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Today the EU and Switzerland signed a historic new tax transparency agreement, which will significantly improve the fight against tax evasion. Under the agreement, both sides will automatically exchange information on the financial accounts of each other’s residents from 2018. This spells an end to Swiss bank secrecy for EU residents and will prevent tax evaders from hiding undeclared income in Swiss accounts. The agreement was signed this morning by Commissioner Pierre Moscovici and Janis Reirs, Latvian Minister of Finance on behalf of the Latvian Presidency of the Council for the EU, and by the Swiss State Secretary for International Financial Matters, Jacques de Watteville.

Pierre Moscovici, European Commissioner for Economic and Financial Affairs, Taxation and Customs, said: “Today’s agreement heralds a new era of tax transparency and cooperation between the EU and Switzerland. It is another blow against tax evaders, and another leap towards fairer taxation in Europe. The EU led the way on the automatic exchange of information, in the hope that our international partners would follow. This agreement is proof of what EU ambition and determination can achieve.”

The automatic exchange of information is widely recognised as one of the most effective instruments for fighting tax evasion. It provides tax authorities with essential information about their residents’ foreign income, so that they can assess and collect the taxes that are due on them.
Under the new EU-Swiss agreement, Member States will receive, on an annual basis, the names, addresses, tax identification numbers and dates of birth of their residents with accounts in Switzerland, as well as other financial and account balance information. This new transparency should not only improve Member States’ ability to track down and tackle tax evaders, but it should also act as a deterrent against hiding income and assets abroad to evade taxes.

The new EU-Swiss agreement is fully in line with the strengthened transparency requirements that Member States agreed amongst themselves last year. It is also consistent with the new OECD/G20 global standard for the automatic exchange of information.

The Commission is currently concluding negotiations for similar agreements with Andorra, Liechtenstein, Monaco and San Marino, which are expected to be signed before the end of the year.

It is such a pleasure to be back in Brazil – one of the first countries I visited as Managing Director of the IMF. It is a special pleasure to be here in Rio de Janeiro, which hosted the last IMF Annual Meetings held in Latin America – back in 1967. I am delighted to say that our Annual Meetings will return to the region this year, and I look forward to seeing many of you in Lima in October.

It is also a pleasure to take part today in such an important event on monetary policy. Inflation targeting has been a key pillar of Brazil’s solid macroeconomic framework for the past 15 years. Together with fiscal responsibility and the flexible exchange rate, inflation targeting has brought important benefits to this country—sustaining high growth while stabilizing inflation. This was achieved as public debt was reduced and international reserves built up – and even more importantly, while lifting millions of people out of poverty. This is a remarkable feat.

Yet, the global financial crisis and, more recently, the changing external landscape are challenging policymakers in many emerging market economies. It is reigniting an active debate about the role of monetary policy, including inflation targeters.

For example, how to ensure price stability if there is uncertainty about the economy’s productive capacity? How to secure financial stability if macro-prudential policies are not sufficiently effective in alleviating systemic risk? And how to make sure that monetary policy reinforces other macroeconomic policies in supporting growth and job creation?

These are important challenges not only for Brazil, but for other central banks in the region.
As Alice Rivlin – former Vice Chair of the U.S. Fed – once said: “The job of the central bank (and in turn Central Bankers) is to worry.”
So today’s conference is particularly timely in helping us address some of those “worries” on the horizon. In that spirit, I would like to share my perspective on three topics:

(i) First, changes in the global landscape and implications for Latin America and Brazil;

(ii) Second, how to build resilience to a more challenging outlook in the near term; and

(iii) Third, how to restore and sustain robust and inclusive growth.

1. Latin America—big strides so far, more challenging times ahead
Let me begin by highlighting key macroeconomic achievements of the past and challenges for the region in the future.

Over the past few decades, countries in the region have overcome formidable challenges. Think of the debt crisis and lost decade of the 1980s. Growing out of that experience, policymakers in many parts of Latin America have made impressive achievements. They have reduced public debt, strengthened their monetary frameworks, replenished their external reserves, and – for many of them – opened their borders to trade.

In a context of rising commodity prices and favorable external conditions, these policies brought about a welcome change in the macroeconomic scene. Between 1990 and 2009, the region grew by 3 percent on average annually, inflation stabilized at low levels, and tremendous progress was made in a number of areas of social development.

For example, poverty has declined throughout the region, and the middle class now comprises almost half of Latin America’s population, compared to only 20 percent a decade ago. Financial inclusion has also improved—more than half of the region’s adults had access to a bank account in 2014, compared to less than 40 percent only three years earlier.

In many ways, Brazil is emblematic of these trends. Yesterday I had the opportunity to witness first-hand some of the country’s social programs in action. Bolsa Familia and Brasil sem Miseria are renowned and much admired programs. I was especially struck by something I knew less about until yesterday—the effort to empower women, including by offering them training so they can be successful, independent entrepreneurs in their communities.

Again, these are impressive achievements on which Brazil is to be congratulated. And yet, Brazil and much of the region now stand at a very challenging juncture, with lower global demand and continued slowdown in domestic activity.

What are the global challenges?
For a start, global growth remains modest and uneven – at 3.5 percent this year, roughly the same pace as last year. Important trading partners such as China are slowing, whereas advanced economies are recovering at different speeds—faster in the United States, slower in Europe and Japan.
At the same time, the decline in oil and commodity prices appears likely to persist, and U.S. interest rates are set to edge higher. The exact timing of interest rate lift-off and its impact on global capital flows is uncertain – despite this being the most anticipated monetary policy decision one can remember. It is no surprise that this is a key concern on the minds of central bankers in this and other regions.

Even though it is not the central forecast in our outlook, the prospective normalization of U.S. monetary policy could create market volatility, with broader implications for the global economy. Continued effective communication from the U.S. Federal Reserve will help telegraph future policy moves and temper the potential for abrupt asset price movements.

It is also our view that an increase in interest rates that reflects a robust improvement in the U.S. economy is likely to bring positive effects for the region overall. Naturally, those countries more directly linked to the United States are better positioned to benefit from such improvement. For countries such as Brazil, the spillovers from stronger U.S. growth – and therefore stronger global growth – would be positive.
More broadly, the asynchronous stance in monetary policy in advanced economies is likely to contribute to volatility in major exchange rates in the period ahead.

Putting all these factors together, our latest forecasts for Latin America and the Caribbean envisage a fifth consecutive year of slower growth than the year before—of less than one percent in 2015. For Brazil, like many other observers, we anticipate a contraction of one percent this year and a modest recovery next year.

So the near-term outlook is challenging. Yet, being the optimist that I am, with every challenge, I see an opportunity—to learn from the past and to build a better future. A key lesson of the 2013 taper episode is that resilience to external volatility is built at home, with strong policies and strong fundamentals.
This brings me to my second topic – building resilience, where Brazil is laying the foundations by strengthening macroeconomic policies.

2. Reinforcing policy frameworks to build resilience
Like other countries in the region, Brazil appropriately responded to the global financial crisis by implementing countercyclical policies. And like many other countries in the region, it maintained the stimulus as it saw a hesitant recovery in growth.
Of course, with hindsight, a decline in Brazil’s potential growth—not so evident back in 2011—was playing a role, an issue on which you will hear more from the Fund staff today .

Boosting growth is imperative – but this is more about supply than demand. Strengthening macroeconomic policies is the preferred approach to secure stability and enhance resilience to external shocks.

Encouragingly, the Brazilian government is pursuing such a strategy. It has announced primary surplus fiscal targets of 1.2 percent of GDP this year and 2 percent of GDP in 2016–17, with a number of measures adopted to achieve these targets. Such a gradual yet significant increase in the primary surplus is necessary to bolster credibility in domestic policymaking.

At the same time, key administered prices are being updated, in an effort to ensure the efficient use of scarce resources in the economy. Important as it is, a side effect of this step has been rising inflationary pressures. To prevent these relative price changes from affecting medium-term market expectations, monetary policy appropriately went into a tightening mode since late last year.

Indications are that this policy is working. Even though inflation in 2015 will be on the high side as a result of the relative price changes, the expectation is that it will revert within the band in 2016, and continue to converge toward the central target thereafter.

Overall, therefore, the recent strengthening of fiscal and monetary policies – together with a strong international reserves position and a flexible exchange rate system – is critical in bolstering the credibility and resilience of Brazil’s economic policy frameworks.

So Brazil is clearly on the right track.
This is also the case for other countries in the region, where we see a significant strengthening of macroeconomic policies.
Of course, in the context of declining growth, this stance has critics. Yet, our analysis suggests that the merits of further stimulus could put at risk the hard-won credibility of past policy efforts. That credibility is especially important in restoring and sustaining prospects of strong, balanced, and inclusive growth.
Which leads me to my third and final topic—the structural reforms needed to boost productivity and ensure durable gains in potential growth.

3. Reigniting robust and inclusive growth—tapping the promise of structural reforms
The distinguished 19th century Brazilian author, Jose de Alencar, once said: “Success is born from the will in reaching a goal. Even without reaching the target, he who seeks and overcomes hurdles will, at a minimum, achieve amazing things.”

Clearly, in the current environment, restoring solid growth and maintaining hard-won macroeconomic and financial stability in the region will prove challenging. However, the current difficulties may also open up opportunities for addressing long-standing weaknesses and implementing reforms to launch a new phase of prosperity and social progress. By overcoming “hurdles”, amazing things can be accomplished.

Let me underscore that steps are needed in many areas. I will highlight three – and again, use Brazil to illustrate some of the challenges common to the region.

First on my list is plugging infrastructure gaps. Inadequate infrastructure is a key hurdle for productivity in many Latin American economies, including Brazil. For example, according to the World Economic Forum Surveys, there are issues with the quality of roads, ports, and air transport in the country.

In that context, the Infrastructure Concession Program is an important and timely step in the right direction. Of critical importance is that it calls for the private sector to play a key role.

As Minister Levy recently remarked in a seminar in Washington, Brazil has a long history of successful private participation in the development and management of infrastructure. The Rio-Niteroi bridge, which is easy to see from most vantage points in Rio and whose concession was auctioned recently, is a good example

Second on my list is reducing the cost of doing business. For example, Brazil’s tax system is characterized by a complex set of indirect taxes, including at the national and sub-national levels. These generate high tax compliance costs.

Simplifying the State level Taxes on the Circulation of Goods and Services (ICMS) and the federal sales taxes could significantly improve the business environment. At the same time, addressing budgetary rigidities can help increase the efficiency of public spending.

Third on my list of priorities to help boost growth is rejuvenating trade integration. Latin America, and notably, Brazil can still reap large benefits from deeper integration into global value chains and greater transfer of technology from trade partners.

Asia provides a useful example of the benefits of integration in regional and global value chains. Across major emerging markets, Brazil has one of the smallest volumes of trade in goods and services relative to GDP. So even modest efforts aimed at greater trade integration could significantly bolster growth prospects.
Brazil has ongoing initiatives in all these areas, some better known or more advanced than others. The key now is vigorous and ambitious implementation if they are to give the boost in growth and prosperity we all hope to see.

Conclusion
Let me conclude.
Over the past few years, we have seen some important shifts in fortunes in this region, mostly along North-South lines. Back in 2010, it was the North cooling down and the South heating up. Today, we see a Northern spring and Southern chills.
Yet from where I stand, I can see immense opportunity for the whole region—renewed growth and prosperity blossoming in the North and South alike. And I see Brazil as a prime candidate to lead by example. True, the external environment has become less friendly and domestic constraints are non-trivial. Yet with perseverance and the right policy choices, that brighter outlook is within reach.
I cannot leave Brazil without making reference to one of its most important icons in an area where it has always excelled. It was the great Pele who said: “Success is no accident. It is hard work, perseverance, learning, studying, sacrifice and most of all, love of what you are doing or learning to do.”

As we approach our Annual Meetings in Lima, Peru, I am confident that policymakers will find the perseverance, inspiration, and yes, courage, to make the right choices and deliver a new era for the region. And just like in football, each and every country must do its part for the whole region to win.
Obrigada—thank you.

My theme is taken from Jean Monnet, who in 1976 wrote: “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.”2 This quote is discussed in the interesting recent paper by Luigi Guiso, Paola Sapienza, and Luigi Zingales, whose view of Monnet’s contention can be deduced from the title of their paper: “Monnet’s Error?”3 There are similar quotes from others, among them Jacques Chirac in 2003 and the former chief economist of the ECB, Ottmar Issing, in 2010.4 I first heard a statement to this effect from Jean-Claude Trichet at the 2011 Jackson Hole conference.5

An extended 2015 version of the Monnet contention would take the form: “The first step on the road to European union was the creation of the Coal and Steel Community in 1951. At the start, we did not have a road map, but we had the goal of ensuring that the countries of Europe would never again go to war, and to that end, we had to build an institutional structure that would make another European war impossible. From time to time we encountered obstacles in that process. These obstacles often led to crises, but the crises were overcome, and from each crisis, the prospects for a united, prosperous, and peaceful Europe emerged stronger. And that is what will happen this time too.”

