Bellwether Europe 2013 Speech

Mr. David Lipton
First Deputy Managing Director, International Monetary Fund
London, April 25, 2013

As prepared for delivery

I am very happy to be here today at Bellwether Europe 2013. This conference is examining the crucial issues facing the region at this point of a long, drawn out crisis. I am honored to present the views of the IMF in such distinguished company.

I have been asked to speak today to the topic of “Saving the Euro.” On reflection, that topic might have been more suitable a year ago, before the euro area governments and institutions took important steps that gave us some distance from that worst-case scenario.

In the present setting, I would like to speak about the next steps—the crucial reforms that Europe still needs to adopt if it is to place the crisis in the rearview mirror and finally return to growth and job creation. That process is by no means assured, but it is attainable. Our baseline scenario for the region—which I’ll return to in a moment—sees continued Euro area recession this year and a return to modest growth next year. But there is also a risk that Europe could fall into stagnation, which would have very serious implications for households, companies, banks, and other bedrock institutions. So, to decisively avoid that dangerous downside policy makers must act now to strengthen the prospects for growth.

But before turning to the essential next steps, let’s begin with a quick overview of the outlook for the global economy.

Most of you know that the IMF has been saying that the world is settling into a three-speed recovery, and needs to shift to a full speed recovery, by which we mean strong, sustained, and balanced growth. Today’s three speed growth has the emerging market and developing economies doing well with growth expected to exceed 5 percent this year and near 6 percent in 2014.

Advanced economies are growing at a much slower pace. But there is an increasing split between the U.S. and the euro area. The U.S. economy is gaining momentum with signs of a revival in private sector demand that seems to be outweighing the impact of the sudden fiscal consolidation imposed earlier this year. The housing market is gathering steam, consumers are spending again, and business confidence is picking up. With less fiscal drag next year, growth could exceed 3 percent.

As I said, we see the euro area only returning to modest growth of about 1 percent next year. For now, there is a deep ongoing recession in some periphery countries and weakness in the core. Investment is declining, and unemployment continues to rise. Financial markets remain fragmented, undermining the transmission of monetary policy. This contributes to divergence in private interest rates, and reduces access to credit, particularly for smaller enterprises. Reform fatigue is setting in.

It is against this backdrop that the risk of a stagnation scenario is most worrying. If recovery does not materialize, the euro area could find itself facing the specter of policy quicksand—in which relentless balance sheet deterioration drags the economy in deeper and blunts the impact of even bold policy adjustment. We saw that scenario play out in Japan over the past 20 years. It has only been in recent months that the new government and BOJ leadership have started to take more vigorous action to escape deflation decisively.

And the reality is that Europe still faces severe vulnerabilities that—if unaddressed—could degenerate into a stagnation scenario. Consider these issues:

In our preoccupation with sovereign debt, we tend to overlook the huge overhang of private debt in some countries that could be a deadweight on demand and bank balance sheets for a long time.

We’ve already seen the hit that households have taken in the periphery economies because of the sharp correction in home prices (e.g. Ireland). This could only worsen without renewed growth (e.g. Spain, Belgium and the Netherlands).

On the corporate side, we know how much the level of debt has increased over the past decade, particularly in the periphery. We elaborated on this development in our recent Global Financial Stability Report. During the crisis, gross corporate debt to GDP—for large, publicly listed companies—has reached around 180 percent in Spain and 160 percent in Portugal. A significant portion of that debt is owed to banks in core countries. Measured on a debt-to-equity basis, a portion of Italy’s corporate sector is rising into stressed levels. In the event of a prolonged stagnation, corporate profits would slacken further, putting pressure on companies to deleverage and increasing the risk of debt distress.

Corporates are not being helped by bank retrenchment back into home markets. This is most pronounced from the periphery; French and German banks reduced their exposures to these markets by some 30-40 percent between mid-2011 and the third quarter of last year.

Even more pernicious is the persistent, and growing, divergence in funding costs between core and periphery banks. This is undermining borrowing and lending, and reinforcing the pressures to deleverage.

None of this bodes well for banks in a stagnation scenario. They are already weak. But higher levels of corporate and household defaults and credit losses would threaten a second round of bank balance sheet deterioration.

And that’s why Europe, which in principle has agreed to a formidable reform agenda, has to avoid taking two steps forward and one step back, and get the policy job done decisively. The euro area still lacks a single resolution authority to join the nascent supervisory authority. A legal and institutional framework for orderly corporate workouts is lacking.

This is a bleak picture, but it is not preordained. The fact is that there is much that can be done now to ensure that stagnation is not in Europe’s future. Unfortunately, there is no single silver bullet, no one action that will fix all the problems and restore growth. Rather, Europe needs to act on several fronts, in essence wherever action can make a contribution to recovery. It may be frustrating and politically difficult to muster support for actions that are not in and of themselves decisive. But there is little or no alternative to everyone doing their part. Let me talk about everyone doing their part.

First, country responsibilities.

