eurozone

In the Eurozone, monetary policy has been the only instrument used to support final demand. With the ECB having played its final card by embarking on a comprehensive QE programme, it is now time to focus on supply side policy to make the recovery last.

Recessions and periods of subdued economic growth reflect a shortfall in demand so it is logic that countercyclical economic policy focuses on boosting final demand. Theoretically this can be done using fiscal policy (lowering taxes and/or increasing government spending) or monetary policy, or a combination of both. Within the Eurozone, fiscal policy has been a drag on growth for years and monetary policy has been the only weapon to fight the headwinds of fiscal austerity, a regulatory framework which forced banks to deleverage and a strong currency. It doesn’t come as a surprise that growth has been particularly slow, causing the output gap to widen and disinflation to gather force. Not only has monetary policy been the only instrument, its use has also been very gradual. By contrast, in the US, policy has been far more aggressive with the zero lower bound of policy rates being reached quickly and several waves of QE since.

With the ECB decision to embark on a broad-based asset purchase programme including government bonds, we have now reached the limits of monetary policy. This is the final card, and as emphasized by Mario Draghi in Jackson Hole at the end of August last year, there is only so much that monetary policy can do. Our political leaders now have three options. One is shifting the emphasis towards fiscal policy. We have to be realistic on this: Germany is not keen to reflate its economy so as to act as a locomotive for the rest of the Eurozone because it is concerned about the long term dynamics of its public finances (ageing) and about free-riding behaviour of its European partners. Ideally one would want to see a coordinated approach with countries like France and Italy committing to a gradual but steady reduction of their budget deficits and Germany in turn, spending more. A second option is to do nothing under the expectation that the improvement in the Eurozone cyclical environment in the second half of this year, on the back of low rates, a weaker euro and cheaper oil, will automatically generate second round effects with activity entering a self-sustained recovery. It is way too early to say whether this will happen, because it depends on the strength of this year’s recovery and the extent to which consumers and business think this will last (‘confidence breeds confidence’).

A third option is to focus on structural policy now, which to a large extent corresponds to supply-side policy. Such a policy covers many aspects: infrastructure, R&D, innovation, competitiveness, ease of doing business, flexibility (including the labour market), etc. To put it differently, it is a set of factors which determine whether companies can create an edge in their industry, are competitive in price terms and are able and willing to seize opportunities (‘willing’ refers to the absence of administrative burdens). If one considers that monetary policy or cheaper oil create a positive impulse which moves the economic engine into first gear, a favourable structural environment maximises the chances that after a while it will move into second gear. Another reason why to do it now is that to the extent that supply-side measures impose adjustment costs in certain sectors, it is better to do this when the economic environment as a whole is on the mend.