COMMISSION STAFF WORKING DOCUMENT Analysis of the Euro Area economy Accompanying the document Recommendation for a Council Recommendation on the economic policy of the Euro Area
Date: 2017-11-22
Institutions: Directorate-General for Economic and Financial Affairs, European Commission
Subjects: EU employment policy, Euro Group (euro area), economic growth, economic reform, fiscal policy, investment promotion, stability pact, structural adjustment, unemployment

EN 

  EN 

   EUROPEAN COMMISSION  Brussels, 22.11.2017 SWD(2017) 660 final  COMMISSION STAFF WORKING DOCUMENT Analysis of the Euro Area economy Accompanying the document Recommendation for a Council Recommendation on the economic policy of the Euro Area {COM(2017) 770 final}  
 
 
1. Macroeconomic context and developments  

The  economic  expansion  in  the  euro  area  continues  and  has  become  increasingly  broad-
based across countries. The recovery is increasingly driven by domestic demand, with private 
consumption as the key driver of growth and investment picking up. Employment continued 
to  increase  throughout  2016  and  the  first  half  of  2017.  The  unemployment  rate  has  seen  a 
significant reduction, though it is still higher than in 2008. 

The  recovery  is  nonetheless  characterised  by  some  atypical  features:  subdued  core 
inflation and wage growth that do not reflect the labour market improvements as signalled by 
standard  labour  market  indicators,  a  large  current  account  surplus  and  a  persisting,  but 
declining, investment gap (Figure 1). In particular, subdued wage growth appears to be related 
to  low  inflation  expectations  feeding  in  wage  negotiations,  low  productivity  growth  and 
remaining labour market slack. 

Divergences across euro area countries in terms of GDP per capita and unemployment 
rates persist (Figure 2). The years prior to the crisis saw a trend of real convergence within 
the euro area, which was temporarily reversed by the economic crisis, with a diverging trend 
observed  until  2012.  Real  convergence  prior  to  the  crisis  coincided  with  widening  current 
account imbalances within the euro area, also fuelled by large capital flows from the core to 
the  periphery  that  did  not  always  translate  into  sustainable  investment,  accompanied  by 
increasing  differences  in  relative  competitiveness  among  countries.  The  accumulation  of 
current  account  imbalances was accompanied by strong domestic  demand dynamics leading 
to a moderate reduction in cross-country differences in unemployment rates.  However, when 
the  global  financial  crisis  hit,  the  ensuing  adjustment  process  led  to  sharp  corrections  in 
current  account  balances  and  to  labour  shedding  in  countries  with  current  account  deficits, 
which triggered divergences in unemployment in the area. After 2013, labour market reforms 
introduced  in  the  aftermath  of  the  crisis  and  the  ensuing  recovery  process  stimulated  a 
reduction  in  unemployment  divergences,  without  an  associated  increase  in  current  account 
imbalances.  While  differences  in  unemployment  rates  decreased,  differences  in  the  total 
number of hours worked across the euro area started increasing (Figure 2). This relationship 
between  the  cross-country  variation  in  current  account  balances,  unemployment  rates  and 
hours worked throughout the process of rebalancing, as just described, also hints at persisting 
labour market slack. The latter could explain some of the aforementioned atypical features of 
the euro area recovery.  

Significant  imbalances  persist,  as  the  adjustment  took  place  mostly  on  the  side  of  net 
external  debtors.  While  much  progress  has  been  achieved  among  net  debtor  countries  in 
correcting  their  current  account  deficits,  large  current  account  surpluses  remain  in  some 
creditor countries. This points to a remaining overall shortfall in aggregate demand at the euro 
area level, which contributes to a large current account surplus for the euro area, projected to 
decline gradually from at 3.3% of GDP in 2016 to 2.9% of GDP in 2019. The countries that 
lost competitiveness before the crisis indeed experienced significant adjustments thereafter (in 
terms of changes in the real effective exchange rate, REER, based on unit labour costs, ULC - 
see Figure 2). In some debtor countries, gains in cost competitiveness are now moderating or 

1 

 
 
 
even  fading  out,  while  prolonged  wage  moderation  in  creditor  countries  makes  the  relative 
competitiveness adjustments more difficult. 

The  net  international  investment  positions  of  the  most  indebted  Member  States  have 
been  improving  at  a  slow  pace  and  sustained  rebalancing  efforts  are  still  needed. 
Countries  that  had  large  deficits  for  a  long  time  still  have  large  negative  net  international 
investment  positions  that  represent  vulnerability.  As  large  negative  net  international 
investment positions are generally coupled with large stocks of private or  government debt, 
the  maintenance  of  prudent  current  account  positions  in  net  debtor  countries  is  also  the 
counterpart of a necessary internal deleveraging process. The extent to which the deleveraging 
process  in  net  debtor  countries  comes  at  the  expense  of  their  recovery  prospects  crucially 
depends  on  the  deleveraging  pace,  on  the  growth  and  inflation  environment  and  on  the 
strength of demand dynamics in the rest of the euro area and in non-euro area countries.  