This leaves us with three questions: Has modern Europe developed primarily through crises? Will it be stronger when this crisis is over? And what challenges or crises is Europe likely to have to deal with in future? Despite the fact that political and economic aspects of the structure of the European economy have inherently been closely intertwined throughout history–and saying this, one thinks of the Romans and later of Charlemagne–I will focus on the economic aspects of the European project, and primarily on its monetary and financial aspects.6

Intra-European monetary and exchange rate problems have for centuries bedeviled European countries and intra-European trade, and led to the desire for greater exchange rate stability–perhaps through some form of treaty or agreement, or even through a monetary union. Of course, the desire for greater exchange rate stability is true also of almost the entire world, and is reflected in the original Articles of Agreement of the International Monetary Fund.

The first modern international attempt to regularize monetary relations among independent European states was that of the Latin Monetary Union (LMU), which came into force in 1866. The original members were France, Belgium, Switzerland, and Italy. The Papal States joined later in the same year, and Greece and Rumania joined in 1867.7 The members agreed to fix exchange rates among them by setting the amounts of silver and gold (weights and fineness) in the national coinage, with a specified exchange rate (15.5) between silver and gold. In addition, a limit of 6 francs per inhabitant was set on the value of smaller coins issued by each country, “because of their substantial seigniorage.”8

The LMU fixed exchange rates within a bimetallic international system. Kindleberger notes that in setting up the Union, the Swiss, Belgians, and Italians were in favor of moving to the gold standard, but that “French resistance dominated” (p. 68). “Then came a series of blows to silver” (p. 68), the most important occurring after the establishment of the Reichsbank, when Germany in 1873 shifted from bimetallism to the gold standard, and the Reichsbank started selling its silver. In practice this moved the LMU to a gold standard, a change that was formally recognized in 1878–the year of the International Monetary Conference called by the United States to maintain bimetallism, an effort which failed.

The exchange rates established by the LMU became ineffective during and after World War I, and the Union was formally ended in 1927.9 Kindleberger writes consolingly that “from 1865 to 1867, … the Latin Monetary Union worked reasonably well, and its success suggested the desirability of expanding it to arrive at a ‘universal money'” (p. 69).

Now to post-World War II Europe, and the question of whether Europe has emerged stronger through crises. The Treaty of Rome, establishing the European Economic Community (EEC), was signed in 1957 by the six original members: Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany, the same group that had set up the Coal and Steel Community. The aim was economic integration among the six members, including a common market and a customs union. At that time, the Bretton Woods agreement and capital controls were still producing reasonable stability in exchange rates.

However, as Bretton Woods began to unravel in the 1960s, exchange rates became more unstable, and appreciations and depreciations against the dollar led to sizable shifts in bilateral rates among European currencies. Yet the EEC continued to work within the Bretton Woods framework, even as the Bretton Woods approach began to be modified at the end of the decade and the beginning of the 1970s. Of particular difficulty to members of the EEC, under some circumstances the exchange rate bands specified in the Smithsonian agreement permitted movements of up to 9 percent between any pair of currencies.

In response to these pressures, members of the EEC agreed in 1972 to the so-called “snake”–or “the snake in the tunnel”–that attempted to limit exchange rate fluctuations of each currency relative to the dollar.10 However, this system was soon tested, notably by the oil crises of the 1970s, as both the effects of the oil price increases themselves and the policies adopted in response differed across countries. Denmark and the United Kingdom exited the snake soon after entering, Italy dropped out in 1973, and France participated intermittently during the mid-1970s, first dropping out in 1974.

The snake was a failure, a failure that created problems, though not clearly a crisis. If exchange rates among members of the EEC were to be stabilized in the new world of floating rates, the Community had to invent a substitute. In 1978, the members of the EEC created the European Monetary System, which started with an Exchange Rate Mechanism (ERM I) that limited currency fluctuations relative to a basket of national currencies.11 All members except the United Kingdom participated in ERM I. The arrangement also committed central banks to intervene to support the resulting bilateral rates as they approached the limits of the permissible bands. Countries in the ERM also adopted policies that lowered inflation, bringing interest rates into closer alignment. The initial success of the ERM encouraged European leaders to lift capital controls and built momentum toward monetary union, which was reflected in the Maastricht Treaty (the Treaty on European Union), agreed to in 1991 and signed in 1992.

However, strains also emerged under the ERM, in an environment in which the Bundesbank emerged as the dominant central bank in Europe, and the Deutschmark as the dominant European currency. This led other countries in the ERM to follow German monetary policy. In part as a consequence of German reunification, the pressures generated by diverging fiscal policies and tightening German monetary policy contributed to the ERM crisis of 1992. Moreover, the earlier lifting of capital controls and the promises to intervene to support rates that were ultimately not credible put tremendous pressure on the pegged rates–and on relations among some members of the EEC. The crisis forced the United Kingdom and Italy out of the ERM and forced others (Portugal and Spain) to devalue their currencies.

The ERM crisis was an apt illustration of the difficulties of trying to manage exchange rates among countries operating under markedly different economic conditions. However, rather than dissuading policymakers from trying to limit exchange rate fluctuations within a system that would nonetheless preserve the possibility of some exchange rate flexibility, the experience seemed to encourage them to continue with the plan of the Maastricht Treaty to introduce a single currency and a common monetary policy at the beginning of 1999. Here indeed was an example of a crisis leading to a strengthening of the European system–though the process to create EMU–the Economic and Monetary Union, not the European Monetary Union–began well before the ERM crisis.

The exchange rate and central banking provisions of the Maastricht Treaty were introduced on the schedule set out in 1991, with the ECB coming into existence in 1999. Until about 2009, the monetary aspects of the plans for the development of the European Union (EU) seemed to be a major success–but not a sufficient success to persuade all members of the Union to become members of the ECB and adopt the euro, with the most notable standout being the United Kingdom.

The ERM crisis also drove home the need for greater coordination of fiscal policies in the run-up to monetary union. Members of the EU agreed to the Stability and Growth Pact in 1996. Although, as we all know, the conditions of the pact have not always been observed, nor enforced by Brussels, the acknowledgment of the need for a coordinated fiscal policy to complement monetary union was still a step forward–one which may be drawn on in future.

What lessons can we draw from this history of the region’s economic and monetary responses to earlier crises? Do the results bear out the spirit of the statements by Monnet and others about each crisis leading to greater strength? Certainly, each setback and each crisis spurred policymakers to take steps that they might not otherwise have taken at that time, and the end result of those steps has been a more unified European monetary union. Successive crises have not deterred policymakers from the goal of economic integration, but rather seemed to strengthen their belief in the need for it–and that integration is stronger today than it ever was in the past.

Looking back, the progress in this project from its earliest days after World War II until today has been impressive. Trade integration has led to the free flow of goods within the EU, and this has brought economic gains. Greater trade integration has in turn generated a continued desire for greater monetary integration, which was put in place in 1999, and until recently seemed to be a major success. That success in turn made crystal clear the need for more fiscal integration–a challenge for the future, to which we will return.

What about the present crisis of the euro area? Two or three years ago, there was widespread skepticism on the western shores of the Atlantic and the English Channel about the viability of the monetary union, and there was much discussion of what would happen after the breakup of the present euro area–whether there would be one or two euro areas, one for the stronger countries, one for the weaker, and if so, how well each of the two blocs would fare.

With one sentence–the sentence that included the words “whatever it takes”– that skepticism was largely, though not totally, erased. With one decision–the decision to implement QE–it became clear that the ECB has the capacity both to decide to implement monetary policy at the zero lower bound–indeed below the zero lower bound–and to succeed in implementing that policy. There can be no one whose Bayesian priors have not moved in favor of the survival of essentially the present euro area, even though we still await the outcome of the Greek crisis, and even though we know that the present crisis is not yet over.

Is this an example of the success of the Monnet approach? Absolutely. European monetary policy in the earlier part of the Great Financial Crisis was innovative, particularly in the invention of full-allotment outright monetary transactions. That policy was inspired by crisis, as were the innovative policies undertaken by the Fed in the United States. More important than that: It is hard to believe that a European banking union would have been put in place by 2014 if it had not been for the crisis. And it is no less difficult to believe that a Single Supervisory Mechanism would have been set up absent the crisis. Of course, one may say that the ability to make these difficult decisions depended on the skills of the leadership of the ECB–and that is true, and will always be true. But the fact is that, when needed, Europe produced the monetary policy leadership it needed.

What of the future? What crises, what extremely difficult decisions, await the EU? Some are already visible. The decision to use the single currency to drive the European project forward was a risky one, and at some stage or probably in several stages, it will be necessary to put the missing fiscal framework into place. And that, if it happens, will be another example of a crisis–the present crisis, one hopes–whose solution will have strengthened the European enterprise. For success in this area must be one of the most difficult economic challenges facing the EU after the present crisis is over.

Also awaiting the EU are the possibilities of major difficulties associated with the current Greek crisis and, later, with a potential British exit. One can of course imagine many different types of future crises, including crises that could develop out of the worsening geopolitical situation in which the Western world finds itself. And one could go on.

Experience tells us that the best way to deal with future crises is to strengthen the economic framework in which they will be confronted. That will require a great deal of thought about how to deal with future crises that could most easily be solved by an exchange rate adjustment, and it will also require developing a better mechanism to ensure that member states run responsible financial and budgetary policies. It means also seeking solutions to the difficult demographics now confronting many European countries.

And it means the continuation of a courageous and effective monetary policy, and courageous and effective regulation and supervision of the financial system–albeit a monetary policy that could do even better if accompanied by an expansionary fiscal policy.

All that has been done so far makes it very likely that EMU–the Economic and Monetary Union–will survive this crisis. But in the longer run, EMU will not survive unless it also brings prosperity to its members. That means that the most important challenge of the future will require an increase in productivity growth in Europe–and that is a challenge that faces the entire developed world.

Let me conclude by congratulating you, the management and staff of the ECB, on what you have achieved in your short history, and especially in the last few years. And best wishes for future success in continuing to do your share in contributing to the building of Europe–preferably without having to face too many future crises, useful as Monnet’s approach suggests such crises could be.

Today I would like to speak with you about the outlook for the U.S. economy. I should note at the outset that my remarks today reflect my own views and not necessarily those of others in the Federal Reserve System.

The Recession and the Recovery So Far
As you all know, the economy is still recovering from the Great Recession, the worst downturn since the terrible episode of the 1930s that inspired its name. The recession began more than seven years ago, the result of the collapse in the housing market and the financial crisis that it sparked. Rhode Islanders are well aware of the great toll taken by the recession. The unemployment rate hit 10 percent nationally, and it reached 11.3 percent here in Rhode Island. Nationally, payrolls shrank by some 8-1/2 million, about 6 percent, and the 41,000 jobs lost in Rhode Island represented close to 8 percent of the state’s employment. U.S. economic output fell more than 4 percent nationally, the most since the Great Depression, and many of the hardest-hit industries, including housing construction and manufacturing, are important to the Rhode Island economy.1

The Federal Reserve took action to help stabilize the financial system during the crisis, and we have supported the economic recovery with monetary policy actions designed to hold down longer-term interest rates. With this help, the economy has made significant strides. The pace of job gains has gradually strengthened, and payrolls expanded by more than 3 million in 2014 alone. The unemployment rate has come down steadily to 5.4 percent in April. One sign of a stronger labor market is that the number of job openings has risen impressively, and another is that more workers are quitting their jobs, signaling greater confidence in their ability to find a new job.

Rhode Island is sharing in this recovery, but I am well aware that economic conditions remain difficult here. Rhode Island’s unemployment rate improved very slowly during the recovery, and, for a time, it was the highest of any state. The jobless rate has come down a lot over the past year or so, but at 6.3 percent in March, unemployment here remains above the national average, and payroll employment has yet to regain its pre-recession peak.

In recent months, some economic data have suggested that the pace of improvement in the economy may have slowed, a topic I will address in a moment. And even with the significant gains of the past couple years, it is only now, six years after the recession ended, that the labor market is approaching its full strength.

I say “approaching,” because in my judgment we are not there yet. The unemployment rate has come down close to levels that many economists believe is sustainable in the long run without generating inflation. But the unemployment rate today probably does not fully capture the extent of slack in the labor market. To be classified as unemployed, people must report that they are actively seeking work, and many people without jobs say they are not doing so–that is, they are classified as being out of the labor force. Most people out of the labor force are there voluntarily, including retirees, teenagers, young adults in school, and people staying home to care for children. But I also believe that a significant number are not seeking work because they still perceive a lack of good job opportunities.

In addition to those too discouraged to seek work, an unusually large number of people report that they are working part time because they cannot find full-time jobs, and I suspect that much of this also represents labor market slack that could be absorbed in a stronger economy. Finally, the generally disappointing pace of wage growth also suggests that the labor market has not fully healed. Higher wages raise costs for employers, of course, but they also boost the spending and confidence of customers and would signal a strengthening of the recovery that will ultimately be good for business. In the aggregate, the main measures of hourly compensation rose at a rate of only around 2 percent through most of the recovery. And in Rhode Island, average hourly earnings have not risen at all in the past year. Nationally, there are at least some encouraging signs of a pickup so far this year.2 The fact that some large companies, such as Wal-Mart and Target, have announced wage increases for their employees also might be a sign that larger wage gains are on the horizon.

