Difficult Policy Choices Await Europe As Recovery Gets Under Way

Growth projected at 2 1/4 percent for Europe in 2010

Well designed fiscal consolidation, strengthening banks key in short run

Addressing governance issues, structural challenges will help build confidence

While the recovery remains sluggish and uneven, it represents a turnaround for Europe, which was gripped by fears over sovereign solvency in May 2010 that threatened monetary union.

Emerging Europe is climbing out of its deepest post-transition recession and is projected to grow faster than advanced Europe, the report says.

Defying testing times

Six months ago, concerns about economic prospects in Europe ran high as strains in Greek sovereign bond markets started to spread to other countries and sectors. Amid tumbling equity markets and a sharply depreciating euro, doomsayers predicted a breakup of the euro area and a relapse of the global economy into recession.

The recovery has withstood the turmoil in financial markets thanks in large measure to a forceful policy response, including the establishment of the European Stabilization Mechanism to backstop EU governments with financing problems, the report points out. Europe’s economy is projected to expand by 2¼ percent this year and next (see table). However, the recovery is bound to remain modest and dependent on the pull of the global economy.

Policymakers face difficult choices as they tackle vulnerabilities while nursing a fledgling economic recovery. Fiscal policy needs to strike a delicate balance between supporting demand through deficits on the one hand, and addressing unsustainable debt dynamics and eroding market acceptance on the other.

Financial sector reform faces the dual task of reviving credit growth and strengthening a still vulnerable system (see chart). Implementing structural reforms to facilitate the necessary adjustment in the real economy will require strong political will during a time of high unemployment and uncertain economic prospects. A strengthened governance framework would help build much needed confidence.

Moderate recovery in advanced Europe

Advanced Europe emerged from recession in the second half of 2009 and is projected to grow at 1.7 and 1.6 percent this year and next. According to the report, these moderate growth rates reflect not only well known structural rigidities that limit potential growth, but also the temporary nature of the factors that were driving the recovery early on. Going forward, restocking, decisions to move ahead with...