The last few years following the financial crisis have been crucially important in changing the way we think about monetary policy in Europe. At least I hope this is the case.
A speech by Yves Mersch, member of the executive board of the ECB, at the Institute of international European affairs, captures the situation that Europe faces today and proposes the necessary changes to be implemented. I would personally love to see this materialize, but we all know too well that there is always a disparity between real economic analysis and actual policy action which may be highly influenced by politics.
The following, is a short summary and interpretation of the speech, which I think captures the general ECB sentiment. For those interested, I highly recommend you have a look at the original over at www.ecb.europa.eu
Why has potential growth fallen?
First of all, what is growth? Growth can be defined as the economic activity that can be sustained by the available production factors; capital, labor, and technology.
Investment was the hardest hit by the crisis. This can be attributed to the necessary readjustment process following a prolonged period of over-investment in housing and construction.
Developments in labor have been weak, and much of this is due to structural problems in the Eurozone labor markets
The challenge the ECB faces going forward is how to increase, in a sustainable way, potential growth, while preventing any of these changes from causing short-term turmoil in these fragile times.
For this, there are three main tools that the ECB is planning on using to address these issues.
Yves starts by acknowledging from the beginning that monetary policy can do nothing to affect the supply capacity of the economy. At most, monetary policy can buy time for the necessary structural reforms to take place.
However, if monetary policy was at most neutral before, the collapse of the financial sector has broken down the transmission mechanism by which the monetary stimulus reaches the “real” economy. Furthermore, most of the credit issued by the ECB isn’t even being directed into what the ECB intended it to. This is the case especially with sovereign debt, which due to legislation, can be considered a risk-free assets, given the bond belongs to the domestic country. This created a situation by which most of the discounted loans the ECB gave out during the post-crisis period went towards financing public deficits. Obviously, this is a perversion of the system which needs to be changed.
Overall, we can expect rates to remain the same for the time being. You might call this accommodative, but this is a relative term, especially if you contrast it with the actions taken by the Federal Reserve, which has more than quadrupled its balance sheet in the last few years.
However, the importance of monetary policy is small, compared to the financial and fiscal reforms which may take place.
Financial sector reform
The financial sector holds a key role in the creation of wealth. A strong driver of aggregate productivity growth is “churn” between firms.
This means that old obsolete firms must leave way to new better more innovative firms to take their place. This process is aided by the financial sector, which ensures that credit allocation supports this process.
However, this process has been undermined by weak bank balance sheets. Some big banks have moved away from “risky” investments, limiting the new entrants to the market, while other banks have engaged in ever-greening of loans (prolonging loans indefinitely), preventing the exit of firms.
If what I understand is correct, we may see a big restructuring of the whole banking sector. In fact, many ECB members have already warned this is going to involve a number of bank failures. In the same way that weak firms have to leave place to better ones, the same must apply to banks. The previously implemented policies of bank bail-outs, which propped up weak banks have been devastating to the economy and a proper free-market type recapitalization is necessary, and hopefully imminent.
This problem in the banking sector is also being tackled by both the ECB and the free-market with the proliferation of alternative funding, namely, capital market financing, where corporations issue their own debt. The problem with this is that small and medium-sized businesses cannot pursue this course of action.
Together with this, reforms will also aim to eliminate incentives which lead to misallocation of central bank loans, as previously mentioned.
Finally, and most importantly, we have structural reforms. If financial reforms are intended to ensure banks can provide credit for new businesses, we also must consider, what is the ideal environment for businesses to thrive? Structural reforms are essential to raise the trend components of the inputs to production (investment and labor) and the efficiency with which they are used (total factor productivity)
For Euro area economies, the main area of change is regulatory barriers. There are many regulations which restrict both capital and labor expansion and mobility.
In conjunction with this, we can also add reforms to the pension system towards a more free market approach, where the money put into pension plans is invested in financial assets, rather than the pay as you go system that we have in most countries.
Also, measures will be put into place, as recently in Spain, to further liberalize the labor market, especially trying to shift from passive labor policies, such as unemployment benefits, towards active ones, like job search assistance and training.
Optimally, we should probably reform the whole education system, but that is a subject for another time.
Lastly, an improvement in resource allocation both of capital and by improving labor mobility, are necessary to ensure sustained growth and more competition.
The challenges that that we face today, are not much different than before, what is different is the situation we are in. We’ve had year after year of misguided policy action and it’s finally taking its toll. We have a stagnant economy across Europe. It may sound a bit sad, but it seems to be that the only way for policymakers to do the right thing is when they have no other choice. Finally, we have gotten to that stage.
Indeed, Yves Mersch, points towards the apparent inconsistency in recent years between reform and re-election.
However, there is hope that now the ECB leaders will do the right thing.
The formula is rather simple:
Forget about monetary policy as a tool towards achieving growth. We must focus our efforts on lasting reforms.
Firstly, we must allow weak banks to fail, something that we didn’t do following the crisis of 08, and follow the principles of normal recapitalizations. The bad debt and malinvestment of the pre-crisis era must be eliminated and all the inefficient projects liquidated. A new sanitized financial system will pave the way for future growth.
Together with this the ECB proposes reforms to liberalize the European markets and also, and very importantly, reduce the presence of governments in the economy, since the burden of regulation is limiting potential growth.
While this plan may fall short of destroying the “corporatist” system we live in today, where government and big corporations can work together to favor their own interests, this is certainly a move in the right direction.
In contrast with ECB policy, the Federal Reserve and U.S. may go a different way completely. Obama has already promised to increase the minimum wage, and though the Fed is now tapering its purchases, I personally wouldn’t be surprised if they were to reverse this, and push ahead with further QE.
2014 may be a turning point for the two western giants. All that is left now is to sit back and enjoy the show.
James Foord, 2nd year student of economics at UPF and author of 21stcenturyeconomics.wordpress.com