This improvement in the labor market has brought the economy closer to one of the two goals of monetary policy assigned to the Fed by the Congress–maximum employment. Less progress has been made toward the other goal, price stability. Consumer price inflation remains below the Fed’s stated objective of 2 percent. The notion that inflation can be too low may sound odd, but over time low inflation means that wages as well as prices will rise by less, and very low inflation can impair the functioning of the economy–for example, by making it more difficult for households and firms to pay off their debts. Overall consumer price inflation has been especially low–close to zero–over the past year, as the big fall in oil prices since last summer lowered prices for gasoline, heating oil, and other energy products. But inflation excluding food and energy, which is often a better indicator of where overall inflation will be in the future, has also been low, below the Fed’s 2 percent objective both now and for almost all of the economic recovery. Inflation has been held down by the continued economic weakness during the slow recovery and, more recently, by lower prices of imported goods as well as the fall in oil prices. With oil prices no longer declining, and with the public’s expectations of future inflation apparently stable, my colleagues on the Federal Open Market Committee (FOMC) and I believe that consumer price inflation will move up to 2 percent as the economy strengthens further and as other temporary factors weighing on inflation recede.

A number of economic headwinds have slowed the recovery, and to some extent they continue to influence the outlook. These headwinds include, first, the fact that the housing crash left many households with less wealth and higher debt, weighing on consumer spending. Many homeowners lost their homes, and many more ended up “underwater,” owing more on their mortgages than their homes were worth. Economists have noted that areas of the country that saw a larger boom and bust in housing have subsequently fared worse economically than other areas of the country.3 Rhode Island is one such place. While the housing bust was not as large here as in Florida, Nevada, and parts of California, it was larger than average, and the largest in New England. This factor likely has contributed to the fact that the overall recovery here in Rhode Island has lagged.4

In some respects, this headwind has diminished. Home prices have moved up appreciably in many areas of the country, alleviating the burden for many homeowners, though the improvement in some areas, including Rhode Island, has lagged. Nationally, the share of mortgages that are underwater fell by about one-half between 2011 and 2014.5 And credit availability for mortgages has improved as well, although mortgages are still very hard to obtain for would-be homeowners without pristine credit records. So I would score this headwind as still a concern, but one that is likely to continue to fade.

A second headwind, also quite important here in Rhode Island, has come from changes in fiscal policy to reduce budget deficits. At the federal level, the fiscal stimulus of 2008 and 2009 supported economic output, but the effects of that stimulus faded; by 2011, federal fiscal policy actions became a drag on output growth when the recovery was still weak. Meanwhile, states and municipalities, faced with serious budget problems due to the recession and required by law to balance their budgets, were forced to cut spending and raise taxes. The recovery has by now boosted tax revenue in most states, though Rhode Island, I know, is among those areas still facing considerable budget strain. Overall, fiscal policy actions at both the federal and the state and local levels look like they are no longer a significant drag on economic growth. So this headwind, I hope, is mostly behind us.

A third headwind has been the restraining influences on the United States from the global economy. I won’t say as much about this factor today, but I will make just a few observations. Initially the euro-area crisis was the biggest headwind coming from the rest of the world. Supported by monetary stimulus, reduced fiscal drag, and significant institutional reforms, the recovery in the euro area now appears to be on a firmer footing. However, growth in many other parts of the global economy, including China and some other emerging market economies, has slowed. Weak growth abroad, together with its accompanying implications for exchange rates, has dented U.S. exports and weighed on our economy. This headwind too should abate as growth in the global economy firms, supported by monetary policies that generally remain highly accommodative.

Factors Affecting the Outlook
With the waning of the headwinds that I have discussed, the U.S. economy seems well positioned for continued growth. Households are seeing the benefits of the improving jobs situation, and consumer confidence has been solid. In addition, the drop in oil prices amounts to a sizable boost in household purchasing power. The annual savings in gasoline costs has been estimated at about $700 per household, on average, and savings on heating costs–especially here in the Northeast, where it was so cold this winter–are also large.6 Given these energy savings on top of the job gains, real disposable income has risen almost 4 percent nationally over the past four quarters. Households and businesses also are benefiting from favorable financial conditions. Borrowing costs are low, supported by the Fed’s accommodative monetary policies. And credit availability to both households and small businesses has improved.

In recent months, as I noted earlier, there has been some softness in the economic data. Recent indicators of both household spending and business investment have slowed, and industrial output has declined. The Commerce Department’s initial estimate was that real gross domestic product was nearly flat in the first quarter of 2015. If confirmed by further estimates, my guess is that this apparent slowdown was largely the result of a variety of transitory factors that occurred at the same time, including the unusually cold and snowy winter and the labor disputes at ports on the West Coast, both of which likely disrupted some economic activity. And some of this apparent weakness may just be statistical noise. I therefore expect the economic data to strengthen.

All of that said, the headwinds facing our economy have not fully abated, and, as such, I expect that continued growth in employment and output will be moderate over the remainder of the year and beyond.

Despite the recovery I noted in home prices and a greater number of home sales, residential construction activity remains quite low. I mentioned the ongoing issues with mortgage credit, but more generally, many years of a weak job market and slow wage gains seem to have induced many people to double-up on housing, and many young adults continue to live with their parents. Population growth is creating a need for more housing, whether to rent or to own, and I do expect that continuing job and wage gains will encourage more people to form new households. Nevertheless, activity in the housing sector is likely to improve only gradually.

The pace of business investment has also been only modest during this recovery, and some of the reasons might persist a while longer. Businesses seem not to have had sufficient confidence in the strength and durability of the recovery to undertake substantial capital expenditures. Moreover, some analysts have suggested that uncertainty, not only about the strength of the recovery but also about economic policy, could be a significant factor. And the fact that many businesses seem to be holding large amounts of cash may suggest that risk aversion is playing a role.

Weak investment in the energy sector is also likely to persist. This represents the negative side to the fall in oil prices, one being felt by the oil-producing regions of the country. New domestic oil drilling has plunged over the past few months, and we have also seen a slowdown in activity in sectors that supply oil production companies, including steel and certain types of machinery. I would add, however, that, on balance, the plusses for energy consumers from the fall in oil prices almost surely outweigh the minuses. Remember that we are still a net importer of oil.

Putting it all together, the economic projections of most members of the FOMC call for growth in real gross domestic product of roughly 2-1/2 percent per year over the next couple of years, a little faster than the pace of the recovery thus far, with the unemployment rate continuing to move down to near 5 percent by the end of this year. And for inflation, as I noted earlier, my colleagues and I expect inflation to move up toward our objective of 2 percent as the economy strengthens further and as transitory influences wane.

Of course, the outlook for the economy, as always, is highly uncertain. I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so. For many reasons, output and job growth over the next few years could prove to be stronger, and inflation higher, than I expect; correspondingly, employment could grow more slowly, and inflation could remain undesirably low.

Implications for Monetary Policy
Given this economic outlook and the attendant uncertainty, how is monetary policy likely to evolve over the next few years? Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner. Delaying action to tighten monetary policy until employment and inflation are already back to our objectives would risk overheating the economy.

For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.

After we begin raising the federal funds rate, I anticipate that the pace of normalization is likely to be gradual. The various headwinds that are still restraining the economy, as I said, will likely take some time to fully abate, and the pace of that improvement is highly uncertain. If conditions develop as my colleagues and I expect, then the FOMC’s objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.

Having said that, I should stress that the actual course of policy will be determined by incoming data and what that reveals about the economy. We have no intention of embarking on a preset course of increases in the federal funds rate after the initial increase. Rather, we will adjust monetary policy in response to developments in economic activity and inflation as they occur. If conditions improve more rapidly than expected, it may be appropriate to raise interest rates more quickly; conversely, the pace of normalization may be slower if conditions turn out to be less favorable.

Longer-Run Growth
Before I conclude, let me put this discussion into a longer-term context. The Federal Reserve’s objectives of maximum employment and price stability do not, by themselves, ensure a strong pace of economic growth or an improvement in living standards. The most important factor determining living standards is productivity growth, defined as increases in how much can be produced in an hour of work. Over time, sustained increases in productivity are necessary to support rising incomes.

Here the recent data have been disappointing. The growth rate of output per hour worked in the business sector has averaged about 1-1/4 percent per year since the recession began in late 2007. This rate is down from gains averaging 2-3/4 percent over the preceding decade. I have mentioned the tepid pace of wage gains in recent years, and while I do take this as evidence of slack in the labor market, it also may be a reflection of relatively weak productivity growth.

Productivity depends on many factors, including our workforce’s knowledge and skills and the quantity and quality of the capital, technology, and infrastructure that they have to work with. Economists debate how optimistic to be about our nation’s productivity prospects. Some argue that the decade starting in the mid-1990s was exceptional, with unusually large advances in information technologies, and that the more recent period provides a better guide to the future. Others are more optimistic, suggesting that recent technological innovation remains as impressive as ever, and that history shows it may take some years to fully reap the economic benefits of such innovations.7 I do not know who is right, but I do believe that, as a nation, we should be pursuing policies to support longer-run growth in productivity. Policies to strengthen education, to encourage entrepreneurship and innovation, and to promote capital investment, both public and private, can all be of great benefit.

It also is possible that a portion of the relatively weak productivity growth we have seen recently may be the result of the recession itself.8 Firms slashed their capital expenditures during the recession, and as I noted earlier, the increases in investment during the recovery have been modest. In particular, investment in research and development has been relatively weak. Moreover, a lack of financing may have impaired the ability of people to start new businesses and implement new ideas and technologies. As the economy strengthens further, many of these processes could work in reverse, boosting our productivity prospects. To the extent this is so, Federal Reserve actions to strengthen the recovery may not only help bring our economy back to its productive potential, but it may also support the growth of productivity and living standards over the longer run.

Structural and cyclical policies – including monetary policy – are heavily interdependent. Structural reforms increase both potential output and the resilience of the economy to shocks. This makes structural reforms relevant for any central bank, but especially in a monetary union.

For members of monetary union resilience is crucial to avoid that shocks lead to consistently higher unemployment, and over time, permanent economic divergence. It therefore has direct implications for price stability, and is no less relevant for the integrity of the euro area. This is why the ECB has frequently called for stronger common governance of structural reforms that would make resilience part of our common DNA.

Structural reforms are equally important for their effect on growth. Potential growth is today estimated to be below 1% in the euro area and is projected to remain well below pre-crisis growth rates. This would mean that a significant share of the economic losses in the crisis would become permanent, with structural unemployment staying above 10% and youth unemployment elevated. It would also make it harder to work through the debt overhang still present in some countries. Finally, low potential growth can have a direct impact on the tools available to monetary policy, as it increases the likelihood that the central bank runs into the lower bound and has to resort recurrently to unconventional policies to meet its mandate.

But the euro area’s weak long-term performance also provides an opportunity. Since many economies are distant from the frontier of best practice, the gains from structural reforms are easier to achieve and the potential magnitude of those gains is greater. There is a large untapped potential in the euro area for substantially higher output, employment and welfare. And the fact that monetary policy is today at the lower bound, and the recovery still fragile, is not, as some argue, a reason for reforms to be delayed.

This is because the short-term costs and benefits of reforms depend critically on how they are implemented. If structural reforms are credible, their positive effects can be felt quickly even in a weak demand environment. The same is true if the type of reforms is carefully chosen. And our accommodative monetary policy means that the benefits of reforms will materialise faster, creating the ideal conditions for them to succeed. It is the combination of these demand and supply policies that will deliver lasting stability and prosperity.

In every press conference since I became ECB President, I have ended the introductory statement with a call to accelerate structural reforms in Europe. The same message was also conveyed repeatedly by my predecessors, in three quarters of all press conferences since the introduction of the euro. The term “structural reforms” is actually mentioned in approximately one third of all speeches by various members of the ECB Executive Board. By comparison, it features in only about 2% of speeches by governors of the Federal Reserve.

Our strong focus on structural reforms is not because they have been ignored in recent years. On the contrary, a great deal has been achieved and we have praised progress where it has taken place, including here in Portugal. Rather, if we talk often about structural reforms it is because we know that our ability to bring about a lasting return of stability and prosperity does not rely only on cyclical policies – including monetary policy – but also on structural policies. The two are heavily interdependent.

So what I would like to do today in opening our annual discussions in Sintra is, first, to explain what we mean by structural reforms and why the central bank has a pressing and legitimate interest in their implementation. And second, to underline why being in the early phases of a cyclical recovery is not a reason to postpone structural reforms; it is in fact an opportunity to accelerate them.

The importance of structural reform

Structural reforms are, in my view, best defined as policies that permanently and positively alter the supply-side of the economy. This means that they have two key effects.

First, they lift the path of potential output, either by raising the inputs to production – the supply and quality of labour and the amount of capital per worker – or by ensuring that those inputs are used more efficiently, i.e. by raising total factor productivity (TFP). And second, they make economies more resilient to economic shocks by facilitating price and wage flexibility and the swift reallocation of resources within and across sectors.

These two effects are complementary. An economy that rebounds faster after a shock is an economy that grows more over time, as it suffers from lower hysteresis effects. And the same structural reforms will often increase both short-term flexibility and long-term growth.

