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Speech - Imbalances & Inequalities in the EU: Challenges to the Europe 2020 Strategy

Met dank overgenomen van Europese Commissie (EC), gepubliceerd op vrijdag 10 oktober 2014.

European Commission

[Check Against Delivery]

László Andor

Commissioner for Employment, Social Affairs and Inclusion

Imbalances & Inequalities in the EU: Challenges to the Europe 2020 Strategy

Lecture at Université Libre de Bruxelles

Brussels, 10 October 2014

Ladies and gentlemen,

I am grateful for the chance to speak to you at the beginning of the new academic year concerning two crucial and related problems which the European Union currently faces: major socio-economic imbalances between Member States, particularly in the euro zone, and rising social inequalities within some countries.

High levels of income inequality are a problem from the viewpoint of social fairness and cohesion, and they practically invalidate the notion of equality of opportunity.

Inequalities have been on the rise since the 1970s in many countries of the world, including in Europe. But in many European countries inequalities have risen more sharply in the context of the macroeconomic adjustment during the euro zone crisis.

In some EU Member States various measures of inequality show no change or even improvement. This means that a serious divergence has developed between the core and periphery of the eurozone. This divergence is not only serious but also dangerous for the stability of the monetary union and the cohesion of the EU as a whole.

I will therefore argue that to reverse these trends, many Member States need to strengthen their employment and social policies. Without more solidarity, trends of rising inequality cannot be reversed.

But I would also like to emphasise that in order to combat socio-economic imbalances and divergence within the EMU, the EMU itself also has to be reconstructed, in particular through the creation of a counter-cyclical fiscal capacity.

The sovereign debt crisis in the euro area and the divergence it unleashed

The last five years have been dominated by the worst financial, economic and social crisis in the history of the European Union — a crisis that should never have happened and which we should certainly never have to go through again.

More accurately, Europe has gone through not one, but two crises.

The effects of the first financial and economic crisis in 2008-9 were felt by the world as a whole.

The second euro zone recession since 2011, from which we still have not recovered, has been something unique to Europe and stemmed from shortcomings in the design of our Economic and Monetary Union. Nowhere else in the industrialised world did something similar happen.

When the global financial and economic crisis worsened in autumn 2008, EU governments agreed to coordinate measures to stimulate the economy, including by increasing their national budget deficits on a temporary basis. This came to be known as the European Economic Recovery Package.

This fiscal stimulus was partly discretionary and partly the work of so-called automatic stabilisers within national budgets, namely reduced tax revenue and increased social expenditure at the cost of increased budget deficit. This stimulus helped to generate a recovery in GDP and to reduce unemployment in 2010.

But while the United States continued to experience a robust and job-rich recovery, the EU nose-dived into a second recession in 2011.

The reason for this decoupling was that the EMU had been unprepared to handle a sovereign debt crisis of some smaller Member States.

It had no lender of last resort, no collective framework for resolving bad debt, and no mechanism for managing aggregate demand in the economy.

Debts from financial markets were replaced by debts from official sources, which turned the euro zone into a club of debtors and creditors, set against each other.

We entered a double-dip recession in 2011, accompanied by capital flight from less stable countries towards more stable ones, causing further financial and economic polarisation.

The euro zone crisis produced a dramatic rise in unemployment. And although we have experienced some improvement in the last 12 months, unemployment in Europe remains still much higher today than at the peak of the first recession in early 2010.

The sovereign debt crisis cast the monetary union — and the EU as a whole — into an existential crisis.

The EU only started to emerge from this financial maelstrom when the European Central Bank announced it was ready to launch its outright monetary transaction programme, and the Presidents of the European Council, the Commission, the European Central Bank and the Eurogroup came forward with a long-term plan for revamping the Economic and Monetary Union.

The sovereign debt crisis has shown that without a lender of last resort, a central budget or a coordination arrangement geared to stabilising aggregate demand, our Economic and Monetary Union had been designed for fair weather — but not for the storm of a financial and economic crisis.

Emergency lending to troubled countries was always agreed at the last minute. But the EMU has proven to be a trap in terms of making it difficult and very costly to restore these countries’ growth potential.

Member States suffering from capital outflows could no longer support their economies through tailor-made monetary policies and devaluation in their exchange rate, while at the same time being subject to strict rules on fiscal policy and credit conditionalities which at least partially turned out to be counter-productive.

The contractionary effects of these strategies have put the EU at a competitive disadvantage in global terms.