2. The policy mix 

Consistency and balance  in the  overall policy mix for the euro area,  including monetary, 
fiscal  and  structural  policies,  are  crucial  to  ensure  a  robust  and  sustainable  economic 
recovery.  

In  recent  years,  the  policy  mix  in  the  euro  area  has  been  skewed  towards  monetary 
policy, which resorted to  new unconventional  tools to achieve the ECB's medium-term 
inflation  objective,  thereby  supporting  growth  and  job  creation.  In  the  aftermath  of  the 
crisis, fiscal policy became expansionary, however already in 2010 the stimulus was reduced 
and  in  2011  it  was  contractionary.  Monetary  policy  subsequently  engaged  in  a  sustained 
accommodative  policy,  although  progressively  approaching  the  effective  lower  bound  on 
interest  rates.  In  2012  a  monetary  policy  expansion  went  along  with  a  contractionary  fiscal 
policy stance. In more recent years, new unconventional monetary policy tools have instead 
been  matched  by  a  broadly  neutral  fiscal  stance  (Figure  3).  Meanwhile,  Member  States,  in 
particular  those  most  hit  by  the  crisis,  engaged  in  long-delayed  structural  reforms  of  their 
economies.  

The  ECB  has  initiated  a  recalibration  of  its  asset  purchases  in  view  of  the  gradual 
convergence  of  inflation  rates  towards  the  ECB's  aim,  the  increasingly  broad-based 
economic  expansion  and  the  continued  effective  pass-through  of  monetary  policy 
measures to the financing conditions of the real economy. An ample degree of monetary 
stimulus remains in the euro area as domestic price pressures are still muted overall and the 
economic  outlook  and  the  path  of  inflation  remain  conditional  on  continued  support  from 
monetary  policy.  This  calls  for  a  supportive  role  from  other  policies,  whenever  space  for 
policy action is available. In particular, Member States with weak demand conditions and still 
significant slack in the labour market should remain firmly focussed on completing the reform 
agenda to converge upwards towards the best performers in terms of institutional and market 
structures. 

2 

 
 
 
 
 
Figure 1 – Macroeconomic developments and outlook for the euro area 

The  euro  area  recovered  its  pre-crisis  level  of  GDP 
per capita in 2016 and is expected to recover its pre-
crisis level of employment in 2017. 

The latest European Commission economic forecasts 
project a continuation of the expansion with a slight 
moderation in the next 2 years (2.2% in 2017,  2.1% 
in 2018, and 1.9% in 2019). 

Inflation,  and  in  particular  core  inflation,  remains 
subdued. Inflation has been persistently below the 2% 
reference value. 

Wage  growth  remains  subdued.  Growth  in  nominal 
unit  labour  costs  based  on  hours  worked  remain 
below  the  inflation  reference  value,  dragging  down 
core inflation. 

Nominal Unit Labour Costs growth - EA 

Labour market slack is still present in the euro area. 

The  euro  area's  current  account  surplus  further 
increased in 2016 and remains large, pointing to low 
domestic demand. 

3 

 
 
 
 
 
 
 
 
 
Figure 2: Divergences and rebalancing in the euro area  

Differences  in  unemployment  across  the  EA10  Member 
States  strongly  increased  with  the  crisis.  Dispersion  of 
GDP per capita remained on a rising trend until 2012, 
followed by a very moderate decrease by 2016.  

(EA10 is EA12 without LU and IE) 

The  post-crisis  sharp  adjustments 
in  current 
account  (CA)  balances  increased  divergences  in 
unemployment. After 2013, following labour market 
in  unemployment  has 
reforms, 
corresponded  to  increasing  divergences  in  hours 
worked rather than increase in CA imbalances. 

the  reduction 

Prior to the crisis, losses in competitiveness were 
associated with lower current account balances… 

…but since 2009 net external debtors have 
undergone significant adjustments in 
competitiveness. 

Adjustment has taken place mostly in countries with large net external liabilities, while surpluses of large net 
creditors persist and imbalances in the euro area remain sizeable. 

4 

 
 
 
 
 
 
 
 
Figure 3: Fiscal and monetary policy stance in the euro area – 2002-2016 

Notes: (1) The fiscal stance is defined here as the change in structural primary balance. To extend the series back in time, 
before 2011, the change in the cyclically adjusted primary balance was corrected for one-off measures. (2) For the monetary 
policy  stance  the  "shadow  rate"  is  used  here  to  capture  the  overall  impact  of  conventional  and  unconventional  monetary 
policy  tools  that  provide  monetary  stimulus  to  the  economy  (though  the  shadow  rate  is  only  one  of  the  instruments  that 
should  be  looked  at  to  evaluate  the  monetary  policy  stance).1  The  shadow  rate  should  nonetheless  be  used  with  a  lot  of 
caution because i) its estimated value is subject to model uncertainty; ii) it is based only on information embedded in interest 
rates and may not fully reflect all quantitative aspects of monetary policy; and iii) there is no proper benchmark for it akin to 
that for official policy rate.  Source: DG ECFIN calculations based on AMECO and ECB data. 

