THE MECHANICS OF A STRONG EURO AREA IMF Policy Analysis Editors Petya Koeva Brooks and Mahmood Pradhan I N T E R N A T I O N A L M O N E T A R Y F U N D ©International Monetary Fund Not for Redistribution © 2015 International Monetary Fund Cover design: IMF Multimedia Services Division Cataloging-in-Publication Data Joint Bank-Fund Library The mechanics of a strong Euro area / editors: Petya Koeva Brooks and Mahmood Pradhan – Washington, D.C : International Monetary Fund, 2015 pages; cm Includes bibliographical references and index ISBN 978-1-49830-553-2 (paper) ISBN 978-1-51356-676-4 (ePub) ISBN 978-1-51357-943-6 (Mobipocket) ISBN 978-1-51357-224-6 (PDF) Euro Monetary policy – European Economic Community countries Currency question – European Economic Community countries Global Financial Crisis, 2008–2009 I Koeva, Petya II, Pradhan, Mahmood, 1957– III International Monetary Fund HG930.5.M43 2015 Disclaimer: The views expressed in this book are those of the authors and not necessarily represent the views of the International Monetary Fund, its Executive Board, or management Please send orders to: International Monetary Fund, Publication Services P.O Box 92780, Washington, DC 20090, U.S.A Tel.: (202) 623-7430 Fax: (202) 623-7201 E-mail: publications@imf.org Internet: www.elibrary.imf.org www.imfbookstore.org ©International Monetary Fund Not for Redistribution Contents Foreword v Acknowledgments vii Preface ix Contributors xiii Abbreviations and Acronyms xvii PART I THE LEGACIES OF THE CRISIS Investment in the Euro Area: Why Has It Been Weak?�������������������������������������������������������������������� Bergljot Barkbu, S Pelin Berkmen, Pavel Lukyantsau, Sergejs Saksonovs, and Hanni Schoelermann Indebtedness and Deleveraging in the Euro Area�������������������������������������������������������������������������25 Fabian Bornhorst and Marta Ruiz-Arranz Rebalancing: Where Do We Stand and Where to Go?������������������������������������������������������������������49 Thierry Tressel and Shengzu Wang PART II THE ROLE OF MONETARY POLICY AND THE FISCAL FRAMEWORK Fragmentation, the Monetary Transmission Mechanism, and Monetary Policy in the Euro Area������������������������������������������������������������������������������������������������75 Ali Al-Eyd and S Pelin Berkmen Possible Subordination Effects of Eurosystem Bond Purchases�����������������������������������������������95 Nico Valckx, Kenichi Ueda, and Manmohan Singh An Early Assessment of Quantitative Easing��������������������������������������������������������������������������������� 107 S Pelin Berkmen and Andreas (Andy) Jobst Fiscal Consolidation under the Stability and Growth Pact: Some Illustrative Simulations������������������������������������������������������������������������������������������������������������� 139 Derek Anderson, Marialuz Moreno Badia, Esther Perez Ruiz, Stephen Snudden, and Francis Vitek Fiscal Governance in the Euro Area: Progress and Challenges����������������������������������������������� 149 Luc Eyraud and Tao Wu PART III COMPLETING THE ECONOMIC AND MONETARY UNION (EMU) A Banking Union for the Euro Area��������������������������������������������������������������������������������������������������� 173 Rishi Goyal, Petya Koeva Brooks, Mahmood Pradhan, Thierry Tressel, Giovanni Dell’Ariccia, Ross Leckow, and Ceyla Pazarbasioglu 10 Toward a Fiscal Union for the Euro Area����������������������������������������������������������������������������������������� 195 IMF Staff Team Led By Céline Allard ©International Monetary Fund Not for Redistribution iii iv Contents PART IV THE ROLE OF STRUCTURAL POLICIES AT THE EURO AREA LEVEL 11 Capital Market Development: Financing of Small and Medium-Sized Enterprises in the Euro Area������������������������������������������������������������������������� 219 Ali Al-Eyd, Bergljot Barkbu, S Pelin Berkmen, John Bluedorn, Andreas (Andy) Jobst, and Alexander Tieman 12 Youth Unemployment in Europe: Okun’s Law and Beyond����������������������������������������������������� 239 Angana Banerji, Huidan Lin, Sergejs Saksonovs, and Rodolphe Blavy Index������������������������������������������������������������������������������������������������������������������������������������������������������������������������� 259 ©International Monetary Fund Not for Redistribution Foreword In line with its mandate, the International Monetary Fund has over the years been reviewing the design of and developments in the Economic and Monetary Union (EMU) in Europe With the introduction of the euro as the single currency in 11 European Union member states at the beginning of 1999, the IMF faced the new challenge of having to conduct surveillance for a systemically important monetary union It has addressed this situation by pursuing a dual-track approach: conducting a surveillance exercise of the euro area’s policies that provides an adequate context for national Article IV consultations with the now 19 members of the euro area Furthermore, with the introduction of the euro and the single monetary and exchange rate policy conducted by the European Central Bank (ECB), the bilateral relationship with the ECB has been reinforced, as reflected in the granting of IMF observer status to the ECB in 1998 The ECB, the European Commission, and other European institutions and bodies responsible for policies falling within the purview of the IMF participate in regular consultations with Fund staff as part of the IMF’s surveillance for the annual report on euro area policies As such, the IMF is an important counterpart on macroeconomic, macro-financial, and macro-critical structural policy issues that are crucial to the functioning of the euro area as a whole and of its member states The Fund has also given increased attention to further improvements to the institutional framework governing the euro area Following the global financial crisis in 2008, IMF surveillance of the euro area has been especially useful in the challenging environment facing the euro area The subsequent euro area sovereign debt crisis added to the challenges the EMU had to cope with In this more recent period, the Fund has significantly intensified its surveillance, including of the euro area and its constituent countries It has responded to the shortcomings exposed by the crisis with new initiatives and a strengthening of practices in key areas, for example, with better analysis of spillovers, macrofinancial linkages, and risk assessment In addressing the imperfections of the euro area governance