDP

Dec

2010

-7.6

-0.2

0.9

1.9

2.4

3.0

3.4

% ch

ange

Sept

201

1-7

.0-0

.40.

61.

92.

42.

93.

3

Gros

s pu

blic

deb

tDe

c 20

1066

9911

312

012

512

412

3

% GD

PSe

pt 2

011

6595

109

115

118

117

116

Budg

et b

alan

ce

Dec

2010

-14.

4-3

2.0

-10.

5-8

.6-7

.5-5

.1-4

.8

% GD

PSe

pt 2

011

-14.

2-3

2.0

-10.

3-8

.6-6

.8-4

.4-4

.1

Sour

ces:

Gre

ece

– M

ay 2

010

proj

ectio

ns, I

MF

(201

0a);

the

thre

e m

ore

rece

nt p

roje

ctio

ns, I

MF

(201

1d),

IMF

(201

1e) a

nd IM

F (2

011e

),re

spec

tivel

y. Ir

elan

d –

the

Dece

mbe

r 201

0 pr

ojec

tions

are

from

IMF

(201

0b),

and

the

thre

e m

ore

rece

nt p

roje

ctio

ns a

re fr

om IM

F(20

11a)

,IM

F 20

11a)

and

IMF

(201

1e),

resp

ectiv

ely.

Wes

tNo

rth

Sout

hCe

ntra

lEa

st

Austria

Belgium

France

Germany

Netherlands

Denmark

Finland

Ireland

Sweden

UK

Greece

Italy

Portugal

Spain

Czech Rep.

Hungary

Poland

Slovakia

Slovenia

Estonia

Latvia

Lithuania

Bulgaria

Romania

United States

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

old

new

Med

ium

term

Labo

r mar

ket i

neffi

cien

cy

Busi

ness

regu

latio

n

Netw

ork

regu

latio

n

Reta

il se

ctor

regu

latio

n

Prof

essi

onal

ser

vice

s re

gula

tion

Long

term

Inst

itutio

ns a

nd c

ontra

cts

Hum

an C

apita

l

Infra

stru

ctur

e

Inno

vatio

n

Tabl

e 4:

Str

uctu

ral r

efor

m s

core

boar

d

Sour

ce: B

rueg

el (b

ased

on

the

met

hodo

logy

of I

MF,

2010

c an

d Al

lard

and

Eva

raer

t, 20

10) u

sing

OEC

D, W

orld

Eco

nom

ic F

orum

and

Fras

er In

stitu

te d

ata.

Not

e: th

e sc

oreb

oard

is re

lativ

e to

the

‘adv

ance

d’ O

ECD

coun

trie

s, ie

OEC

D co

untr

ies

apar

t fro

m M

exic

o an

d th

e ce

ntra

l Eur

opea

n m

embe

r sta

tes.

Col

our c

odes

: Dar

k gr

een:

the

indi

cato

r is

bette

r by

mor

e th

an o

ne s

tand

ard

devi

atio

n th

at th

e av

erag

e; li

ght g

reen

:be

tter t

han

the

aver

age

but b

y no

mor

e th

an o

ne s

tand

ard

devi

atio

n; y

ello

w: w

orse

than

the

aver

age

but b

y no

mor

e th

an o

ne s

tand

ard

devi

atio

n; o

rang

e: w

orse

than

the

aver

age

betw

een

one

and

two

stan

-da

rd d

evia

tions

; red

: wor

se th

an th

e av

erag

e by

mor

e th

an tw

o st

anda

rd d

evia

tions

. The

‘new

’ ver

sion

of t

he in

dica

tors

is b

ased

on

WEF

Glo

bal C

ompe

titiv

enes

s Re

port

201

1/12

(tha

t has

dat

a fro

m th

e ye

ar20

09),

OEC

D go

ing

for g

row

th 2

011

(dat

a 20

08 a

nd 2

009

only

for 2

indi

cato

rs),

Fra

ser 2

011

(200

9 da

ta),

and

Wor

ld B

ank

doin

g bu

sine

ss (2

010

data

). Th

e ‘o

ld’ v

ersi

on is

bas

ed o

n da

ta fr

om 2

003-

2005

.Ea

ch in

dica

tor s

how

n ar

e co

nstr

ucte

d fro

m a

larg

e nu

mbe

r of m

ore

deta

iled

indi

cato

rs, s

ee IM

F ( 2

010c

) and

Alla

rd a

nd E

vara

ert (

2010

) for

det

ails

.