The  existence  of  cross-border  spillovers  is  a  key  reason  for  the  coordination  of  economic 
policies in the euro area.  

The high degree of economic and financial integration among euro area countries implies that 
shocks and policies at national level have important spillover effects on the whole area.  

Cross-border spillovers from fiscal policy measures can be sizeable. Recent simulations,2 
for  instance,  show  that  fiscal  multipliers  and  spillover  effects  (in  terms  of  impact  on  other 
countries'  GDP)  are  much  larger  when  monetary  policy  operates  in  a  zero  lower  bound 
environment, compared with normal times. An increase in public investment in countries with 
fiscal space would generate significant positive spillovers to the rest of the euro area. Long-
term  GDP  effects  would  exceed  the short-term  impact  as  public  investment  would  raise  the 
productivity of private capital and labour over a sustained period of time. At the same time, 
failure  to  reduce  public  debt  and  the  risk  of  renewed  market  pressure  on  high  public  debt 
countries would have negative effects for the whole euro area.  

Spillovers  from  structural  reforms  are  generally  found  to  be  positive  too,  although 
smaller.  The  simultaneous  implementation  of  structural  reforms  throughout  the  euro  area 

1   Data are based on McCoy, E. and U. Clemens (2017), "A Calibration of the Shadow Rate to the Euro Area 

2  

Using Genetic Algorithms", European Economy Discussion Paper 051, July 2017. 
In 't Veld, J. (2016), "Public investment stimulus in surplus countries and their euro area spillovers", ECFIN 
economic briefs 16, August 2016. 

5 

 
 
 
 
 
 
                                                 
would have a bigger effect on output than they would if they were implemented by countries 
in isolation. This highlights again the benefits of coordinated policy action.  

Reforms  in  one  country  can  also  affect  policy  action  in  other  countries  by  influencing 
political  constraints.  The  lack  of  incentives  for  implementing  difficult  reforms  might  be 
mitigated when policy action is taken in a coordinated manner across the Member States. 

3. Fiscal policy 

3.1. The fiscal stance in the euro area 

A broadly neutral fiscal stance at aggregate level for the euro area appears appropriate in 
the light of the current economic recovery characterised by some atypical features, the debt 
legacy  from  the  crisis  and  the  expected  recalibration  of  asset  purchases  by  the  ECB. 
Striking the right balance between ensuring the long-term sustainability of public finances, 
depending  on  country-specific  conditions,  and  supporting  the  economic  recovery  is 
essential.  

The  overall  fiscal  stance  of  the  euro  area  is  broadly  neutral  in  2017.  It  is  expected  to 
remain so in 2018 and in 2019 (under a no-policy change assumption for the latter year) 
(Figure  4).  A  broadly  neutral  fiscal  stance  for  the  euro  area  appears  still  appropriate  in  the 
light  of  the  current  economic  recovery,  which  is  strengthening  but  remains  atypical  and 
incomplete. This is even more relevant in the context of persistent debt legacy from the crisis. 

There  are  nonetheless  considerable  differences  at  national  level,  with  some  countries 
facing  the  need  to  consolidate,  while  others  have  some  fiscal  space.  A  differentiated 
approach  to  national  fiscal  policies  is  thus  needed  in  order  to  balance  the  objectives  of 
stabilising the economy and ensuring the long-term sustainability of public finances. 

It is also important to reduce excessive debt levels and re-build fiscal buffers, in order to 
be  able  to  absorb  potentially  upcoming  shocks.  According  to  the  latest  Commission 
economic forecast, the aggregate debt level for the euro area is expected to reach around 89% 
of  GDP  at  the  end  of  2017  and  decline  to  around  87%  and  85%  in  2018  and  2019 
respectively. Public debt levels have decreased on average at a slow pace and remain close to 
their historic peaks in several euro area countries. The strengthening recovery in the euro area 
and  the  associated  steepening  of  the  yield  curve  observed  since  the  fourth  quarter  of  2016 
suggest that the opportunity presented by the current low financing cost environment might be 
slowly fading.  Where debt ratios are high, curbing less growth-friendly spending and cutting 
tax loopholes is important for strengthening the sustainability of public finances.  

6 

 
 
 
 
 
 
 
 
3.2. The quality and composition of public finances  

Member  States'  fiscal  policies  can  contribute  to  both  stabilisation  and  sustainability  by 
improving the quality, composition and governance of their public finances. 

The  major  part  of  past  consolidations  relied  on  revenue  measures  (Figure  5).  This 
contrasts with findings3 that expenditure-based consolidation, in general, tends to weigh less 
on growth and have more persistent effects on deficit and debt levels.  

Figure 4: Fiscal policy and developments in the euro area 

Fiscal policy is on average countercyclical in the euro 
area this year. 

The overall fiscal stance for the euro area is broadly 
neutral in 2017 and is expected to remain so in 2018. 
Fiscal adjustment (change in the structural primary deficit) 

Growth-friendly expenditure, such as investment, has the potential to stimulate aggregate 
demand in the short term and raise potential growth over the longer term. Public investment 
has fallen over recent years. There is a need to ensure high-quality public investment to boost 
knowledge-intensive  and  sustainable  growth,  in  particular  by  investing  in  the  quality  of 
education and training. Evidence suggests significant room for improving the efficiency and 
effectiveness of public spending on education.  

