Corrado Passera

Minister of Economic Development, Infrastructure and Transport

WEF Notes on Europe

Davos, 24th January 2013

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

Executive summary and key messages Over the past two-three years, the Eurozone members have badly mismanaged the crisis, with huge and unnecessary costs. Some important repairs were made in 2012 (Outright Monetary Transactions, revision of the Treaty for a fiscal compact, EFSF/ESM mechanisms, roadmap for further integration starting from a single supervisory mechanism in banking). Nevertheless the most difficult challenges still lie ahead: macroeconomic imbalances nurtured by mounting competitiveness/productivity gaps within the Eurozone, lack of growth and mounting labour malaise. The Eurozone policy response to the crisis have been so far mainly focused on budgetary austerity, fiscal tightening and micro-management of national budgets, but now revamping sustainable growth and sustained job creation must be priority number one. Europe needs a new direction and a new thinking. The most important way of tackling Europes sluggish growth prospects is to complete and deepen the single market, adopting a common industrial policy and speeding the way towards a single political entity. We need unity and cooperation to reduce imbalances and to define a common growth agenda. Alternatively, we may end up playing a prisoners dilemma game that leads to a suboptimal equilibrium: continued muddling through or possibly a disorderly collapse. For a new Renaissance in Europe the national and European level should cooperate at least on three major steps: o First, countries in the South of Europe should fundamentally overhaul their economies, adopting structural reforms to shore up public finances, to foster competitiveness and bridge productivity gaps: pension reform, labour market reform, fiscal reform are the key levers. In particular, they have to increase their labour market flexibility by easing firing procedures and by encouraging hiring, by raising retirement ages as part of pension reforms. Productivity should

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

be boosted by intensifying competition and helping SMEs and startups to growth in scale, to become more innovative and more internationalized; o Second, countries adopting structural reforms should not be left alone in such efforts. They should find an Europe not coming in rescue but being in support. Benefits from structural reforms take some time to emerge and bear fruits, while social and political costs presents immediate and severe bills. It is thus crucial to give reform prone countries some limited flexibility in deficit spending, particularly when is concentrated on investments and some external support with more symmetric economic policies and shared adjustments between creditor and debtor countries in Europe. It is necessary to coordinate economic policies. The strong economies in the northern core of Europe, with Germany on the forefront, must stop focusing on deficit reduction for a while and generate more spending and inflation, by offsetting wage moderation and domestic consumption. o Third, the Eurozone needs to continue working on a continent-wide stimulus program. At the June 2012 EU summit a growth compact was announced to boost spending by roughly one percent of the regions GDP. We should enforce that commitment by beefing up the European Budget and by devoting more of its resources to investments. Finally European countries can jointly issue so called project bonds aimed at boosting investments in infrastructures and European communication and energy networks. The ECB can play a much stronger role in revamping growth, as currently done by most big central banks in the world. The ECB should abandon orthodox inflation targeting monetary policy and do more to stimulate growth and employment. OMT operations are sterilized and dont produce any money expansion: this puts Europe and the euro at a serious competitive disadvantage in comparison with the US, Japan or China, where the printing press is working in full steam and help getting out from the crisis.

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

Italy has regained international credibility for the structural reforms adopted in crucial areas during last year. We refer in particular to: o o o Pension system reform; Taxation system reform; Labour market reform.

Growth Agenda implemented by Government in Italy offer an interesting example for defining a new strategy at EU-level, particularly for the following items: o o o o An EU wide strategy for energy; Measures in favour of innovative start-up companies; Supporting innovation and implementation of Digital Agenda; Facilitating the involvement of private capital to accelerate the realization of infrastructures (Project Bonds); o Rationalizing public incentives to companies.

