ECB/Mersch: Reviving growth in the euro area

07 February 2014

Mersch said that in order to raise potential growth, action was relevant in three policy areas: monetary policy; financial sector repair; and, most importantly, structural reforms.

The latest data suggest that economic growth has continued to pick up in the euro area, with activity being supported not only by net exports, but also by internal consumption. Nevertheless, the recovery remains relatively weak and uneven, and there is a long way to go to bring down the very high levels of unemployment. This raises the question of how we can revive sustainable growth across the euro area.

In my view, there are limits to how much we can expect from demand stimulus. This means that to revive growth we have to look mainly to the supply capacity of the economy – that is, its potential growth. And here the situation is not encouraging. Starting with capital, investment has been one of the main casualties of the crisis. Developments in labour supply have also been weak. 

These developments create two interrelated challenges for policymakers. The first is how to prevent the fall in observed growth from feeding back into potential growth. Here the key issue is to avoid that rising long-term unemployment and structurally low investment create hysteresis effects. The second challenge is how to raise potential growth in a durable way. These challenges are interrelated because, to the extent that we can achieve an upward shift in the future growth potential, it will affect growth expectations today. For this reason, I see policy action on both fronts as urgent. And there are three policy areas that I see as relevant: monetary policy; financial sector repair; and, most importantly, structural reforms.

Monetary policy

We know that monetary policy can help buy time for necessary structural measures to be implemented. But there has also been some discussion recently among central bankers as to whether monetary policy can have more lasting effects. For example, if an extended period of low demand is creating hysteresis effects, a more accommodative monetary policy that boosts the economy may prevent a permanent downward shift in productivity. That is, it can for a time prevent a cyclical fall in growth from becoming structural too quickly. The jury is still out on this discussion, but some see that monetary policy can play a ‘defensive’ role in a period of economic weakness.

Financial sector repair

There is considerable empirical evidence that a strong driver of aggregate productivity growth is "churn" between firms – less productive firms exiting the market and new innovative firms entering, or existing firms reallocating resources to more productive sectors. The job of the financial sector is to ensure that credit allocation supports this process.  However, what seems to have happened, at least in parts of the euro area, is that banks with weak balance sheets have retarded this process. Weak banks also appear to have slowed down sectoral reallocation. Financial sector repair therefore has to be at the core of any policy to raise euro area growth potential. And to ensure that lending is directed towards productive activity, in my view there are two policy priorities:

• The first is to strengthen bank balance sheets – that is, for losses to be properly acknowledged and for adequate recapitalisation to follow.
• The second priority is to encourage alternative funding sources in the euro area and to develop capital market financing, so that long run productivity growth is not so dependent on the health of banks.

Structural reforms

Structural reforms are essential to raise the trend components of the inputs to production (investment and labour) and the efficiency with which they are used (total factor productivity).

• First, while investment in the euro area may pick up as the uncertainty caused by the crisis recedes, to raise trend investment there needs to be fresh opportunities for firms to develop new business models and grow. For euro area economies, the main area where that can be achieved is through addressing regulatory barriers – for example, planning laws that limit retail expansion or transport regulations that hinder cross-border projects.
• Second, given weak demographic trends in Europe, raising trend labour supply is only really possible through further reform measures, such as reducing labour market duality and shifting from passive labour market policies.
• Third, total factor productivity is unlikely to reverse its downward trend without structural reforms to improve resource allocation. By fostering competition and reducing economic rents, such reforms ensure that resources – and rewards – flow to high productivity sectors, which in turn supports innovation and technological progress.

Conclusion

The challenges the euro area is facing today to raise its growth potential are not new. Since the 1990s we have known that supply conditions in the euro area needed to be reformed. This was the aim of the failed Lisbon Agenda. And indeed, it was the context for a famous quote about the apparent inconsistency between reform and re-election.

What is new today, however, is the urgency for action. We are facing the risk of a structural set-back in growth. We can therefore no longer afford to delay, nor should we over-burden monetary policy. Structural reforms are a must.

For this reason, the apparent contradiction between reforms and re-election may now be moot, simply because citizens want growth, and without reforms it will not materialise. There is no country in the euro area that has delayed reforms and achieved economic outcomes with which their citizens are content.

When I think of the euro area today, I am reminded of Winston Churchill’s line about ‘always doing the right thing… after exhausting all the alternatives’ . We have spent two decades exhausting all the alternatives in Europe – and so now I trust that the only path left to us is the right one.

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