Greg Ip

Articles by The Economist’s U.S. Economics Editor

ECB, heal thyself: How Europe’s low inflation impedes fiscal and structural reform

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Sep 8th 2014, 16:22 by G.I. | WASHINGTON, D.C

Europe does not yet have its equivalent of Japan’s Abenomics, but Mario Draghi, president of the European Central Bank, pretty much advocated it in his press conference last week. Europe, he said, needs fiscal, monetary and structural policy working together, the three arrows of Abenomics. He acknowledged the ECB’s duty of getting inflation, now 0.3%, back up to its target of near 2%. But the ECB, he said, can’t rescue Europe alone: it needs help from fiscal and structural reforms.

Of course, he’s right that monetary policy can’t initiate fiscal consolidation or liberalize product and labour markets, and that both those things are essential to Europe’s long term health. But the ECB can help determine whether either of those things succeeds. For Europe’s fiscal and regulatory policy makers to do their jobs, it will help immensely if the ECB does its own.

Let’s start with fiscal consolidation. Mr Draghi’s predecessor, Jean-Claude Trichet, used to extoll the stimulative benefits of fiscal consolidation; the confidence of investors and business would soar when they saw government finances put on a stable path. But in practice, fiscal consolidation was equated with austerity: near term cuts to spending or increases in taxes that pummeled demand at a time when the ECB, with interest rates close to zero, couldn’t compensate. The result was to add to the disinflationary pressure on the region, making it harder for the ECB to do its job (as Mr Draghi now points out).

But the reverse is also true: low inflation makes fiscal consolidation harder. It automatically reduces the growth in nominal GDP and all else equal, raises the debt to GDP ratio. Debt dynamics would be left unchanged if nominal interest rates fall by the same magnitude as inflation. But that won’t happen if interest rates are jammed against the zero nominal bound as they are in the euro zone, and pretty much the entire rich world. In that situation, falling inflation or deflation leads to rising real interest rates in the periphery, and makes it ever harder to reduce debt ratios . Indeed, if falling inflation causes investors to question the sustainability of the debt, it could lead to higher, not lower, nominal interest rates. In 2012 the International Monetary Fund examined six case studies over the last century of fiscal consolidation efforts when debt topped 100% of GDP. It concluded that a crucial element of successful consolidation was easy monetary policy. Lower real interest rates made it much easier to lower debt to GDP ratios. The most poignant example of the opposite was Britain in the 1920s which implemented both fiscal and monetary austerity in an effort to return sterling to its pre-war gold parity. The result was that nominal reductions in debt were frustrated by falling prices and high real interest rates. Britain ended the period with debt to GDP much higher than it started. The lesson for Europe is that if the ECB could get inflation back to 2%, fiscal consolidation would be easier.

Mr Draghi has tacked away from Mr Trichet’s embrace of austerity. “It would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy,” he said in Jackson Hole.  “The existing flexibility within the rules could be used to better address the weak recovery and to make room for the cost of needed structural reforms.” He is not calling for the abandonment of debt stabilization; only that it be done in way that spares near-term demand.

But Mr Draghi has replaced Mr Trichet’s preoccupation with austerity with an obsession of his own over structural reform. He said after last week’s meeting of the governing council: “There is no fiscal or monetary stimulus that will produce any effect without ambitious and important and strong structural reforms.” Yet, as with fiscal consolidation, the ECB needs to recognize its own role: getting inflation back to target would make structural reform much easier.

Structural reform is a catch-all phrase for a wide variety of policies, from reducing judicial backlogs to increased competition for professional services. But where it matters most is labour markets. High nominal wages and poor productivity caused peripheral countries to lose competitiveness vis a vis Germany during the 2000s, leading to large current account deficits. Restoring competitiveness requires reducing wages relative to Germany. But in most of peripheral Europe, wages are difficult to cut and permanent workers difficult to fire. This is due both to institutions such as collective bargaining and to the fact that nominal wages are downward sticky. Even in flexible labour markets like America’s, workers resist nominal wage cuts and firms are reluctant to impose them. Positive inflation makes it possible for firms to reduce real wages by simply holding nominal wages constant. In the absence of real wage declines, the alternative is fire workers instead, which of course raises unemployment and squeezes demand. Mr Draghi has contrasted the experience of Ireland, where real wages fell, with Spain, where they rose, in the wake of their respective debt busts. This, he explains, is why unemployment rose less in Ireland.

So peripheral countries face a dilemma: they need lower real wages to regain competitiveness, but lower wages reduce nominal GDP which makes fiscal consolidation harder. That’s why getting inflation higher throughout the euro zone is critical. If the region’s inflation rate were to return to 2%, or even a bit higher, it would imply prices and wages running well ahead of 2% in Germany, and behind it in the periphery, making real wage adjustment far easier, but without outright deflation or job cuts, which undermine nominal output and thus fiscal consolidation. Zsolt Darvas of Bruegel, a think tank,calculated a year ago that if Italy and Spain must reduce inflation by 1 percentage point because euro-area inflation has undershot the ECB’s 2% target, their primary surpluses must be higher, by 1.3% and 1% of GDP, respectively, to achieve the same fiscal consolidation.

Of course, even if the ECB were to undertake quantitative easing by buying government bonds to get inflation back to target, that is no guarantee that governments would do their part by implementing long-run fiscal consolidation or structural reforms. That is why many in Germany would like any QE to be contingent on France and Italy committing to reforms. Without that quid pro quo, the ECB simply takes the pressure off recalcitrant governments to act, much as they frittered away the time bought with Mr Draghi’s pledge to “do whatever it takes” to save the euro.
Despite the appeal of that logic, it’s the wrong course to take. Structural reforms will never be politically popular. For governments nonetheless that wish to pursue them, as Italy and France claim to, higher inflation and thus higher nominal growth will lessen the pain, and thus the political price, making it likelier the reforms can pass, and will stick. And when governments won’t do their job? That’s unfortunate, but it can’t be a reason for the ECB to fail at its own.

The original article is linked here.


Written by gregip

September 8, 2014 at 9:08 am

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