The economy is expanding supported by accommodative macroeconomic policies
Better risk sharing is needed for a resilient and sustainable monetary union
OECD Economic Surveys: Euro Area 2018
Abstract
The euro area is expanding…
The euro area economy is growing robustly. The euro area economy has expanded since 2014 (Figure A), helped by very accommodative monetary policy, mildly expansionary fiscal policy and a recovering global economy. GDP growth is projected to slow somewhat, but to remain strong by the standards of recent years.
Source: OECD (2018), OECD Economic Outlook: Statistics and Projections (database) and updates.
…but should fix its remaining fragilities
Ensuring the sustainability of the monetary union in the future requires further reforms. Improved economic conditions are also reflected in increasing citizens’ support for the common currency. However, further reforms in the architecture of the monetary union are needed to enhance its resilience to downturns and ensure its long-term sustainability. In particular progress with banking union including risk reduction and sharing should be made rapidly. A fiscal stabilisation tool for the euro area would help to absorb country-specific and common euro area shocks and complement member states fiscal policies. Finally, reforms aimed at creating a genuine capital markets union should continue.
Monetary policy should stay accommodative
While remaining accommodative for now, monetary policy will have to gradually normalise. Monetary policy has strongly supported the recovery. Yet, headline inflation remains well below target and monetary policy should be firmly committed to remaining accommodative as long as needed to put inflation back on track. At the same time, the ECB should prepare for a gradual normalisation as inflation is expected to progressively return to objective. To avoid the risk of unintended market disruptions during the normalisation process, the ECB could reinforce its forward guidance on expected policy rate paths and commit to reduce its balance sheet only after the first interest rate hike and then only gradually. To minimise possible side effects of accommodative monetary policy, especially in countries that are experiencing strong expansion, macroprudential tools should be used to shield the financial system from overexposure to systemic risks, for example credit financed housing price bubbles, while other policies should also help avoid building up significant imbalances. To facilitate the use of macroprudential policy instruments, better collection of granular and harmonised data, in particular on commercial real estate, would be helpful.
Resolving non-performing loans would boost credit and investment. Rapid resolution of remaining non-performing loans is key to facilitate new bank lending in former crisis countries and better transmission of monetary policy across the euro area. Policies to address non-performing loans are multifaceted and include better supervision to prevent build-ups in the future, the development of secondary markets for distressed assets, better aligned insolvency and debt recovery frameworks and further restructuring of the banking system. The EU Council Action Plan (2017) and the package of concrete measures on NPLs proposed by the European Commission (2018) are welcome and should be implemented swiftly. In particular, the creation of national asset management companies could be facilitated and help banking systems struggling with high levels of NPLs to work-out certain types of impaired assets.
The recovery should be used to improve fiscal positions
The European fiscal framework must ensure fiscal positions improve in good times. In some cases in the past, good times were not used to improve fiscal positions sufficiently and the crisis led to significant increases in public debt ratios. The expected broadly neutral fiscal stance in 2018 is appropriate, but as countries’ economy expands and output gaps close, the countries with high debt ratios should ensure that debt-to GDP ratios fall significantly by improving fiscal positions further (Figure B). This requires among others raising national awareness, notably through a more active role of fiscal councils, that fiscal consolidation is desirable in good times, together with implementing sound economic policies. In addition developing also stronger incentives by revising some aspects of the current European fiscal framework, as recently proposed by the European Fiscal Board, is needed.
Source: OECD (2018), OECD Economic Outlook: Statistics and Projections (database).
While adjusting the current framework is an interesting avenue to ensure improved fiscal balances in good times, it is likely to make the European fiscal framework – which already includes multiple numerical targets, procedures and contingency provisions – even more complex. Simplifying the rules, while keeping necessary flexibility to take into account the overall assessment of the economic situation, would make them more operational. Eventually countries should consider following an expenditure objective that ensures a sustainable debt ratio.
