25 February 2013

Karl Whelan: A plea for growth to Europe's politicians

Confidence Fairies and Supply-Side Reforms

With public and private sectors cutting spending, cost competitiveness only improving slowly and the global economy doing poorly, where is the growth for debt-distressed economies supposed to come from?

Not long ago, the popular theme among Europe’s leaders was that budget cuts would restore economic growth by boosting confidence among households, firms and financial markets. Experience has not been kind to this story, instead favouring the traditional Keynesian interpretation that fiscal contraction is, well, contractionary.

In recent years, European leaders have adopted a different story about where growth will come from. This narrative accepts that fiscal adjustment has a negative impact on the economy but emphasises that the impetus for growth will come from positive supply-side reforms.

As a mainstream economist, I agree that many of the eurozone countries currently in difficulty could benefit over time from supply-side reforms in product markets and labour markets. These reforms can improve competitiveness and promote efficiency.  However, I don’t agree these are the ideal policies to promote growth in debt-distressed countries or that they should be expected to offset fiscal austerity. 

It is even possible that reforms that have a positive long-run impact can have a negative impact in the short run. For example, reforms to reduce firing costs may have important long-run effects in making it more attractive to hire workers in Spain or Italy. But the short-run impact of these reforms could be to further increase unemployment as firms lay off large amounts of workers.

Politically, disruptive reforms are also difficult to implement at times when governments are already unpopular because of fiscal austerity and recession. German politicians regularly point their own successful labour market reforms in the last decade.  “We took our medicine and now so should you” is a common German theme...

Perhaps the clearest statement of the policy approach of the euro area’s surplus countries was Bundesbank President Jens Weidmann’s speech last year titled “Rebalancing Europe”. Weidmann believes that any attempt to reduce the current account surpluses of Germany and other “core” euro area countries would be a bad idea. Instead, he views Europe’s route to success as being one in which we compete with the US and China to run current account surpluses across the euro area.

For me, this position echoes the “mercantilist” approach that economists from Adam Smith onwards have rejected.  The euro area’s balance with the rest of the world has generally been close to balance. It has moved slightly into surplus lately but there is no reason to equate euro area current account surpluses with economic success.

Even if there was an argument for this route, the world’s other trading blocs are all adopting monetary policies that are likely to curb the euro area’s current account surplus.  Unlike the hard-money ECB, most other leading central banks are happy to see their currencies depreciate which will make it all the more difficult for the euro area to run a current account surplus.

Stronger than We Think

I know these comments won’t be well received by many. I know many of you believe that there is no room for core euro area countries to raise spending. However, borrowing rates for countries like Germany area are close to zero and the euro area as a whole has a debt ratio similar to areas such as the UK and the US, where central banks are actively willing to purchase sovereign debt. A eurobond-financed stimulus programme would be economically feasible and effective; the feasibility problem is a political one. The shortfall of spending that afflicts growth and reform in the euro area is largely due to our own unwillingness to use available policy choices to solve our problems.

To conclude, I believe that if the euro area is to succeed as a combined economic entity we need to understand that we are not as weak as many think we are. Europe has many economic strengths and if we believe in those strengths and act in our common interest, we can put the euro project back on the path to success.

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