For example, reforms aimed at encouraging reallocation will not only support faster adjustment, but also higher productivity through raising allocative efficiency. [1] Reforms aimed at strengthening competition will not just encourage greater price flexibility, but also higher investment as young firms are able to enter new markets and expand more quickly. [2]

A comprehensive package of structural reforms will therefore tend to increase both resilience and growth. These are clearly issues in which any central bank has a keen interest. But this is especially true for the central bank of a monetary union – and even more so in the conditions we face today. Let me explain why.

Increasing resilience to shocks
In terms of resilience, the ability of each economy in a monetary union to adjust quickly to shocks is essential for price stability and, over time, for the long-term viability of the union.

This is because, faced with a negative demand shock, a more flexible economy will tend to react by immediately lowering prices, but agents will then expect inflation to rise again as the shock fades, ensuring a firm anchoring of inflation expectations. By contrast, an inflexible economy is more likely to adjust through higher unemployment, which exerts a more prolonged downward pressure on inflation and is therefore more likely to weigh on inflation expectations. This in turn can lead to higher real interest rates and compound the effect of the shock.

Whereas in a single country setting the central bank could respond directly to such a contractionary effect, in a monetary union monetary policy cannot be tailored to developments in particular countries. There are also no large-scale fiscal transfers across countries in the euro area to play a compensating role in supporting demand. This implies that economies with insufficient flexibility risk more prolonged disinflation, consistently higher unemployment, and over time, permanent economic divergence.

The way different euro area economies have reacted to the crisis bears this point out. Labour and product market rigidities contributed to a more painful adjustment process in the stressed economies, which was initially driven more by compression of demand than by a reduction of costs relative to other economies, albeit with differences across countries based on their initial degree of flexibility. As a result, we now face a situation of significant divergence in unemployment across the euro area.

This has direct implications for price stability: slow adjustment has contributed to the protracted disinflation we have witnessed since 2011 and to making inflation expectations more fragile. But it is also directly relevant for the ECB through its effect on the integrity of the currency. Like any political union, the cohesion of the euro area depends on the fact that each country is permanently better off within the union than without. Convergence is therefore essential to bind the union together, while permanent divergence caused by structural heterogeneity has the opposite effect.

For this reason, that every national economy is sufficiently flexible should be accepted as a part of our common DNA. It has to be a permanent economic feature that comes with participation in the euro area, in the same way that the Copenhagen Criteria are permanent political features of membership of the EU.

And this is why, as I have said many times, I believe there is a strong case for governance of structural reforms to be exercised jointly at the euro area level: to help each country to achieve the necessary level of resilience; and to ensure that they maintain that resilience permanently [4]. Since structural reforms in any euro area country are a legitimate interest of the whole union, there needs to be stronger ownership of reforms not just at the national level, but at the European level as well.

Several countries have however made significant progress with structural reforms during the crisis, and we can already see how this has altered the relationship between inflation and unemployment. Various estimates of the euro area Phillips curve show that, while the slope has varied over time, it has steepened in recent years. In particular, there is evidence that inflation has become increasingly responsive to cyclical conditions in countries that have reformed their product and labour markets, such as Spain [5] and Italy [6].

Raising potential growth
Besides this issue of resilience, as the central bank of the euro area we also have another, equally direct interest in structural reforms. This is related to their effect on growth – or more specifically, the challenges posed by a period of low potential growth.

International institutions currently estimate potential growth to be below 1% in the euro area, compared with above 2% in the US (Chart 3). [7] This is in part a result of the effects of the crisis on investment and, via hysteresis, structural unemployment. But it also reflects weak underlying trends in productivity growth and labour supply. Consequently, while some of the effects of the crisis on investment and employment are expected to unwind, potential growth is projected to remain well below pre-crisis growth rates.

This is problematic for at least three reasons.

First, it would mean that the output gap would close at a notably lower level of output, at which point monetary policy would have to return to a more neutral stance (Chart 4). A significant share of the economic losses suffered across countries would therefore become permanent. Structural unemployment would stay around 10%. Youth unemployment would also remain elevated, with devastating effects for individuals in terms of labour market “scarring”. [8] And this would ultimately affect society as a whole as, given our demographics, realising the potential of the young and their capacity for innovation is essential for long-term sustainability.

Second, a situation of persistently low potential growth would make it even harder to work through the debt overhang that still exists in parts of the euro area. For firms that took on debt based on pre-crisis growth expectations, low potential growth acts as a major barrier to new investment, as any profits generated will likely be absorbed by servicing existing debt. And we do see signs that this effect has been operative in euro area: there is a clear negative correlation between corporate debt-to-GDP levels in different countries at the beginning of the crisis and the evolution of business investment since.

Third, low potential growth can have a direct impact on the tools available to monetary policy to deliver its mandate. The reason is that low potential growth implies a lower equilibrium real interest rate, which in turn means that, faced with a negative output gap, nominal policy rates need to go lower still to steer output back to potential. This materially increases the likelihood that central bank policy runs into the constraint set by the effective lower bound for interest rates, which is not far below zero. It therefore also increases the likelihood that we have to resort recurrently to unconventional policies to meet our mandate.

When in 2003 we clarified our objective to keep inflation below but close to 2%, we assumed an equilibrium real interest rate of 2% on average. [9] The probability of hitting the effective lower bound under this assumption was very low. Today, imperfect indicators of the equilibrium real rate, such as real forward rates at long horizons, suggest that it may have fallen to much lower levels. In this context, higher potential growth would facilitate the stabilisation task of monetary policy by allowing the equilibrium real rate to rise.

The untapped potential of the euro area
For all these reasons, structural reforms that reverse the downward drift in potential growth are now vital for the euro area, which is why I believe, as the guardian of the currency, we have a legitimate interest in talking about them. But we should recognise that our weak long-term performance also provides an opportunity. Since many economies are distant from the frontier of best practice in at least some policy areas, the gains from structural reforms are easier to achieve and the potential magnitude of such gains is greater.

To give just one example, research by the OECD suggests that committed convergence towards best practice across labour and product markets, tax policy and pensions would raise GDP per capita by about 11% after ten years for the average EU country. In the US, which starts from a more favourable position, the benefit would be under 5%. [10]

And it is not difficult to understand why the benefits of reform could be so high in the euro area. High levels of structural unemployment, compounded by high numbers of underemployed and discouraged workers, imply a latent potential in our economies for a major positive shock to labour supply (Chart 5). We also have scope for a large catching-up in terms of productivity growth. TFP has increased by only 1.5% between 2000 and 2014 in the euro area, far below the 10.9% increase in the US over the same period.

The type of policies that could release this upward shock to potential growth are not just those focused on price flexibility. They include, on the labour supply side, policies aimed at providing job search support for the long-term unemployed and requalification for the low skilled. And on the TFP side, policies that encourage the reallocation of resources – which could be powerful in the euro area given the wide and skewed distribution between the least and most productive firms [11] (Chart 7) – and policies that accelerate the diffusion of new technology, where the euro area on the whole lags some way behind the US (Chart 8).

There are many other examples one could give. The important point, however, is that in the euro area today structural reforms are not about creating minor efficiencies or marginal gains. They are about unleashing an untapped potential for substantially higher output, employment and welfare. And in the current environment, this would play a crucial role in ensuring that the ongoing cyclical recovery becomes a stronger, structural recovery.

Structural reform in a fragile demand environment

This discussion on the importance of structural reforms leads in principle to only one conclusion: the earlier they take place, the better.

However, while most of us might agree with this statement in normal times, the fact that interest rates have reached the effective lower bound, coupled with the still fragile cyclical situation, makes the situation less straightforward. In particular, the question has been raised as to whether implementing structural reforms when the economy is still weak would be counterproductive, in the sense that it would make it harder to achieve our mandate by further reducing short-term demand.

One argument that has been put forward in this context is that, if reforms lead to a credible increase in aggregate supply, they will exert downward pressure on inflation expectations. And if nominal interest rates cannot fall because monetary policy is at the lower bound, real interest rates will then rise, creating contractionary short-term effects. [12]

A parallel argument in favour of postponing structural reforms relates to their short-term effects on employment. The reasoning is that reforms implemented at the trough of the cycle or too early in the recovery may increase job insecurity among workers, which may in turn result in a rise in precautionary savings and thereby reduce consumption. Factors such as a depressed housing market would also exacerbate these effects by hindering geographical mobility and the reallocation of resources. [13]

There is some empirical foundation to these concerns. For example, research suggests that reforms that increase employment flexibility, such as reducing employment protection, are more likely to depress demand during downturns. [14] I would however reject the conclusion that this means all structural reforms should be postponed.

The reason is that the short-term impact of structural reforms does not just depend on when they are implemented, but how – namely, the credibility of reforms, the type of reforms and their interaction with other policy measures. And if structural reforms are well-designed along these parameters, they can in fact have a largely neutral, if not positive impact on short-term demand – and even in adverse cyclical conditions.

Credibility of reforms
First, if reforms are credible their positive effects on short-term demand, via confidence, can more than compensate for any negative effects on inflation via increased supply.

This is because, for firms, an upward shift in potential growth implies higher expected revenues and higher future profitability, which should in turn encourage them to bring forward investment into the present. And investment, remember, raises both supply tomorrow and demand today. It can therefore in no way be construed as being detrimental to our monetary policy objective.

A similar logic applies to households and their life-cycle income. Reforms that raise expectations of life-cycle income should immediately support current consumption. To give just one example of this effect, an extension of the retirement age should lift not only medium-term supply – by expanding the active population – but also short-term demand, by reducing the need for precautionary savings ahead of retirement.

But credibility is crucial in determining how quickly these positive effects materialise. If there is uncertainty about the timeline over which reforms will be implemented, or about the commitment of successive governments to maintaining them, it will take longer for firms and households to adjust their expectations and the benefits of reforms will be delayed. [15] Moreover, if reforms are not perceived to be sustainable under a wide variety of conditions – for example, if a pension reform is unrealistic over the longer-term – agents will anticipate a reversal in the future and refrain from adjusting their behaviour today.

We have used our Euro Area and Global Economy (EAGLE) [16] model to analyse for a medium-sized euro area country the effect of credibility and timely implementation [17] – in this case for a structural reform in the services sector – and we find the benefits of reforms are clearly brought forward, even in a situation where monetary policy is constrained by the zero lower bound (Chart 11). This provides a strong rationale to implement reforms in a way that is committed, credible and consistent. [18] And such an approach is in fact And such an approach is in fact even more important for reforms to yield short-term benefits in the special environment we face today.

Following seven years of crisis marked by several false dawns, firms and households have become more hesitant about taking on economic risk. This is mirrored in the fact that medium-term growth expectations among forecasters have not only shifted downwards in that period, but the distribution of possible outcomes has also widened (Chart 9). In this uncertain context credibility is key, as the strength of the reform signal has an even stronger determination over the magnitude of the short-term benefits.

Type of reforms
Those short-term benefits can also be maximised, however, if the type of reforms is carefully chosen. How structural reforms affect the economy is of course complex, but the evidence suggests that the short run gains can be amplified if reforms are well designed, packaged and sequenced [19], with a focus on measures that minimise short-term costs.

For example, the experience of Germany during the crisis suggests that reforms aimed at adjustment through the intensive margin – that is, working hours and wages – are less likely to have negative short-term effects than reforms that operate through the extensive margin – i.e. dismissals. [20] This is supported by new micro level research from the Eurosystem which shows that, for a larger sample of countries, firms with flexibility at the plant-level have reduced employment less during the crisis than those bound by centralised wage bargaining agreements, partly because they have been more able to adjust wages to economic conditions. [21]

Moreover, if reforms are targeted specifically at frictions that hold back investment demand, their short-term effects should be largely positive, even at the bottom of the cycle. For instance, reforms directed at sectors with large pent-up demand, such as professional services and retail trade, could be expected to elicit a rapid investment response. [22] Indeed, our EAGLE simulations show that the short-term benefits from structural reform in the service sector arise mainly via a strong reaction of investment.

Similarly, reforms designed to reduce bottlenecks to new investment that come from onerous business conditions should also have mainly benefits in the short-term. This would include measures such as reducing the administrative burden on young firms, or speeding up insolvency proceedings that raise the opportunity cost of investment by tying up capital for years longer than initially assumed. For many euro area countries there are several “low hanging fruit” that can still be picked in this area (Chart 10).

The EAGLE simulations show that if reforms are also well coordinated across the euro area, the short-term benefits for a medium-sized country can be further maximised, especially in terms of limiting the downward effects on inflation (Chart 12). This reinforces what I have said about the need for stronger common governance of structural reforms in the euro area: if all countries reform together, then all countries benefit more. And these findings hold even under the assumption that monetary policy is constrained.

Structural and cyclical policies – including monetary policy – are heavily interdependent. Structural reforms increase both potential output and the resilience of the economy to shocks. This makes structural reforms relevant for any central bank, but especially in a monetary union.

For members of monetary union resilience is crucial to avoid that shocks lead to consistently higher unemployment, and over time, permanent economic divergence. It therefore has direct implications for price stability, and is no less relevant for the integrity of the euro area. This is why the ECB has frequently called for stronger common governance of structural reforms that would make resilience part of our common DNA.