Improvements  in  the  functioning  of  national  fiscal  frameworks  and  well-managed 
spending reviews can support the pursuit of a credible and growth-friendly fiscal policy. 

3   European Commission (2014), Report on Public Finances in EMU 2014, part IV. 

7 

-0.50.00.51.01.5(change in the structural primary balance)201220132014201520162017 fiscal consolidationfiscal expansion2018 2011Member States' intentions  Latest Commissionforecast 
 
 
 
 
 
 
 
 
 
 
 
 
                                                 
Figure 5: Composition of public finances in the euro area (tax and spending) 

The largest part of the fiscal effort in past years (2011-
17) relied on revenue measures and lower interest 
expenditures. 
Composition of fiscal effort, EA (2011-17),% GDP 1 

The share of social benefits in total expenditure has 
increased while the shares of investment and wages 
have decreased. 
Change in the share of total expenditure of selected 
expenditure items, EA (2011-17), pps. 

Taxes on labour income are the most important source 
of tax revenues in the euro area. 
Taxes as % of GDP, 2015 

ATP impacts on Effective Average Tax Rate in the euro 
area. 
Impact  of  ATP  on  the  Effective  Average  Tax  Rate 
(EATR) in the euro area 2 

Notes: (1) The Discretionary Fiscal Effort (DFE) combines a top-down approach on the expenditure side with a bottom-up or 
narrative approach on the revenue side. It consists of the increase in primary expenditure net of cyclical components relative 
to economic potential on the one hand, and of discretionary revenue measures on the other hand. See European Commission 
(2013), "Measuring the fiscal effort", Report on Public Finances in EMU, part 3. (2) "Hybrid financing" refers to a strategy 
where firms use mismatch in tax treatment of a financial instrument between two countries to obtain double deduction or no 
or  low  taxation;  "IP  box"  refers  to  a  strategy  relying  on  the  use  of  a  patent  box  to  obtain  lower  taxation  on  IP  revenues; 
"Financing  via  offshore"  relies  on  debt  shifting  using  a  no-tax  country  (which  has  concluded  tax  treaties  with  euro  area 
countries) to locate financial profits and benefit from interests deduction in high tax countries. Controlled foreign companies 
rules and thin capitalization rules are disregarded in the calculations of the EATR. 

Improving  the  overall  structure  and  design  of  taxation  can  free  resources  for  public 
investment,  education  and  healthcare  and  can  contribute  to  supporting  investment, 
employment and improving social fairness.  

8 

0.00.51.01.52.02.53.0Discretionary Fiscal EffortImprovement of the thestructural balancePrimary ExpenditureRevenuesInterest expenditure-1.5-1.0-0.50.00.51.01.52.02.53.0InvestmentSocial paymentsWages 
 
 
 
 
 
 
The overall tax burden in the euro area is high and skewed towards labour (Figure 5). 
For  euro  area  Member  States,  the  tax  burden  on  labour,  as  measured  by  the  tax  wedge,4  is 
among the highest in the world. For low income earners it standed in 2015 at around 41% for 
the euro area (against around 38% for the EU and around 29% and almost 31% in the US and 
Japan respectively). Reducing the tax burden on labour, while shifting it to other bases, can 
support  consumption,  stimulate  labour  supply  and  increase  work  incentives  for  low-income 
earners, beyond improving firms’ profitability and cost-competitiveness. The shift should be 
towards tax bases that are less detrimental to growth, such as, for instance, consumption taxes, 
recurrent housing taxes and environmental taxes.5 The distributional effects of a tax shift to 
alternative bases should be taken into account. 

Simplifying tax systems and addressing tax fraud, evasion and avoidance are essential to 
make  tax  systems  more  efficient  and  fairer.  In  particular,  measures  against  aggressive  tax 
planning  (ATP)6  are  essential  to  secure  government  revenues,  impede  distortions  of 
competition  between  firms,  preserve  social  cohesion  and  fight  increasing  inequalities.  The 
mobility  of  capital,  which  has  increased  with  the  introduction  of  the  euro  and  the  ensuing 
suppression  of  currency  risks,  facilitates  tax  arbitrage  by  multinational  enterprises.  This  is 
therefore  a  particularly  relevant  issue  for  the  euro  area.  The  Common  Consolidated 
Corporate Tax Base7 (CCCTB) would be another powerful tool against tax avoidance, while 
improving the Single Market for businesses. All measures to tackle tax abuse can also provide 
additional revenues to support labour tax reductions.  

ATP  negatively  affects  government  revenues  and  has  clear  spillover  effects  within  the 
euro  area.  Although  the  extent  of  these  practices  and  their  impact  on  total  tax  revenues  is 
hard to measure with precision, losses can be estimated at between EUR 40 and 60 billion.8 
ATP creates a tax-induced redistribution of tax revenues across euro area Member States on 
top of an overall loss due to lower effective taxation.  

