IMF Book

The chapter lays out the roadmap for policymakers. Beyond supportive demand policies and completing the euro area’s institutional infrastructure, supporting the European recovery requires addressing high private and public sector debt, removing structural obstacles in product and labor markets, and finding new sources of growth by tapping into increasingly important cross-border supply chains.

Private and public sector debt is high in the euro area, and private sector debt may be more detrimental to growth than public sector debt. Therefore, facilitating the household and corporate deleveraging process should be a priority, while fiscal consolidation should come gradually over the medium-term.

In the aftermath of the pre-crisis borrowing binge, firms needed to cut costs to restore profits and repair balance sheets. In countries with inflexible wage structures and/or dualistic labor markets, cost cutting was done by shedding labor while in countries with more flexible labor markets, wages adjusted instead. This helps explain why employment losses in some countries have been so high relative to output losses, and suggests that reducing labor market duality and enhancing wage flexibility will help protect jobs.

Sovereign debt is very high in many countries. The task of bringing it down is made difficult by a weak growth outlook, shifting the burden of adjustment to fiscal consolidation. History suggests that it can still be done, but requires a gradual approach (where possible), embedded in credible medium-term frameworks, and designed so as to protect growth.

The euro crisis has laid bare pre-existing structural weaknesses in euro area labor markets, including an inadequate or incomplete policy response to previous shocks that resulted in a high degree of labor market duality in many countries. Only comprehensive reform can tackle these structural weaknesses, reduce unemployment and mitigate the social cost of restructuring.

The labor markets in the Balkan economies are a case in point. Unemployment is high, and the rates of job creation are low. Key factors that have contributed to these problems include rigid labor market institutions, labor costs, and particularly the unfinished transition process. Structural reforms in all areas will be crucial to attract FDI flows and promote employment.

Recent progress in the euro area notwithstanding, there is significant scope for structural reforms in product and labor markets, with the specific priorities varying across countries. A model-based simulation exercise illustrates that ambitious structural measures can lift euro area real GDP substantially, although it takes time for full benefits to materialize.

Taking a closer look at the many levers of structural reform, this chapter assesses their cross-country impact and develops an illustrative framework to prioritize reforms, based on their impact on growth as well as on the possible implementation costs. The analysis highlights that different reform agendas will be appropriate for different countries.

Some of the large pre-crisis current account imbalances in Europe are unwinding, but often in a context of weak growth and employment. The analysis highlights the need for an appropriate mix of policies, both macroeconomic and structural, to facilitate a growth-friendly adjustment.

Supply chains play a strong role in explaining cross-country export performance in Europe. Competitive wages, trade-friendly reforms, and a similar industrial structure help downstream countries link with export hubs. These factors can assist euro area periphery countries link up with supply chains and sustain the recovery.