Director Jean Pisani-Ferry addresses the questions about Europe's structure, governance and competitiveness that arose from the financial crisis. Among them: Why was Europe hit so hard by the financial crisis? What does the crisis tell us about Europe's internal challenges? How lasting and severe will the fiscal and consequences be? What is the agenda for financial reform?
As the European economy slowly emerges from the Great Recession of 2008-2009, questions abound that will occupy the minds require the energy of policymakers for many more months or possibly years: why was Europe hit so hard by the financial shock? What does the crisis tell us about Europe's internal challenges? How lasting will its consequences be? How severe will its social consequences be? How serious will its fiscal consequences be - and how can they be contained? And finally, what is the agenda for financial reform? Let me take them one by one.
The crisis was not made in Europe, but so far at least, its consequences have been roughly as severe in Europe as in the US. This is a shocking fact that requires explanations. There are essentially three non-exclusive explanations. First, as the EU and the US financial sectors were deeply integrated, Europe's banking system got paralysed exactly at the same time as its US counterpart. True, it is not Europe but China that financed the US current account deficit and accumulated dollar balances. But this had to do with net savings flows. In gross terms, Europe's holdings of US securities at the beginning of 2007 dwarfed China's (and furthermore it consisted much more in private securities such as corporate bonds and structured financial products whose value was directly affected by the consequences of the sub-prime crisis. Second, Europe had several internal weaknesses that were revealed by the crisis. First, the UK, Spain and Ireland had experienced a real estate boom of major magnitude and they were directly hit by the reversal of housing demand and prices. Second, several countries in the Mediterranean and the Central and Eastern region were running unsustainable current account over 10% of GDP that were financed by intra-EU savings flows (especially from Germany and other Northern European countries); the crisis gave the signal that time had come to adjust. Third, some counties, especially Germany, were very exposed to world trade, and were hit severely by its collapse. Together, these three factors help explain why there was a severe European crisis.
The same factors help explain why the recovery is still weak and why it will take time for the EU to recover fully. Unlike the US, Europe is a very bank-based economy, meaning that most companies rely on bank loans rather than on corporate paper markets to finance their investments. As long as some banks that have suffered significant losses (either on the US market or on their domestic real estate loan portfolio) have not rebuilt their capital base, they remain reluctant to lend, thereby putting a brake on the speed and the strength of the recovery. In spite of governments having moved swiftly to address the banks' problems and prevent systemic failures, not all financial institutions have fully recognised the extent of the inevitable write-downs and some therefore remain under-capitalised. It is well known from the Japanese experience that 'zombie banks' are a real economic threat and this threat has not fully dissipated in Europe. In addition, Europe as a whole did not enter the crisis with a weak current account position and therefore that does not have to undergo a major macroeconomic adjustment (this is a significant difference with the US), several economies within it have to undergo such adjustments - away from consumption and deficit-financed booms, towards investment-led, domestically-financed and thereby sustainable growth, or away from finance
and real estate, towards new sectors whose nature is yet unknown. This is bound to weigh on their growth performance.
A weak recovery is having two consequences. First, unemployment is likely to increase significantly. Unlike the US, European companies did not respond to the crisis with major lay-offs. There were some exceptions (for example in Spain, where workers on temporary contracts were made redundant) but in general companies rater chose to keep their employees while putting them on reduced schedules or partial redundancy. Germany is the best example of such behaviour: thanks to a temporary reduced working time scheme subsidised by the government, there has been virtually no unemployment increase in spite of the country having suffered a 5% output decline in 2009. But absent a strong recovery, companies now need to start adjusting their payroll. This is especially the case in the traded goods sectors where European producers already struggle to remain competitive vis-à-vis US and Chinese producers in spite of the appreciation of the euro. The upshot is that the labour market will continue to deteriorate for some time. This is creating a politically untenable situation where workers see several banks returning to profit and giving out hefty bonuses while their own situation continues to deteriorate. Furthermore, weak or a delayed recovery means that laid-off workers and new entrants in the labour market will risk remaining idle for long, thereby losing their human capital if not exiting the labour force altogether. The second consequence of a weak recovery is that forgone investment will result in a lower capital stock when growth starts accelerating, thereby also making some of the temporary output loss permanent. Financial crises generally result in such permanent output losses and the fear in Europe is that it will be true this time too. So governments need to find out what kind of reforms they should conduct to minimise such permanent output losses but they also need to make contingent plans for the case they would turn out to be unavoidable. It is precisely the fear of such permanent output losses that is prompting discussion on the so-called 'exit strategies'. Together with central banks, governments responded to the crisis with speed and force and they can be commended for this. But they have started worrying about the longer-term fiscal cost of the situation. It is not only the stimulus that needs to be withdrawn. In fact, it is generally a minor part of the problem. More significant are the forgone revenues - as governments sectors are large a 1% GDP loss roughly implies a 0.5% of GDP revenue loss - and the interest burden resulting from newly accumulated public debt. By the time the public debt ratios have stabilised they will have increased by some 30% of GDP or more, which implies for the medium term some 1.5% additional interest burden . So the magnitude of the fiscal adjustment that will need to be carried out has no precedent in recent decades. Financial markets have started realising this and they are getting nervous, as shown by the downgrading of the Greek government bonds' ratings and the simultaneous rise of the interest rate spreads between Greece and Germany. Anxiety is part excessive. But it adds to preexisting concerns and pushes governments towards fiscal consolidation. It is now planned to start the budgetary adjustment in 2011 and to pursue it over several years (some smaller countries like Ireland or Hungary are starting in 2010 already). This is sensible, provided the recovery strengthens sufficiently in the meantime. If this is not the case by Summer 2010, when final budgets are presented to parliaments, European governments will be confronted to a delicate balancing act: either to proceed with the adjustment, at the risk of killing a feeble recovery; or to postpone it, at the risk of eliciting negative market reactions. Fears about the strength of the recovery and the priority justifiably given to budgetary adjustment over monetary normalisation means that interest rates are likely to remain very low for a long time. Even though the European Central Bank and the other central banks of the EU have started mopping up the huge amounts of liquidity they provided in Autumn 2008, they are bound to keep monetary policy supportive for at least the quarters to come. This entails the risk of creating conditions for financial instability through new asset price bubbles or carry trade among currency areas. To prevent them, the Europeans have decided to put in place a new framework for so-called 'macro-prudential supervision'. In a nutshell, the idea is to make a new body consisting mainly of central bankers responsible for spotting threats to financial stability and for issuing warnings to financial supervisors and possibly also governments. The system is complex because it involves both EU and national authorities, and it is untested. But at least this is an attempt to draw the consequences from the crisis and to depart from the previously dominant attitude that gave priority to preserving national prerogatives in the field of supervision in spite of the growing integration of markets and financial institutions across countries. Time will tell whether it is the start of the building up of a new pan-European regulatory and supervisory architecture. To sum up, Europe is entering the new decade with both comfort and anxiety. Comfort, because the policy system it created at the end of the 1990s has passed an exceptionally severe stress test; anxiety, because several severe challenges remain. It is to be hoped that the former will help confront the latter.
(*) Jean Pisani-Ferry is the Director of Bruegel, the Brussels-based economic think tank
This column was published in Chinese business magazine Century Weekly.