Speech

Europe: From Recovery to Resurgence?

November 14, 2017

Good afternoon. Thanks to UBS for inviting me to this event. I would like to set the stage for your discussions here today and tomorrow by offering a few IMF perspectives on issues that Europe is grappling with these days. 

Introduction 

Let me start with an overview of where the European economy stands in the effort to move beyond financial crisis, economic retrenchment, and political realignment and on to growth. Then, I’m going to look ahead to policies which can help Europe sustain growth momentum—and to build defenses that will be needed against the next shock. 

My basic point is something that the IMF has been saying:  today’s recovery offers an opportunity to fix the roof while the sun is shining. But the moment also has a deeper historical resonance.  In the wake of the financial crisis, we are at a turning point:  reforms and a renewed, pragmatic commitment to the next stage of cooperation could propel Europe’s economy to resurgent prosperity. 

That comment may have you asking, “Does this IMF guy realize he is speaking in London, in 2017?

A reasonable question.

I won’t attempt to explore the political ramifications of Brexit. Much has been said and the choices are coming into focus.  While it remains difficult to predict all the consequences, the prospect of Brexit surely concentrates our minds on the future of the financial system architecture.  And on the question of how to avoid fragmentation of banking and capital markets, which would prove costly.  With the untangling of the markets and institutions whose Euro-based lifeblood flows through London, it will be essential to address the where’s and how’s of the financial integration and oversight capacity that the EU-27 will require. 

I will come back to the subject of financial architecture. But not to get ahead of myself, let’s first take a look at the current economic situation.

Global and European Economic Developments

The global economy is in a good place. We have upgraded our forecast all year, most recently to 3.6 percent this year and 3.7 percent in 2018. While some fuel and commodity exporting countries are still in adjustment mode, all of the advanced economies, and most emerging markets are growing and 75 percent of the global economy is accelerating. With import-intensive investment higher across advanced economies, trade is once again expanding faster than GDP, spreading the benefits of economic recovery.

This is also true of Europe. We released a Regional Economic Outlook for Europe yesterday, which projects growth of 2.4 percent in 2017 and 2.1 percent next year.  European joblessness, including among the youth, remains stubbornly high. And in too many cases, wage growth in manufacturing continues to trail behind productivity growth.

That said, in Europe, we are seeing the most evenly distributed growth picture in more than 20 years.

Several European countries have demonstrated a commitment to needed reforms that will promote stronger growth. That said, those efforts need to be intensified across the region.

Let’s zoom in on the Eurozone, where headline inflation remains subdued; below the ECB’s objective to be close to 2 percent. We have consistently and firmly supported the ECB’s accommodative monetary policy—and that remains our view.

I know that some of you see this differently, because of your concerns about financial market excesses and the related asset price appreciation. We too see stability risks in a world where interest rates remain very low for a very long time, risks we detailed in our recent Global Financial Stability Report.   But in our view, the credibility of the ECB depends on achieving its stated objective, so it should remain focused on its mandate.  It is better to address financial stability risks focusing on improving micro- and macro-prudential supervision and regulation in banking and financial markets.  The time has come to make that policy arsenal real and effective, and to coordinate such policies across the European economy.  And needless to say, it is essential that private sector financial institutions police themselves to reduce their own vulnerabilities.

So, beyond monetary policy, how to ensure that this recovery remains sustained and stable?

You may have heard our argument before, but it bears repeating: all countries need more growth friendly fiscal policy, with more investment in areas such as infrastructure, education, and R&D to boost potential growth. Countries with fiscal space have more options, and those without it should work to rebuild buffers now—before monetary accommodation ends—to avoid sharper adjustments later.

Finally, all countries should take advantage of the environment of recovery to put in place the structural reforms that can increase potential growth. That means, among other reforms, transforming product and labor markets, and adjusting to demographic change and migration.

These measures—monetary, fiscal and structural—are the core of the project of “fixing the roof”.

European Financial Market Reforms

But it is time to go beyond that triad and beyond national policy issues to take on broader systemic issues:  financial market reforms that can both support higher levels of growth and diminish the risk of future crisis. That means creating a financial system that will allow Europe to make the most of the single market in goods and services.  Europe does not yet have the banking system and capital markets that optimize financial intermediation and maximize defenses against shocks.

First and foremost, some countries and many banks still need to tend to the lingering legacies of the crisis and in some cases recent recessions. There has been considerable progress: NPL ratios across Europe have declined from their post-crisis peaks, and we see the stock of NPLs falling below 900 billion euros this year. But there is still more work to be done.

Some of the largest banks that face market funding pressure have made considerable progress in this area, as well as in rationalizing costs and boosting their capital. But overall, adjustments across the region have been uneven.

This reflects an industry in which long established, national structures remain the norm—some with cooperative or state ownership; others with outmoded business models; many with weak profitability and thin capital bases. In an era of rapidly changing markets and technology that is permitting competition, including from nonbank institutions, there are too many small banks, too many branches, and too much cost.

Many banks show consistently low returns on assets and equity, which may continue with low rates and flat yield curves.  That makes it harder to raise capital and renders banks more vulnerable to a future shock. Meanwhile, regulators are rightly insisting on bigger capital buffers.

The ECB’s guidance and its latest provisioning proposal can help create the right incentives to further reduce NPLs. But there is a serious need for industry consolidation and rationalization, including weeding out non-viable banks and encouraging M&A.