ATP distorts the level playing field between firms.  A recent study demonstrates potential 
significant reduction in effective taxation for companies that engage in ATP, using structures 
that  involve  at  least  two  euro  area  countries  (Figure  5).9  It  can  allow  them  to  gain  market 

5  

4   The tax wedge is defined as the sum of personal income taxes and employee and employer social security 
contributions net of family allowances, expressed as a percentage of total labour costs (the sum of the gross 
wage and social security contributions paid by the employer). 
Johansson,  Å.,  Heady,  C.,  Arnold,  J.,  Brys,  B.  and  L.  Vartia  (2008),  "Taxation  and  economic  growth", 
OECD Economics Department Working Paper 620, OECD Publishing. 

6   ATP consists in taxpayers' reducing their tax liabilities through arrangements that may  be legal but are in 
contradiction  with  the  intent  of  the  law.  It  occurs  through  three  main  channels:  debt  shifting,  strategic 
location of intellectual property rights and intangibles assets and misuse of transfer pricing. In all cases, the 
strategy  consists  in  artificially  increasing  expenses  in  countries  with  higher  taxation  and  artificially 
increasing profits in countries with lower taxation. 

7   The  relaunch  of  the  CCCTB  provides  as  a  first  step  a  single  set  of  rules  to  calculate  companies'  taxable 
profits in the EU and as a second step the allocation of the consolidated taxable profits shared between the 
Member States using an apportionment formula. 

8   Own computations based on Dover, R., Ferrett, B., Gravino, D., Jones, E., and S. Merler (2015), "Bringing 
transparency,  coordination  and  convergence  to  corporate  tax  policies  in  the  European  Union",  European 
Parliament Research Centre Study. 

9   ZEW, Centre for European Economic Research (2016), "The Impact of Tax Planning on Forward-Looking 

Effective Tax Rates", Taxation Papers, European Commission, working paper no. 64. 

9 

 
 
                                                 
 
shares and raise entry barriers to the detriment of other firms (mostly domestic and/or smaller 
firms). Evidence has been found of a link  between ATP and higher mark-ups and increased 
industry concentration, which may lead to inefficiencies and high consumer prices.10  

ATP  calls  for  coordinated  action  at  European  level.  Due  to  capital  mobility,  the  fight 
against  ATP  can  only  be  truly  effective  if  all  countries  act  in  a  coordinated  fashion  at  euro 
area level.  

4. Structural reforms, economic resilience and real convergence  

Comprehensive  and  appropriately  sequenced  product  and  labour  market  reforms  can 
improve economic resilience, increase productivity growth and foster real convergence and 
fairness.  In  particular,  convergence  towards  resilient  economies  is  fundamental  for 
improving the functioning of EMU as the experience of the past years has shown how lack 
of  resilience  in  one  or  several  economies  of  the  euro  area  can  have  significant  and 
persistent effects not only on the countries concerned but also on other countries and the 
euro area as a whole. 

Structural  and  institutional  features  of  labour  and  product  markets  and  a  well-
functioning  state  sector  are  important  determinants  of  economic  resilience  and  real 
convergence.11  Resilient  economic  structures  prevent  shocks  from  having  significant  and 
long-lasting  effects  on  income  and  employment.  In  this  way,  they  reduce  economic 
fluctuations  and  prevent  strong  spillover  effects  of  the  kind  experienced  in  the  euro  area 
during  the  economic  and  financial  crisis.  Strengthening  resilience  entails  acting  on:  i) 
reducing  the  vulnerability  of  economies  to  shocks;  ii)  increasing  their  shock-absorption 
capacity; and iii) increasing their ability to recover from the shocks.  

Sequencing  and  packaging  of  labour  and  product  market  reforms  are  crucial  to  fully 
harness  the  positive  effects  they  can  have  on  investment,  growth  and  employment. 
Reforms  in  product  markets  tended  to  be  associated  with  an  increased  likelihood  of  labour 
market reforms following suit (based on past data). This  is  in line with  the expectation that 
reforms in product markets facilitate the entry of new firms, increase overall activity, thereby 
leading to an expansion in labour demand. Lower rents are also likely to reduce resistance to 
labour market reforms.12 The ability of the public administration to deliver efficient services 
and to implement reforms timely is a key cross-cutting factor in the achievement of economic 
and social objectives. 

10   OECD (2015), "Measuring and Monitoring BEPS", action 11, 2015 final report, p 181. 
11   Economic resilience is defined as the economy's ability to withstand shocks and recover quickly to potential 
thereafter. Real convergence is convergence in living standards, typically measured by GDP per capita. The 
two  concepts  bear  a  strong  relationship  in  that  resilient  economies  are  better  able  to  resume  long-term 
growth  and  prevent  severe  negative  social  consequences  of  downturns,  thus  fostering  real  convergence  in 
the longer run (for example by containing hysteresis risks following a crisis). 

12    Da Silva, A.D., Givone, A., and D. Sondermann (2017), "When do countries implement structural reforms?" 

ECB Working paper 2078, June 2017. 

