IMF/Shafik: Europe's choice - Risk stagnation or pursue integration

11 October 2013

Europe should make a decisive push to revitalise its economy and complete the reforms needed to achieve a fully integrated EMU, writes Shafik on the IMF blog.

• 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 centralised 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 labour 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 per cent and 1 per cent respectively within five years. Think of the difference that could make to the lives of millions of people in Europe and beyond.

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