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Resilient recovery in the euro area
The economic recovery in the euro area is continuing at a moderate, but firming, pace, and is broadening gradually across sectors and countries. Real GDP growth has expanded for 15 consecutive quarters, growing by 0.4% during the final quarter of 2016 according to the Eurostat flash estimate. Economic sentiment is at its highest level in nearly six years and unemployment is back to single-digit figures. Looking beyond the euro area, the global economy, too, is showing increasing signs of a cyclical upturn.
The euro area economy has been resilient in the face of a number of risks and uncertainties at global level. One example of its improving resilience is the fact that domestic demand is now the mainstay of real GDP growth. Previously, growth in euro area was closely correlated with the strength of international trade, but that relationship has weakened recently; last year’s growth would not have been possible in view of the lacklustre international conditions.
Our monetary policy measures have been a key contributor to these positive economic developments. The comprehensive set of measures introduced since June 2014 has worked its way through the financial system, leading to a significant easing of financing conditions for consumers and firms. Together with improving financial and non-financial sector balance sheets, this has strengthened credit dynamics and supported domestic demand.
The recovery has been accompanied by a broad-based improvement in measures of confidence. Measured confidence for industry, construction, services and households is in positive territory, and particularly strong for measures of future expectations. This is in line with the normally high correlation between measures of confidence and economic activity. Households and businesses which are confident about the future are more likely to spend and invest than those which are concerned.
Despite the resilient recovery in the euro area, and strong indicators of confidence across all sectors, measures of political and policy uncertainty have been rising recently, although asset markets are not significantly pricing in tail risks. The recent bouts of uncertainty are a source of concern, and represent a downside risk to the economic outlook. Today I would like to discuss the potential impact of uncertainty on economic activity and the role of institutions in counteracting uncertainty and providing stability.
Uncertainty and economic developments
[...] The one indicator of uncertainty that appears elevated, and has been so since the UK referendum is political uncertainty. This measure counts how frequently newspaper articles cite “uncertainty”, “economy” or similar, and particular policy words, such as “deficit” or “regulation”. A number of recent events have sparked this rise in political uncertainty. Since the US elections, the outlook for that country’s fiscal policy and trade policy has been uncertain. In the run-up to the elections in several European countries, the headlines are reflecting political uncertainty about the future attitude of Member States towards European integration. Not to forget the process of withdrawal of the United Kingdom from the European Union and the significant uncertainty that inevitably surrounds the future relationship between the UK and the EU27.
These recent bouts of political and policy uncertainty have come on top of the existing and more enduring sources of “structural” uncertainty about the economic outlook in advanced economies. What do we really know about the impact of new technologies and innovation on tomorrow’s economic landscape? Will secular stagnation be the new economic reality? [...]
It is important for us economists to be humble when forecasting the future. Debating concepts such as ‘secular stagnation’ may be fashionable now, but we should remember only a decade ago it was fashionable to debate the ‘Great Moderation’. By the same token, the observed resilience of a moderate economic recovery and strong confidence indicators should not lead to complacency. Respondents to survey questions can be influenced by what they consider to be a normal benchmark. If the new normal after the Great Recession is below its pre-crisis level, the same levels of confidence indicators can point to lower growth rates than before the crisis. Indeed, measures of capacity utilisation are high in an environment of persistent economic slack. How resilient the recovery really is to policy uncertainty is also not known. The World Bank’s Global Trade Watch report suggests that policy uncertainty is already weighing on world trade. [...]
The importance of economic narratives
Following financial crises, political uncertainty is often elevated. According to a recent study, votes for extreme parties can increase by on average 30%, while government majorities shrink, parliaments end up with a larger number of parties and become more fractionalised. Thus the political landscape becomes more gridlocked at precisely the moment when decisiveness is typically required.