10 

 
 
 
 
                                                 
Both  the  short-  and  long-term  effects  of  various  types  of  structural  reforms  matter. 
Some reforms can also have negative short-term effects on aggregate demand, which can be 
offset, at least partly, by an appropriate sequencing and packaging, to take advantage of their 
complementarities.13  Product market reforms strengthen the pass-through of reforms on the 
labour  market  to  product  markets.  Increased  competition  in  product  markets  leads  to  lower 
prices that can  sustain  changes  in  real wages.14 In  turn, labour  market reforms can  ensure a 
smooth  reallocation  of  labour  in  response  to  adjustments  triggered  by  product  market 
deregulation.  The  beneficial  effects  of  reform  packaging  are  also  supported  by  empirical 
analysis.15  The  simultaneous  implementation  of  labour  and  product  market  reforms  is 
estimated to improve growth dynamics in the short run.  

The  relative  contribution  of  different  types  of  structural  reforms  to  GDP  growth 
changes  over  the  time  horizon.  In  the  short  run,  labour  market  reforms  (increased 
participation, active labour market policies and benefit reforms), tax reforms (shifting taxation 
towards indirect taxes) and product market reforms (higher competition in services sector and 
lower entry costs) have the largest effects. Effects of education/training (or skills enhancing) 
reforms, as well as of innovation reforms (R&D promoting policies), become sizeable in the 
medium to long run (Figure 6).16   

During the crisis euro area countries have made significant reform efforts. Although the 
pace of reforms has differed across countries, most efforts were in the field of labour market 
regulations  (EPL)  and  framework  for  labour  contracts,  collective  bargaining,  active  labour 
market policies (ALMP), education, skills and life-long learning, and to some extent access to 
finance.  This  helped  to  increase  the  adjustment  capacity  of  the  economies  and  improve 
competitiveness. Conversely, progress was much more limited with regard to the removal of 
barriers in product markets (Figure 6). 

13   Banerji, A., Crispolti, V., Dabla-Norris, E., Duval, R. A., Ebeke, C. H., Furceri, D., Komatsuzaki, T. and T. 
Poghosyan  (2017),  "Labor  and  Product  Market  Reforms  in  Advanced  economies:  fiscal  costs,  gains  and 
support", IMF Staff Discussion Notes No. 17/03.   

14    Blanchard,  O.  and  F.  Giavazzi,  (2003),  "The  Macroeconomic  Effects  of  Regulation  and  Deregulation  in 

Goods and Labor Markets", The Quarterly Journal of Economics, Vol. 118, August, pp. 879-907. 

15   Berti, K. and E. Meyermans (2017), "Maximizing the impact of labour and product market reforms in the 

euro area – sequencing and packaging", Quarterly Report on the Euro Area 2017/2. 

16   Varga,  J.  and  J.  in  't  Veld  (2014),  "The  potential  growth  impact  of  structural  reforms  in  the  EU:  a 

benchmarking exercise ", European Economy Economic Paper no. 541. 

11 

 
 
 
 
 
 
 
 
 
 
                                                 
Figure 6: Structural reforms, economic resilience and growth effects 

Labour  market,  tax  and  product  market  reforms  have 
largest  GDP  effects  in  the  short  run;  education/training 
have sizeable effects in the medium to long run; innovation 
and R&D in the very long run. 

GDP effects after 5, 10, 20, and 50 years, by reform areas 
(difference from baseline) 

Significant  differences  still  exist  in  relation  to  business 
environment between EA Member States. 

Labour market reform efforts over 2008-13 have tended to 
be  more  pronounced  in  countries  with  initially  higher 
unemployment rates.1 

Product market reform efforts over 2008-13 have also tended 
to be more pronounced in countries with initially higher level 
of regulation, but with more limited progress.2 

Implementation of 2011-2016 CSRs linked to active labour 
market policies in euro area MS to date. 

Implementation  of  2011-2016  CSRs 
environment in euro area MS to date. 

linked 

to  business 

Notes: (1) Reform effort in labour market is measured as the number of labour market reform measures by country and year, 
where  pension  reforms  are  excluded  (source:  LABREF).  (2)  Reform  effort  in  product  markets  is  defined  as  the  change  in 
OECD PMR from 2008 to 2013 (positive value means the level of PMR has declined). Data for the PMR in 2008 are missing 
for Bulgaria, Croatia, Cyprus, Latvia, Lithuania, Malta and Romania. 

12 

 
 
 
 
 
 
 
 
4.1  Labour market and social protection systems 

Well–functioning  labour  markets  and  social  protection  systems  play  an  important  role  in 
supporting economic resilience and social fairness in the euro area. 

The experience of the crisis highlighted the need for improved policy coordination in the 
economic and social spheres. The European Pillar of Social Rights aims at progress towards 
future-proof, fair and well-functioning labour markets and welfare systems. The 20 principles 
set out in the Pillar fall into 3 broad chapters: 1) equal opportunities and access to the labour 
market;  2)  fair  working  conditions;  and  3)  social  protection  and  inclusion.  Well-designed 
active labour market policies support job matching and facilitate job transitions. Active labour 
market policies and support measures help reducing long-term unemployment17 by activating 
jobless people who can participate in the labour market, providing individualised support for 
job search, training and re-qualification, while contributing to social fairness.  