Structural reforms are equally important for their effect on growth. Potential growth is today estimated to be below 1% in the euro area and is projected to remain well below pre-crisis growth rates. This would mean that a significant share of the economic losses in the crisis would become permanent, with structural unemployment staying above 10% and youth unemployment elevated. It would also make it harder to work through the debt overhang still present in some countries. Finally, low potential growth can have a direct impact on the tools available to monetary policy, as it increases the likelihood that the central bank runs into the lower bound and has to resort recurrently to unconventional policies to meet its mandate.

But the euro area’s weak long-term performance also provides an opportunity. Since many economies are distant from the frontier of best practice, the gains from structural reforms are easier to achieve and the potential magnitude of those gains is greater. There is a large untapped potential in the euro area for substantially higher output, employment and welfare. And the fact that monetary policy is today at the lower bound, and the recovery still fragile, is not, as some argue, a reason for reforms to be delayed.

This is because the short-term costs and benefits of reforms depend critically on how they are implemented. If structural reforms are credible, their positive effects can be felt quickly even in a weak demand environment. The same is true if the type of reforms is carefully chosen. And our accommodative monetary policy means that the benefits of reforms will materialise faster, creating the ideal conditions for them to succeed. It is the combination of these demand and supply policies that will deliver lasting stability and prosperity.

***

In every press conference since I became ECB President, I have ended the introductory statement with a call to accelerate structural reforms in Europe. The same message was also conveyed repeatedly by my predecessors, in three quarters of all press conferences since the introduction of the euro. The term “structural reforms” is actually mentioned in approximately one third of all speeches by various members of the ECB Executive Board. By comparison, it features in only about 2% of speeches by governors of the Federal Reserve.

Our strong focus on structural reforms is not because they have been ignored in recent years. On the contrary, a great deal has been achieved and we have praised progress where it has taken place, including here in Portugal. Rather, if we talk often about structural reforms it is because we know that our ability to bring about a lasting return of stability and prosperity does not rely only on cyclical policies – including monetary policy – but also on structural policies. The two are heavily interdependent.

So what I would like to do today in opening our annual discussions in Sintra is, first, to explain what we mean by structural reforms and why the central bank has a pressing and legitimate interest in their implementation. And second, to underline why being in the early phases of a cyclical recovery is not a reason to postpone structural reforms; it is in fact an opportunity to accelerate them.

The importance of structural reform

Structural reforms are, in my view, best defined as policies that permanently and positively alter the supply-side of the economy. This means that they have two key effects.

First, they lift the path of potential output, either by raising the inputs to production – the supply and quality of labour and the amount of capital per worker – or by ensuring that those inputs are used more efficiently, i.e. by raising total factor productivity (TFP). And second, they make economies more resilient to economic shocks by facilitating price and wage flexibility and the swift reallocation of resources within and across sectors.

These two effects are complementary. An economy that rebounds faster after a shock is an economy that grows more over time, as it suffers from lower hysteresis effects. And the same structural reforms will often increase both short-term flexibility and long-term growth.

For example, reforms aimed at encouraging reallocation will not only support faster adjustment, but also higher productivity through raising allocative efficiency. [1] Reforms aimed at strengthening competition will not just encourage greater price flexibility, but also higher investment as young firms are able to enter new markets and expand more quickly. [2]

A comprehensive package of structural reforms will therefore tend to increase both resilience and growth. These are clearly issues in which any central bank has a keen interest. But this is especially true for the central bank of a monetary union – and even more so in the conditions we face today. Let me explain why.

Increasing resilience to shocks
In terms of resilience, the ability of each economy in a monetary union to adjust quickly to shocks is essential for price stability and, over time, for the long-term viability of the union.

This is because, faced with a negative demand shock, a more flexible economy will tend to react by immediately lowering prices, but agents will then expect inflation to rise again as the shock fades, ensuring a firm anchoring of inflation expectations. By contrast, an inflexible economy is more likely to adjust through higher unemployment, which exerts a more prolonged downward pressure on inflation and is therefore more likely to weigh on inflation expectations. This in turn can lead to higher real interest rates and compound the effect of the shock.

Whereas in a single country setting the central bank could respond directly to such a contractionary effect, in a monetary union monetary policy cannot be tailored to developments in particular countries. There are also no large-scale fiscal transfers across countries in the euro area to play a compensating role in supporting demand. This implies that economies with insufficient flexibility risk more prolonged disinflation, consistently higher unemployment, and over time, permanent economic divergence.

The way different euro area economies have reacted to the crisis bears this point out. Labour and product market rigidities contributed to a more painful adjustment process in the stressed economies, which was initially driven more by compression of demand than by a reduction of costs relative to other economies, albeit with differences across countries based on their initial degree of flexibility (Chart 1). [3] As a result, we now face a situation of significant divergence in unemployment across the euro area (Chart 2).

This has direct implications for price stability: slow adjustment has contributed to the protracted disinflation we have witnessed since 2011 and to making inflation expectations more fragile. But it is also directly relevant for the ECB through its effect on the integrity of the currency. Like any political union, the cohesion of the euro area depends on the fact that each country is permanently better off within the union than without. Convergence is therefore essential to bind the union together, while permanent divergence caused by structural heterogeneity has the opposite effect.

For this reason, that every national economy is sufficiently flexible should be accepted as a part of our common DNA. It has to be a permanent economic feature that comes with participation in the euro area, in the same way that the Copenhagen Criteria are permanent political features of membership of the EU.

And this is why, as I have said many times, I believe there is a strong case for governance of structural reforms to be exercised jointly at the euro area level: to help each country to achieve the necessary level of resilience; and to ensure that they maintain that resilience permanently [4]. Since structural reforms in any euro area country are a legitimate interest of the whole union, there needs to be stronger ownership of reforms not just at the national level, but at the European level as well.

Several countries have however made significant progress with structural reforms during the crisis, and we can already see how this has altered the relationship between inflation and unemployment. Various estimates of the euro area Phillips curve show that, while the slope has varied over time, it has steepened in recent years. In particular, there is evidence that inflation has become increasingly responsive to cyclical conditions in countries that have reformed their product and labour markets, such as Spain [5] and Italy [6].

Raising potential growth
Besides this issue of resilience, as the central bank of the euro area we also have another, equally direct interest in structural reforms. This is related to their effect on growth – or more specifically, the challenges posed by a period of low potential growth.

International institutions currently estimate potential growth to be below 1% in the euro area, compared with above 2% in the US (Chart 3). [7] This is in part a result of the effects of the crisis on investment and, via hysteresis, structural unemployment. But it also reflects weak underlying trends in productivity growth and labour supply. Consequently, while some of the effects of the crisis on investment and employment are expected to unwind, potential growth is projected to remain well below pre-crisis growth rates.

This is problematic for at least three reasons.

First, it would mean that the output gap would close at a notably lower level of output, at which point monetary policy would have to return to a more neutral stance (Chart 4). A significant share of the economic losses suffered across countries would therefore become permanent. Structural unemployment would stay around 10%. Youth unemployment would also remain elevated, with devastating effects for individuals in terms of labour market “scarring”. [8] And this would ultimately affect society as a whole as, given our demographics, realising the potential of the young and their capacity for innovation is essential for long-term sustainability.

Second, a situation of persistently low potential growth would make it even harder to work through the debt overhang that still exists in parts of the euro area. For firms that took on debt based on pre-crisis growth expectations, low potential growth acts as a major barrier to new investment, as any profits generated will likely be absorbed by servicing existing debt. And we do see signs that this effect has been operative in euro area: there is a clear negative correlation between corporate debt-to-GDP levels in different countries at the beginning of the crisis and the evolution of business investment since.

Third, low potential growth can have a direct impact on the tools available to monetary policy to deliver its mandate. The reason is that low potential growth implies a lower equilibrium real interest rate, which in turn means that, faced with a negative output gap, nominal policy rates need to go lower still to steer output back to potential. This materially increases the likelihood that central bank policy runs into the constraint set by the effective lower bound for interest rates, which is not far below zero. It therefore also increases the likelihood that we have to resort recurrently to unconventional policies to meet our mandate.

When in 2003 we clarified our objective to keep inflation below but close to 2%, we assumed an equilibrium real interest rate of 2% on average. [9] The probability of hitting the effective lower bound under this assumption was very low. Today, imperfect indicators of the equilibrium real rate, such as real forward rates at long horizons, suggest that it may have fallen to much lower levels. In this context, higher potential growth would facilitate the stabilisation task of monetary policy by allowing the equilibrium real rate to rise.

The untapped potential of the euro area
For all these reasons, structural reforms that reverse the downward drift in potential growth are now vital for the euro area, which is why I believe, as the guardian of the currency, we have a legitimate interest in talking about them. But we should recognise that our weak long-term performance also provides an opportunity. Since many economies are distant from the frontier of best practice in at least some policy areas, the gains from structural reforms are easier to achieve and the potential magnitude of such gains is greater.

To give just one example, research by the OECD suggests that committed convergence towards best practice across labour and product markets, tax policy and pensions would raise GDP per capita by about 11% after ten years for the average EU country. In the US, which starts from a more favourable position, the benefit would be under 5%. [10]

And it is not difficult to understand why the benefits of reform could be so high in the euro area. High levels of structural unemployment, compounded by high numbers of underemployed and discouraged workers, imply a latent potential in our economies for a major positive shock to labour supply (Chart 5). We also have scope for a large catching-up in terms of productivity growth. TFP has increased by only 1.5% between 2000 and 2014 in the euro area, far below the 10.9% increase in the US over the same period (Chart 6).

The type of policies that could release this upward shock to potential growth are not just those focused on price flexibility. They include, on the labour supply side, policies aimed at providing job search support for the long-term unemployed and requalification for the low skilled. And on the TFP side, policies that encourage the reallocation of resources – which could be powerful in the euro area given the wide and skewed distribution between the least and most productive firms [11] (Chart 7) – and policies that accelerate the diffusion of new technology, where the euro area on the whole lags some way behind the US (Chart 8).

There are many other examples one could give. The important point, however, is that in the euro area today structural reforms are not about creating minor efficiencies or marginal gains. They are about unleashing an untapped potential for substantially higher output, employment and welfare. And in the current environment, this would play a crucial role in ensuring that the ongoing cyclical recovery becomes a stronger, structural recovery.

Structural reform in a fragile demand environment

This discussion on the importance of structural reforms leads in principle to only one conclusion: the earlier they take place, the better.

However, while most of us might agree with this statement in normal times, the fact that interest rates have reached the effective lower bound, coupled with the still fragile cyclical situation, makes the situation less straightforward. In particular, the question has been raised as to whether implementing structural reforms when the economy is still weak would be counterproductive, in the sense that it would make it harder to achieve our mandate by further reducing short-term demand.

One argument that has been put forward in this context is that, if reforms lead to a credible increase in aggregate supply, they will exert downward pressure on inflation expectations. And if nominal interest rates cannot fall because monetary policy is at the lower bound, real interest rates will then rise, creating contractionary short-term effects. [12]

A parallel argument in favour of postponing structural reforms relates to their short-term effects on employment. The reasoning is that reforms implemented at the trough of the cycle or too early in the recovery may increase job insecurity among workers, which may in turn result in a rise in precautionary savings and thereby reduce consumption. Factors such as a depressed housing market would also exacerbate these effects by hindering geographical mobility and the reallocation of resources. [13]

There is some empirical foundation to these concerns. For example, research suggests that reforms that increase employment flexibility, such as reducing employment protection, are more likely to depress demand during downturns. [14] I would however reject the conclusion that this means all structural reforms should be postponed.

The reason is that the short-term impact of structural reforms does not just depend on when they are implemented, but how – namely, the credibility of reforms, the type of reforms and their interaction with other policy measures. And if structural reforms are well-designed along these parameters, they can in fact have a largely neutral, if not positive impact on short-term demand – and even in adverse cyclical conditions.

Credibility of reforms
First, if reforms are credible their positive effects on short-term demand, via confidence, can more than compensate for any negative effects on inflation via increased supply.

This is because, for firms, an upward shift in potential growth implies higher expected revenues and higher future profitability, which should in turn encourage them to bring forward investment into the present. And investment, remember, raises both supply tomorrow and demand today. It can therefore in no way be construed as being detrimental to our monetary policy objective.

A similar logic applies to households and their life-cycle income. Reforms that raise expectations of life-cycle income should immediately support current consumption. To give just one example of this effect, an extension of the retirement age should lift not only medium-term supply – by expanding the active population – but also short-term demand, by reducing the need for precautionary savings ahead of retirement.

But credibility is crucial in determining how quickly these positive effects materialise. If there is uncertainty about the timeline over which reforms will be implemented, or about the commitment of successive governments to maintaining them, it will take longer for firms and households to adjust their expectations and the benefits of reforms will be delayed. [15] Moreover, if reforms are not perceived to be sustainable under a wide variety of conditions – for example, if a pension reform is unrealistic over the longer-term – agents will anticipate a reversal in the future and refrain from adjusting their behaviour today.

We have used our Euro Area and Global Economy (EAGLE) [16] model to analyse for a medium-sized euro area country the effect of credibility and timely implementation [17] – in this case for a structural reform in the services sector – and we find the benefits of reforms are clearly brought forward, even in a situation where monetary policy is constrained by the zero lower bound (Chart 11). This provides a strong rationale to implement reforms in a way that is committed, credible and consistent. [18] And such an approach is in fact And such an approach is in fact even more important for reforms to yield short-term benefits in the special environment we face today.

