What’s Holding Europe Back?

As part of OpenCanada’s coverage of the 7th annual Toronto Global Forum organized by the International Economic Forum of the Americas, we sat down with Pier Carlo Padoan, Chief Economist and Deputy Secretary-General at the OECD, to talk about Europe’s economic recovery from the 2008 financial crisis. Formerly a professor of economics at the University La Sapienza of Rome, Padoan also served as the Italian Executive Director at the International Monetary Fund from 2001-2005 with responsibility for Greece, Portugal, San Marino, Albania and Timor Leste. We talked to Padoan about what it will take to secure the economic and political future of the Eurozone.

I’d like to start off with the Eurozone’s growth trajectory. Is there reason to be positive?

The Eurozone is slowly getting out of the recession. Whether the growth we’re seeing now is sustainable remains the big question. So far, the improvements we’ve seen are mostly in the periphery, where the recovery has predominantly been export-led. The same can be said of Germany, although that country is of course in a much better state. What this means is that domestic demand is still weak.

And what is responsible for that?

Well, in the periphery countries there’s been a huge fiscal and structural adjustment that has compressed domestic household income. And of course, investment has yet to come back. Until we see investment resuming we cannot say that the Eurozone is really in better shape.

The lag in investment is related to the fact that in many periphery countries, growth was excessive before the crisis. It was excessive because it was fueled by large amounts of credit. So much of that investment proved unsustainable – the activity in the housing market in Spain, for example. Investment in Portugal and Italy was similarly unsustainable. The same goes for Ireland and the resultant banking bubble. When the recession hit Europe, all these weaknesses exploded. Now readjustments are taking place.

How is the policy climate in Europe impacting investment?

We know that policy uncertainty holds back investment. Even if companies have money to invest, when they don’t have a clear sense of the regulatory environment, the tax environment, the fiscal environment, they prefer to wait and see. When policy uncertainty is high, short-term liquidity becomes more attractive than long-term investment.

In Europe, the sources of uncertainty are several. Firstly, at the national level, companies do not know when domestic demand will resume because of the adjustment process. They do not know what the impacts of structural adjustment will be in the short term; often it leads to contraction, after which it produces stronger long-term growth.

Another level of uncertainty occurs at the Eurozone level. The Eurozone is still in the making – it was badly designed in the beginning because the emphasis was on fiscal adjustment and inflation convergence. No attention was paid to the need for a strong financial system. Now we know that we have to repair the financial system. And we know that this will be a long process involving ongoing asset quality review and stress tests to assess the balance sheets of the banks. But it will also involve moving ahead with creating a banking union, which is of course a highly political challenge. Many governments are now more interested in being careful with their own banks but not European banks. But if we are to have a European banking union, more countries will need to adopt a European perspective.  This of course clashes with the many different views among Eurozone members. This is going to be a hard test for Europe and we still do not know what the outcome will be.

If you were charged with restoring confidence in the future of the Eurozone, what steps would you take?

First of all, fiscal consolidation has made a lot of progress, the extent of which has been underestimated. We are about to see the debt levels of a number of countries in the Eurozone start to decline either next year or the year after. This is a very important change because the fact that countries will be entering an easier fiscal environment as they move forward should boost confidence.

But perhaps the most important step is addressing unemployment. Unemployment remains very high – it’s around 12% in the Eurozone. It’s not declining and it’s concentrated among young people. When unemployment is large there are several negative consequences: households don’t have money to spend, production does not grow, and confidence collapses. What can be done? Well, the European governments have been discussing possible measures that would directly address unemployment, especially youth unemployment. The issue is that many of these measures, which would provide support for training or lower taxes on labour, have fiscal implications and so governments find themselves crashing up against fiscal constraints.

I am of the view that the very tight fiscal rules which Europe currently has in place could be temporarily relaxed in order to make the necessary resources available to boost employment. This would be self-sustaining because if you generate more employment, you generate more wealth and then your fiscal situation is rebalanced automatically. You cannot have a recovery if your financial system is not viable. And you cannot translate that recovery into jobs if your labour market isn’t operating smoothly.

Is there a counterargument to loosening the rules?

The counterargument is that if fiscal relaxation were to be implemented today, countries would not use the space as intended. But there is a lot of debate in Europe about this. For example, there is the so-called contractual agreement hypothesis, which is basically that countries should be allowed to have more fiscal space if they commit to changing labour market rules to support increased employment.

Are you optimistic that Europe can address unemployment and strengthen the Eurozone?

I think unemployment and strengthening the Eurozone are big challenges. The latter is a big political challenge because anti-European sentiment is growing in many countries. The next European election risks returning a European parliament that will have a significant number of members who are anti-European and who will therefore vote against any measures that will strengthen Europe. So this is a turning point and I hope Europe’s political leaders realize that.

At the end of the day, the issue facing all European countries across all issues is whether or not to accept a common dimension to their policies. Basically they must decide whether they are prepared to adopt a federal approach. This acceptance is indispensable. For a federal state to be viable in a broad sense, acceptance must be chosen, as Canada knows very well.

Is the choice really that stark?

Putting the Euro in place introduced a huge federal element into all political and economic choices and so, ultimately, the choice is whether or not to keep the Euro. This is what we’re talking about – let’s not fool ourselves. Although it may be less dramatic than it was last year, at the end of the day, the issue remains on the table. But I continue to be moderately optimistic that Europe is going forward rather than backwards.

As you know, Canada has recently concluded a free trade agreement with the EU. Do you think exposing more protected sectors to foreign competition can help Europe recover?

I can think of more benefits from opening up than costs. Every time there is an opening up of markets, there are costs, of course. But given that the global economy as a whole needs to be thinking seriously about how to create sustainable growth, I very much welcome these “regional” trade agreements – even though a pure theory of trade would say you need more multilateral agreements to get the maximum benefit. But we know that the Doha Round is dead. So I am very confident that broad transatlantic and trans-pacific trade agreements would definitely help boost growth.

Also, because this agreement will push Europe to deal with deeper barriers – not just border barriers but barriers to things like services that drive productivity in an advanced economy – I think it’s a welcome step forward. Of course, the devil is in the details.

A trend toward broad regional trade agreements could impact the global economy in a big way. What do you think is the biggest shift now underway in the global economy?

I see two shifts. Firstly, the sense that collective action is important is stronger now. Emerging economies recently have proved to be weaker than expected, undermining the idea that there might be parts of the world that are immune from the global financial crisis. There is a new conscientiousness that there is a global dimension to the problems we’re facing. Secondly, there is a growing appreciation of the fact that economic growth per se is not sufficient to solve problems. We understand now that for a multidimensional environment, we need multidimensional policies.

So now the challenge is to adapt our policies to focus not only on quantitative growth, but also on quality and distribution of growth, because all these elements are correlated. We need to ask, what will policies designed solely to boost growth do to say, inequality? What about sustainability? Because it’s not just about growth anymore.