Furthermore, the euro zone crisis has led to social consequences that cannot be acceptable in the European Union.

While the EU employment rate was over 70% in 2010, it fell to 68.3% in 2013. More than 25 million people are unemployed across Europe today. This means that we have moved away, and not towards, our Treaty objective of full employment, and also away from the 75% employment target of the Europe 2020 Strategy.

Likewise, we have made negative progress on the social inclusion target of Europe 2020.

The number of people in or at risk of poverty or social exclusion was 118 million in 2010, but 124 million in 2012.

Crucially, these aggregate figures hide enormous disparities between Member States.

Some countries like Austria or Germany are enjoying economic growth and high employment. However, many other Member States are struggling with continued economic contraction, with unemployment rates near or over 20% and with declining household incomes and rising levels of poverty.

Again, I would like to stress that the problems are concentrated in the euro area, which is bound together by a single monetary policy without a fiscal capacity.

In the adjusting countries on the euro zone periphery, the second recession has meant rising long-term unemployment, poverty, social inequalities and emigration of many young people, often to other continents, which represents a clear human capital loss for Europe as a whole.

If we look at the divergence within the EMU in a longer-term perspective, we will see that today’s socio-economic imbalances and disparities are without precedent since the launch of the monetary union more than two decades ago.

This graph compares unemployment rates within the group of 12 countries that started using the euro in 2001. It compares on the one hand the north and core of the euro area and on the other hand the south and the periphery - and it goes back all the way to the early 1990s. In the middle you can see the average unemployment rate for the EU28.

You can see that the gap between unemployment rates in the northern and southern parts of the euro area was considerable in the 1990s, but they were moving in the same direction. From the late 1990s until 2008, a convergence towards lower unemployment rates can be observed, which was then followed by a massive and unprecedented divergence, particularly strong during the second euro zone recession.

We could analyse the situation also in terms of GDP developments since the mid-1990s: there was an almost complete symmetry in the GDP trajectories of the north and south of the euro zone for over a decade - until the sovereign debt crisis that erupted in 2010. Also in this sense, the recent divergence within the EMU is unprecedented.

Why did Europe become so divided in terms of economic and social outcomes?

The sovereign debt crisis since 2010 and the policies undertaken in response to it have substantially weakened the power of the welfare state.

In particular, they have weakened the effectiveness of so-called automatic fiscal stabilisers at the national level, which basically means the ability of a state to immediately act in a countercyclical 8way as tax revenues drop and social expenditure increases.

Until 2010, national budgets were able to counter the economic downturn by running deficits. Since 2010, many national governments have lost this ability and austerity policies in many cases actually aggravated the economic crisis.

This means that instruments that were historically used to limit the social impact of crises were not available any more, while there has been nothing newly introduced to replace them.

Over several years, internal devaluation was undertaken in an attempt to stabilise the troubled economies and to boost their economic competitiveness. However, it has certainly not borne any good fruit in terms of improving the employment and social situation.

Moreover, internal devaluation is a recipe that cannot be applied in many countries at the same time because it undermines overall demand. If many countries cut their wages and lay off workers, nobody wins in terms of relative competitiveness but everybody loses. If, in exceptional circumstances, internal devaluation helps a country to return to growth, it does so at a very high price.

Rising inequality has been a part of this high price that has been paid.

Income inequalities in Europe

I have promised to speak also about socio-economic inequalities within countries, so let us have a look at recent developments across Europe.

This slide comes from the Commission’s recent publication examining various measures of prosperity “beyond GDP”. 1

It shows how the ratio of income inequality between the top quintile and the bottom quintile of the population has evolved during the crisis across the EU.

Unfortunately the graph works with data only till 2011, so it does not capture subsequent increases in inequalities in countries like Latvia. But it still gives a relatively good picture how income inequalities have risen, especially in countries that experienced significant downturns (on the right hand side - e.g. Spain, Greece, Italy and Hungary).

We can also have a look at a few country examples of how income inequalities have evolved:

Here we see that in Germany, growth in real income between 2006 and 2011 has been rather even across the income distribution. The rich and the poor have experienced roughly the same, very mild income growth.

By contrast, in Spain, the pre-crisis boom benefitted the richest groups the most, and the financial and economic crisis had a hugely different impact on real incomes across the distribution. Especially the 20% of people with lowest incomes have experienced a massive drop in real incomes, while the top 40% were still as well off in 2011 as they had been in 2003.