***

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

Strategies for Eurozone future Over the past three years, the Eurozone members have badly mismanaged the crisis, with huge and unnecessary costs. There are several reasons to be disappointed: the Greek problem has not been tackled swiftly and properly when it was pretty easy to manage. Contagion was allowed to spread around Europe. Some important repairs were made in 20121: o The awakening of the ECB has produced several miracles. The Outright Monetary Transactions (OMT) has been of paramount importance to restore confidence in financial markets, to lessen the risk of euro break up, and to produce a better functioning monetary policy transmission mechanism; o The revision of the Treaty with the introduction of norms on fiscal policy governance and budgetary discipline (fiscal compact); o The establishment of the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) in order to provide liquidity to countries (and banking systems) under financial stress; o A road map for further integration and reinforced institutional governance has been sketched, starting from a single supervisory mechanism, in order to achieve a banking union. Nevertheless the most difficult challenges still lie ahead and much remains to be done by unwilling politicians. Despite apparent calm on the financial markets has removed pressure for immediate policy action on the Eurozone crisis, no illusions that the storm is ending soon should be entertained. We may be just in the eye of the hurricane. The long awaited move from the ECB, and Mario Draghi s commitment to do whatever is necessary (and sufficient) to make the euro an irreversible choice, have helped to lower market pressure and to bridge financing needs. However the forces that could eventually break up the Eurozone are still there, being largely untamed. These forces are called: lack of growth, economic divergence within the Eurozone, and mounting labour unease.
1

For a good overview of things done in 2012 see attached Verso una vera Unione Economica e Monetaria? by Fabrizio Saccomanni (2013).

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

Revamping growth and job creation is priority number one in Europe. o While the global economy is registering a positive trend, Europe has essentially stopped growing, and, everything being equal, there is little hope of growth resuming in the near term (see slides 3-5). According to IMF, since 1999, while world economy has recorded a 55% increase in GDP, the increase for both EU as a whole and the Eurozone has been barely about 20%. This year the Eurozone will shrink by 0,4%, while the United States and Japan will grow by more than 2%, Russia will expand by 4%, India by 5% and China by 8%. o Labour unease is growing in Europe at a much faster pace than official unemployment. In the Eurozone the officially unemployed are almost 18 millions (see slide 9). If we add more than 6 millions of discouraged workers, involuntary part-time workers, under-employed in temporary working conditions, the area of labour unease reaches another almost 15 million people.

Another key challenge remains unresolved: turning the Eurozone into an optimal currency area, with economies similar enough to sustain a single monetary policy.

When European leaders opted for monetary union in 1992, they wagered that European economies would converge toward one another. They set convergence criteria according to which the deficit-prone countries of southern Europe would adopt German economic standards (i.e. lower price inflation and wage growth, more saving and less spending) and Germany would become a little more like them, by accepting more government and private spending and higher wage and price inflation.

This did not occur. Now, with the Eurozone in crisis, the true implications of this gamble are becoming clear. Making European economies converge means assuring that their domestic macroeconomic behaviours are sufficiently similar to one another to permit a single monetary policy at a reasonable cost, aligning national trends in public spending, competitiveness, productivity and other areas.

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

This will first require Europe to reject the common misdiagnoses of today's crisis. The problem is not primarily one of debt profligacy (see slides 7-8), which is rather a by-product: economic divergence is at the heart of the European crisis, particularly the North-South divide within Europe.

The success of the euro in its infancy didnt help to correct initial imbalances. It paradoxically contributed to exacerbating them. While Germany and some other northern countries kept labour cost under control and maintained fiscal discipline and moderate levels of debt, southern countries took profit of easy and cheap access to financing in order to postpone structural reforms, and increase both private and public spending.

Financial imbalances were mostly the consequence of underlying and mounting economic imbalances arising from widening competitiveness/productivity gaps among diverging member countries. In 2011 Germanys trade surplus (160 billion euros) roughly equalled the rest of the Eurozones combined trade deficits.

To

amend

such

mistakes

convergence

and

cooperation

on

pro-

competitiveness and pro-growth policies should be the driving forces of a new European Renaissance. The Eurozone policy response to the crisis has been so far mainly focused on budgetary austerity, fiscal tightening and micro-management of national budgets. Such a strategy has been successful in restoring confidence. It is now imparting a recessionary impact on the Eurozone, with perverse drawbacks on debt to GDP ratios. It is also aggravating the original sin of the currency area: nurturing asymmetry in burden sharing and increasing divergence within the Eurozone. The debt-to-GDP ratio is best reduced through sustained GDP growth. A bit of inflation and real GDP growth may help to bring the debt-to-GDP down painlessly. In a context of scarce international labour mobility and lack of wage and price flexibility in some Eurozone countries, a centralised ex-post transfer scheme is necessary, but the policies that are needed to get the Eurozone back on track do not seem to be politically feasible. The adopted Macroeconomic Imbalances procedure, a mere ex-ante monitoring device for detecting asymmetries is probably counter -

