Structural Reforms Will Not Mitigate The Risk Of Deflation In Europe

In a speech delivered at the Central Bank of Latvia on October 17^th, Benoit Coeuré, member of the executive board of the ECB and apparently one of the currently few close confidants of Mario Draghi, argued that speeding up the pace of structural reforms in the Eurozone could be key to averting the area from sliding into deflation. If the implementation of structural reforms was more akin to a ‘big bang’, he claimed, we would see stronger demand as a result, even in the short-run. This is because households and firms, assured of their future higher incomes, would immediately start consuming and investing more. This, he stated, could outweigh any short-run negative effects of reforms on inflation.

Policy-inflicted problems’

He based his propositions on three points. First, he said that his suggestion followed from the special ‘initial’ conditions that ‘we face after the crisis’: the large debt overhang in both private and public sectors, the relatively high rates of structural unemployment and the excessive rent-seeking behaviors in sectors which had long been protected from international competition. The first two of these limit the availability and effectiveness of fiscal and monetary policies in stimulating demand.

These circumstances, however, have been, to a significant extent, the results of chosen policy responses to the crisis and failing to consider them as such does not give any hope for correcting policy mistakes and avoiding them in the future. With the exception of Greece, the large public sector debt overhang has been the outcome of relentless fiscal austerity and the unnecessarily long-lasting recession it has led to. Public debt to GDP ratios shot up against any forecast or economic adjustment program assumptions; especially in those member states that received bail-outs. Fiscal austerity and its depressing effects on demand only made the paying back of private sector debt even harder.

Structural unemployment, that is, the rate of unemployment that we should expect to see when an economy produces an output level equal to its potential, has increased due to the prolonged recession which itself has by now reduced the potential output in most EU member states. Both structural unemployment and potential output growth are only likely to get worse as long as aggregate demand remains depressed due to hysteresis, a risk that even Mario Draghi has by now publicly acknowledged.

Faster internal devaluation has been too costly

Secondly, Coeuré claimed that the particular context of the Eurozone, that is, the fact that several member states have had to pursue asymmetric internal devaluation in order to reverse the divergences in real exchange rates/relative prices between the core and the periphery in the run-up to the crisis made a ‘big bang’ approach to structural reforms a more preferred option. Insofar as structural reforms speed up internal devaluation, the faster the relative price adjustment takes place, the sooner expectations about income and prices can start looking upwards again. To press this point, he compared Ireland and Latvia’s experiences to those of Spain, Greece and Portugal.

Leaving aside any objections on whether such an asymmetric adjustment strategy could have possibly worked, this is an argument which essentially denies the implications of a short-run trade-off between inflation and output, what is widely known as the Phillips Curve, in which expectations about inflation (past or future) matter. Given that expectations matter for current inflation, a sharper internal devaluation requires larger output losses than a more gradual one (see also the analysis of Simon Wren-Lewis). In other words, with a sharp internal devaluation, underpinned by a ‘big bang’ of structural reforms, we end up with the same adjustment in real exchange rates but with a higher waste of resources than if the internal devaluation were more gradual.

Figure 1 above shows that by 2013 (when the latest actual GDP figures were available) Ireland and Latvia, just like Greece, Portugal and Spain, had yet to recuperate the loss in output they suffered during the crisis.

Moreover, in a 2014 study of the long-term damage from the Great Recession in OECD countries due to hysteresis effects, Laurence Ball found that Ireland experienced the second largest loss, over 30 percent, in terms of forecasted potential output for 2015 within the OECD group, second only to Greece and way more than Spain and Portugal. It is hard to see, all other reservations about Coeuré’s argument aside, how the residents of Ireland must have been more reassured than those in Portugal or Spain of their future higher incomes to start spending on consumption and investment right away. The evidence does not seem to support the idea that it was the faster pace of any reforms in Ireland that has made the difference to how fast it recovered and how it seems less at risk of deflation at the moment.

Unfortunately, that study did not cover Latvia. However, even if the Coeuré hypothesis were correct in the Latvian case (a big if given the losses in actual output which have yet to be recovered and the large net migration there), a crucial difference between Latvia and the rest of the Eurozone periphery is that the Latvian banks were promptly and effectively recapitalized which avoided the credit squeeze experienced elsewhere in the Eurozone.

Coeuré argues that Say’s law, ‘supply creates its own demand’ should be given some consideration in the case of the Eurozone. Apart from the fact that this fallacy has been dismissed as nonsensical several decades ago, it is exactly the specific conditions of the Eurozone that could not possibly lend any credibility to it. Even if, against all these trends, households and firms in the Eurozone wished to bring forward their consumption and investment, they would be credit constrained. This is because six years into the crisis and three stress tests of the national banking systems later, too many banks in the area are still too weak to provide the credit flows that would be necessary for economic recovery.

Vested interests and credit constraints in Europe

This brings me to his third point. Carrying out structural reforms at a faster pace and across the board of sectors they touch upon would also strengthen the sense among citizens that the costs of such ‘necessary’ reforms are distributed fairly, by going against all rather than just some of the ‘vested interests’ that usually oppose such reforms. While this is a very laudable concern, one cannot help but wonder whether the entirety of ‘vested interests’ Mr. Coeuré refers to include the financial sector lobby in Europe.

Irresponsible lending practices of an under-regulated financial sector can account to a large extent for what happened in the Eurozone in the run up to the crisis. The bail-outs and their conditions pushed the cost of adjustment entirely onto tax payers in the core and the periphery and away from the very same banks that had been financing this credit expansion. One could hardly call this fair distribution of adjustment burdens. And yet, following the ECB’s comprehensive assessment of the largest European banks’ balance sheets’ health, there were overt concerns about the extent to which the new supervisor of systemic banks would go all the way in exposing lenders too weak for (the Eurozone’s) comfort, especially as this would upset national governments.

The question of structural reforms diverts the policy debate from what it should be focusing on

The current threat of deflation is due to the fact that aggregate demand in the Eurozone has been trailing well below aggregate supply. The presence of hysteresis suggests that demand side measures alone may not suffice to restore sustainable recovery. It is also true that the use of demand management policies is currently facing important constraints, at the bottom line of which is the fact that the EMU still lacks important elements of a political union. Yet, diverting the policy debate towards supply-side reforms as the only tool really available in national policymakers’ hands is not a sign of pragmatism but of dangerous delusion. Supply-side policies cannot substitute for demand. What Europe needs is a program of public investment, more aggressive quantitative easing and a serious rethinking of the content of the fiscal rules to allow national fiscal policies to play a more stabilizing role in the context of EMU.