This graph points to many problems, including weaknesses in financial regulation, but it especially shows the low ability of the Member State in question to mitigate adverse socio-economic developments through tax and expenditure policies.

Monitoring key employment and social indicators through a new scoreboard

Ladies and Gentlemen,

Employment and social outcomes are probably decisive factors in the sustainability and legitimacy of the monetary union. This is why I have been drawing your attention to divergent developments in variables such as unemployment rates and income inequalities.

The Commission and other players have been paying increasing attention to these problems in the context of the debate on the so-called social dimension of the Economic and Monetary Union, which has been on-going for about two years.

That term “social dimension of the EMU” has been somewhat misleading, since the point is not to give the EU or the euro area competence for social policies.

The point is to create conditions enabling to restore convergence in employment and social outcomes and other economic fundamentals throughout the currency union, so that we strengthen the whole EMU's growth potential.

Since Member States of a monetary union cannot unilaterally adjust to economic shocks through the exchange rate and the interest rate, unemployment and social crises are likely to develop to a greater extent within the currency union rather than outside it.

The “spill-over effect” of employment and social imbalances means that action - or lack of action - as regards employment and social challenges can affect other Member States.

An unemployment crisis in one country translates into lower demand for other countries’ products and services. A prolonged period of high unemployment also implies a loss of human capital that undermines future productivity and therefore the growth potential of the entire EMU. Moreover, social crises may also fuel political instability - examples of this are not hard to find in today's Europe.

For the first two decades of the EMU's history, employment and social problems did not really count as major concerns. The original design of the Economic and Monetary Union did not take sufficient account of developments in the real economy and structural issues that are vital for the currency union to function properly.

However, over the last two years, recognition has grown that the EMU's economic governance needs to reflect social and employment challenges better, in order to ensure that they are tackled in an effective and timely way before they blow out of proportion.

That was why one year ago the Commission proposed and the Council endorsed the use of a scoreboard of key employment and social indicators in the European Semester process.

The scoreboard is incorporated into the annual Joint Employment Report published each autumn with the Annual Growth Survey.

It features five headline indicators that focus on employment and social trends which can severely undermine employment, social cohesion and human capital.

They are:

  • the unemployment rate;
  • the rate of young people neither in employment, nor in education or training and the youth unemployment rate;
  • the real gross disposable income of households;
  • the at-risk-of-poverty rate of the working-age population;
  • income inequality as determined by the S80/S20 ratio, which compares the income of the top fifth of the population and the bottom 20%.

What the scoreboard indicates today is growing divergence in employment and social developments across the EU, and in particular within the euro area.

Prior to the crisis, most social and employment performance indicators were converging across the EU.

But since 2008, the gap has been growing wider, as we have already seen.

The Commission used the findings of the scoreboard when drafting the 2014 Staff Working Documents and country-specific recommendations during the 2014 European Semester process. It has proven to be a useful tool, helping to identify which employment and social challenges need to be addressed where.

Therefore I hope that the scoreboard will serve also our successors as they try to better reflect employment and social concerns in EU-level economic policy-making.

Reconstruction of the EMU

By way of conclusion, let us briefly look into what has been done and what can still be done to address the design flaws of the EMU and to better deal with the problems of cyclicality and asymmetry.

In essence, this analysis shows us that the EMU in its current form lacks proper tools to manage two essential features of any economy: asymmetry and cyclicality.

The challenges of asymmetry and cyclicality are relatively easily addressed in a flexible exchange rate regime, but are much more difficult to tackle in a currency union.

Asymmetric shocks by definition cannot be mitigated by euro-zone wide policies such as monetary policy.

In the absence of a fiscal capacity that would mitigate asymmetries within the EMU, and in the absence of a coordinated adjustment by both deficit and surplus countries, the only available mechanism of adjustment turned out to be internal devaluation.

This means that the reconstruction of the EMU has to go beyond the steps that have already been taken.

The euro-area crisis has led to the establishment of a permanent European Stability Mechanism that can bail out euro-area member countries.

A banking union has also been agreed and starts being put in place. This means that we have a framework for better resolving financial crises at the EMU level and for reducing the risk of further bank bailouts with taxpayer money.

But the main design flaws of the EMU — the absence of a lender of last resort and of a common fiscal capacity — still remain to be fixed.

And in addition to these design flaws, we need to deal with the new problem of massive employment and social divergences which have developed in the EMU during the crisis.

