Challenges facing Europe

Europe has made important progress in harnessing and reinforcing its policies and institutions to recover from a double-dip recession and improve crisis management. Very supportive monetary policy has helped growth to pick up gradually over the past two years (Figure 1, Panel A), and contributed to reduce tensions in sovereign debt markets (Figure 1, Panel B). The effect of fiscal policy on demand has turned broadly neutral. Important building blocks of banking union, on both supervision and resolution fronts, have come into operation, improving the resilience of the European financial system. Confidence in the European project has recovered from its lows in 2013, although it is still well below what it was before the crisis (Figure 2).

However, many legacies of the crisis are still unresolved, and major new problems have emerged. Unemployment is still high in many countries, and there is a wide dispersion across the euro area (Figure 3). Despite the somewhat stronger economy, inflation is close to zero, well below the European Central Bank (ECB) target of just under 2%. Unlike in the United States, investment is still far below 2007 levels, especially in those countries hit hardest by the crisis (Figure 4), mainly due to weak demand but also to high non-performing loans and, in many countries, high corporate indebtedness, which hamper credit (OECD, 2015a). Political tensions have flared up recently due to large inflows of refugees, and have put strains on border-free travel within the Schengen zone. The reintroduction of border controls in some Schengen zone countries is a setback for European integration.

These challenges weigh on economic performance and, more broadly, on the quality of life of European citizens. Well-being in the euro area often displays large disparities across countries (Figure 5). These tend to be most acute in income, labour market outcomes and subjective well-being, all of which were deeply affected by the crisis. Furthermore, some countries often find themselves among the best or the worst performers in most dimensions of well-being (Figure 5). Improving well-being requires stronger and more even growth and job creation across the euro area, but also reforms in specific policy areas, such as education and health, where the composition and efficiency of public spending plays a crucial role.

Building a better future calls for stronger collective action on several fronts. Despite recent progress, banking union remains incomplete, which hampers monetary policy transmission and capital market integration, and the resulting mutual dependence of national governments and national banks poses vulnerabilities during a crisis. Joint action is also needed to protect external borders and share the financial burden of the refugee inflow. Public investment remains depressed, due to strong and lopsided fiscal consolidations in the recent past, which have fallen heavily on capital spending, and insufficient consideration of cross-country spillovers. Business investment is further hampered by the high levels of corporate debt overhang, by remaining weaknesses in some national banking systems and by scant progress in goods and services markets integration after the crisis, not least through the persistence of high regulatory heterogeneity.

In this context, the 2016 OECD Economic Survey of the euro area mainly focusses on fiscal and financial challenges, and the 2016 OECD Economic Survey of the European Union on structural reform priorities to complete the Single Market. The main messages of the euro area Survey are:

• To deal with the problems they face, member states need to harness European institutions to develop and implement collective and co-operative solutions.

• The euro area economy is gradually recovering, but investment remains weak and the wide disparity in economic performance and well-being is still a major concern.

• Collectively strengthening aggregate demand and financial sector performance will be critical to ensuring that growth picks up and unemployment continues to decline.

Fostering recovery and rebalancing

Growth has gathered pace since mid-2014, supported by successive rounds of monetary expansion (Figure 6). The sharp fall in global oil prices has raised household incomes and fiscal policy is no longer weighing on domestic demand. Exports grew robustly for several quarters, reflecting the euro depreciation and stronger activity in major markets, such as the United Kingdom and the United States. More recently, a stronger euro and the slowdown in emerging markets have made export growth decelerate markedly. Business investment has disappointed, largely due to weak growth expectations and, in some countries, credit constraints.

Economic performance has been uneven from country to country. The sovereign debt crisis and the associated large fiscal and macroeconomic adjustment efforts by the countries hit hardest (e.g. Greece, Ireland, Italy, Portugal and Spain) led to very divergent output and unemployment developments across the euro area. This divergence has been modestly reversed over the past two years, with some of those countries recording above-average growth. Despite narrowing interest rate differentials and significant reductions in lending rates, credit and investment in most of those countries have remained hampered by high non-performing loans and corporate debt (Figure 7), and incomplete capital market integration. The exceptions have been Ireland, where large multinationals do not depend on domestic banks for financing, and Spain, which has made significant progress in cleaning up banks’ balance sheets.