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Wednesday, 30 October 2013

Forget the € and demand management!

The title of this post is a bit exaggerated, yet it helps stressing the gist of the point I want to make: policy makers, market participants and ordinary citizens should start devoting less attention to the € and to demand management and should concentrate, instead, on supply issues.
Let me expand a little this basic idea.

In the acute phase of the €-area crisis, re-denomination risk, that nice euphemism for the  possible demise of the €, attracted the attention of policy makers, markets and public opinion. The overriding question was whether that bold experiment in which 17, and soon 18, countries  have a single currency was about to fail. The question was made even more pressing by the justified fear that a demise of the € would have brought with it an existential threat to the entire European Union construction. Fear led to action and, as I showed in a previous post (Hurray, a crisis!), the crisis is being exploited to complement the Maastricht construction with its missing components: banking and fiscal union and some tools to mutualise idiosyncratic shocks. This development confirms a decades long historical pattern, according to which Europeans do what they have to do to protect the European construction when they, finally, understand they cannot just further postpone action. The hope, or fear, about a demise of the €, depending on how you feel about it, is still not fully dispelled in some quarters but even the most skeptical observers concede that it has drastically lost in intensity. My own assessment is that, if the current policies will be further pursued, in particular completing banking union, we will have dealt for good with the acute phase of the crisis. Therefore the interesting question now is not whether the € will survive but rather what is the economic future of the countries which have it as their single currency. More specifically, is the €-area looking for a long period of anaemic growth, flirting with deflation, similar to or even worse than the experience of Japan for the last 15 years? Is the €-area condemned to a long run rate of growth below 1.00 per cent?

Once one puts the question in these terms, two consequences emerge clearly: first, the problems of the €-area have little to do with its choice to have a common currency, second, over a long term horizon, supply conditions trump demand. My exaggerated title just puts these two points in relief.

Of course, I am not denying that there is still a demand component in the current lacklustre macroeconomic performance of the €-area. And this is not a particularly original thought: in a way this is the unanimous view of the Governing Council of the ECB, which wants constant or lower interest rates. Indeed, I am somewhat surprised that the ECB does not put its hand where its mouth is by reducing rates to win its tug of war with the market, as I argued in a previous post (Upward bias vs. downward bias: who will win?). But this is of minor importance when one takes a medium to long-term perspective. 

To have decent growth it is of course necessary, but by no means sufficient, to have an efficient financial system, capable of intermediating a large amount of funds at reasonable cost. In the €-area this basically means that the banking system must fully reestablish its ability to intermediate funds, even if a revitalisation of the Asset Backed Securities market [1] and a development of the capital market should also contribute to the performance of the financial system. The big question when thinking about the rehabilitation of the banking system in the €-area is whether the "Comprehensive Balance Sheet Assessment" into which the ECB is engaging will finally clarify what is the real situation of banks in the €-area and thus remedy impaired situations and lift the veil of doubt that hobbles the entire banking system. I have covered this issue in a previous post (Is the ECB a central bank overburdened with risk?).

Over the long run, three factors are decisive for growth: first, labour, i.e. demographics and participation to the labour force; second, physical and human capital, i.e. investment, education and training; third, the efficiency with which capital and labour are combined in production, i.e. Total Factor Productivity (TFP). The prospects about all three factors are mixed in the €-area and the growth prospects lacklustre.

Demographic trends are dispiriting: fertility rates are, at around 1.6, well below the level of 2.1 which would maintain the size and age structure of population constant and it is only  thanks to favourable assumptions about immigration, an increase of participation rates of women and older men and a reduction of unemployment that employment is projected by the EU Commission [2] to increase until 2021. After that, the ageing of European population prevails and employment starts a downward trend.

Capital accumulation is not expected, again according to the Commission, to provide much of a fillip to productivity. TFP, in its turn, is assumed to lead to an increase in labour productivity of 1.00 per cent. I think this is optimistic given developments over the last 10 years inwhich a number of €-area countries had negative TFP and the entire area was well below this level [3]. Given all its assumptions, the Commission projects average growth in euro area at around 1.25 per cent until 2020. Similar projections are contained in Consensus Forecasts of October 2013 [4]. The Commission projections for the entire EU until 2060 hover around 1.5 per cent.

Even with favourable assumptions, growth prospects are definitely disappointing and one can not exclude that the €-area will do worse than the reported projections. There is, therefore, the need to redouble the efforts to improve demographic trends, while also better managing immigration, and to support TFP growth through structural measures. The favourable development noted by the OECD, according to which "The pace of reforms has been particularly high in euro area countries under financial assistance programmes or direct market pressures (e.g. Greece, Ireland, Italy, Portugal and Spain), including in politically-sensitive areas such as labour regulation and welfare systems. " [5] has to be extended in time and over more countries to avoid a long period of stagnation in the €-area.

In conclusion, the challenge of the risk of a demise of the € will be definitely won if there will be enough perseverance in completing the policies launched to react to the crisis. My judgment is that this will indeed be the case. A new challenge is opening up, however, for the € area: to promote more vibrant long term growth through incisive supply side measures. Whether the €-area will manage to do this is an open question.  

[***] Research assistance was provided by Mădălina Norocea.
[1]  Europe in transition. Bridging the funding gap. White paper, Prime Collateralised Securities, March 2013 
[2] The 2012 Ageing Report : Economic and budgetary projections for the 27 EU Member States (2010-2060), EC, May 2012 
[3] Catching-up processes in the euro area , published in the Quarterly report on the euro area, EC, 2013
[4] Consensus Economics

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