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

productive. Instead of transferring resources to countries suffering shocks, it punishes them. The EU construction is at a crossroads in its history. It is fundamental to clearly understand where do we stand and, furthermore, where we are heading to. Recent years crisis highlighted an indisputable evidence: European policies are merely defined as a response to events, pro-activity is quite exceptional. There is an overall and worrying lack of vision. Europe needs a new direction, a new thinking, a new inspiration. Europe needs something more than fear of break-up to make it again the great project it was for half a century. It is true the Europe today lacks important motivating forces that once propelled their politicians towards unity: peace and the memory of a devastating bloodshed2, post war economic reconstruction, Cold War imperatives, German reunification. Nevertheless economic fundamentals to sustain the case for a more and more integrated EMU are even stronger than in the past. To recognise them we should draw all the consequences of the major challenges that we are facing today and that are fundamentally changing our world at a spectacular speed in something which is rather different from what we could imagine just 10/15 years ago when the EMU was designed. The most compelling new economic rationale in favour of stronger European unification is in fact the rise of non-western emerging powers in particular in South Eastern Asia: mainly China, but also India and Brazil. It is not difficult to say and predict that in a globalised multi-polar world even Germany will be a small to medium sized power. The most important way of tackling Europes sluggish growth prospects and growing social malaise is to complete and deepen the single market. We need to improve competitiveness, as Germany did so impressively and not merely paid lip service to that goal in a catalogue of good intentions called Lisbon Agenda or meaningless dj vu called Europe 2020. We need to develop a more effective foreign policy, a more integrated geopolitical approach.
2

That is why the historian Tony Judt could still title a history of Europe that covers the 60 years up to 2005 with a single word: Postwar.

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

We currently lack a single industrial policy : in a competitive play ground where globalization goes hand in hand with massive state intervention and where we assist to the revamping of state capitalism, European state aid legislation seems more and more out of tune.

We have to recognize not only the importance of the steps made so far, but also the necessity to define a road map for the future of our continent as a single political entity on the world stage. Otherwise every single country inside EU, even Germany, will be condemned to a progressive loss of its political and economic relevance. More Europe is the solution. Less Europe is not plan B, it is, quite frankly, a disaster.

The European construction was based on

mutual sharing of costs and

advantages of a single currency union. The burden of adjustment must be more equally shared among Europe's deficit countries and surplus countries. If this does not occur, the survival of the euro will be called into question and Europe will face a long-term economic catastrophe that could drain its wealth and power for the rest of this decade and beyond. Single country efforts in correcting imbalances, fostering competitiveness and producing growth are not likely to be self sufficient. Single countries cannot be left alone: member states should do their homework on fiscal consolidation but sustainable growth and job creation are also European issues. The national level and the European level needs to work together on a common growth agenda. We need unity and cooperation. We need an idem velle, idem nolle! If dominant strategies at both national and European level remain not sufficiently cooperative, we may end up playing a prisoner's dilemma game. This is dangerous because it may lead to a suboptimal equilibrium where everybody is worse off and there are no winners on the battlefield. Europeans should trust in the essentially democratic nature of the EU, which will encourage them to distribute the costs of adjustment and convergence more fairly within and among countries. In order to escape the possibility of being stuck in suboptimal outcome, we must define a common strategy on growth, which requires cooperation on at least three major steps:

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

First, with fiscal consolidation rules being in force, countries must adopt convincing structural reforms. In most Eurozone countries, structural reforms are as needed now as they were before the crisis. Some progress has been made (for example in Italy) but it is a long and painful process with limited advantages in the short term, particularly when single countries willing to reform are left alone and social costs are not rewarded by tangible benefits. Many countries must increase their labour market flexibility by easing firing procedures and by encouraging hiring, by raising retirement ages as part of pension reforms (Italy has provided a benchmark in this field) and by promoting collective bargaining within industries or even firms instead of only on the national level. Productivity should be boosted by intensifying competition and helping SMEs and start-ups to growth in scale, to become more innovative and more internationalized.