11


agenda? Most of it clearly still makes sense. Edu-cation, research, and the increase in participationand employment rates are perfectly sensibleobjectives in the current context, and the goals ofensuring climate-friendly and inclusive growth arealso appropriate.

Implementing this agenda requires a significantstepping-up of efforts. Progress so far is veryuneven within the EU. While indicators related tothe five main EU2020 targets are readily available(eg Eurostat), in Table 4 we construct ascoreboard, based on the methodology of IMF(2010c) which was also used in Allard andEvaraert (2010), which assesses the variousstructural indicators in 2005 and currently. Theseindicators do not relate to all five main EU2020targets, but to certain aspects of growth that couldbe improved with structural reforms. In itsprogress with structural reforms, the North groupis unsurprisingly much further ahead than theWest group and, especially, the South group,which is severely lagging on all criteria. Whilecountries under a programme face very strongexternal pressure to reform, the main challenge isto foster improvements in countries such as Italy,that are performing poorly, but are not underIMF/EU programmes.

4.2 Composition of fiscal adjustments

The vast majority of European countries are facingmajor fiscal challenges. Assessments of thedetails vary, but concur in considering that reach-ing sustainable budgetary positions will requireexceptionally large and sustained adjustmentsamounting to more than 10 percentage points ofGDP in Greece, Ireland, Portugal, Spain and the UK(IMF, 2011). A large number of European countriesare expected to need adjustments of the order of 5to 10 percent of GDP.

There is a broad consensus that these adjust-ments should be as growth-friendly as possible.This implies, first, striking the right balancebetween revenue-based and spending-basedadjustments; and second, selecting from revenueand spending measures the least detrimental togrowth. Although there is no ready-made generalmetric to design growth-friendly adjustment pack-ages, it is widely accepted that revenue measures

tend to involve more adverse supply-side effectsthan spending measures; that tax measures thatbroaden the tax base or do not directly distortincentives to work and invest are preferable; andthat spending cuts should preserve public invest-ment in infrastructure, education and research.

These simple criteria can be used to assess themeasures planned and implemented in EU coun-tries. An appropriate starting point is a late 2010IMF survey of country exit strategies conductedfor G20 members and a group of countries (includ-ing Greece, Ireland, Portugal and Spain) facingexceptionally high adjustments (IMF, 2010d). Thiscomprehensive survey suggested that virtually allcountries facing medium-scale adjustment(between 5 and 10 percent of GDP starting from2009 positions) were planning expenditure-basedadjustment whereas countries facing large-scaleadjustments (above 10 percent of GDP) were rely-ing more on mixed strategies. Interestingly, nocountry was planning a revenue-based adjust-ment. Second, most countries were envisagingstructural reforms of the government sector aimedat reducing the size of the public service and lim-iting the growth of social transfers. Overall, cuts inpublic investment amounted to about one-sev-enth of total spending cuts. Third, planned taxmeasures gave priority to broadening tax bases asopposed to increasing taxes, especially in the fieldof direct taxation of labour and capital, and toincreased consumption taxes. This was primafacie evidence of the governments’ intention tomake fiscal adjustment as growth-friendly as pos-sible.

The worsening conditions on government bondmarkets changed the course of events completely.Under increasing pressure, governments had tofront-load planned measures, or even to adoptemergency measures in an attempt to meet mar-kets’ apparently insatiable demand for fiscal con-solidation. The belt tightening was not limited toprogramme countries (Greece, Ireland and Portu-gal) but also extended to Italy, Spain and France,which all approved extraordinary fiscal consolida-tion measures in August and September.