Following seven years of crisis marked by several false dawns, firms and households have become more hesitant about taking on economic risk. This is mirrored in the fact that medium-term growth expectations among forecasters have not only shifted downwards in that period, but the distribution of possible outcomes has also widened (Chart 9). In this uncertain context credibility is key, as the strength of the reform signal has an even stronger determination over the magnitude of the short-term benefits.

Type of reforms
Those short-term benefits can also be maximised, however, if the type of reforms is carefully chosen. How structural reforms affect the economy is of course complex, but the evidence suggests that the short run gains can be amplified if reforms are well designed, packaged and sequenced [19], with a focus on measures that minimise short-term costs.

For example, the experience of Germany during the crisis suggests that reforms aimed at adjustment through the intensive margin – that is, working hours and wages – are less likely to have negative short-term effects than reforms that operate through the extensive margin – i.e. dismissals. [20] This is supported by new micro level research from the Eurosystem which shows that, for a larger sample of countries, firms with flexibility at the plant-level have reduced employment less during the crisis than those bound by centralised wage bargaining agreements, partly because they have been more able to adjust wages to economic conditions. [21]

Moreover, if reforms are targeted specifically at frictions that hold back investment demand, their short-term effects should be largely positive, even at the bottom of the cycle. For instance, reforms directed at sectors with large pent-up demand, such as professional services and retail trade, could be expected to elicit a rapid investment response. [22] Indeed, our EAGLE simulations show that the short-term benefits from structural reform in the service sector arise mainly via a strong reaction of investment.

Similarly, reforms designed to reduce bottlenecks to new investment that come from onerous business conditions should also have mainly benefits in the short-term. This would include measures such as reducing the administrative burden on young firms, or speeding up insolvency proceedings that raise the opportunity cost of investment by tying up capital for years longer than initially assumed. For many euro area countries there are several “low hanging fruit” that can still be picked in this area (Chart 10).

The EAGLE simulations show that if reforms are also well coordinated across the euro area, the short-term benefits for a medium-sized country can be further maximised, especially in terms of limiting the downward effects on inflation (Chart 12). This reinforces what I have said about the need for stronger common governance of structural reforms in the euro area: if all countries reform together, then all countries benefit more. And these findings hold even under the assumption that monetary policy is constrained.

Interaction with other policy measures
But it is also important to underline that this assumption is in fact inaccurate for the euro area today. Contrary to models in the literature, monetary policy is not constrained because we have reached the lower bound. Rather, as I laid out in a recent speech in Washington, I think we have demonstrated in recent months how effective monetary policy can be when it has to resort to unconventional measures. [23]

The difference this makes in terms of the short-term effects of reforms is clearly visible in our EAGLE simulations. With monetary policy able to respond to any negative inflation shocks consumer price inflation is barely affected (Chart 13).

What has been constrained in the euro area in recent years is fiscal policy, as some countries faced a loss or near loss of market access. But we should remember that, in these circumstances, structural reforms are in fact crucial to support fiscal stabilisation. Insofar as they raise expectations of future government revenue, they make public debt more sustainable, lessen the constraint of market discipline, and thereby reopen fiscal space.

In any event, demand is today being meaningfully buttressed in the short-term by monetary policy, and the stance of fiscal policy is broadly neutral. The arguments for postponing structural reform therefore become less convincing still. Any reforms undertaken now will in fact have an improved interaction with macroeconomic stabilisation policies. And I would go even further: I would argue that our current monetary stance in fact makes accelerating structural reforms desirable, because it brings forward their positive demand effects.

For example, the literature suggests that a well-functioning banking sector is key to reap the short-term benefits of reforms, as it ensures that funds flow quickly to the new investment opportunities they create. [24] In this context, the combination of our interest rate and credit easing policy, together with the recently completed Comprehensive Assessment of bank balance sheets, can be seen as creating the ideal conditions for reforms to succeed.

By bringing real interest rates well below the medium-term growth rate, this policy package is creating strong price incentives to invest. And by improving the transmission of those low real rates into actual borrowing conditions, it ensures that the financial sector can quickly reallocate finance to firms that capitalise on those incentives.

In this way, accommodative monetary policy supports structural reform by ensuring that the investment and employment benefits materialise faster. And structural reform, by reducing uncertainty about the future macro- and microeconomic outlook, supports monetary policy by releasing the pent-up investment demand that accommodative policy creates.

It should therefore be clear that the argument that accommodative monetary policy constitutes an excuse for governments and parliaments to postpone their reform efforts is incorrect. In fact, I would submit it actually makes reforms less socially and politically costly, as it reduces the time it takes for reforms to produce positive effects. All this confirms my main contention that the current environment, per se, creates no reason for delay.

Conclusion

The economic outlook for the euro area is brighter today than it has been for seven long years. Monetary policy is working its way through the economy. Growth is picking up. And inflation expectations have recovered from their trough.

This is by no means the end of our challenges, and a cyclical recovery alone does not solve all of Europe’s problems. It does not eliminate the debt overhang that affects parts of the Union. It does not eliminate the high level of structural unemployment that haunts too many countries. And it does not eliminate the need for perfecting the institutional set-up of our monetary union.

But what the cyclical recovery does achieve is to provide near perfect conditions for governments to engage more systematically in the structural reforms that will anchor the return to growth. Monetary policy can steer the economy back to its potential. Structural reform can raise that potential. And it is the combination of these demand and supply policies that will deliver lasting stability and prosperity.

Growth patterns are increasingly divergent in Central, Eastern, and Southeastern Europe (CESEE), says a new report by the International Monetary Fund (IMF). The group of countries stretching from the Baltic states all the way to Turkey have been affected differently by external forces – oil prices, strength of the euro area recovery, and geopolitical tensions. Furthermore, some of the countries are still afflicted with debt overhang and are not likely to grow out of it without deep institutional reforms, in addition to supportive macroeconomic policies. These are the main conclusions of “Mind the Credit Gap,” the IMF’s new Regional Economic Issues report, launched today in Budapest at a conference hosted by the Central Bank of Hungary.

Weak investment is a common challenge in a very heterogeneous region. Investment is being held back by still low demand growth in much of Europe and uncertainty both at the global and the euro area level, but also by an incomplete private sector balance sheet clean-up. While credit deleveraging is necessary, it tends to be more protracted and a drag on growth when debt problems are pervasive, macroeconomic policies are not sufficiently supportive, and institutional frameworks are not flexible enough.
“CESEE countries face a challenging dilemma: strengthen private sector balance sheets that have been damaged by the slump in demand and employment caused by the financial crisis; and, at the same time, achieve again investment levels that will support the growth rates their economies need to catch up with the more advanced European countries,” said Jörg Decressin, Deputy Director in the IMF’s European Department.

Divergent performances
Cheaper oil and stronger euro area recovery are supporting faster growth in the Baltics (Estonia, Lithuania and Latvia), Central and Eastern Europe (CEE – Czech Republic, Hungary, Poland, Slovakia, Slovenia), and in Turkey. However, persistent structural weaknesses and an incomplete private sector balance-sheet clean-up have prevented Southeastern Europe (SEE – Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Kosovo, Macedonia FYR, Montenegro, Romania and Serbia) from fully benefitting from the same tailwinds.

In contrast, Commonwealth of Independent States (CIS – Belarus, Moldova, Russia and Ukraine) countries are expected to contract due to lower oil prices and sanctions (Russia) and the fallout from geopolitical tensions and ongoing macroeconomic adjustment (Ukraine).

According to the report, market volatility and geopolitical problems are the main risks that could negatively affect countries in emerging Europe. An increase in geopolitical tensions related to Russia and Ukraine, as well as a deterioration of the situation in Greece loom in the horizon. The beginning of rising of interest rates in the United States could increase funding costs and reduce capital flows to the region. On the upside, euro area growth may be stronger than expected on the back of the European Central Bank’s Quantitative Easing and lower oil prices.

Reviving investment remains a challenge for much of the region. Apart from global and regional uncertainties, pressures stemming from the deleveraging process have weighed down on growth and had a negative impact on GDP everywhere although less in CEE countries.
How can countries grow out of debt?

Support domestic demand; complete private sector balance sheet clean-up; and foster a pick-up in investment to ensure a robust recovery is the complex and often conflicting challenge ahead of policy makers in the CESEE countries. How to achieve that? The answer is a multi-front approach:
Macroeconomic policies should be mindful of the credit gaps: in countries where debt-related risks continue to weigh on demand, supportive macroeconomic policies are essential.

Fiscal consolidation is needed in many CESEE countries, but should not be too stringent, with the risk of derailing the recovery.
Monetary policy should remain accommodative particularly in countries facing deflationary risks.

Structural and institutional reforms are critical for lifting potential growth, especially for countries still facing private sector debt overhang: creating more efficient debt resolution frameworks; improving the business environment to raise productivity and reduce structural unemployment; making labor markets more flexible, so as to give companies more options to carry out necessary adjustments, other than only cutting back on investment.

WILMINGTON, Del. – The vast majority of Americans (90 percent) recognize the importance that access to credit plays throughout their life, according to the new Chase Slate Credit Survey. However, when it comes to awareness of their personal credit health there are gaps. Nearly four-in-ten Americans (39 percent) admit they do not know their current credit score, and more than half (52 percent) do not know that paying bills on time is the factor that has the largest impact on their credit score.

The survey reveals that Americans who have previously checked their credit score consider a “good” score to be 719 on average1. This is 51 points higher than what is considered to be good by those who have never checked their score (668). What Americans may not realize is that even a score of 719 might not give them access to credit at the best rates.

“Having healthy credit could mean the difference between achieving major life goals, such as buying a home or starting a small business, and never realizing those dreams. Yet too many Americans don’t have access to information and tools that empower them to properly plan for the future and manage their credit health,” said Pam Codispoti, President of the Mass Affluent Business for Chase Card Services.

Only 37 percent of Americans feel very confident that their current credit score can help them accomplish certain personal goals in their life, and many wish their credit score were higher. Two-thirds (66 percent) say they would like to be able to improve their credit score over the next year, yet only one-in-three (35 percent) have a plan they feel confident will allow them to succeed and one-fifth (22 percent) admit they have never taken any steps to do so.

Chase recently introduced the new Slate Credit Card, which provides cardmembers with a Credit Score & More feature. Cardmembers have access to their FICO® Score for free as well as the reasons behind their score, a summary view of their credit bureau information and helpful suggestions to manage their credit health. With Slate, cardmembers have the information and insights to understand where they stand so that they can move forward with confidence. The feature is available to Slate cardmembers online at Chase.com.

“Chase is committed to providing our cardmembers with insights and relevant, reliable tools that give them a financial edge,” said Codispoti. “The new Chase Slate credit card offers them their FICO Score as well as the ability to explore key details from their credit bureau report and drill down on each attribute for context, education and an indication of where they stand. It’s a comprehensive picture of their credit health, and one we believe will be valuable and empowering along their financial journeys.”

Americans are checking their scores – but not always for the right reasons

While a majority of Americans say they check their score – with as high as 59 percent having checked in the last year – only two-in-ten Americans (22 percent) say they check their score because it is an important part of managing their finances.

“Your credit score is much more than just a number – it’s a key indicator of credit health that helps you assess where you stand and what’s within reach,” says personal finance expert and Chase Slate financial education partner Farnoosh Torabi. “Checking your score, and checking it regularly, is a simple step you can take now to introduce more positive financial habits into your life. The higher your score, the more likely you are to be deemed eligible for a loan or receive better terms and interest rates.”

Of those who have never checked their credit score, 44 percent say it’s because they did not have a reason to, while one-in-four (27 percent) say they do not have enough time and energy or it’s too much effort to obtain their score.

Generation Xers face credit health headfirst

The Chase Slate Credit Survey suggests Gen Xers are bolder about facing their credit health than other age groups. Just four percent of Gen Xers say they have never checked their score, compared to roughly one-in-five Millennials (19 percent) and 13 percent of Boomers. Further, a majority of Gen Xers (67 percent) claim they know their score, trailed by 60 percent of Boomers and 55 percent of Millennials. The survey hints that hindsight has something to do with it – more than three-in-five Gen Xers (62 percent) claim they would have benefitted from knowing their credit score at some point in their lives.

Although Boomers consider a good score on average to be 726 – higher than Gen Xers (712) and Millennials (695) – they are seemingly less proactive about credit health than their generational counterparts. More than one-in-four Boomers (28 percent) admits they have never taken steps to improve their credit score, compared to 19 percent of Millennials. Yet Millennials appear to be more self-assured than their older counterparts, as nearly three-in-five Millennials (59 percent) say they would be comfortable disclosing their credit score to their parents, compared to only 35 percent of Gen Xers.

Americans tend to keep credit health close to the vest

According to survey findings, Americans are more comfortable disclosing their age (70 percent) and their weight (12 percent) than their credit score (11 percent) or their income (7 percent). Almost half (44 percent) indicate they would not be okay disclosing their credit score to their partner, and even more wouldn’t be comfortable sharing with their parents (62 percent), their siblings (72 percent) or their best friend (75 percent). One quarter of Americans (26 percent) say they would not be comfortable sharing their credit score with anyone.