Second, provide a useful meaning to coordination in economic policies. The strong economies in the northern core of Europe, with Germany on the forefront, must stop focusing on deficit reduction for a while and generate more spending and inflation, by offsetting wage moderation and sluggish domestic consumption. They should buy more of Greeces or Spains or Italys goods and less of their debt s. There is a strong case for symmetrical adjustment: northern creditor countries should sustain credible structural reform efforts in southern debtor countries, by relaxing budget constraints and off-setting contractionary economic policies.

Third, the Eurozone needs to continue working on a continent-wide stimulus program. At the June 2012 EU summit a growth compact was announced to boost spending by roughly one percent of the regions GDP. We should enforce that commitment by beefing up the European Budget and by devoting more of its resources to investments (particularly focusing on transportation, new communication and energy networks). Also the ECB can play a much stronger role in revamping growth, as currently done by most major central banks in the world. The ECB can stimulate the economy through quantitative easing. Finally European countries can jointly issue so

10

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

called project bonds aimed at boosting investments in infrastructure and European communication and energy networks.

***

Institutional design and economic policy tools The European crisis is rooted in a flawed institutional design. The EMU design took shape in the early 1990s and comprised an extensive, but incomplete, monetary union anchored by the euro and the ECB. But it included very limited economic union (the single market is still a few step forward a free trade area), no fiscal union, no banking union, no shared economic governance institutions and no meaningful coordination of structural economic policies.

Monetary policy We have established a single currency, but we do not have a properly equipped monetary policy yet. We need to complete the single currency architecture with all instruments and governance mechanism to grant its full accomplishment and stability: an European Central Bank endowed with all monetary policy tools to grant liquidity and well functioning financial markets and working as all other Central Banks in the world, as a lender of last resorts to banks and governments. Indeed, every central bank in the world, like the Fed, the Bank of Japan or the Bank of China, massively uses monetary policy stimulus to sustain economic growth and employment, rather than limiting its action to target and manage inflation. Any of such institutions has adopted different strategies to pursue growth targets, mobilizing huge resources to contrast recessionary pressures: massive quantitative easing in the US, large refinancing of public debt issuance in Japan or subsidizing credit by controlled interest rates in China. The size of central bank interventions through purchases of securities is over 20% of GDP by the Bank of England and around 17% of GDP by the Fed (see slide 6). Markets responded euphorically, with

11

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

stock prices in the US, for example, reaching post-recession highs: with so much underutilized productive capacity and so dismal economic prospects in the near term, the risk of producing high inflation remains negligible. ECB is working instead in quite the opposite direction. ECB interventions amounts to less than 4% of Eurozone GDP and remain limited on the secondary market. LTRO and OMT are important instruments to bridge funding gaps in the banking system after massive capital flight and to restore a decently effective monetary policy transmission mechanism by lowering pressure on spreads on government bonds without eliminating market discipline. However such instruments do not imply new money going to the real economy, they are emergency tools to cope with financial imbalances. ECB is thus not really sustaining, unless in a very indirect way, growth and unemployment, being strictly anchored to inflation targeting. While limiting market anguish the ECB is also focused on forcing Eurozones leaders to prioritize reforms. The primary purpose of ECB interventions is not to get rid of market anxieties (and discipline), it instead aims to induce national leaders to fundamentally reform the Eurozones institutions and structurally overhaul their economies. The central bank cannot directly compel democratically elected leaders to comply with its wishes but it can refuse to bail their countries out and thereby permit the crisis to pressure European and national leaders to act. It is worthwhile also to focus on the functioning of the European banking system. Banks are at the heart of a double diabolic loop which limits lending capacity and lower the banking multiplier with pervasive effects on growth (via financial constraints): o The first loop links banks to public debt. Over the last two years, with international investors flying away, national public debts have been alarmingly concentrating in their respective banks. Part of the liquidity provided by the ECB has been consumed by banks to buy public debts. As these debts loose market value, banks suffer losses and consume capital (also because of wrong pro-cyclical rules defined by European regulators). As a result banks should deleverage by curtailing lending to the real economy, which leads to a credit crunch, which slows growth down;