This can delay necessary policy responses, such as cleaning up the financial sector, which prolongs the post-crisis recovery. And such uncertainty, reflected in the media, can gradually build a narrative of doom and gloom around the economy or around the existing institutions – a seeping pessimism, which over time alters investors’ and consumers’ expectations, and thereby their behaviour. [...]
This is a serious matter. The outcome of the UK referendum can be partly attributed to the decades-long development and spread of negative popular narratives about European integration. More generally, the events I mentioned earlier are the culmination of a broader anti-establishment and anti-globalisation narrative that has gained more traction in advanced economies. As narratives often are key determinants of economic and political outcomes, it is important to be wary of them.
The stabilising role of institutions
[...] The move over recent decades to grant independence to central banks owes much to the problem of time consistency. When monetary policy was under the control of governments, there was always an incentive to “cheat” and deliver higher than expected inflation to temporarily increase output. The existence of this incentive, and the inability of governments to credibly commit to the right policy, gave rise to de-anchored inflation expectations.
Independent central banks with a clear mandate to maintain price stability have been successful in anchoring inflation expectations. Having an explicit inflation objective provides its own stabilising narrative – people can trust the central bank to deliver inflation, and can base their economic decisions on that expected inflation rate. In recent years, the ECB has been an anchor of stability, creating an effective bulwark against deflationary narratives when they appeared in the euro area. By acting forcefully, the ECB has prevented deflationary dynamics from materialising.
But institutions need to be strong in order to deliver in the face of shocks. To put this in perspective, consider how two periods of global economic integration have fared under different institutions. Global economic integration has fluctuated over time and is now higher than at any time in the past. Another period of high integration, in the decades prior to World War I, ended abruptly as a financial crisis of global proportions, accompanied by a credit crunch, broke apart bilateral arrangements and paved the way for several rounds of retaliatory tariff increases.
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The European Union as provider of stability and protection
The European Union and the Single Market have successfully delivered decades of peace and growing prosperity throughout Europe. There has been a steady process of strengthening trade and economic links, based on the foundations of democracy, a strong social model and the rule of law. These institutions are Europe’s answer to the questions posed by globalisation, a democratic way to reap the benefits of economic integration while still protecting consumers and workers.
The Single Market is more than just a customs union or a dense network of free trade agreements between countries. It is in fact an innovative forward step in economic evolution. It provides the legal framework for trade between Member States, underpinned by the four fundamental freedoms – free movement of goods, services, labour and capital.
This framework is vital to give companies confidence to invest and integrate across national borders. For trade to flourish, businesses need to be certain that contracts will be honoured, competition rules will be fairly enforced, property rights respected and standards adhered to. In ensuring the rule of law, the Single Market reduces barriers to trade, labour mobility and competition and increases technological diffusion between countries. Take as a recent example the abolition of mobile phone roaming fees across the Union, which was a decision based on the principles of the Single Market that protects consumers.
This is not to say that the European Union is perfect. Strong institutions should always strive to improve and make sure their policies bring more value to citizens. We should also be clear about what European institutions are and what they are not. There is a widespread narrative according to which Brussels imposes its decisions on Member States. Yet all regulations and directives adopted in Brussels are decided according to a political process involving the governments of all Member States, which are all represented in the Council, and elected representatives of all European citizens. The Union has built over time a set of strong institutions for Member States to decide together matters of common interest.
But it is important to recognise the tensions that exist between the individual priorities of nation states and the pooling of national sovereignty for mutual gain. The regulations for the Single Market need to be strong enough to promote innovation, but not so tight that they stifle it. By the same token, countries have to be able to pursue their own social agendas where these do not clearly clash with the principles of the Single Market. The principle of subsidiarity is important.
Take as an example the fiscal framework under the Stability and Growth Pact. There are important rules to ensure government finances are run in a sustainable fashion. Yet beyond the parameters for fiscal sustainability, the framework allows for wide divergences in aggregate tax rates, the share of the public sector in total output and for national priorities in public spending. These are at the discretion of each sovereign Member State. [...]