There has been a lot of focus on fiscal policy. This is not a simple choice between austerity and growth. Many countries in Europe will need sustained adjustment to ensure the sustainability of public finances. We have argued for clear and specific commitments to medium-term fiscal consolidation and a case-by-case assessment of what is an appropriate pace of consolidation. But we also need to talk about how to make fiscal policy more growth-friendly, in essence about the composition of spending and revenues for any given deficit. As we see it, countries that can afford to support the economy need to do so—but in ways that encourage the private sector to invest and boost demand.

Another country responsibility is better structural policies. Countries should press on to tackle long-standing rigidities in order to raise medium-term growth prospects. Southern Europe, and even some of the core, needs to increase its competitiveness in the tradeable goods sector, especially through labor and product market reforms. So far, much of the reduction in current account deficits has come because demand is sluggish. For a stronger, sustained improvement — enough to boost exports that will create jobs for the unemployed — countries need a broader and more durable improvement in competitiveness, based on structural reform. In Northern Europe, even where national competitiveness is not the issue, reforms could help generate a more vibrant services sector.

Second, European responsibilities.

The ECB has pursued a very accommodative conventional stance, which should certainly be maintained. There is still a bit of room for further easing, especially given subdued inflationary pressures.

But traditional monetary policy has proven not to be enough. Europe’s monetary union has become fragmented, with households and companies in some countries face lending rates elevated well above those in the core, clogged credit channels, and where neither seem to be very responsive to traditional ECB policy action. And the ECB has taken extraordinary action to protect monetary union with the LTRO and conditional OMT. Unfortunately, fragmentation continues and remains debilitating. No one has a quick and simple recipe for eliminating fragmentation, but it will probably require additional unconventional measures from the ECB and action on banking union.

Europe has decided to go ahead with banking union, and implementing the agreed Single Supervisory Mechanism will be a key step. To understand what is at stake, one need only look to the national supervision in Cyprus and elsewhere that permitted banks to grow to several times GDP and to acquire huge portfolio concentration risks. Or, one can look to the regulatory ring-fencing we see at present, where national authorities prevent pan-European banks from shifting liquidity from one country to another. That ring-fencing, done in the interest of national macro-prudential concern, can run contrary to euro-zone macro-prudential concern, as it raises costs for banks where liquidity is needed and intensifies banking system fragmentation. The Single Supervisory Mechanism should allow institutional, national, and Eurozone interests to be taken into account.

A full Banking Union has other key elements, and resolution mechanisms is one. The case of Cyprus highlighted the need for clarity ex ante on how bank failures will be handled. In the midst of crisis, governments chose to bail out banks, because of the potential contagion and risks to stability of resolution. For Europe to return to normal, there will need to be a reversion to the claimants on banks taking institutional responsibility for a potential failure, to avoid moral hazard in bank behavior and asset pricing, as well as the eventual tax payer burdens. To get from here to there, a single resolution authority should be established and the practices to be followed should be elaborated. That will ensure that when banks do need to be wound up, it will be clear who will do it, how it will be done, and who will pay.

And let me take a moment here, as this last point — who will pay– is at the heart of many difficult discussions ongoing on this subject. A primary reliance on taxpayers or funds based on bank contributions is leading some countries to fear they will likely pay for problems in other countries. But a market-based bail-in approach, as is being considered in the EU Directive on Bank Recovery and Resolution, would require banks to hold a minimum amount of securities with features that permit them to be written-off or converted to equity if capital buffers fall too low. This approach, which we support, places the primary burden on each institution and its creditors rather than its country, and could defuse some of the political tension on this subject, while at the same time starting to redress concerns about moral hazard.

Beyond resolution, a common safety net is another essential element. It is needed to weaken bank-sovereign links by reassuring depositors. This would involve common deposit insurance and common backstop.

The other union Europe needs to contemplate is fiscal union. That will surely take time, and further discussion by members to choose the precise end point. But investors are making decisions today based on their perceptions of what Europe will be tomorrow. With some of the inherent shortcomings of Europe’s architecture exposed by this crisis, what is needed is to clarify that change is coming. So, more steps toward fiscal union—including a greater capacity for risk sharing to avoid intense pockets of crisis—are also essential in order to further strengthen the foundations for the monetary union.

Third, the rest of the world has a role to play.

The call for global rebalancing is not getting the traction it deserves. As deficit countries control budget deficits and domestic demand to adjust, as they should, the global economy will end up with sluggishness unless surplus countries boost domestic demand. In the last year, imbalances have reduced, but some of that reflects sluggishness of demand rather than rebalancing. Rebalancing is not in and of itself the answer to Europe’s problems, but when all the margins for action are narrow, every margin counts.

Conclusion

I recognize that this is a broad and difficult agenda. The steps taken so far by the euro area have demonstrated the huge political obstacles that must be overcome, and the political willingness to overcome them. Those steps have been important, and the worst economic risks have receded.

But the growth challenge remains and the downside is daunting. The risk of stagnation is not remote in the face of weak growth, fragmented markets, impaired balance sheets, and half-completed reforms.

All of that said, I remain optimistic. Much of what Europe has achieved over the decades seemed improbable at the outset. Europe has risen to the challenge on difficult issues over and over again. Policy makers continue to demonstrate their commitment to the “project”, and the IMF remains confident that they will continue to meet their commitments. That requires urgent and sustained action now and in the future.