Opinion

Opportunities and risks in Europe in 2018

The new year could very well see the positive story of 2017 continue in Europe – but a number of looming policy and political problems cannot be ignored.

By: Date: December 30, 2017 Topic: European Macroeconomics & Governance

This opinion piece was also published in Nikkei Veritas, Nikkei Asian Review, and Kathimerini

As 2017 draws to a close, it is a good moment to review the main risks for the upcoming year and explore some of the opportunities. Let’s start with the opportunities: 2017 has been a good year for the global and the European economy. GDP growth numbers have been revised upwards in Europe with the notable exception of the United Kingdom. Unemployment has been falling rapidly while employment is at an exceptionally high level.

2018 could very well bring a continuation of that positive story. Balance sheets of banks and corporations are stronger than a year ago. Banks have made progress with addressing their non-performing loan portfolios, even though a lot of work remains to be done. Corporate debt to GDP ratios have been falling. Meanwhile, fiscal deficits have also fallen so that the need for austerity is receding. France has enacted some important labour market reforms that should help with the labour market, meanwhile Italy should benefit from the labour market reforms enacted in 2015.

Yet, there are important risks. The most important policy area that will deserve careful deliberation and cautious action is monetary policy. As the global financial crisis unfolded, the European Central Bank (ECB) and other central banks greatly extended their monetary policy toolboxes and adjusted their operational frameworks.

The main characteristic of monetary policy in recent years is that the main instrument, the interest rate, has been at the zero lower bound and has de facto become ineffective. This has lead the ECB to follow in the footsteps of the US Fed and use other ways to implement monetary policy. These so-called unconventional monetary policies have left central banks with large balance sheets. In fact, the various measures of the ECB have resulted in the quadrupling of the size the ECB’s balance sheet to above 4 trillion euros, more than 2 trillion euros resulted from the government bond purchase programme.

As growth picks up in the euro area, the discussions on when and how to normalise monetary policy will accelerate. One important question is whether to first normalise the interest rates, i.e. increase the main interest rate, and then to phase out government bond purchases or the other way around. Overall, the European policy makers seem to prefer to first phase out bond purchases and only then move the short term interest rate. As a result, the yield curve could first steepen before it may gradually shift upwards. This sequencing of the normalisation process would correspond to that of the US Federal Reserve, which started with tapering (ie gradually reducing asset purchases), then increasing key policy rates slowly before reducing passively the size of the balance sheet.

The debate on the optimal size of the central bank’s balance sheet has not yet been settled. It is a question of fundamental importance on whether and how quickly to reduce the balance sheet size of the ECB and absorb the large amounts of liquidity in the markets. If liquidity is removed too quickly, long-term interest rates and asset prices may react drastically. This could result in substantial financial instability. In my view, the ECB should therefore only gradually reduce its balance sheet size. But even then, financial stability risks may be the most important thing to watch next year.

There are other risks: a number of elections, most notably in Italy may change the political landscape in Europe substantially. Progress has been made on avoiding a cliff-edge Brexit but politics remains highly unstable and could still undermine a smooth progress towards a close trade agreement. Meanwhile, Germany still has no government and any broader debate on how to shape the future of Europe’s monetary union is therefore on hold. So overall we look into another exciting year ahead.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint.

Due to copyright agreements we ask that you kindly email request to republish opinions that have appeared in print to communication@bruegel.org.

View comments
Read article More on this topic More by this author

Opinion

Brexit and Finance: Brace for No Impact?

Amid the daily high drama of Brexit, it is easy to lose track of the structural shifts, or lack thereof, that may be associated with the UK’s possible departure from the European Union. One of them, and not the least, is the potential impact on the European and global financial system.

By: Nicolas Véron Topic: European Macroeconomics & Governance Date: October 14, 2019
Read article More on this topic More by this author

Podcast

Podcast

Brexit: a European Odyssey

Nicholas Barrett and Guntram Wolff talk to Kalypso Nicolaïdis, author of Exodus, Reckoning, Sacrifice: Three Meanings of Brexit. Together they discuss the mythology that binds Britain to continental Europe

By: The Sound of Economics Topic: European Macroeconomics & Governance Date: October 11, 2019
Read article Download PDF More on this topic More by this author

Policy Contribution

With or without you: are central European countries ready for the euro?