framework as designed at the outset of the EMU, a shift from national toward more coordinated or centralized policymaking has been taking place The Fund has actively made suggestions about how to reinforce the institutional architecture of the EMU, advocating in particular more financial and fiscal integration This book presents a vivid example of Fund staff contributions of pertinent advice to euro area policymakers based on sound analytical underpinnings reflecting broad cross-country experiences Looking to the future, IMF surveillance of the euro area will inevitably adjust in light of strengthened EMU architecture The main elements of a banking union have already been put in place, most notably the Single Supervisory Mechanism and the Single Resolution Mechanism The recent Five Presidents’ Report on Completing Europe’s Economic and Monetary Union sets out various ideas for a further deepening of the EMU Based on the experience of the past few years, as illustrated in this book, I have no doubt that the assessments and advice provided by Fund staff will continue to be highly appreciated by euro area policymakers as they strive toward a more complete EMU Peter Praet Member of the Executive Board European Central Bank ©International Monetary Fund Not for Redistribution v This page intentionally left blank ©International Monetary Fund Not for Redistribution Acknowledgments This book is the product of a long period of collaboration among many departments at the IMF In addition to numerous colleagues in the European Department, including our Director Poul Thomsen and his predecessor Reza Moghadam, we are extremely grateful to our colleagues in the Fiscal Affairs Department; the Legal Department; the Monetary and Capital Markets Department; the Research Department; and the Strategy, Policy, and Review Department All these departments have played an active role not only in reviewing the chapters in this volume, but also as energetic participants in the policy discussions at the Fund that have ultimately shaped the agenda for the annual Article IV consultations with the euro area institutions Many of our colleagues worked very closely with us and are authors of some of the chapters in this volume We are also extremely grateful to numerous officials—certainly way too many to mention individually here—in Europe During the past four years we have benefited from extensive discussions on all of the topics covered here with officials at the European Commission, the European Central Bank, the European Stability Mechanism, the European Investment Bank, and the European Banking Authority They have all been exceptionally generous with their time and, without assigning any responsibility, their detailed comments have undoubtedly improved all of the chapters herein ©International Monetary Fund Not for Redistribution vii This page intentionally left blank ©International Monetary Fund Not for Redistribution Preface The euro area has experienced an unprecedented economic downturn and exceptional financial market turmoil in the past few years Policymakers have faced the twin challenge of addressing cyclical economic weakness—not unlike other industrial countries following the global economic crisis—and the underlying weaknesses in the architecture of the currency union, weaknesses that appear to have been masked during the first relatively calm years of the Economic and Monetary Union (EMU) Among member states, many structural weaknesses were exposed when economic performance declined significantly and financial markets became more discerning It would be an understatement to say euro area policymakers have been busy addressing these challenges Demand support in response to the pervasive weakness throughout the region has necessarily relied heavily on monetary accommodation given the constraints of the Stability and Growth Pact (SGP), including the need to balance growth and debt stability objectives in some countries At the same time, the euro area has embarked on fundamental changes in its financial and economic architecture, such as the Banking Union, a much stronger and clearer bail-in mechanism for resolution of banks, and more centralized supervision of banks at the European Central Bank (ECB) under the Single Supervisory Mechanism Much has been done, yet important concerns linger Unemployment, especially among the young, is still stubbornly and unacceptably high, posing the risk of a lost generation Debt levels—both public and private—remain elevated Capital markets have become more f ragmented as cross-border flows have declined and banks have become more national The impact of these reversals of trends toward more integration has been felt particularly in the small and mediumsized enterprise (SME) sector, where borrowing rates remain too high in some countries and credit flows too weak Very low inflation is a worrying sign of the anemic recovery It signals still- substantial slack in the euro area, and complicates the task of reducing debt and unemployment And persistently low investment and high unemployment threaten the long-term productive capacity of the euro area economy A strong and sustained recovery is needed to repair the damage from the crisis Because many factors are weighing on growth, no single action can address its revitalization Instead, reviving growth requires complementary policy actions to (1) support demand (by undertaking monetary policy measures and pacing fiscal adjustment while preserving the integrity of the SGP), (2) make more progress on EMU architecture (by repairing bank balance sheets and advancing and consolidating the banking union agenda), and (3) boost trend growth and foster rebalancing (by implementing structural policies) This book focuses on the analytical underpinnings of real-time policy advice given to euro area policymakers during four cycles of the IMF’s annual Article IV consultations (2012-15) with euro area authorities The papers in this collection are part of the background analysis for the IMF’s policy perspectives on the euro area They are presented here in their original form (many of these were published as “Selected Issues Papers” supporting the “Staff Reports” of the Article IV consultations during 2012 to 2015, while some were published as “Staff Discussion Notes”) The book does not cover some important policy developments since July 2014 In particular, it does not assess the Bank Recovery and Resolution Directive, and some of the recent changes in the Stability and Growth Pact ©International Monetary Fund Not for Redistribution ix