Table 5 provides evidence on the composition ofthe recent consolidation measures. It is apparentthat giving priority to growth has often given way

12


Greece Original version of IMF/EU Programme 11.1% GDP

(May 2010) 47.8%expenditure

0.36 16.2% structuralreforms (*)revenues

Reinforced Medium Term Fiscal Strategy 12% GDP

(June 2011) (on top of what already implemented)

0.525 0.475

expenditure revenues

2nd emergency round (September 2011) 1.1% GDP

(Property tax on electricity-powered buildings)

--1

revenues

Portugal IMF/EU EFF Programme 10.6% GDP

(May 2011) 0.67 0.33


Emergency measures due to fiscal slippages 1.1% of GDP

(August 2011)--

1

revenues

Spain Emergency measures (August 2011) 0.5% GDP

~50% ~50%


Emergency measures (September 2011) 0.2% GDP

--1

revenues

Italy Fiscal Consolidation Package (August 2011) 3.6% GDP

<50% >50%


France August 2011 0.6% of GDP

-->80%

revenues

to expediency. In all countries surveyed, recentadjustments are either mixed or revenue-based. Itis probable that they are also markedly growth-friendly in the choice of detailed measures.

Evidence thus indicates that the growth-adverseimpact of the precipitous adjustment plans thatare being implemented in response to marketstrains are likely to go beyond standard Keyne-sian effects and also result in potentially adversesupply-side effects. This is in part unavoidable. Butgood intentions are of little help if they arereneged on under the pressure of events. Whereasthere is no magic bullet to address this problem,at least a close monitoring of national plans withinthe context of the ECOFIN Council is called for.

Table 5: Composition of recent fiscal adjustments in selected euro-area countries

Source: Bruegel based on IMF (2010a, 2010d, 2011a, 2011b), Greek Ministry of Finance (2011), ECB (2011), Spanish Min-istry of Finance (2011a, 2011b), and news reports in Financial Times, Sole24Ore and LaVoce.info. Note. (*) In the case ofGreece, in addition to direct revenue and expenditure measures, IMF (2010a) included a third category called Structuralreforms, which comprise lower expenditures resulting from improvements from budgetary control and processes and higherrevenues due to improvements in tax administration.

4.3 Growth policy under constraints

A key challenge for several euro-area countries ishow to implement growth strategies in the contextof 'wrong' prices. When prices perform theireconomic role they convey information to agentsabout the profitability of working or investing invarious sectors; this in principle leads to sociallyoptimal choices. In this context the main task ofpolicies is to boost the supply of labour and capitaland to create a level playing field for employeesand firms.

Things are different, however, when prices are'wrong'8, which is particularly relevant in the Euro-pean context because of real exchange-rate mis-

8. This traditionally hap-pens when they fail to take

account of externalities.Environmental costs hereare a well-known example

but there are other external-ities, either positive (when

firms contribute to knowl-edge) or negative (when

they fail to take intoaccount the impact of indi-vidual decisions on aggre-gate financial stability). In

this type of context morehands-on policies, including

industrial policies, can beadvisable, as argued in

Aghion et al (2011).

13


alignments within the euro area and in countriesin a fixed exchange-rate regime. Countries thatexperienced major domestic demand expansionin the first ten years of EMU must reallocate capi-tal and labour to the traded-good sector in spite ofa still overvalued real exchange rate. Withoutpolicy-driven incentives, private decisions arelikely to lead to suboptimal factor allocation in thissector, ultimately hampering growth.