This divergence is clearly at odds with the EU's Treaty objectives of balanced economic growth, full employment and social progress.

Divergence in a monetary union is particularly dangerous when we lack tools to overcome it or to compensate for it. In a large macro-economy which is diverse, it is supposed to be the role of fiscal policy to deal with imbalances.

As you know, the European Union has a very small budget of 1% of GDP. Within that budget, EU cohesion policy - which is mainly geared towards the development of economically peripheral regions - amounts to only 0.4% of EU GDP.

However, this is a budget for the Single Market of the EU28, and cohesion policy aims at promoting long-term convergence (or at least preventing long-term divergence) between countries and regions forming this Single Market.

By comparison, no budget exists at the level of the euro area, even though the bond of common currency is much stronger and reduces national autonomy much more than the Single Market.

For two decades, Member States have been willing to be bound together by a common currency, with a single exchange rate and interest rate, while not introducing any sort of fiscal risk-sharing.

Therefore if we want to seriously reinforce the EMU and strengthen its resilience against economic shocks, we should in my view work on establishing a reliable mechanism for short-term, countercyclical fiscal transfers across euro area Member States.

The Commission’s November 2012 Blueprint for a deep and genuine EMU clearly envisaged the introduction of a fiscal capacity at the EMU level in the long term.

The subsequent report from the Presidents of the European Council, the Commission, the European Central Bank and the Eurogroup stated that such fiscal capacity should help the Economic and Monetary Union to absorb economic shocks.

The expert literature of the past few years has put forward a number of options for automatic fiscal stabilisers at monetary union level.

Most of them share a focus on mitigating short-term cyclical downturns occurring in parts of the euro area as opposed to compensating for structural differences.

In other words, the point is to maintain spending at a sufficient level during a downturn before companies that struggle are turned around or replaced by new ones and before workers who have lost their jobs can find new employment.

Focusing fiscal transfers on mitigating asymmetrically distributed cyclical shocks means that, over the long term, all participating Member States are likely to be both contributors to and beneficiaries of the scheme.

But even if the balance is not zero after some time, the fact that economic crises would be less serious and would not last as long would benefit us all. Let’s be clear: the way the EMU functions today is economically sub-optimal for all participants, even those Member States who are doing relatively better than others.

In my view, the best idea for an automatic fiscal stabiliser at Economic and Monetary Union level is a scheme which offers greater stabilisation on the basis of developments in short-term unemployment.

The great advantages of unemployment as an indicator are that it follows developments in the economic cycle very closely, is easily understandable, and can be measured easily and quickly.

Such a scheme should clearly focus on cyclical unemployment caused by a fall in aggregate demand, as opposed to structural unemployment caused by skill mismatches, less-efficient labour market institutions and the like.

The key point is that a limited and predictable scheme of partial fiscal risk-sharing focused on the short term could help the EMU to finally be able to manage the problems of cyclicality and asymmetry.

By being triggered automatically, it could help prevent short-term shocks from turning into massive divergence. Essentially, such a scheme would represent insurance for the Member States of the monetary union.

Asymmetric cyclical shocks will always occur. The question is whether we choose to live in a system that is very vulnerable to such shocks, or if we insure ourselves in a way that we can avoid repeating the crisis experience of the last five years.

What I am advocating is not “more Europe” for its own sake, but a mechanism that strengthens each Member State’s autonomy precisely by stabilising the EMU.

Basic European unemployment insurance is one possible way forward in strengthening the EMU and preventing harmful divergence from developing further.

It would represent a safety net for national welfare states and to some extent it could also help them to combat socio-economic inequalities, although it certainly could not replace the role of redistributive policies at national level.

Ladies and Gentlemen,

The Europe 2020 targets for employment and social inclusion cannot be realistically reached unless the EMU is reformed. Indeed, the EMU should be able to deal with asymmetries and downturns through other ways than internal devaluation.

Unemployment and poverty have reached unacceptable levels, but we also need to address rising inequalities.

If we do not manage to undo the divergence that emerged within the EMU, at some point the single exchange rate and single interest rate may simply stop making sense for the highly heterogeneous euro zone, and Europe may enter the path of economic but also political disintegration.

In order to prevent this from happening, I believe it is in everybody's interest to do what it takes to strengthen and rebalance the EMU.

1 :

EU Employment and Social Situation Quarterly Review, September 2014, supplement “Towards a better measurement of wealth and inequalities”

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