12

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

As the recession spreads and deepens, bank loans quality deteriorates putting more pressure on bank lending. This second diabolic loop links banks and the real economy;

This diabolic loops are partly the result of an ECB which is not allowed to buy issuance of national public debt securities, because in case of a loss a fiscal transfer may be produced. The ECB can be a lender of last resort to banks buying huge amounts of government bonds but not directly to governments;

Growth in Europe will not return unless bank lending is adequately available.

Exchange-rate policy In addition, ECB is not actively pursuing a real exchange-rate policy. As a result, the Euro exchange rates is just a by-product of actions being taken in Washington, Tokyo or Beijing. This is a particularly crucial issue now, because other main economic areas are putting in place expansionary policies (Japan recently announced a 170 billion euro package of measures to increase growth: the decision came on the heels of major quantitative easing announced by the U.S. Federal Reserve), that appreciate the euro vis--vis other currencies, reducing exports competitiveness outside European borders and undermining growth prospects.

Fiscal policy and Budget Obviously, monetary policy is necessary in a short and mid-term perspective but we need structural measures that would truly stimulate growth, including an expansionary fiscal policy. Fiscal policy demanded to single member states with no real economic policy coordination, apart from a generalized fiscal compact balanced budget rule inclined to set rigorous fiscal consolidation as key policy objective, is likely to increase macroeconomic imbalances among member states and divergence in productivity and firms performances.

13

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

European problems are not limited to ECB statute, EU institutional bodies face also some difficulties regarding financial resources they can use. The EU budget is now mainly focused on spending rather than investments . Also its allocation is not a secondary reason of concern, because still a large majority of funds are devoted to agriculture.

Defining an agreement on budget is complicated, because also its size is the result of complex inter governmental negotiations (with some countries willing to increase it and others to reduce it). Until no automatic contribution from member states will be envisaged, this will constitute a crucial issue. We anyway need to beef up the European Budget to increase investments in European infrastructures, research & innovation and competitiveness.

Shortly, we need more Europe but a spectacularly different one .

*** Italy and its growth Agenda Italy has regained international credibility for the structural reforms adopted in crucial areas during last year: o Pension system. We brought to conclusion a reform process started in the mid 90's, achieving a fully contribution based system which guarantee financial sustainability in the short as well in the long run, linking retirement age and contributory periods to changes in life expectancy and increasing retirement age up to 67 years; o Taxation system. Taxes on property has been aligned with European standards, taxes on firms and labour have been lowered. A great emersion of the tax base has been achieved through a more severe fight against tax evasion; o Labour market. This reform will achieve a flexible but fair labour market for all, ending the present duality among insiders and outsiders. Firing for economic reasons is easier, in order to facilitate hiring: reform helps the

14

WEF - Davos Notes on Europe

Davos, 24th January 2013 Speaking Notes

young into their first job and ensure people who lose their job find another rapidly; A specific focus on productivity. Tax relief on productivity bonuses has been reintroduced for the three-year period 2013-2015, with the total funding amounting to 2.2 billion euros. These resources have been set to encourage second-level collective bargaining: part of the remuneration is linked to the achievement of productivity gains, instead indexed to programmed inflation rate. Growth Agenda implemented by Government in Italy offer an interesting example for defining a new strategy at EU-level. This is particularly true for the following items: o Setting a detailed strategy for energy. It is crucial to adopt a single approach inside the EU, while currently policies are quite different at national level; o Measures in favour of innovative start-ups. A similar strategy could increase the EU capacity to attract international investments and to foster growth and competitiveness; o Supporting innovation and implementation of Digital Agenda in order to promote digital networks and increase the use of innovative technologies; o Facilitating the involvement of private capital to accelerate the realization of infrastructures, introducing innovative tools like Project Bonds; o Rationalizing public incentives to companies, in order to achieve a much more efficient management of the resources available, using them to support the production system with projects of a considerable strategic interest.

15