The debate on euro adoption by central European EU countries has intensified in the last years. In this Policy Contribution the author does not review all the complex aspects of euro-area enlargement, but analyse a particularly important issue: the build-up of macroeconomic vulnerabilities and the subsequent adjustments.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: October 10, 2019
Read article More on this topic More by this author

Blog Post

Long term real interest rates fell below zero in all euro area countries

The 10-year real government bond yield, which is the nominal yield deflated by expected inflation, has fallen below zero in Italy and Greece, boosted by increased market confidence for their new governments. Romania is the only remaining EU country with a positive real interest rate. Negative real interest rates vastly help fiscal sustainability and provide a great opportunity to invest in much needed infrastructure and the transition to a carbon-neutral economy.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: October 8, 2019
Read article More on this topic More by this author

Opinion

Europe: en finir avec la politique en silos

Projetée dans un monde de rapport de force dont les principaux protagonistes ne séparent pas géopolitique et économie, l’UE va devoir conduire un changement de logiciel culturel, une mutation organisationnelle et un rééquipement opérationnel, explique l’économiste Jean Pisani-Ferry.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: October 8, 2019
Read article More on this topic More by this author

Blog Post

Thomas Piketty's New Book: Impressive Research, Problematic Solutions

Thomas Piketty’s Capital in the Twenty-First Century blended history, statistics, and theory. Capital and Ideology his new magnum opus, is long enough (1,200 pages) to lump together several books: a quantitative history of inequality through time and space, from medieval Europe and ancient India to present-day societies; a largely noneconomic theory of social stratification; an investigation into the social roots of current populism; and a political manifesto for the European left.

By: Jean Pisani-Ferry Topic: Global Economics & Governance Date: October 3, 2019
Read article More on this topic More by this author

Opinion

How to ward off the next recession

Despite confident official pronouncements, the deteriorating state of the global economy is now high on the international policy agenda. The OECD recently revised down its forecasts to 1.5% growth in the advanced G20 economies in 2020, compared to almost 2.5% in 2017. And its chief economist Laurence Boone warned of the risk of further deterioration – a coded way of indicating a growing threat of recession.

By: Jean Pisani-Ferry Topic: Global Economics & Governance Date: October 2, 2019
Read article More by this author

Blog Post

Why structural balances should be scrapped from EU fiscal rules

A prominent team from DG ECFIN of the European Commission challenged some of the criticisms of the EU’s methodology for estimating potential output and output gaps, as well as their role in the EU fiscal framework. In this post, I conclude that their responses to the criticisms they considered are questionable. More importantly, they overlook serious problems with the EU’s potential output methodology.

By: Zsolt Darvas Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: October 1, 2019
Read article Download PDF

External Publication

European Parliament

Challenges ahead for the European Central Bank: Navigating in the dark?

Since the second half of 2018, signs of a slowdown have been piling up in the euro area. The ECB will face major challenges in this potentially difficult period: its main tools are nearly exhausted, the monetary union in which it operates is still incomplete, and it lacks the understanding of what the ‘new normal’ looks like. The authors, therefore, urge the ECB to review its strategy and framework to be able to face these challenges.

By: Grégory Claeys, Maria Demertzis and Francesco Papadia Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: September 25, 2019
Read about event

Past Event

Past Event

Climate change and the role of central banks

What connections exist between central banks and climate change, and what are the resulting implications?

Speakers: Emanuele Campiglio, Paul Hiebert, Pierre Monnin, Kjell G. Nyborg, Luiz Awazu Pereira da Silva, Mario Quagliariello, Mattia Romani, Paweł Samecki and Dirk Schoenmaker Topic: Energy & Climate, European Macroeconomics & Governance Location: Narodowy Bank Polski, Świętokrzyska 11/21, 00-919 Warsaw Date: September 16, 2019
Read article Download PDF

Policy Contribution

European Parliament

Hybrid and cybersecurity threats and the European Union’s financial system

The authors document the rise in hybrid threats and cyber attacks in the European Union. Exploring preparations to increase the resilience of the financial system they find that at the individual institutional level, significant measures have been taken, but the EU finance ministers should advance a broader political discussion on the integration of the EU security architecture applicable to the financial system.

By: Maria Demertzis and Guntram B. Wolff Topic: European Macroeconomics & Governance, European Parliament, Finance & Financial Regulation, Testimonies Date: September 12, 2019
Read article More on this topic More by this author

Opinion

Economic priorities for new EU leadership

Europe is no longer in crisis mode. However, it remains vulnerable; it is unprepared and it is procrastinating. Following European elections this May, new leaders are about to take their positions at the main European institutions for the next 5 years. They have the power in their hands to take action. But more importantly, they have the power to convene 28 states, which, if united, can play a significant global role. What are the urgent challenges that require collective European action?

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: September 10, 2019
Load more posts