Economic Crisis In Europe

Economic crisis in Europe: Cause, consequences, and responses – A report by the European Commission
István P. Székely, Paul van den Noord, 6 Oct 2009
The European economy is in its deepest recession since the 1930s. This column says that swift policy response avoided a financial meltdown, but turning the ongoing recovery into sustained growth requires action on five challenges: boostingpotential output, enhancing labour market flexibility, preparing fiscal consolidation, facilitating intra-EU adjustment, and unwinding global imbalances. Europe also needs an improved crisis-management framework, lest this happen again.
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The financial crisis that began in 2007 is without precedent in post-wareconomic history (Eichengreen and O’Rourke, 2009). It was preceded by a long period of rapid credit growth, low risk premia, abundant liquidity, and the development of real estate bubbles. Overstretched leveraging positions rendered financial institutions extremely vulnerable to corrections in asset markets. As a result, a downturn in a relatively small corner of the financial system (the US subprimemarket) was sufficient to topple the whole structure. Such episodes have happened before (e.g. Japan and the Nordic countries in the early 1990s, the Asian crisis in the late-1990s), but they remained largely regional. The important difference is that, like during the Great Depression of the 1930s, the current crisis is global.
While it may be appropriate to consider the Great Depression as thebest benchmark in terms of its financial triggers, it has also served as a great lesson. Governments and central banks are now well aware of the need to avoid the policy mistakes of the 1930s. Bank runs have been avoided, monetary policy has been eased aggressively, and governments have released substantial fiscal stimulus. Unlike during the Great Depression, countries in Europe or elsewhere havenot resorted to protectionism large enough to have a macroeconomic impact. This crisis demonstrates the importance of EU coordination, even as it has called attention to the need for further progress in this regard.
Five key challenges
Notwithstanding the heavy policy intervention, the EU economy, like other developed economies, is projected to shrink by some 4% in 2009, the sharpest contractionin the EU's history (European Commission 2009). Signs of incipient recovery abound, but this is expected to be rather sluggish as demand will remain depressed due to deleveraging across the economy as well as inevitable structural adjustments. As discussed in a recent Commission report (European Commission 2009), the crisis is likely to raise five challenges.
1. Unless policies changeconsiderably, the growth potential will suffer as parts of the capital stock are obsolete and increased risk aversion will weigh on capital formation and R&D (see Costello et al. 2009).
Recent studies suggest that past episodes of financial distress have resulted in sizeable output losses that are never entirely recovered. Estimates emerging from econometric work by the European Commission andsimulations with its QUEST model put the potential output loss at up to 5%. Moreover, a reversal of financial development may weaken the incentives for structural reform, thereby adversely affecting potential growth further. But the historical evidence shows that crises also provide great opportunities to undertake far-reaching structural measures. This opportunity should not be missed.
2. While joblosses have been contained so far, eventually the impact of rapidly rising unemployment will be felt.
So far lower levels of activity have been reflected mainly in shorter working hours, fostered by employment support schemes that have limited the increase in headline unemployment statistics (Figure 1). The relatively muted unemployment response may partly be the result of past labour market...