ENSURING AN EUROPEAN RECOVERY

Prakash Loungani
Advisor, Research Department, IMF Co-Chair, Jobs & Growth Working Group, IMF October 12, 2013

VIEWS EXPRESSED ARE THOSE OF THE PRESENTER AND SHOULD NOT BE ASCRIBED TO THE IMF .
I thank Ezgi Ozturk for excellent research assistance.

Outline
1. Recovery is here (fingers crossed) 2. Why did it take so long?
Comparison with Asian crisis countries Comparison with previous global recoveries

3. How to keep it going

1. Recovery is here (fingers crossed)

The annual projections

WEO Real GDP Growth Projections
(percent change from a year earlier)

World 2013 (Oct. 2013) 2013 (Jul. 2013) 2014 (Oct. 2013) 2014 (Jul. 2013)

U.S.

Euro Area

Japan

Brazil

Russia

India

China

2.9

1.6

-0.4

2.0

2.5

1.5

3.8

7.6

3.1

1.7

-0.6

2.0

2.5

2.5

5.6

7.8

3.6

2.6

1.0

1.2

2.5

3.0

5.1

7.3

3.8

2.7

0.9

1.2

3.2

3.3

6.3

7.7
4

Source: IMF, World Economic Outlook.

A closer look

Euro Area and Selected European Countries: GDP Growth (Percent) 2009 Euro area Germany France Italy Spain -4.4 -5.1 -3.1 -5.5 -3.8 2010 2.0 3.9 1.7 1.7 -0.2 2011 1.5 3.4 2.0 0.4 0.1 2012 -0.6 0.9 0.0 -2.4 -1.6 2013 -0.4 0.5 0.2 -1.8 -1.3 2014 1.0 1.4 1.0 0.7 0.2 2015 1.4 1.4 1.5 1.1 0.5

Source: IMF, World Economic Outlook database.

A dire unemployment situation

A lost generation?

Correlation between Change in Unemployment and Change in GDP

(2012, in percent)
7 Change in Unemployment Rate

6
5 4 3

Euro Area

2
1 0 -1 -2 -3 -8 -6 -4 -2 Real GDP Growth 0 2 4

2. Why did it take so long?

Europe had worse initial fiscal position than Asian crisis countries
4.0 KOR 2.0 THD IDN 0.0 0 20 40 60 80 100 120 140

Fiscal balance (as % of GDP)

-2.0

-4.0

-6.0 POR -8.0

-10.0 GRC -12.0 IRE -14.0

General government debt (% of GDP)

Data for Asian and European countries is for respectively 1996 and 2009.

Asia adjusted more via exchange rates, Europe via domestic adjustment
5 POR GRC -5 IRE

THD

-15

REER adjustment

-25

KOR

-35

-45

IDN -55 -6 -4 -2 0 2 4 6 8 10

Fiscal adjustment (% of GDP)

REER adjustment measured over 1997-98 for Asian countries and 2010-12 for European countries. Fiscal adjustment measured as change in fiscal balance between 1996-2000 for Asian countries and 2009-2012 for European countries.

EUR access higher in % quota but not in % of financing needs

50.0
IDN

45.0
IMF financing as % of gross financing needs

KOR

40.0
35.0 30.0

25.0
20.0 15.0
GRC2 POR

10.0
5.0

THD

GRC1 IRE

0.0 0 500 1000 1500 2000 2500 3000 3500 IMF financing as % of Quota

Financing needs comprise current account balance and short-term debt (at remaining maturity). For Korea, shortterm debt is on a maturity basis. The first Greek program (GRC1) was not fully disbursed.

Asia rebounded faster

110
Eurozone program countries 105 Real GDP level, crisis start = 100 Asian program countries

100

95

90

85 t-1 t t+1 t+2 t+3 t+4

Simple group averages of real GDP levels

A Recovery on Track? World Real GDP per capita

Figure 1. Real GDP Per Capita (index, PPP weighted)

130
World

120

Global Recession Year Average of previous recoveries

110

Recovery from the Great Recession

100

90

80 -4 -3 -2 -1 0 1 2 3 4

Notes: Dashed lines denote WEO forecasts. Indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line show the PPP-weighted average of the countries in the sample.

The Divergence in Recovery between Advanced Countries and Emerging Markets

Figure 2. Real GDP per Capita: Advanced Countries and Emerging Markets (index, PPP weighted) Advanced Countries Emerging Markets

130
120 110 100 90 80 -4 -3 -2 -1 0 1 2 3 4
Global Recession Year Average of previous recoveries

130 120 110 100 90 80 -4 -3 -2 -1 0 1 2 3 4

Recovery from the Great Recession

Notes: Dashed lines denote WEO forecasts. Indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line show the PPP-weighted average of the countries in the respective group.

Divergence in Government Spending between this Global Recovery and Past Global Recoveries
Figure 3. Real Primary Expenditure (index, PPP weighted)

Advanced Countries
150 150

Emerging Markets

120

120

90

90

60 -4 -3 -2 -1 0 1 2 3 4

60 -4 -3 -2 -1 0 1 2 3 4

Average of previous recoveries

Recovery from the Great Recession

Notes: Dashed lines denote WEO forecasts. Indexed to 100 in the year before global recession. Zero is the time of the global recession year. Each line show the PPP-weighted average of the countries in the respective group.

