Growth in the euro area has stalled once again and inflation is dangerously low. But there is no agreement within it on the policy response. Here is why.
From an aggregate macroeconomic standpoint the situation looks fairly simple. Growth was negative in 2012 and 2013, and it is set to be very low in 2014. Since the financial turmoil abated at the end of 2012, policymakers have been betting on a self-sustained recovery that would gradually gain momentum. It has not materialized. Furthermore, inflation is declining fast: on a year-on-year basis it was 2.6 percent in August 2012, 1.6 percent in August 2013 and 0.3 percent in August 2014. With such a low inflation, the burden of past debt weighs considerably on private agents and governments.
Add to that the external surplus, which exceeds 2 percent of GDP. The diagnosis seems straightforward: the euro area suffers from insufficient domestic demand. If private agents are reluctant to spend, the public sector should substitute them and borrow to finance investment. This would help revive growth and create momentum. This could be done at low cost because ultra-low interest rates – ten-year bonds on triple-A euro-area countries debt are below 1.2 percent and maturities below three years carry a negative interest rate – are an invitation to tap bond markets.
There are a few economic objections to this prescription, none of which is compelling. The first is that it overlooks that European countries suffer from a supply problem, too. It is indeed true that in several of them potential output is assessed by experts to be growing at a very slow pace. This certainly calls for pro-growth reforms, but this does not invalidate the existence of a demand shortfall. The truth is that the euro area suffers at the same time from inadequate demand and too low productivity. Any economist's immediate response would be that these countries need both to stimulate now (to revive demand) and implement growth-enhancing reforms (to improve the structural performance).
The second objection is that it's the job of monetary policy job to stimulate demand and make sure inflation is on target at a bit less than 2 percent. Again, this is correct, but the problem is that monetary policy is running out of steam. After the early September decisions, policy rates are now clearly negative. The European Central Bank (ECB) is providing cheap funding to banks in considerable amounts and it has indicated intention to buy from them securitized loans so that they can lighten their balance sheets. Its remaining weapon is the outright purchase of government bonds, but as rates are already very low, its impact could be limited. As ECB president Mario Draghi indicated in his August speech in Jackson Hole, the time has come to call fiscal policy to the rescue.
The third objection is that public debt in the euro area is already at an alarmingly high level. It is true that it has reached 95 percent of GDP on average, roughly 30 percentage points more than before the crisis. But the situation is not significantly different from that of Britain and the United States – and it is much more favorable than in Japan. Furthermore, and importantly, additional borrowing in conditions of ultra-low interest rates is not a curse provided it is compensated by later retrenchment. The first-best policy for the euro-area countries – at least those that still enjoy fiscal space – would be to borrow now to stimulate demand and credibly commit to cutting spending in the near future.
So why is the policy response apparently muted? What are the reasons the euro area does not apply the standard recipe? There are three, and they are more political and institutional than economic.
First, fiscal space is quite unevenly distributed. Germany still enjoys large room to maneuver, France has some but not much, Italy and Spain hardly have any, just to mention the biggest euro members. So a bond-financed investment program would be bound to rely disproportionately on Germany. But Berlin does not wish to go into debt or to take the risks while other euro-area members abstain from running it. Risk-sharing is a serious obstacle.
Second, a relaxation of fiscal discipline, even if justified by adverse economic conditions and even if compensated by tightening of controls over future plans, would still be regarded as a breach of the commonly agreed rules. According to the European fiscal pact, countries in excessive deficit like France should implement at least some consolidation in 2015. Any other decision would be regarded by many as a damaging breach of the common rules.
Third, assuming the other member states would assess that the overall situation is bad enough to justify a relaxation, it would still be difficult for those governments that implemented harsh measures in the midst of financial turmoil to agree to a different treatment for some of their partners. Equality of treatment is the cornerstone of the enforcement of European Union law. Would the countries benefitting from a waiver really oblige themselves to future consolidation or just pretend? Furthermore, governments that recently consolidated would find it hard to justify in front of public opinion that other countries benefit from a waiver.
The obstacles to a concerted response are therefore less a matter of doctrine than a matter of equity, faith in the rules and trust. Can they be overcome? Jean-Claude Juncker, the president-elect of the European Commission, has proposed launching a 300 billion euro EU-wide investment program. It remains to be seen, however, if these investments will materialize. Juncker, who does not have a direct ability to borrow for this purpose, is planning to use a combination of regulatory means and financial engineering to incentivize capital spending. He is putting his own credibility at risk in a complex venture.
The stakes are high because once again there are two different views of the euro system. One implicitly considers that the value of Europe rests on its ability to deliver economic responses to unexpected problems. It calls for flexibility and action. The second regards the European contract as based on the sanctity of equality of treatment, rules and mutual trust. It calls for stability and measure in deciding what to do. These are not spontaneously compatible views. Whether or not a sensible compromise will be found will have profound consequences for the future of the EU.
Jean Pisani-Ferry teaches at the Hertie School of Governance in Berlin and serves as commissioner-general for Policy Planning in Paris. He is a former director of Bruegel, the Brussels-based economic think tank.