Access to high quality education and training is vital to ensure equal opportunities and 
address  skills  mismatches.  Adequate  investments  in  human  capital  through  education  and 
training systems that improve lifelong learning and ensure that skills levels match present and 
future  labour  market needs play a key role in improving the economy's adjustment capacity 
and  real  convergence  in  the  longer  run.  Investment  in  skills  can  also  drive  innovation  and 
increase  productivity  and  competitiveness,  in  addition  to  ensuring  social  inclusion  and 
mobility. This applies particularly to investment in digital skills that are particularly important 
to foster the euro area economy's competitive potential. 

Well-designed  social  protection  is  crucial  to  ensure  adequate  income  support,  promote 
inclusive  labour  markets  and  ensure  appropriate  social  support  through  access  to 
quality  services.  Apart  from  contributing  to  social  inclusion,  social  protection  systems  can 
play  a  strong  role  as  automatic  stabilisers  in  times  of  crisis.  Pension  reforms  and  work-life 
balance policies also are key to foster labour market participation. 

4.2 Product markets and the business environment 

Reforms  that  stimulate  innovation  and  enhance  competition  in  product  markets  bring 
important benefits through reduction in prices and availability of better quality goods and 
services.  Product  market  reforms  that  increase  competition,  reforms  that  improve  the 
business environment and the quality of institutions (including an effective justice system 
that  facilitates  contract  enforcements)  foster  economic  resilience  in  euro  area  Member 
States  by  supporting  the  economy's  capacity  to  cushion  a  shock  and  facilitating  the  swift 
reallocation of resources following it.  

Further integration in the Single Market has proven to be a major engine of growth and 
convergence  between  Member  States.  The  Single  Market  still  holds  considerable 

17  European Commission (2015), Employment and Social Developments in Europe 2015, chapter II.1. 

13 

 
 
 
 
 
                                                 
unexploited potential and significant progress is needed to complete it. The Single Market 
for services (including financial, digital commerce, energy and transport) remains incomplete. 
Attention should nonetheless also be focused on the goods markets to avoid potential market 
segmentation.  Completing  the  legal  environment  for  the  Digital  Single  Market  would  help  
speeding  up  the  digitalisation  of  economic  activities  as  a  necessary  step  to  improving  the 
performance of product markets and global competitiveness. 

Reforms  to  improve  the  quality  of  institutions  and  governance  as  well  as  the  business 
environment are complementary to product (and labour) market reforms. Such reforms 
strengthen  the  positive  impact  of  product  market  reforms  in  the  markets  where  they  are 
implemented  and  in  the  economy  as  a  whole.  Productivity  gains  in  downstream 
manufacturing  sectors  resulting  from  reforms  in  upstream  service  sectors  are,  for  instance, 
conditional to institutional quality.18  

5. Financial sector developments and policy  

Euro  area  financial  markets  showed  signs  of  optimism,  the  overall  resilience  of  banks 
continued to improve, as well  as lending conditions.  Vulnerabilities in the  banking  sector 
nonetheless remain and need to be addressed through measures at national and European 
level. 

Euro  area  financial  markets  showed  signs  of  optimism  over  the  past  year,  as  reflected  in 
higher  stock  prices,  a  gradual  increase  in  long-term  interest  rates  and  stable  or  narrowing 
sovereign spreads. In terms of credit provision to the real economy, bank lending conditions 
improved systematically. Interest rates on new corporate loans remain on a downward trend 
and convergence across Member States continues.   

Notwithstanding these positive trends, euro area  banks continue to be confronted with 
low profitability, especially for small and medium-sized institutions. The profitability of the 
median bank in the euro area remained constrained and often below the cost of capital. The 
cost  of  adapting  banks'  business  models,  the  low  interest  rate  environment,  and  potential 
competition from other forms of finance will continue to exert pressure on banks' profitability. 
Business models may therefore need to further adapt to become sustainable in the long-term. 
At  the  same  time  capital  ratios  are  on  an  increasing  trend  as  new  capital  requirements 
continue to be phased in.  

18   Beverelli, C., Fiorini, M., and Hoekman, B. (2017), "Services trade policy and manufacturing productivity: 

The role of institutions", Journal of International Economics, 104, pp. 166-182. 

14 

 
 
 
 
 
 
 
 
 
                                                 
Figure 7: Banking sector developments in the euro area  

Euro  area  banks  continue  to  be  confronted  with  low 
profitability,  with  performance  varying  significantly 
across Member States. 