Figure 9 gives European Commission (2010) esti-mates of real exchange rate misalignments in theeuro area for 2009 – the latest available estimate– and the changes in real effective exchange ratessince then. The figures presented for the mis-alignment are the average of two measures, onebased on current account norms and the otherbased on the stabilisation of the net foreign-assetpositions. Estimates for 2009 provide lower mis-alignment than estimates for 2008, so we areerring on the side of caution. What is apparent isthat significant misalignments prevail, becausethe real depreciation from 2009 to mid-2011 inthe most overvalued countries (except Ireland)was limited and broadly similar or less than thedepreciation in Germany, the biggest euro-areacountry that already had an undervalued real

Ge

rma

ny

Aus

tria

Ne

the

rla

nds

Fin

lan

d

Be

lgiu

m

Slov

en

ia

Ita

ly

Ire

lan

d

Fra

nce

Slov

aki

a

Spa

in

Gre

ece

Por

tug

al-15

-10

-5

0

5

10

15

20

Real exchange rate misalignment in 2009

Change in ULC-based REER from 2009 to 2011Q2

Change in CPI-based REER from 2009 to 2011Q3

Figure 9: Real exchange rate misalignments ofeuro-area countries in 2009 and adjustmentsince (%)

Source: Bruegel calculation using data from EuropeanCommission (2010) on misalignment and ECB data on realeffective exchange rate (apart from the ULC-based exchangerate of Portugal, which is from the Eurostat and available onlytill 2010Q4).

exchange rate in 2009. Real exchange rate mis-alignments result in meaningful distortions in pri-vate decisions.

Furthermore, the correction of these imbalancesis exceedingly slow. In the previous section welooked at the evolution of unit labour costs andconcluded that with the exception of Ireland, cor-rection has barely started. The persistence of inad-equate prices is bound to be detrimental toefficient capital accumulation and to weigh onpotential output growth.

In this context policies that help correct distor-tions are an integral part of the growth agenda.Such policies may involve:

• Product and labour market reforms (ie improve-ments in several areas assessed in Table 4)that increase the responsiveness of the wage-price system to market disequilibria and helpbring about the required correction in relativeprices;

• Tax-based internal devaluations that foster anadjustment in relative prices;

• Temporary wage/price subsidies or tax breakstargeted at the traded good sector that helprestore competitiveness;

• Industrial policy measures such as sectoralsubsidies that favour accumulation in certainsectors.

EU-IMF sponsored adjustment programmes inGreece, Portugal and Spain include structural com-ponents, some of which include some of the meas-ures listed above. However in the context ofheightened bond-market tensions the focus of pol-icymakers’ attention tends to be budgetary con-solidation. Growth will only return, however, if thestructural agenda is given sufficient weight and ifmeans are mobilised to support it. In countriesthat benefit from Structural Funds, especiallyGreece and Portugal where they are sizeable, wefollow Marzinotto (2011) and advocate temporaryreallocations to support the growth and competi-tiveness aspects of the programmes. Examples ofgrowth-friendly policies that could be supportedthrough this channel include credit for SMEs andtemporary wage subsidies aiming at restoringcompetitiveness.

14


5 CONCLUSIONS

In this paper we have revisited the Europeangrowth issue in the light of recent developments.We agree with the World Bank (Gill and Raiser,2011) that Europe can build on its past achieve-ments, but we emphasise that it cannot afford toremain complacent about its recent and currenteconomic performance. For most of the continent,business-as-usual policies are likely to deliverinsufficient growth to ensure the viability of thesocial model, which is in any case under threatbecause of ageing populations. The challenge ofreviving growth is heightened by the deterioratingperformance of southern Europe and the very lim-ited, or even disappointing, adjustment thesecountries were able to achieve during the lastthree years. The single most remarkable successof the EU, its ability to foster convergence, is underthreat. In ‘new Europe’ convergence is still hap-pening, but it should be strengthened.

On this basis our main policy conclusions are:

• The growth agenda is of paramount importancein the current context. The Polish EU presidencyshould be commended for having selected it asa priority and the detailed proposals in Polishpresidency (2011) should be considered seri-ously;

• The EU2020 agenda remains broadly appropri-ate, but its governance should be improved toachieve more rapid progress on structural reformin countries that are under threat of fallingbehind, making use of the new instrumentsembodied in the European Semester9; structuralreforms in general, and reforms of product andlabour markets in particular, are of paramountimportance especially in countries with weakscores and overvalued real exchange rates;

