In my previous column, I have argued that prolonged negative output gaps in the Euro Area will reduce potential GDP, long-term growth and employment, because the lack of demand will disincentivize investment. What Europe needs, especially the south, is closing the output gap not by reducing supply but by increasing demand. The question is then, which factors are affecting aggregate demand in the Euro Area?
According to standard national income accounting, aggregate demand consists of investment, private and public consumption and the trade balance. All these components respond to different kinds of incentives. Investment can be broken down into purchases of plant and equipment (Gross Fixed Capital Formation) and into changes of inventory by firms. If firms are unable to sell all their output, their inventories go up, which is technically a form of investment, although not a driver of potential growth; if demand is booming, inventories might at first go down and only gradually be replenished by increased production.
It is useful to distinguish private from public investment. Private investment is more sensitive to interest rates and consumer demand, because the profitability of an investment project depends on the discounted value of future cash flows. When lending interest rates are low, the value of investment is high; however, when the expectation of future returns to capital is low because austerity cuts demand, then even low interest rates cannot generate attractive investment projects. This is why many studies found that investment will follow economic growth rather than the opposite.
The purchase of new residential housing by households is another form of private investment. It, too, responds to changes in interest rates, but mainly through the cost of mortgage payments as a share in disposable income. However, when wage and social welfare cuts or tax raises reduce disposable income, households may no longer be willing and able to borrow for buying or improving their homes. In fact, debt defaults will increase, with nasty consequences for banks and their lending practices. Hence, as long as they are not reducing future cash flows for companies, higher wages will stimulate demand, private investment and job creation.
On the other hand, public investment depends largely on policy decisions by public institutions. In periods of large demand gaps, it can therefore serve as an important substitute for private investment. Yet, over the last three decades, public investment as a share of GDP has steadily fallen in Europe, while the share of public consumption has increased. This has made it quantitatively more difficult to stimulate demand, with negative consequences for long-run growth, because public consumption does not have the same demand effect as investment. When public consumption is properly financed by taxes, public and private consumption complement each other and the demand effect is limited. This justifies balancing budgets over the cycle, although in a recession deficits can close the demand gap. By contrast, private consumption, like private investment, depends on wages, taxes, social welfare, and on access to household credit. Hence, austerity reduces both public and private consumption with highly detrimental effects for demand and actual growth.
Finally, the trade balance responds to foreign and domestic demand, which reflects growth differentials and relative prices including exchange rates. Depreciating the (real) exchange rate shifts relative prices in favour of one country at the expense of another. Such mercantilist policies, which are the hard core of German ordo-liberalism, cannot be universally applied. In Europe they imply either Germany gives up some of its competitive advantages, or the south is condemned to remain the poor periphery.
All taken together, these different components of spending add up to aggregate demand, or actual GDP. Figure 1 shows the contribution of these demand components to the GDP growth rates. It is remarkable that since the early 1990s, investment has been absent as a driver of growth in the Euro Area as a whole. Private and public consumption were the most important components, followed by net exports into the rest of the world. But since the financial crisis, domestic consumption has faltered and Euro Area growth is nearly exclusively dependent on trade. Interestingly, this is different in the United States, where the Obama administration has avoided excessive austerity and investment now contributes to raising growth again (it did not do so under Bush).
Among the individual member states of the Euro Area, performances are varied. In the Netherlands and Germany, trade surpluses have overshadowed domestic demand; most of these trade gains were due to net exports within the European Union. However, in Germany there was hardly any contribution from private and public consumption; investment was also weak, although some investment has returned after the Schröder years. In Italy all components were weak. France, Portugal, Greece and Ireland went through consumer booms after they joined monetary union; the UK did the same on the outside. In Italy, public consumption was important in the first years of EMU, which means that the gains from monetary union where wasted instead of being used for the consolidation of the excessively high public debt levels. High growth in Spain was dominated by investment and private consumption fuelled by the property boom.
After the financial crisis, private consumption, investment and exports have turned negative everywhere in the Euro Area and variations in inventory became the shock-absorbing buffer. Nevertheless, Germany has pulled out of the recession already in 2010 due to a balanced mix of exports, investment and private consumption complemented by public spending. France tried the same, but due to deteriorating competitiveness it was not supported by exports. In most other countries consumption remained flat and growth was depressed by foreign trade and negative investment. Greece is characterized by a collapse of private consumption, investment and exports and an absence of public consumption. In Ireland, net exports have compensated the negative growth of domestic demand, while in Portugal exports and investment are pushing the economy down. Thus, the lack of domestic demand has worsened in and after 2011 when austerity became the dominant economic policy in Europe.
In order to overcome Europe’s unemployment crisis, active demand management is of utmost necessity. The policy objective must focus on bringing aggregate demand for goods and services back into balance with the capacity of supply. Once this is done, the economic growth potential should be improved. How can this be achieved? Conventional policies suggest stimulating investment. In normal times, this may be done by lowering interest rates and relaxing monetary policy, but in the present situation with interest rates close to the zero lower bound, monetary policy has become ineffective. However, if investment follows expectations about demand, one has to focus more directly on how to increase spending. This is why demand management is at the present time the only policy option likely to yield success.
John Maynard Keynes has famously argued that in the situation of a liquidity trap, which is prevailing again today, using debt-financed fiscal policy can be an instrument to compensate the collapsing private demand. Japan has demonstrated that when interest rates are low, high public debt levels are not necessarily a heavy burden for tax payers. However, while traditional Japanese fiscal policy may have prevented the collapse of the economy, it did not bring back economic growth. The new Prime Minister Abe has now embarked on a new strategy by tying together the “three arrows” of expansive monetary and fiscal policies combined with structural reforms. It seems to make a difference. While Abenomics in Japan is an exciting experiment with uncertain outcome, it cannot be copied one-by-one by the Euro Area. Europe does not have the institutional setup that would allow such daring policy shift. However, even marginal policy changes could improve economic growth and employment, if they were properly calibrated.
Europe needs a new policy mix that combines, like in Japan, the already very accommodating monetary policy with new fiscal policy orientations and structural reforms. However, in Europe the range of reforms is broader. The structural reforms prescribed by neoliberals have not worked; they have made things worse. How a new European policy mix could look like, I will discuss in my upcoming columns.
 Collignon, S., (2013) “Macroeconomic imbalances and competitiveness in the euro area”, Trasfer: Eurpean Review of Labour and Research, 19(1), 63-87.