Hispanics distinguish themselves as more forthcoming with their scores and report being more comfortable than Americans overall with disclosing their credit score to their partner (63 percent versus 56 percent, respectively), their parents (49 percent versus 38 percent, respectively) and their siblings (35 percent versus 28 percent, respectively). Comparatively, only 16 percent of Hispanics say they would not share their credit score with anyone.

The survey also reveals that more than one-third (37 percent) of Americans who are married or have a partner do not know their significant other’s credit score. However, only 16 percent say it would have been beneficial to know their significant other’s credit score before getting married. Millennials who are married are more likely to know their spouse’s score (74 percent) than married Gen Xers (61 percent) and Boomers (59 percent).

About the 2015 Chase Slate Credit Survey
The 2015 Chase Slate Credit Survey was commissioned on behalf of Chase Card Services to measure Americans’ understanding, attitudes and perceptions around credit and credit health. The survey was conducted via an online survey by Stratalys Research, an independent research company. Interviews were conducted from February 27 – March 11, 2015 among a nationally representative sample of 1,000 respondents age 18 and older. The credibility interval for a sample size of 1,000 is +/- 3.6% and larger for subgroups.

About Chase
Chase is the U.S. consumer and commercial banking business of JPMorgan Chase & Co. (NYSE: JPM), a leading global financial services firm with assets of $2.6 trillion and operations worldwide. Chase serves nearly half of America’s households with a broad range of financial services, including personal banking, small business lending, mortgages, credit cards, auto financing and investment advice. Customers can choose how and where they want to bank: More than 5,500 branches, 18,000 ATMs, mobile, online and by phone. For more information, go to Chase.com. For more information about Chase Slate, go to ChaseSlate.com.

Let me begin by thanking the organizers for inviting me to participate in this important dialogue on the role of finance in society. The financial sector is vital to the economy. A well-functioning financial sector promotes job creation, innovation, and inclusive economic growth. But when the incentives facing financial firms are distorted, these firms may act in ways that can harm society. Appropriate regulation, coupled with vigilant supervision, is essential to address these issues.

Unfortunately, in the years preceding the financial crisis, all too many firms took on risks they could neither measure nor manage. Leverage, interconnectedness, and maturity and liquidity transformation escalated to dangerous levels across the financial system. The result was the most severe financial crisis and economic downturn since the Great Depression. Almost 9 million Americans lost their jobs, roughly twice as many lost their homes, and all too many households ended up underwater on their mortgages and overburdened with debt. To be sure, some individuals and families borrowed unwisely, but too often financial institutions encouraged the behavior that resulted in such excessive debt.

In my remarks today I will discuss some important reasons why the incentives facing financial institutions were distorted and the steps that regulators are taking to realign those incentives.

The Important Role of the Financial Sector
Before discussing the incentives that contributed to the buildup of risk at financial institutions, I would like to highlight the important contributions that the financial sector makes to the economy and society. First and foremost, financial institutions channel society’s scarce savings to productive investments, thereby promoting business formation and job creation. Access to capital is important for all firms, but it is particularly vital for startups and young firms, which often lack a sufficient stream of earnings to increase employment and internally finance capital spending. Indeed, research shows that more highly developed financial systems disproportionately benefit entrepreneurship.1

The financial sector also helps households save for retirement, purchase homes and cars, and weather unexpected developments. Many financial innovations, such as the increased availability of low-cost mutual funds, have improved opportunities for households to participate in asset markets and diversify their holdings.2 Expanded credit access has helped households maintain living standards when suffering job loss, illness, or other unexpected contingencies.3 Technological innovations have increased the ease and convenience with which individuals make and receive payments.4

The contribution of the financial sector to household risk management and business investment, as well as the significant contribution of financial-sector development to economic growth, has been documented in many studies.5 Such research shows that, across countries and over time, financial development, up to a point, has disproportionately benefited the poor and served to alleviate economic inequality.6

Distorted Incentives in the Financial Sector
Despite these benefits, as we have seen, actions by financial institutions have the potential to inflict harm on society. Instead of promoting financial security through prudent mortgage underwriting, the financial sector prior to the crisis facilitated a bubble in the housing market and too often encouraged households to take on mortgages they neither understood nor could afford. Recent research has raised important questions about the benefits and costs of the rapid growth of the financial services industry in the United States over the past 40 years.7

A combination of responses to distorted incentives by players throughout the financial system created an environment conducive to a crisis. Excessive leverage placed institutions at great risk of insolvency in the event that severe, albeit low-probability, problems materialized. Overreliance on fragile short-term funding by many institutions left the system vulnerable to runs. And excessive risk-taking increased the probability that severe problems would, in fact, materialize. Moreover, regulators–and the structure of the regulatory system itself–did not keep up with changes in the financial sector and were insufficiently attuned to systemic risks. Once concerns began to develop about escalating losses at large firms, insufficient liquidity and capital interacted in an adverse feedback loop. Funding pressures contributed to “fire sales” of financial assets and losses, reducing capital levels and heightening liquidity pressures–culminating in the near collapse of the financial system in late 2008.

Capital and liquidity
Several factors encouraged excessive leverage, including market perceptions that some institutions were “too big to fail.”8 Financial institutions also had an incentive to engage in regulatory arbitrage, moving assets to undercapitalized off-balance-sheet vehicles. The complexity of the largest banking organizations also may have impeded market discipline. In addition, financial intermediation outside of the traditional banking sector grew rapidly in the years up to 2007, leaving gaps in the regulatory umbrella. And conflicts in the incentives facing managers, shareholders, and creditors may have induced banks to increase leverage.9

To strengthen banks’ resilience, the Federal Reserve and the other banking agencies have substantially increased capital requirements. Regulatory minimums for capital relative to risk-weighted assets are significantly higher, and capital requirements now focus on the highest-quality capital, such as common equity. In addition to risk-based standards, bank holding companies and depositories face a leverage ratio requirement. Also, significantly higher capital standards–both risk-weighted and leverage ratios–are being applied to the most systemically important banking organizations. Such surcharges are appropriate because of the substantial harm that the failure of a systemic institution would inflict on the financial system and the economy. Higher capital standards provide large, complex institutions with an incentive to reduce their systemic footprint. We are also employing annual stress tests to gauge large institutions’ ability to weather a very severe downturn and distress of counterparties and, importantly, continue lending to households and businesses. Firms that do not meet these standards face restrictions on dividends and share buybacks. As a result of these changes, for the largest banks, Tier 1 common equity–the highest-quality form of capital‑‑has more than doubled since the financial crisis.

New liquidity regulations will also improve incentives in the financial system. Prior to the crisis, institutions’ incentives to rely on short-term borrowing to fund investments in riskier or less liquid instruments were distorted in two important ways. First, many investors were willing to accept a very low interest rate on short-term liabilities of financial institutions or on securitizations without demanding adequate compensation for severe-but-unlikely risks, such as a temporary loss of market liquidity. Perhaps these firms expected government support or simply considered illiquidity a very remote possibility. Second, institutions’ attempts to shift their holdings once concerns about credit or liquidity risk arose created a fire-sale dynamic that amplified declines in market values, causing unanticipated spillovers onto other institutions and across markets.10

Recently implemented regulations aim to strengthen liquidity. For example, a new liquidity coverage ratio requires internationally active banking organizations to hold sufficient high-quality liquid assets to meet their projected net cash outflows during a 30-day stress period. A new process–the Comprehensive Liquidity Analysis and Review–sets supervisory expectations for liquidity-risk management and evaluates institutions’ practices against these benchmarks. A proposal for a net stable funding ratio would require better liquidity management at horizons beyond that covered by the liquidity coverage ratio. A proposed capital surcharge for the largest firms would discourage overreliance on short-term wholesale funding. Also, the Securities and Exchange Commission has adopted changes in regulations that may help avoid future runs on prime money market mutual funds (that is, money funds that invest primarily in corporate debt securities). And reforms in the triparty repo market have reduced risks associated with intraday exposures.

Large, complex institutions and too big to fail
In the aftermath of the crisis, the Congress tasked the banking regulators with challenging and changing the perception that any financial institution is too big to fail by ensuring that even very large banking organizations can be resolved without harming financial stability. Steps are under way to achieve this objective. In particular, banking organizations are required to prepare “living wills”–plans for their rapid and orderly resolution in the event of insolvency. Regulators are considering requiring that bank holding companies have sufficient total loss-absorbing capacity, including long-term debt, to enable them to be wound down without government support.11 In addition, the Federal Deposit Insurance Corporation has designed a strategy that it could deploy (known as Single Point of Entry) to resolve a systemically important institution in an orderly manner.

The crisis also revealed that risk management at large, complex financial institutions was insufficient to handle the risks that some firms had taken. Compensation systems all too frequently failed to appropriately account for longer-term risks undertaken by employees. And lax controls in some cases contributed to unethical and illegal behavior by banking organizations and their employees. The Federal Reserve has made improving risk management and internal controls a top priority. For example, the Comprehensive Capital Analysis and Review, which includes the stress tests that I mentioned, also involves an evaluation to ensure firms have a sound process in place for measuring and monitoring the risks they are taking and for matching their capital levels to those risks. Also, supervisors from the Fed and other agencies have pressed firms to improve their internal controls and to make their boards of directors more directly responsible for compensation decisions and employee conduct.

Changes to Regulatory and Supervisory Focus
As I noted, the financial crisis revealed weaknesses in our nation’s system for supervising and regulating the financial industry. Prior to the crisis, regulatory agencies, including the Federal Reserve, focused on the safety and soundness of individual firms–as required by their legislative mandate at the time–rather than the stability of the financial system as a whole. Our regulatory system did not provide any supervisory watchdog with responsibility for identifying and addressing risks associated with activities and institutions that were outside the regulatory perimeter. The rapid growth of the “shadow” nonbank financial sector left significant gaps in regulation.

In response, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) expanded the mandate and authority of the Federal Reserve to allow it to consider risks to financial stability in supervising financial firms under its charge. Within the Federal Reserve System, we have reorganized our supervision of the most systemically important institutions to emphasize what we call a “horizontal perspective,” which examines institutions as a group and in comparative terms, focusing on their interaction with the broader financial system. We also created a new office within the Fed to identify emerging risks to stability in the broader financial system–both the bank and nonbank financial sectors–and to develop policies to mitigate systemic risk. The Dodd-Frank Act created the interagency Financial Stability Oversight Council, chaired by the Treasury Secretary, and the Federal Reserve is a member. It is charged with identifying systemically important financial institutions and systemically risky activities that are not subject to consolidated supervision and designating those institutions and activities for appropriate supervision. And it is charged with encouraging greater information sharing and policy coordination across financial regulatory agencies.

Where We Stand
My topic is broad, and my time is short. Let me end with three thoughts. First, I believe that we and other supervisory agencies have made significant progress in addressing incentive problems within the financial sector, especially within the banking sector. Second, policymakers, including those of us at the Federal Reserve, remain watchful for areas in need of further action or in which the steps taken to date need to be adjusted. And, third, engagement with the broader public is crucial to ensuring that any future steps move our financial system closer to where it should be. Active debate and discussion of these issues at this conference and in other forums is important to improve our understanding of the challenges that remain.

References
Admati, Anat R., Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer (2013a). “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Socially Expensive,” Leaving the Board Working Paper 2065. Stanford, Calif.: Stanford Graduate School of Business, October 22.

—— (2013b). “The Leverage Ratchet Effect,” Leaving the Board Working Paper 3029. Stanford, Calif.: Stanford Graduate School of Business, December 2.

Beck, Thorsten, Asli Demirgüç-Kunt, and Ross Levine (2007). “Finance, Inequality and the Poor,” Leaving the Board Journal of Economic Growth, vol. 12 (March), pp. 27-49.

Board of Governors of the Federal Reserve System (2015). “Federal Reserve Survey Provides Information on Mobile Financial Services,” press release, March 26.

Cecchetti, Stephen G., and Enisse Kharroubi (2012). “Reassessing the Impact of Finance on Growth,” Leaving the Board BIS Working Papers 381. Basel, Switzerland: Bank for International Settlements, July.

Financial Stability Board (2014). “Adequacy of Loss-Absorbing Capacity of Global Systemically Important Banks in Resolution.” Leaving the Board Basel, Switzerland: FSB, November 10.

Fort, Teresa C., John Haltiwanger, Ron S. Jarmin, and Javier Miranda (2013). “How Firms Respond to Business Cycles: The Role of Firm Age and Firm Size,” Leaving the Board IMF Economic Review, vol. 61 (August), pp. 520-59.

Goldsmith, Raymond W. (1969). Financial Structure and Development. New Haven: Yale University Press.

Gorton, Gary, and Guillermo Ordoñez (2014). “Collateral Crises,” Leaving the Board American Economic Review, vol. 104 (February), pp. 343-78.

Gorton, Gary, Stefan Lewellen, and Andrew Metrick (2012). “The Safe-Asset Share,” Leaving the Board American Economic Review, vol. 102 (May), pp. 101-6.

Greenwood, Robin, and David Scharfstein (2013). “The Growth of Finance,” Leaving the Board Journal of Economic Perspectives, vol. 27 (Spring), pp. 3-28.

Guiso, Luigi, Paola Sapienza, and Luigi Zingales (2004). “Does Local Financial Development Matter?” Leaving the Board Quarterly Journal of Economics, vol. 119 (August), pp. 929-69.