Better risk sharing is needed for a resilient and sustainable monetary union
Risk sharing is important in a monetary union. As monetary policy should only react to area-wide shocks and may, from time to time, be constrained by an effective lower bound for its policy rates, other policy tools need to be available to deal with large or asymmetric shocks. In the euro area incomplete banking union and fragmented capital markets prevent higher levels of private risk sharing through broader range of savings and investment opportunities; public risk sharing through fiscal transfers currently is virtually non-existent (Figure C).
1. Public risk sharing refers to cross-border fiscal redistribution, whereas private risk sharing refers to the smoothing effect of cross-border factor income (capital and labour) and credit markets.
2. See figure 22 for details.
Source: European Commission (2016), "Cross-Border Risk Sharing after Asymmetric Shocks: Evidence from the Euro Area and the United States", Quarterly Report on the Euro Area 15(2), Brussels.
Banking reforms must address the potentially harmful link between banks and their sovereigns. Banking union remains unfinished business. Since financial intermediation in the euro area remains predominantly bank-based (Figure D), progress in this area is key to achieve greater private risk sharing. The resolution fund needs to be backstopped by rapidly available financial resources to ensure its credibility in the event of another large systemic shock, a role that could possibly be played, in a fiscally-neutral way, by the European Monetary Fund, as recently proposed by the European Commission. Building on progress in risk reduction, a rapid agreement on a common deposit insurance scheme is necessary to complete the banking union. To further loosen the potentially harmful link between banks and sovereigns, introducing charges that rise with the degree of concentration of sovereign debt in banks’ portfolios and other policies could incentivise banks to diversify their holdings of sovereign debt (Figure E). A combination of policies, including a gradual introduction of higher capital charges on excessively high debt holdings of one country and the introduction of a European safe asset, is needed and should be considered in parallel.
Outstanding loans and bonds of non-financial corporations as % of GDP, period average
Source: Eurostat, European Central Bank, US Bureau of Economic Analysis, Board of Governors of the Federal Reserve System, and Securities Industry and Financial Markets Association.
Public risk sharing would help to counter large negative shocks. Private risk sharing that gives households and firms access to a wide range of investment and borrowing opportunities is likely to provide the bulk of risk sharing also in the euro area. However, private risk sharing may not always be sufficient in the aftermath of large negative shocks and has even declined in periods of crisis. The Five Presidents’ Report therefore correctly calls for the creation of a fiscal shock-absorption capacity at the euro area level to complement national fiscal policies and the European Commission has made an interesting proposal in May 2018.
Holdings of euro area general government securities¹ in % of total assets, March 2018
1. Domestic government securities denote own-government securities other than shares held by monetary and financial institutions (excluding central banks). Other government securities refer to other euro area government securities held by MFIs.
Source: ECB (2018), Statistical Data Warehouse, European Central Bank.
A fiscal stabilization function would be a vehicle for public risk sharing. One avenue to implementing such fiscal stabilisation function is a euro area unemployment benefit re-insurance scheme that would be activated in case of large negative shocks. While financed by all euro area countries, financing costs would over time be raised for countries that repeatedly draw on the fund. This would mitigate the risk of permanent transfers and provide a fiscal incentive to each country to pursue its own stabilisation policies. It would also be an instrument that, by reducing the negative impact of downturns, could help to increase citizens’ trust in the euro project. To strengthen countries’ fiscal incentives further, the access to the stabilization capacity should be conditional on compliance with fiscal rules prior to the shock.
More integrated capital markets can facilitate private risk sharing. Better integration of euro area capital markets would lead to more diversified sources of financing and more substantial cross-border investment. Progress on harmonising insolvency regimes would remove an important barrier to cross-border financial intermediation, by reducing legal uncertainty and facilitating the efficient restructuring of companies and resolution of non-performing loans. In addition to removing the bias towards debt financing over equity, the tax preference for debt over equity should be addressed in the context of the Common Consolidated Corporate Tax Base proposal. Fast-paced financial innovation in the non-banking financial sector and the departure of the United Kingdom from the EU also provide a rationale for further convergence of supervisory regimes.