Eurozone: More Reforms Needed to Strengthen Recovery

Support demand to combat low inflation and boost employment.

Mend balance sheets, complete banking union to restart credit.

Do structural reforms to spur productivity and redress external imbalances.

There is finally something to cheer about in the eurozone, the report’s authors said. The economy is gradually recovering, and financial markets are upbeat. Strong policy actions have helped engineer this turnaround.

But the recovery is turning out to be weaker than expected, the report said, and not all countries are growing. Output and investment are still well below pre-crisis levels. High unemployment, large debt burdens, higher real interest rates in stressed economies, weak banks and contracting credit pose obstacles to the resurgence of domestic demand. This leaves the region too dependent on foreign demand, and exposed to external risks, be it geopolitical fissures, or slowing growth in trading partners. The outlook for growth is modest.

Low inflation is pervasive, said the report’s authors, who noted that if inflation remains well below the price stability objective of the European Central Bank (ECB), debt burdens will grow more onerous, real interest rates will remain unnecessarily high, stifling demand, and central bank credibility could be eroded.

There are also supply-side roadblocks to growth, the report noted. Rigidities and gaps in capital, labor, and product markets continue to hamper productivity, job creation, and the shift of resources from the non-tradable to the tradable sector. Persistently high unemployment and low investment could reduce the economy’s capacity to grow in the foreseeable future.

Reform fatigue is setting in, the report observed. The outcome of the European elections may not bode well for further integration within the eurozone, jeopardizing reforms necessary to support the recovery.

To counter these risks, the report called for concerted policy efforts to strengthen the recovery and raise inflation.

Support demand until Europe is back on its feet

Public policy needs to prop up domestic demand until the threat of lowflation has subsided and banks are ready to lend again The ECB’s recent actions aim at just that. But the ECB may need to do more if inflation stays stubbornly low, the report said. It may need to expand its balance sheet substantially, as other major central banks have done, to provide a strong signal that it will use every available tool to fulfill its price stability mandate.

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