France and Germany cannot resign to this state of affairs. For sure, their situations differ. Germany is on several accounts much better off, at least in the short-run. But to focus on these differences would be beside the point. We are approaching a tipping point. The economic, social and political dangers that Europe is facing are a threat to all. Division would hurt everyone. It is the common responsibility of Berlin and Paris to prevent it from happening.
Disagreement on the disease however hampers agreement on the cure. Some blame anaemic potential growth and call for reforms to bolster potential growth. Some blame deficient aggregate demand and call for more supportive monetary and fiscal policies. Others blame fragmentation and put faith in a strengthening of European integration.
We find these controversies pointless. Lacklustre productivity growth is prima facie evidence of supply deficiency. The combination of high unemployment and falling inflation is prima facie evidence of a demand shortfall. Differentials across interest rates within the same currency area are prima facie evidence of fragmentation. The truth is that Europe suffers from multiple ills.
Narrow solutions cannot be the answer to a broad problem. Structural reforms alone would help strengthen potential growth but they would do little, if anything, to support actual growth in the short term; they might even accentuate deflationary trends. Demand support alone would risk being perceived as a short-lived, soon-to-be-reversed endeavour; it would likely not convince investors to bet on Europe’s future. Long-term visions for more Europe do not address any of the immediate challenges and national shortcomings; also they might look so distant from current woes that they run the risk of being seen by citizens as irrelevant at best.
So action is needed on all three fronts. The question is how. If Europe were a single country with a single, credible government, the answer would be simple: it would go for what is known as a two-handed strategy, combining ambitious pro-growth reforms and a fiscal policy support in the form of temporary public investment or immediate tax cuts in anticipation of future government spending cuts. The central bank would also make clear that provided the reforms are real and the commitment to later consolidation is credible, it stands ready to serve as a “backstop to government funding” (to quote ECB President Draghi’s recent speech at the Jackson Hole conference).
But we are not in this situation. Reforms depend on national decisions. There currently is no “fiscal stance” at the level of the monetary union. Rather, aggregate fiscal policy is a sum of all national fiscal policies. Most governments in Europe suffer from weak credibility. Trust has been dented by failures to deliver on pledges and disagreements over the handling of the euro crisis. The European fiscal framework should in principle be strong enough to make consolidation commitments binding, but its own credibility is flimsy. Asking for a strong monetary stimulus is economically right, but the ECB cannot commit to stand behind individual national governments.
In this context, there have been calls for a “split” policy-mix. The argument goes: Germany would stimulate demand while other countries, France included, would reform. The problem with this approach is however that debt over and above what is desirable from a national point of view cannot be traded against reforms in other countries.
Another solution would be to establish at the euro-area level a fiscal capacity or in plain words a budget, equipped with a capacity to borrow. While certainly the most straightforward and desirable solution in the long term, it can hardly be regarded as a timely response to the current situation. The main hurdle is the lack of own resources. A joint borrowing vehicle does not make sense without a straightforward financing mechanism attached to it.
In this context investment has emerged as everybody’s favourite response. There is much to say in favour of it, because it contributes both to strengthening supply and to boosting demand. Since 2007 investment weakness in Europe has reduced significantly potential output and aggregate demand. Its resumption would strengthen competitiveness, lift growth and create jobs.
But while underinvestment is a key problem, solving that problem requires more than just throwing money at it. We do not believe that the main constraint to investment is the lack of financing mechanisms. To invest, companies also need to anticipate framework conditions, strong demand perspectives, profitability and regulatory clarity. Absent these components, cheaper and safer financing will simply substitute more expensive and more uncertain one.
What we offer in this report is a pragmatic way out of this impasse.
Henrik Enderlein and Jean Pisani-Ferry