Divergence in Government Spending between this Global Recovery and Past Global Recoveries: US and Euro Area

Deleveraging

3. How to keep it going

The (overloaded) policy agenda

Banking union
Macro policies
Fiscal Monetary

Labor market & structural policies ** External conditions

US monetary policy actions Emerging market growth

Banking union
Ongoing reforms should be expedited, including a final agreement on the Bank Recovery and Resolution and Deposit Guarantee Scheme (DGS) Directives by the European Parliament.
European partners should agree on a strong resolution mechanism based on a centralized authority, supported by a common fiscal backstop, with powers to trigger resolution and make decisions on burden-sharing to ensure timely and least-cost resolution.

Fiscal policy
Fiscal consolidation inevitable in high-debt countries, but it also reduces short-term growth. Getting the pace and composition of consolidation right is therefore essential. The pace and composition of adjustment should be attuned to country circumstances. Pace: Where financing allows, adjustment should be conducted at a gradual pace that balances the need to reduce structural deficits against that of not undermining the recovery, and automatic stabilizers should be allowed to operate. Composition: The expenditure and revenue mix in adjustment plans should be calibrated to reduce negative short-term effects on economic activity, while enhancing long-term growth prospects and protecting the most vulnerable. Fiscal adjustment should be based on credible medium-term plans.

Monetary policy
Forward guidance that rates will remain low

But also dependent on US monetary policy actions

US conditions
Unemployment Rate
(percent)
10 50

Government Bond Yields and GDP Growth From Consensus Forecast

(percent
3.0

49
May 22, 2013 2.5

48

Unemployment rate (left scale) Employment as percent of population

47

2.0

46

GDP growth in 2013 1.5 GDP growth in 2014 10-year government bond yields

45

4 2006

44 07 08 09 10 11 12 13 Jan. 2013 Mar. 13 May 13 Jul. 13

1.0 Sep. 13
25

Sources: Bloomberg, L.P., Consensus Forecast; and IMF staff estimates.

Impact on Europe from US developments

Policy Rate Expectations 1/
0.6

Key Interest Rates 2/

(percent)
U.S. average 30year fixed rate mortgage 7 Germany 6 United States 5

(percent; months on x-axis; dashed lines are from the April 2013 WEO)

0.5 United States 0.4 Europe

4 0.3 3 0.2 2 0.1

0 t t+12 t+24 t+36 2007 08 09 10 11 12 Sep.

Source: Bloomberg, L.P. 13 1/ Expectations are based on the federal funds rate for the United States, the sterling overnight interbank average rate for the United Kingdom, and the euro interbank offered forward rate for Europe; updated September 24, 2013. 26 2/ Interest rates are 10-year government bond yields unless noted otherwise.

But inflation pressures are very low. Thus, our WEO assumes that monetary policy stays very accommodative in advanced economies.

Inflation and inflation expectations remain subdued

Euro area United States

Global aggregates: Headline Inflation

(year-over-year percent change; dashed lines are the six-to-ten-year inflation expectations)
6 5 4 3 2 1 0 -1 -2 2002 04 06 08 10 12 14: Q4 27

Sources: Consensus Forecast; and IMF staff estimates.

Getting macro right will help labor markets

There is sometimes the nave belief that unemployment must be due to a defect in the labor market, as if the hole in a flat tire must always be at the bottom, because that is where the tire is flat (Solow, 2000). "It takes a heap of Harberger triangles to fill an Okun's gap. (Tobin, 1977)

Framework
Large increase in unemployment in advanced economies during the crisis Cyclical or structural unemployment? How to achieve the relative price adjustment in periphery Euro countries? Can labor market reforms reduce the natural unemployment rate and raise potential growth?
Staff Discussion Note (Blanchard, Jaumotte, Loungani) looks at IMF advice in this light

Unemployment during the Great Recession

Initial increase cyclical rather than structural Greater uncertainty about relative proportions now, but remains largely cyclical in our view Beveridge curve quite stable; moreover shifts may not be sign of increase in natural rate (Diamond 2013) Other measures of mismatch back to normal Lack of deflation not a sign of small unemployment gap

Stability of Okuns Law (even during the Great Recession) suggests jobs will return if the growth returns.
Hence focus of IMF policy recommendations remains on getting growth back
3

Labor Market Flexibility: Moving Beyond Mantras

Recommendations: Labor Market Policies

Extension of unemployment benefits
Iceland, Greece But reduction in Portugal

Targeted interventions to help some groups

Youth; Low-skilled; Long-term unemployed (see chart that follows)

Move away from duality

Too late to stop layoff of temporary workers But reduction in employment protection on permanent contracts could help hiring as recovery takes hold

Recovery differs across groups

Youth (aged 15-24)

Low-skilled (aged 25-64)
115.0

Older workers (aged 55-64)

High-skilled (aged 25-64)

110.0

105.0

100.0

95.0

90.0

Ratio of each group's employ ment relativ e to ov erall employ ment,

OECD av erage,

2008 Q1-2011 Q4, index = 100 at the start of the

crisis

33

Competitiveness
In some Euro area countries, need reduction in relative wages Best way to achieve would be through national tripartite agreement
Experience of Latvia, Ireland, Greece

Without such an agreement

More flexibility in wage-setting Reduction in public sector wages Reduction in minimum wage Fiscal devaluations

Higher inflation in North relative to South

3

Medium-run Growth
Higher potential growth and lower natural rate of unemployment desirable
Product market reforms
essential for medium-run but can hurt in the short-run

Labor market reforms

move away from duality more flexible wage-setting Reduce tax distortions to raise participation, particularly for females Raising retirement age and adjusting benefits to raise participation of older workers