Europe Puts Too Much Faith in Supply-side Economics
Supply-side thinking now dominates European economic policy. Most governments, and the European Commission, argue that attempts to boost demand would be counterproductive, achieving little but a delay to the necessary consolidation of public finances. With close to unanimity, they believe that structural reforms offer the only hope for depressed European economies: these reforms will improve competitiveness and confidence, leading to stronger growth, a rebalancing of trade between European countries and sustainable public finances. But are policy-makers and the Commission putting excessive faith in the power of structural reforms? Is there a risk that a strategy weighted so heavily towards supply-side measures could actually end up further eroding Europe's growth potential? And is it right to argue that structural reforms will help bring about sustainable rebalancing?
Few doubt the need for structural reforms in Europe. The region needs faster productivity growth and this requires, among other things, more flexible and competitive markets: labour and capital must be freer to move from slow growing sectors to faster-growing ones. But structural reforms alone will not achieve this. Indeed, in the short to medium term such reforms will further depress demand. Only in the long-term could they have the desired effect and only then if businesses invest in new organisational structures and new products, and if workers (especially young ones) have the right skills and experience. But business investment is at historic lows in Europe as firms worry about the lack of demand.
And unemployment is back to levels last seen in the early eighties and set to remain chronically high for years. In short, the damage done to Europe's supply-side by very low investment and mass unemployment is likely to offset the potential benefits of the reforms. For example, all the academic evidence shows that persistently high unemployment does lasting damage to economies' human capital and hence growth potential.
A further problem is the nature of the structural reforms underway in Europe. Supply-side reforms in the context of the eurozone largely mean labour market reforms, or more particularly, labour market reforms that erode the bargaining power of labour. By contrast, there is much less emphasis on opening up markets for goods and services to greater competition, which is arguably more important from the perspective of economic growth. This is perhaps unsurprising. Germany's Hartz IV reforms, which are the inspiration for much of what the eurozone is doing, led to a weakening of workers' bargaining power, but did little to promote reform of Germany's domestic economy. Indeed, according to the OECD, Spain's product markets are considerably more competitive than Germany's. This helps explain the persistent weakness of German domestic demand: it fell in 2012, with all of the economy's 0.9 per cent growth down to net exports.
The European Commission argues that the structural reforms underway in the peripheral eurozone economies are boosting their trade competitiveness, and points to the narrowing of their current account deficits in 2012 as evidence of this. But this improvement is mainly the result of unprecedentedly weak domestic demand (and hence declining imports) in these economies, rather than rising exports. Faced with stagnation at home, some firms have successfully scrambled to boost exports. However, a sustained rise in exports requires investment in new capacity and products and stronger export demand. Neither is happening: investment in manufacturing is at all-time lows across Europe, but it is especially weak in the periphery. Demand across the European economy, meanwhile, is chronically weak.
Three years ago, the Commission argued that rebalancing within the eurozone needed to be symmetric if it was to be consistent with economic growth. It followed that the onus needed to be on the economies with big trade surpluses to rebalance their trade as much as the deficit ones. In reality, very little emphasis has been placed on rebalancing the surplus economies. And in a report published in December 2012, the Commission downplayed the role that stronger demand in the region's surplus economies would have on the exports of countries such as Spain, Greece and Portugal. The Commission illustrated this by showing the limited impact a 1 per cent increase in German domestic demand would have on the exports of the country's eurozone trade partners: the peripheral ones do less trade with Germany than the country's immediate neighbours, and would hence benefit less from stronger German demand for imports. The Commission acknowledges that there would be second and third round effects - for example, stronger demand in Germany would boost the French economy, which in turn would boost the Spainish one - but almost certainly underestimates the significance of these.
However, the bigger problems with the Commission's analysis are the narrowness of its focus and its use of such a modest increase in German domestic demand to illustrate its point. There is no doubt that a 1 per cent increase would have only limited impact on peripheral countries' exports. But if domestic demand in Germany (and in other surplus economies such as the Netherlands and Austria) expanded by 4 per cent per year over a five year period, the impact on their trade partners would be significant, even on the assumptions employed by the Commission. Moreover, if their demand were to increase by this amount, the surplus economies' ‘marginal propensity to import' (that is, the proportion of any increase in demand spent on imports) would rise: their domestic industries would lack the domestic capacity to service the increased demand and a rising share of it would be met by imports. Firms would be likely to step-up investment in the domestically orientated-sectors of these economies, reducing their trade surpluses, and with it the drag they impose on the rest of the eurozone economy. The flip-side would be stronger investment in the export-orientated sectors of the peripheral countries.
On their own, the structural reforms underway across Europe will bring neither economic recovery nor rebalancing. The current reforms focus strongly on labour markets, and risk leading to similar results across Europe to those seen in Germany: very weak consumption and investment. Europe needs to do much more to strengthen demand, which requires symmetric structural reforms and stimulus. While there is no doubt that Spain needs to reform its labour market, Germany would also benefit from reforms of its product markets. Those governments that have the scope to provide stimulus need to do so: Germany actually posted a budget surplus in 2012. Stronger demand in the countries running trade surpluses will not suffice to rebalance the eurozone economy and return it to growth, but it is an indispensable element of what is needed. The European Central Bank, meanwhile, could redouble its efforts to boost credit growth. As it stands, demand is likely to remain very weak across Europe for a prolonged period of time, further eroding growth potential and the sustainability of public finances.
The Commission's readiness to place so much faith in structural reforms as a solution to Europe's economic ills is a product of the region's political realities. The surplus countries have successfully resisted pressure to take steps to rebalance their economies and there is little appetite among eurozone governments for simultaneous reflation involving fiscal stimulus and quantitative easing by the ECB. The current strategy is not without political risk: the more European policy-makers talk about growth, the less growth there is. Whereas unpopular national governments can be voted out and replaced with ones that do not shoulder responsibility for unsuccessful policies, this is not the case with the Commission, whose standing could suffer long-lasting damage.