Hanson, Samuel G., Anil K. Kashyap, and Jeremy C. Stein (2011). “A Macroprudential Approach to Financial Regulation,” Leaving the Board Journal of Economic Perspectives, vol. 25 (Winter), pp. 3-28.

King, Robert G., and Ross Levine (1993). “Finance and Growth: Schumpeter Might Be Right,” Leaving the Board Quarterly Journal of Economics, vol. 108 (August), pp. 717-37.

Krueger, Dirk, and Fabrizio Perri (2006). “Does Income Inequality Lead to Consumption Inequality? Evidence and Theory,” Leaving the Board Review of Economic Studies, vol. 73 (January), pp. 163-93.

Levine, Ross (2005). “Finance and Growth: Theory and Evidence,” in Philippe Aghion and Steven Durlauf, eds., Handbook of Economic Growth. Amsterdam: Elsevier B.V., pp. 865-934.

Malkiel, Burton G. (2013). “Asset Management Fees and the Growth of Finance,” Leaving the Board Journal of Economic Perspectives, vol. 27 (Spring), pp. 97-108.

Myers, Stewart C. (1977). “Determinants of Corporate Borrowing,” Leaving the Board Journal of Financial Economics, vol. 5 (2), pp. 147-75.

Philippon, Thomas, and Ariell Reshef (2012). “Wages and Human Capital in the U.S. Financial Industry: 1909-2006,” Leaving the Board Quarterly Journal of Economics, vol. 127 (November), pp. 1551-609.

—— (2013). “An International Look at the Growth of Modern Finance,” Leaving the Board Journal of Economic Perspectives, vol. 27 (Spring), pp. 73-96.

Rajan, Raghuram G., and Luigi Zingales (1998). “Financial Dependence and Growth,” Leaving the Board American Economic Review, vol. 88 (June), pp. 559-86.

Stein, Jeremy C. (2012). “Monetary Policy as Financial Stability Regulation,” Leaving the Board Quarterly Journal of Economics, vol. 127 (February), pp. 57-95.

Zingales, Luigi (2015). “Does Finance Benefit Society?” Leaving the Board NBER Working Paper Series 20894. Cambridge, Mass.: National Bureau of Economic Research, January.

1. Recent reviews have highlighted potential costs of a distorted financial sector, but such reviews also emphasize the range of both theoretical and empirical work that has documented the many ways in which the financial sector can support economic efficiency; see, for example, Greenwood and Scharfstein (2013) and Zingales (2015). Guiso, Sapienza, and Zingales (2004) discuss evidence that financial development supports entrepreneurship, and Fort and others (2013) examine the importance of financing for business formation and young firms. Return to text

2. Greenwood and Scharfstein (2013) discuss how an important fraction of growth in the U.S. financial sector reflects the greater demand of households for asset management services and credit. Malkiel (2013) considers similar issues and reviews how improved access to low-cost investment options has benefited households. Return to text

3. Krueger and Perri (2006) analyze how an increase in access to credit contributed to households’ ability to smooth spending despite substantial income volatility. Return to text

4. Changes in payment technologies have been rapid, and an area of particular interest is the fast growth of mobile payment and financial service technologies. The Federal Reserve has conducted several surveys to understand these developments, and the most recent results are discussed in Board of Governors (2015). Return to text

5. A substantial body of research finds that financial development supports economic growth, including Goldsmith (1969), King and Levine (1993), Rajan and Zingales (1998), and Levine (2005). It is noteworthy that this research emphasizes differences across countries, and that the United States is among the most financially developed countries in the world. Return to text

6. Beck, Demirgüç-Kunt, and Levine (2007) show that financial development reduces poverty and inequality in a study examining evidence across countries. Return to text

7.Zingales (2015) raises a number of questions regarding ways in which distortions in the financial sector may contribute to “rent seeking” activity that may promote inefficiency. Philippon and Reshef (2012) examine trends in compensation in the financial sector and the contribution of such trends to the increase in income inequality in the United States in recent decades. Philippon and Reshef (2013) and Cecchetti and Kharroubi (2012) revisit the links between financial development and economic growth, focusing particularly on these relationships around periods of rapid growth in the financial sector or among economies with a large financial sector. Return to text

8. For a review of many factors that may have contributed to leverage in the financial sector and a discussion of how, in some cases, these factors reflect distortions that imply leverage was excessive, see Admati and others (2013a). Return to text

9. The notion that “agency problems”–that is, conflicts in the interests of managers and various stakeholders in firms–may contribute to excessive debt has a long history, most notably following the notion of “debt overhangs” from Myers (1977). Hanson, Kashyap, and Stein (2011) emphasize the potential importance of this issue for the financial sector. Admati and others (2013b) present a related mechanism. Return to text

10. The notion that securities issued by financial institutions may provide liquidity services in a manner that potentially contributes to fragility because such securities do not have the safety and liquidity of publicly issued securities is examined in, for example, Gorton, Lewellen, and Metrick (2012); Stein (2012); and Gorton and Ordoñez (2014). Return to text

11. For a discussion of total loss-absorbing capacity, see Financial Stability Board (2014), a consultative document on a proposal for a common international standard on total loss-absorbing capacity for global systemic banks. The comment period on this FSB proposal ended in February of this year.

The economic outlook for Asia and the Pacific remains favorable, with the region projected to remain the global growth leader over the medium term. While the pace of expansion has moderated since the global financial crisis, robust consumption helped to cushion the blow from weaker external demand. As a region of oil importers and supply chain participants, Asia is set to benefit from the recent decline in world oil prices and the ongoing recovery in advanced economies. However, real and financial volatilities could disrupt this favorable outlook, and further delays in structural reforms could hold back growth. Therefore, policies should remain focused on building resilience and enhancing productive capacity.

Growth in the Asia and Pacific region is expected to hold steady at 5.6 percent in 2015 and to ease slightly to 5.5 percent in 2016. Domestic demand is forecast to continue to drive growth, supported by the windfall boost to real incomes from lower world oil prices and strong labor market conditions. These factors are expected to offset the effect of tighter financial conditions from capital fl ow reversals triggered in part by the prospect of monetary tightening by the Federal Reserve. Net exports are also expected to add only marginally to growth. Across the region, lower oil prices will temporarily push down headline infl ation and, with a large part of the windfall expected to be saved, current account balances will increase.

Nonetheless, considerable heterogeneity is apparent across the region. China is slowing to a more sustainable pace; Japan is expected to see growth pick up following a year of stagnation; exporters of non-oil commodities whose prices have fallen sharply (Australia, Indonesia, Malaysia, and New Zealand) will be adversely affected by the terms-of-trade swing; elsewhere, however, growth is expected to stabilize or increase. In addition, effective exchange rates across the region have diverged, reflecting several factors: (1) in the context of asynchronous monetary policies in major advanced economies, including Japan, some currencies have remained more closely tied to the U.S. dollar, while others
have allowed more flexibility; (2) the differential impact of large changes in the terms of trade on net commodity importers and exporters; and (3) capital is fl owing into some countries but reversing from others. This regional diversity could lead to increased volatility.

While the Asia and Pacifi c outlook remains solid, the balance of risks is tilted to the downside. First, signifi cantly slower-than-expected growth in China or Japan would impact the rest of the region and the world given these economies’ large size and deep trade and fi nancial linkages. Countries with strong supply chain linkages as well as commodity exporters to these large economies would be especially affected. Second, persistent U.S. dollar strength against the euro and the yen would likely exert an autonomous tightening of domestic financial conditions in the region and impose higher debt service costs for fi rms with sizable U.S.-dollar-denominated debt. In addition, a stronger dollar relative to other major currencies could erode export market shares for economies whose currency displays limited flexibility against the U.S. dollar. Third, the rapid buildup of debt across the region could heighten the sensitivity of growth to global financial and inflation conditions. Tighter financial conditions in the United States would raise domestic borrowing costs, while lower global inflation—if imported into Asia—would increase the level of real debt. The resulting increase in the carrying cost of debt could impinge on domestic spending, while higher debt could weaken the credit channel of monetary policy On the other hand, lower world oil prices present an important upside risk for Asia’s growth.

Notwithstanding the projected increase in the world price beginning later this year, over the longer term oil prices are expected to remain signifi cantly below the average of recent years. Additional support to growth could materialize if the supply contribution to the price decline is larger or more persistent than currently envisaged, or if the propensity to spend from the oil price windfall is larger than currently anticipated.

While debt has risen across much of Asia and the Pacific, reaching high levels in some economies, fi nancial sector risks have been contained by sustained income growth and supportive financial conditions. However, risks are evident in the real estate sector, and although bank credit-to-GDP ratios have been increasing more slowly in most economies, previous rapid credit growth has generated sizable positive credit gaps in several economies. Notwithstanding these developments, banks’ balance sheets have generally strengthened across Asia and the Pacific.

Going forward, Asia’s pace of potential growth is likely to remain below precrisis levels. Mirroring developments in realized growth, potential growth has slowed across much of the region. The decline reflects primarily decelerating total factor productivity, although slower growth in labor’s contribution due to aging was a major factor in several economies. Slower total factor productivity growth may reflect diminishing returns from participating in global value chains (see Chapter 2), which could limit productivity gains in the absence of structural reforms. Over the medium term, the region would also benefit from deeper regional financial integration, which has lagged trade integration. Furthering financial integration holds the promise of more efficient allocation of regional savings to meet the region’s large investment needs while also supporting financial inclusion.

What is the role for policy in this environment? Most countries in Asia and the Pacific are in the enviable position of having adequate interest rate and fiscal policy space to supply additional temporary stimulus if needed. However, based on growth and inflation forecasts, current policy interest rates are appropriate across the region, although concerns about fiscal sustainability and financial stability, as well as the risk of renewed global financial volatility, may warrant somewhat tighter stances in several countries. Moreover, policymakers will also need to contend with several countervailing forces, including the temporary fall and subsequent increase in the price of oil, potential capital fl ow volatility, and rising asset prices. Macroprudential policies and foreign currency intervention can assist to contain financial stability risks and address sporadic disorderly conditions in the foreign exchange market, but permitting exchange rate flexibility to absorb shocks. On the fiscal front, the decline in oil and food prices provides a window of opportunity to further reform or phase out subsidies, thereby improving spending efficiency and shielding public spending from future commodity price fluctuations. Further fiscal consolidation is appropriate in countries where public debt remains elevated. Structural reforms remain critical to boost productivity growth across the region, including state-owned enterprise and financial sector reforms in China, initiatives to raise services productivity and labor force participation in Japan, and measures to address supply bottlenecks in India, the Association of Southeast Asian Nations, frontier economies, and small states.

The growing competitiveness and volatility in the world economy, including the rise and fall of currencies and the drop in commodity prices, and the shift of the global economic centre to Asia mean that countries have to adapt. “Within this global transition, our task is clear,” Indonesian President Joko Widodo told over 700 business, government and civil society leaders in the opening session of the 24th World Economic Forum on East Asia.

“We have to reinvent our economies; we have to reinvent our societies.” Indonesia must undergo crucial restructuring, said Jokowi, as he is familiarly known. “Today, we must change from consumption back to production, from consumption to investment in our infrastructure, investment in our industry, but most importantly, investment in our human capital, the most precious resource of the 21st century.”

These changes will not be without pain, he acknowledged. “Change will create winners and losers, but there can be no progress without change. There can be no gain without pain. And even with the pain, my people tell me every week and every month, please change our country.”

The theme of the World Economic Forum on East Asia 2015 is “Anchoring Trust in East Asia’s Regionalism”. ASEAN is to launch the ASEAN Economic Community, a common-market initiative, at the end of the year.

Speaking before Jokowi, Samdech Techo Hun Sen, the Prime Minister of the Kingdom of Cambodia, spoke about that regionalism, noting that two regional trade mechanisms are currently under negotiation – the Trans-Pacific Partnership (TPP), which includes some members of ASEAN, and the Regional Comprehensive Economic Partnership (RCEP), which includes all 10 ASEAN countries. “The two mechanisms should not be confrontational but complementary,” Hun Sen cautioned. He called for the “promoting of deeper regional integration in all sectors through improved connectivity in all aspects – physical, institutional and people-to-people connectivity

Nguyen Xuan Phuc, Deputy Prime Minister of Vietnam, also made a plea for East Asian countries to address challenges and issues among them through collaboration. “It is very important to bear in mind that differences and disputes should be resolved through peaceful measures according to international law,” he said. “Cooperation, mutual respect and trust are indispensable to ensuring the stability and growth of the region.”

Russia, for its part, is looking to cooperate more with the Asia-Pacific region, particularly ASEAN, Arkady Dvorkovich, Deputy Prime Minister of the Russian Federation, told participants. “While we do not have common borders with ASEAN, we are talking about our joint interests in developing many spheres,” such as agriculture, infrastructure development and mining, he said.

In his welcoming remarks, Philipp Rösler, Member of the Managing Board, World Economic Forum, stressed the importance of building trust to turn decisions into reality. “Trust is critical. Without trust, there is no motivation. Without motivation, there is no leadership.” The World Economic Forum on East Asia is “a platform for creating trust and leadership to bring the region into a better future,” he concluded.