Europe places too much faith in supply-side policies

Supply-side thinking now dominates European economic policy.
Most governments, and the European Commission, argue that attempts to boost
demand would be counterproductive, achieving little but a delay to the
necessary consolidation of public finances. With close to unanimity, they
believe that structural reforms offer the only hope for depressed European
economies: these reforms will improve competitiveness and confidence, leading
to stronger growth, a rebalancing of trade between European countries and sustainable
public finances. But are policy-makers and the Commission putting excessive
faith in the power of structural reforms? Is there a risk that a strategy
weighted so heavily towards supply-side measures could actually end up further
eroding Europe’s growth potential? And is it right to argue that structural
reforms will help bring about sustainable rebalancing?

Few doubt the need for structural reforms in Europe. The
region needs faster productivity growth and this requires, among other things,
more flexible and competitive markets: labour and capital must be freer to move
from slow growing sectors to faster-growing ones. But structural reforms alone
will not achieve this. Indeed, in the short to medium term such reforms will
further depress demand. Only in the long-term could they have the desired
effect and only then if businesses invest in new organisational structures and
new products, and if workers (especially young ones) have the right skills and
experience. But business investment is at historic lows in Europe as firms
worry about the lack of demand.

And unemployment is back to levels last seen in the early
eighties and set to remain chronically high for years. In short, the damage
done to Europe’s supply-side by very low investment and mass unemployment is
likely to offset the potential benefits of the reforms. For example, all the
academic evidence shows that persistently high unemployment does lasting damage
to economies’ human capital and hence growth potential.

A further problem is the nature of the structural reforms
underway in Europe. Supply-side reforms in the context of the eurozone largely
mean labour market reforms, or more particularly, labour market reforms that
erode the bargaining power of labour. By contrast, there is much less emphasis
on opening up markets for goods and services to greater competition, which is
arguably more important from the perspective of economic growth. This is
perhaps unsurprising. Germany’s Hartz IV reforms, which are the inspiration for
much of what the eurozone is doing, led to a weakening of workers’ bargaining
power, but did little to promote reform of Germany’s domestic economy. Indeed,
according to the OECD, Spain’s product markets are considerably more
competitive than Germany’s. This helps explain the persistent weakness of
German domestic demand: it fell in 2012, with all of the economy’s 0.9 per cent
growth down to net exports.

The European Commission argues that the structural reforms
underway in the peripheral eurozone economies are boosting their trade
competitiveness, and points to the narrowing of their current account deficits
in 2012 as evidence of this. But this improvement is mainly the result of
unprecedentedly weak domestic demand (and hence declining imports) in these
economies, rather than rising exports. Faced with stagnation at home, some
firms have successfully scrambled to boost exports. However, a sustained rise
in exports requires investment in new capacity and products and stronger export
demand. Neither is happening: investment in manufacturing is at all-time lows
across Europe, but it is especially weak in the periphery. Demand across the
European economy, meanwhile, is chronically weak.

Three years ago, the Commission argued that rebalancing
within the eurozone needed to be symmetric if it was to be consistent with
economic growth. It followed that the onus needed to be on the economies with
big trade surpluses to rebalance their trade as much as the deficit ones. In
reality, very little emphasis has been placed on rebalancing the surplus
economies. And in a report published in December 2012, the Commission
downplayed the role that stronger demand in the region’s surplus economies
would have on the exports of countries such as Spain, Greece and Portugal. The
Commission illustrated this by showing the limited impact a 1 per cent increase
in German domestic demand would have on the exports of the country’s eurozone
trade partners: the peripheral ones do less trade with Germany than the
country’s immediate neighbours, and would hence benefit less from stronger
German demand for imports. The Commission acknowledges that there would be
second and third round effects – for example, stronger demand in Germany would
boost the French economy, which in turn would boost the Spainish one – but almost
certainly underestimates the significance of these.

However, the bigger problems with the Commission’s analysis
are the narrowness of its focus and its use of such a modest increase in German
domestic demand to illustrate its point. There is no doubt that a 1 per cent
increase would have only limited impact on peripheral countries’ exports. But
if domestic demand in Germany (and in other surplus economies such as the
Netherlands and Austria) expanded by 4 per cent per year over a five year period,
the impact on their trade partners would be significant, even on the
assumptions employed by the Commission. Moreover, if their demand were to
increase by this amount, the surplus economies’ ‘marginal propensity to import’
(that is, the proportion of any increase in demand spent on imports) would
rise: their domestic industries would lack the domestic capacity to service the
increased demand and a rising share of it would be met by imports. Firms would
be likely to step-up investment in the domestically orientated-sectors of these
economies, reducing their trade surpluses, and with it the drag they impose on
the rest of the eurozone economy. The flip-side would be stronger investment in
the export-orientated sectors of the peripheral countries.

On their own, the structural reforms underway across Europe
will bring neither economic recovery nor rebalancing. The current reforms focus
strongly on labour markets, and risk leading to similar results across Europe
to those seen in Germany: very weak consumption and investment. Europe needs to
do much more to strengthen demand, which requires symmetric structural reforms
and stimulus. While there is no doubt that Spain needs to reform its labour
market, Germany would also benefit from reforms of its product markets. Those
governments that have the scope to provide stimulus need to do so: Germany
actually posted a budget surplus in 2012. Stronger demand in the countries
running trade surpluses will not suffice to rebalance the eurozone economy and
return it to growth, but it is an indispensable element of what is needed. The
European Central Bank, meanwhile, could redouble its efforts to boost credit
growth. As it stands, demand is likely to remain very weak across Europe for a
prolonged period of time, further eroding growth potential and the
sustainability of public finances.  

The Commission’s readiness to place so much faith in
structural reforms as a solution to Europe’s economic ills is a product of the
region’s political realities. The surplus countries have successfully resisted
pressure to take steps to rebalance their economies and there is little
appetite among eurozone governments for simultaneous reflation involving fiscal
stimulus and quantitative easing by the ECB. The current strategy is not without
political risk: the more European policy-makers talk about growth, the less
growth there is. Whereas unpopular national governments can be voted out and
replaced with ones that do not shoulder responsibility for unsuccessful
policies, this is not the case with the Commission, whose standing could suffer
long-lasting damage.

Simon Tilford is chief economist at the Centre for European Reform.