• Tax-based internal devaluations, temporarywage-price subsidies or tax breaks could helprestore competitiveness;

• The EU should urgently speed up the realloca-tion of Structural and Cohesion Funds in coun-tries under programme to support growth andcompetitiveness, for which a general politicalwill may be there, but action is lacking. Speciallegislation is needed to turn principles intoswift action;

• The proposals for issuing ‘European projectbonds’ by the Commission or increasing thecapacity of the EIB, to fund investmentthroughout Europe, should be considered andimplemented;

• The growth agenda needs to be put in context.It is of little use to set objectives for themedium term if governments depart from themunder the pressure of events. The compositionof fiscal adjustments is a case in point in thisrespect;

• The policy toolkit should be broadened toinclude policies that help direct resources tothe traded goods sectors in a situation whenprices give inadequate signals to economicagents. This implies a more hands-on approach,including industrial policies, than under the tra-ditional agenda.

Europe is so integrated that domestic measuresmay not be sufficient to restore growth in partic-ular countries when the rest of the EU is sinking,even when supported by EU-level initiatives. Theeuro area’s lingering sovereign debt and bankingcrisis is the most important factor in driving con-fidence down, even in those countries where fiscalsustainability has not been questioned. There is anegative feedback loop between the crisis andgrowth, and without effective solutions to dealwith the crisis, growth is unlikely to resume.

9. See an assesment of thefirst European Semester in

Marzinotto, Wolff andHallerberg (2011).

‘The most remarkable success of the EU, its ability to foster convergence, is under threat. The

growth challenge is heightened by the deteriorating performance of southern Europe and the

very limited, or even disappointing, adjustment these countries have been able to achieve.’

15


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APPENDIX: COUNTRY GROUPS

Pre-crisis developments, current difficulties andprospects vary widely across EU countries. To sim-plify matters, we define five major groups, whichwe name according to the cardinal points, and dis-cuss the diverse challenges along these fivegroups:

• West: Austria, Belgium, France, Germany,Netherlands;

• South: Greece, Italy, Portugal, Spain;• North: Denmark, Finland, Sweden, Ireland, UK;• Central: Czech Republic, Hungary, Poland, Slo-

vakia, Slovenia;• East: Estonia, Latvia, Lithuania, Bulgaria,

Romania.

We leave aside the three least populous EU coun-tries, Luxembourg, Cyprus, Malta, because theyhave some unique futures and do not fit well to ourgroups. To control for relative sizes, we use medi-ans for each country group.

Certainly, our groups are heterogeneous. Forexample, Ireland faces different challenges toSweden, and more generally the Scandinavian andAnglo-Saxon economic and social models are dif-ferent. Yet the North group countries share simi-larities, such as good governance indicators andlow structural reform gaps (see Table 4). Thesecountries were also impacted harder by the initialphase of the crisis than countries in our Westgroup, before bouncing back faster (Figure 10).

The countries that joined the EU in 2004-07 are

also heterogeneous. But by analysing in the detailtheir growth model in Becker et al (2010) wecame to the conclusion that the five central Euro-pean countries had developments remarkably dif-ferent from the three Baltic countries, Bulgaria andRomania and their challenges also differ.

For comparison, in some figures we also showdata for the US and China, and for a group of 14countries from Asia and Latin America (not includ-ing China and India):

Asia and Latin America 14: six countries from Asia(Indonesia, Korea, Malaysia, Philippines, Taiwanand Thailand) and eight from Latin America(Argentina, Brazil, Chile, Columbia, Ecuador,Mexico, Peru and Uruguay).

-10% -8% -6% -4% -2% 0%-10%

-5%

0%

5%

10%

15%

20%

Growth from 2007 to 2009

Gro

wth

fro

m 2

00

9 t

o 2

01

3

North SE

FI

IEIT

DKUK

DE

LU

ATBE

NLFR

ES

PT

GR

West

South

Figure 10: GDP growth from 2007 to 2009 andfrom 2009 to 2013 in EU15 countries

Source: Bruegel using data from the IMF (2011d).

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