The  stock  of  NPLs  continues  to  decline,  but  remains 
elevated 
jurisdictions,  while  NPL 
provisioning practices differ across Member States. 

some 

in 

The stock of non-performing loans (NPLs) continues to decline across the euro area. In 
nearly all more affected Member States, NPL ratios have stabilised or are on declining 
trend,  but  progress  remains  slow.  High  NPL  ratios  in  banks'  balance  sheets  may  hinder 
banks'  ability  to  lend,  the  transmission  of  monetary  policy  as  well  as  economic  adjustment 
capacity (as funding is not directed towards the most productive uses). They are also a source 
of  vulnerability  for  the  banking  system  as  a  whole.  High  NPLs  in  some  jurisdictions  have 
potential  spillovers  on  others  within  an  economically  and  financially  integrated  area  like 
EMU.  This  implies  that,  although  tackling  NPLs  remains  primarily  the responsibility  of  the 
affected banks and Member States, in some areas action is needed at European level. On the 
basis of the Action Plan to tackle NPLs that was agreed in the Council in July 2017, and as 
announced in the Communication on Banking Union of 11 October 2017,19 the Commission 
is currently working to deliver a comprehensive package of measures to reduce NPLs in early  
2018. This package will consist of actions related to prudential tools, structural reforms, the 
development of secondary markets and the restructuring of banking systems.  

The completion of the Banking Union and further progress on the Capital Markets Union 
are crucial to strengthening the EMU and fully reaping its benefits. 

Strengthening  the  institutional  architecture  of  EMU  requires,  as  a  matter  of  priority, 
completing  the  Banking  Union  and  further  progress  on  the  Capital  Markets  Union,  in 
parallel to reinforcing the euro area banking sector and adopting risk-reduction measures on 
the  financial  side.  In  order  to  further  support  banks'  efforts  to  reduce  risk  and  improve  risk 
management,  the  Commission  proposed  in  November  2016  a  comprehensive  risk-reduction 
package,  which  is  currently  under  discussion  in  the  European  Parliament  and  the  Council.  

19   COM(2017) 592. 

15 

 
 
 
 
 
 
                                                 
The Commission's latest Banking Union Communication suggested new measures to reduce 
non-performing loans and to help banks diversify their investments in sovereign bonds. 

Completing the Banking Union would reinforce financial integration by reducing barriers 
to  cross-border  banking,  reduce  the  risk  of  a  bank-sovereign  feedback  loop,  as  experienced 
during  the  crisis,  and  enhance  financial  stability.  Progress  on  the  Capital  Markets  Union 
would  foster  cross-border  private  risk  sharing,  thus  strengthening  financial  stability  and 
resilience  of  the  euro  area's  economies  in  case  of  asymmetric  shocks.  It  would  also  foster 
diversification of funding sources for business and support the efficient allocation of capital in 
the euro area. Additionally, more effective and consistent supervision is essential to eliminate 
possibilities  for  regulatory  arbitrage  between  Member  States  in  the  way  that  they  supervise 
financial entities and activities.  

A  common  European  Deposit  Insurance  Scheme  (EDIS)  is  necessary  to  complete  the 
Banking  Union.  This  would  underpin  the  credibility  of  the  Banking  Union  in  the  face  of 
large  shocks  by  ensuring  that  adequate  funding  is  swiftly  available.  The  current  set-up  of 
deposit guarantees is not optimal as national deposit guarantee schemes may be vulnerable to 
large  national  shocks,  in  particular  when  both  sovereign  and  national  banking  sector  were 
under  stress.  For  this  reason,  in  November  2015,  a  gradual  approach  was  proposed  by  the 
Commission,  consisting  of  a  re-insurance  of  national  Deposit  Guarantee  Schemes  (DGS), 
moving subsequently to a co-insurance scheme, where EDIS would intervene at the same time 
as  the  national  Deposit Insurance  Scheme  but  with  progressively increasing  contribution  by 
EDIS. As a final stage, only EDIS was envisaged as the entity in charge of intervening in case 
of payout events. In the recent Communication on the completion of the Banking Union, the 
Commission  has  confirmed  its  ambition  on  this  proposal.  To  revive  the  discussions,  the 
Commission has presented ideas for the European Parliament and the Council to consider, in 
the current negotiations, the possible introduction of the European Deposit Insurance Scheme 
in a more gradual manner, starting only with liquidity support provided by EDIS in the first 
phase and adding gradually loss coverage to the liquidity coverage in the second phase. At the 
end of the second phase EDIS would provide full liquidity and loss coverage. The move to the 
second  phase,  however,  could  be  commensurate  to  progress  achieved  with  regard  to  risk 
reduction  and  the  tackling  of  legacy  issues  that  could  be  measured  through  an  asset  quality 
review. 

Finally,  the  establishment  of  a  common  backstop  to  the  Single  Resolution  Fund  is 
needed  to  reinforce  the  credibility  of  the  Single  Resolution  Mechanism.  As  indicated  in 
the  Commission  Reflection  Paper  on  deepening  EMU  and  reiterated  in  the  recent 
Communication on the Banking Union, for the backstop to be effective it would have to be of 
an adequate size, would need to be activated in a swift manner, and would be fiscally neutral 
given  that  the  Single  Resolution  Mechanism  Regulation  stipulates  that  the  banking  industry 
repays any potential disbursements from the Single Resolution Fund. 

16