Reconfiguring Growth

• Author: Bergljot Barkbu and Jesmin Rahman
• Position: and are Senior Economts in the IMF's European Department.

European policymakers have long known that the EU economy needs fundamental structural changes. Aware that Europe was lagging the United States, the European Union launched the Lisbon Strategy in 2000 to make the region “the most competitive and dynamic knowledge-based economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion” by 2010.

Well before the current crisis, Jean-Claude Trichet, then head of the European Central Bank, wrote, “There are four key priorities for reform in Europe, namely, getting people into work, increasing competition, unlocking business potential, and supporting an innovative environment” (OECD, 2005).

Indeed, according to our research, the long-term gains from product and labor market reforms are substantial and offer a much-needed opportunity to increase Europe’s growth potential. Moreover, a simultaneous EU-wide push for reform could lead to positive spillovers across countries.

The ongoing euro area crisis underlines the importance of reforms—but also increases the complexity of achieving them. Without an independent exchange rate, structural reforms must take the lead when it comes to delivering relative price adjustment for individual countries. But reforms often take time to bear fruit, and the need for growth is immediate. As a result, to generate growth and jobs now, longer-term structural changes must be combined with shorter-term measures to support demand. To anchor these efforts and restore confidence in the viability of the currency union, the euro area should move toward a more complete union.

European policymakers have taken unprecedented action in response to the crisis, both at the central and individual country level. The elements of a solution are there, but further implementation is needed.

What caused the problem?

Lack of growth in some parts of the euro area stems both from severe imbalances in trade and capital flows that built up after the adoption of the common currency and from weaknesses caused by lack of competitiveness, particularly on the labor front, reinforced by higher price increases and labor costs in southern countries since the beginning of the monetary union.

Problems with the labor market are well known. They include, for example, hiring and firing difficulties, high minimum wages, centralized wage bargaining, and restricted access to jobs and certain markets.

To lift growth, policymakers must tackle both imbalances and weak competitiveness.

During the past decade, euro area countries have gone in different directions in pursuit of growth. Exports drove growth in northern euro area countries like Germany and the Netherlands, while southern countries, such as Greece and Spain, relied on domestic demand. Not surprisingly, current account balances and relative prices, including nominal wages, have progressed differently in what are effectively two subregions—North and South. Demand in southern countries was financed largely by borrowing from the northern countries. The southern countries had big current account deficits, while the northern countries ran surpluses.

Once...