Speech

Opening Remarks by Michael Deppler, Director, European Department, International Monetary Fund, at a Press Briefing on Economic Outlook and Issues in Europe

April 14, 2007

Economic Outlook: Cyclically Solid, Structurally Tentative

1. Europe's upswing is showing momentum, raising bright prospects for 2007 and 2008.

• In advanced economies, continuing job creation, falling unemployment, and well-behaved inflation are providing the basis for stronger private consumption.
• In emerging (or more aptly named "converging") economies, business investment has been boosting production and export capacity, but private consumption and residential investment have been running ahead of income. Together, these demand pressures are sustaining current account deficits and putting some upward pressure on inflation.
• Overall, the region is and is expected to remain broadly in external balance. However, very large capital inflows are sustaining large current account deficits in some parts of Europe. These need to be managed prudently by the countries concerned to forestall shifts in risk appetite.

2. Europe may well surprise on the upside. Short-term indicators inspire confidence that the cyclical upswing may exceed expectations, helped by benign financial conditions, the strengthened credibility of macroeconomic policy frameworks and progress on structural reform.

3. Downside risks are mainly external and financial.

• A stronger-than-expected slowdown of the U.S. or a disorderly unwinding of global imbalances are possible, but the impact on Europe would likely be muted relative to the experience in 2001-02.
• The very large cross-border financial flows could push convergence past its speed limits. While in most of converging Europe these flows have been used productively, in some parts financial convergence plays may be running ahead of fundamentals, thus sowing the seeds for trouble should there be a generalized retrenchment from risky assets or a domestic policy slippage.

4. Potential growth remains in limbo in advanced economies, failing to make notable inroads in closing the transatlantic divide in per capita GDP. Encouragingly, recent labor and product market reforms have made progress in reducing structural unemployment, but labor utilization remains low on the continent and signs of a much needed revival in productivity growth are tentative at best.

Monetary and Fiscal Policies: Ensure Lasting Good Times

5. Monetary tightening in the short run will keep inflation well-behaved. While inflation remains generally well contained, with output gaps closing in advanced economies, central banks will likely need to continue to withdraw monetary accommodation. In most emerging countries where monetary policy is available, some further gradual tightening of monetary conditions seems warranted.

6. Fiscal outcomes need to fully reflect the favorable outlook.

• In advanced economies, fiscal policy should aim to extend the recent streak of better-than-planned budget outturns. This will prepare them for less buoyant times and allow them to meet their equity objectives across generations in dealing with the pressures from aging populations.
• In emerging economies, tighter fiscal policies can help ensure smoother convergence. In the fastest growing cases (e.g., the Baltics, the Slovak Republic and Romania) this tightening would mitigate some of the upward pressure on wages and the real exchange rate, assuring a more level ride. In emerging countries where budget deficits are still large (e.g., Hungary, Poland, the Czech Republic and the Slovak Republic), decisive fiscal restraint would crowd-in the private sector and help convergence.

Structural Reforms: Bring the Productivity Train on Track

8. To face globalization and strengthen its internal cohesion and dynamics, Europe needs to be proactive in carrying out its far-from-finished structural reform agenda.

• Reforms have paid off, contributing to a recent record of job creation that matches that of the U.S.
• Labor market reforms need to continue, and the budget rather than restrictive labor market regulations should be used to meet distributional objectives.
• These efforts now need to be complemented with a much greater push on productivity.
• The best way to achieve higher productivity and potential growth is through strengthened competition and contestability of markets. The main instruments are:
• Deregulation of product markets
• Completion of the EU single market, especially through a swift implementation of the Services Directive
• Financial integration

9. Converging economies need to deliver the higher growth potential that investors are anticipating. Success requires sustaining the pace of ongoing structural reforms. This will make the labor and product markets more flexible and facilitate the reallocation of resources that convergence entails. The experience of Portugal shows how convergence can stall when wages and the real exchange rate are allowed to rise in response to anticipated but ultimately wanting increases in productivity.

In sum:

These are good times, which are deserved because policies have been relatively good.
• However, good times have in the past also led to policy short-sightedness and mistakes-mistakes that have cost countries' plenty.
• Moreover, while performance is currently improving, the fact is that Europe's performance has lagged relative to the rest of the world over the past decade: in terms of per capita incomes and productivity for the advanced countries relative to the U.S.; and in terms of per capita income growth for the converging countries relative to other emerging markets, notably those in Asia.
• It is essential to the sustainability of the good times that countries maintain a medium-term focus in their policies and not let better times sidetrack them from addressing the enduring challenges they face-aging, rigidities, and inefficiencies.