Distinguished Speaker Seminar: Ignazio Visco - Economic Outlook and the Policies in the Aftermath of the Crisis: the Euro Area Response

Ignazio Visco, Deputy Director General and member of the Governing Board of the Bank of Italy and former Chief Economist and Head of the Economics Department of the Organisation for Economic Cooperation and Development in Paris, delivered a lecture at ADBI's Distinguished Speaker Seminar Series on 1 March 2010 in Tokyo.

The 2008 crisis may be over as forecasts on world economic growth have now turned positive. But the crisis has put the frailties of the euro area in the spotlight which led many to question the sustainability of the euro area. In this timely lecture on the euro area, Mr. Visco shed light on the euro area's pressing challenges, focusing his views on four points: (1) recovery and monetary policy; (2) fiscal outlook; (3) imbalances and domestic demand; and (4) re-absorbing unemployment and fostering growth that need to be addressed to bolster the region's recovery and to strengthen the monetary union.

Mr. Visco noted that economic indicators in the euro area have generally improved in the last 11 months, buoyed by optimistic firms and households, and by the gradual normalization of financial market conditions. But uncertainty persists in the short-term outlook as economic activity and commodity prices remain volatile; contributions of supporting policy measures and inventory cycle are temporary; and industrial production recovery is sluggish.

That the monetary conditions have been supportive in the wake of the global crisis while medium- to long-term inflation expectations remaining well anchored bespoke of the European Central Bank's (ECB) credibility and sound policies providing the euro area with ample liquidity. The ECB rates, euro overnight index average rate, and the 3-month market rates fell to 1%, 0.3%, and 0.7% respectively. Although inflation is expected to rise in 2010, it will likely fall below the 2% euro area ceiling. Spreads between unsecured and secured rates on three months interbank lending had improved markedly since the collapse of Lehman Brothers, down to around 0.3 in recent months. As securities held by the ECB come to maturity and as the market demand decreases, excess liquidity will gradually be siphoned off from the euro system.

In terms of the euro area's fiscal response to the crisis, Mr. Visco said that both the size and composition have been appropriate. The euro area had successfully contained the crisis and narrowed economic divergences among member states. Discretionary responses of roughly 1% of GDP were taken, although automatic stabilizers are playing a bigger role. However, according to the European Commission, between 2007 and 2011 in the euro area, the debt-GDP ratio will rise from 66% to 88%, a jump unprecedented in peace time. At projected growth rates, it is unlikely that this trend will be reversed soon.

As Mr. Visco has observed, the legacy of the crisis on public finances is a very relevant threat to financial stability, which may raise long-term interest rates owing to rising inflation expectations and sovereign risk premia. Demographic decline also increases the debt burden. Thus designing a credible and transparent exit strategy should be a top policy priority.

He proceeded to the third point on imbalances and domestic demand. The euro area does not have major external imbalances as deficits and surpluses of member countries balance each other out. However, internal imbalances may be a source of tensions and vulnerabilities. Current account imbalances across euro area states are large and widening; so are inflation rates and productivity growth differentials. As domestic demand continues to languish, perhaps except in France, much of the region's growth comes from German and other countries' exports, making the recent recovery susceptible to the fragile state of global trade and inextricably linked with the recovery of the rest of the world.

Like most countries and regions reeling from the crisis, the euro area is faced with the daunting task of re-absorbing unemployment and fostering productivity growth. Wide structural and policy differences in the euro area contributed to the varying degrees of unemployment among euro area countries. Spain's unemployment rate reached 19.4% in November 2009, while it remained largely unchanged in Germany at 8%. German, as well as Italian national policies and labor market institutional settings allow firms to partly adjust their labor input that would keep their workers employed; while in Spain, labor adjustment meant laid-off workers. Yet, low unemployment policy is viable only if output rapidly goes back to pre-crisis levels.

In this respect, Mr. Visco recognized the urgency of fundamental structural reforms to raise potential output in the euro area that would give room for monetary policy without raising inflation. These reforms include: (1) strengthening product market competition; (2) shifting resources to investment in research and development and education; (3) active labor market policies and welfare reforms; and (4) restructuring the financial sector to strengthen banks' resilience. Unless new structural measures are adopted that would shift demand from deficit to surplus countries, recovery in the euro area is likely to be short-lived.

Comments from the audience focused on the challenges of a monetary union without an accompanying political union. This limits the euro area's policies to deal with the crisis of its member economies. Given that deficit countries cannot adjust by way of flexible exchange rates, these countries must save more which may imply less growth, and may not be politically expedient.