EURO THEMES:Growing out of the crisis

ECONOMICS RESEARCH 10 January 2011 PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 84 EURO THEMES Growing out of the crisis The euro area is facing unprecedented challenges. Here we analyse the problems that confront it and propose some solutions that do not entail sovereign debt restructuring, a break-up, or outright political union. Among our recommendations: „ Countries with large fiscal deficits must demonstrate their commitment to achieving, on a clear and credible timetable, primary surplus positions by 2014 at the latest. National rules as stringent as the German ones could be helpful. „ A substantial pre-emptive increase of the amount of funding available from the European Financial Stabilisation Fund should be considered. „ Interest rates on the EU part of currently extended IMF-EU adjustment loans should be reduced. It would be reasonable to lower currently charged funding costs by some 200-300bp, thereby providing additional indirect financial support to periphery countries in need of such assistance. „ Euro area countries should set up independent fiscal auditing bodies, located in each country and coordinated centrally at the euro level, to provide rigorous and regular scrutiny of multi-year government budget programmes. This would also raise national responsibilities and accountability of public finances management (and reduce the risk of confrontation between Brussels and member states). „ A major infrastructure investment programme promoted by the European Commission and European Investment Bank, with a particular focus on improving growth potential, would provide support to offset fiscal austerity. „ Major structural reforms are vital to kick-start the resumption of economic convergence and growth across euro area countries, and to reap the full benefit of the above EU investment programme. „ Provided that the countries in difficulty adhere to rigorous fiscal and structural economic reform initiatives, then more pre-emptive monetary policy action is required, including prolonging the provision of full allotment by the ECB, and maintaining an accommodative stance for as long as possible. Countries in danger of overheating should use domestically oriented policies, including macro-prudential ones, to enable interest rates to remain low for the periphery. The ECB should not rule out the possibility of undertaking a substantial increase in peripheral bond market purchases if conditions were to deteriorate materially. „ To safeguard confidence across the banking sector, we see as necessary the prompt implementation of a common regulatory framework (including for bank resolution), as well as common supervisory practices enforced by the European Supervisory Authorities. In the medium term, the EU should aim to develop this framework into an EU-wide Deposit Insurance Scheme, which would strengthen financial stability, limit deposit runs, and mitigate fiscal liabilities in the event of bank failures, especially for European cross-border financial institutions. Julian Callow +44 (0) 20 7773 1369 julian.callow@barcap.com Laurence Boone +33 (1) 44 58 3236 laurence.boone@barcap.com Frank Engels +49 (0)69 7161 1832 frank.engels@barcap.com Antonio Garcia Pascual +44 (0) 20 3134 6225 antonio.garciapascual@barcap.com www.barcap.com Barclays Capital | Euro Themes: Growing out of the crisis 10 January 2011 2 TABLE OF CONTENTS EXECUTIVE SUMMARY 3 ECONOMIC COMPETITIVENESS 9 A problem of competitiveness ................................................................................................................9 German firms spent the first decade of EMU bringing down unit labour costs ........................13 Problems of the “one size fits all” monetary policy ..........................................................................17 Product market reform ...........................................................................................................................20 The need for labour market reform .....................................................................................................23 THE PUBLIC SECTOR DEBT PROBLEM 30 THE PRIVATE SECTOR DEBT PROBLEM 39 INSTITUTIONAL REFORMS 49 Increasing fiscal transfers.......................................................................................................................50 Improving the existing institutional and economic framework.....................................................53 Break-up or exit of countries from the euro area .............................................................................62 Public and private sector debt restructuring...................