Ideally, this consolidation would include much of the cross-border variety, but Europe’s banking markets have become if anything more confined to national borders over the past 10 years than previously. This is to no small degree the result of country-level regulatory and legislative measures that have maintained de facto barriers instead of encouraging pan-european banking and a single banking market.

All of which leads us inexorably to the imperative: it is time to complete banking union and further harmonize national regulations.

I know this advice seems to fly in the face of recent political winds.

But recent polling across the euro area shows that support for the Euro is at the highest level in more than a decade.  That seems a reasonable proxy for the support of integration, whatever the views of existing governance practices.  With French President Macron’s recent proposals for EU reform—including in the financial sector—France and Germany are talking about ways forward. The EU-27 seem to be beginning the process of digesting what Brexit could mean for them, which is reinforcing a sense of unity. We may be at a moment where the cogency of policy proposals matters to the course of future political action.

Of course, we have already seen progress on the banking front. The Single Supervisory Mechanism was a major step toward ensuring uniform standards across the euro zone. There also has been progress toward common resolution practices with the Single Resolution Board and the Bank Recovery and Resolution Directive.

But several pieces are missing—most importantly common deposit insurance and progress toward a stronger centralized financial safety net that can help mitigate the sovereign-bank linkage that the last crisis enflamed.

Progress on the EU action plan for capital market union is slower than desired. But Brexit likely will change that. As you know, about one-third of the EU’s market-based financing involves London-based banks, including U.S. institutions. Many of these banks already are moving significant chunks of their operations to the continent, which will likely catalyze the process.

But first, there is a need to harmonize national laws and regulations governing capital markets.

That effort will have to span disclosure, securitization norms, and listing requirements; equal treatment arrangements across the EU; and tax and corporate insolvency regimes. Needless to say, as the rules are rewritten, surveillance and enforcement will need to be upgraded—at the national level, and by the ECB and the European Securities and Markets Authority.

Fiscal Framework Reforms

But the financial architecture won’t be whole and healthy unless there is also progress toward more fiscal integration. Without the ability to add some measure of fiscal to the policy mix, Europe will remain locked into second-best policies. Banking union, for example, will be hindered without a fiscal backstop to support bank resolution and deposit insurance.

One can only conclude that the current fiscal arrangements leave the euro area unnecessarily exposed to risks.

The vulnerabilities include the constraints on economic adjustment under the common currency; a lack of fiscal discipline across many countries; and the speed and force with which shocks can travel through the euro area’s financial system.

It would be best to accompany exposure reduction with a degree of risk sharing to help avoid the sovereign-bank nexus that can threaten fiscal stability and the integrity of the single currency. But this also means more effective rules and institutions to reduce moral hazard. It calls for the ability to coordinate fiscal policy when shocks hit and monetary policy is constrained.

The conceptual answer of course is to move toward mutualization of risks and obligations, combined with risk reduction. Of course that is more easily said than done. While there may soon be small steps in that direction, we are in fact a long way from that goal today. A lack of fiscal discipline and the failure of commitments to reform has created a deficit of trust.

How to progress?  That requires some rethink.

Those who advocate mutualization and risk sharing need to acknowledge the logic of those who reject it.  Simply put, if some countries are systematically and predictably going to be givers, and others takers, mutualization means real transfers not risk sharing. For mutualization to be attractive, it must offer a fair deal to all:  you may help others today, but you may need help in the future.  In that setting mutual support makes the union stronger, it is positive sum.  Today, although reform progress is being made in many countries, there remains a disparity.  Some countries have put in place difficult reforms sufficient as a basis for advancing toward fiscal union, while others have not.

Unless there are sufficient improvements in policy making to reduce this disparity,   mutualization will not be a fair deal for all countries and is unlikely to come about.

At the same time, those who argue that each country must put its house in order, without holding out clear and reliable promise of future risk sharing, offer an unattractive future of inadequate institutions, fragmentation, and the risk of debilitating asymmetric shocks.

This predicament amounts to a prisoners dilemma game in which the best outcome — better policy making across Europe, along with mutualization of risks — is not attained.

How can such a game be made cooperative?

There are three components.

Deal with the legacies of the past crisis.  Whatever its causes, until the burdens are apportioned and the legacies are removed, the past will weigh on the future.

Continue programs for economic development to deal with differences in country starting positions and circumstances and to support mutually agreed goals for productivity and income convergence, keeping that process separate from mutualization of risks.

And, proceed to a discussion where mutualization and responsible country policymaking can be pursued in tandem and achieved in steps. 

Conclusion

So, is it just “pie in the sky” to talk about banking, capital market, and fiscal unions? Today it appears to be a distant horizon—but an important one for Europe to reach. Europe would need to face up to its commitments, overcome political constraints—admittedly serious challenges—and a willingness of countries to make difficult adjustments and press on with reforms.

Is there a role for the IMF in this process?  Our responsibilities include working with individual governments to provide the analysis and advice that can help lead to more effective macro-policies, but also supporting multilateral solutions, for the Euro Area, for Europe more broadly, and for the global community.  My words here today are offered up in that spirit.

Europe has made extraordinary progress addressing its economic ills and restoring growth.  Recovery will strengthen its role in the global economy. But there remain the many challenges I have mentioned.  When the sun is shining, what is easiest is not to act. But it is best to fix the roof. Thank you.