In his speech in Jackson Hole, Mario Draghi has launched new thinking for a new economic policy in the Euro Area.
His starting point is the analysis of unemployment (major theme this year in Jackson Hole) which has short-term and more structural explanations. He said that in such an environment, monetary and fiscal policies must be coordinated in the short run to support demand and that at a mid-term horizon structural reforms were needed in order to improve competitiveness and growth autonomy (his text is here)
Short term issues
Mario Draghi is clearly worried as the Euro Area can be characterized by its low economic momentum, its high structural unemployment rate and its low inflation rate (0.4% in July)
On this last point he said more during this conference than in his last monthly press conference following the ECB meeting. He notably said that inflation expectations are moving downward and this could translate to a self-sustained mechanism converging to deflation. He is worried by the inflation trajectory that could go below the ECB target of 2% for an extended period and by the fact that monetary policy alone will probably not be able to change its profile. That’s why he asked for a stronger coordination between monetary and fiscal policies.
After June’s announcements on monetary policy, he said that the ECB has done its job. Interest rates are low for an extended period and a new mechanism will provide liquidity to the banking sector. He said this mechanism could be improved if the ECB can directly buy ABS on the market. He expects that this instrument will be available sooner than later.
But he probably thinks that this is not sufficient to fight the risk of an inflation rate that could be too low for too long. In that case, due to changes in inflation expectations, a deflation environment in a foreseeable future cannot be ruled out.
His analysis is to say that demand is not strong enough to fight the deflation risk. A new instrument is needed. This instrument is fiscal policy.
(Just at this moment he said that there was a huge difference with other central banks in developed countries. As they are lenders of last resort they can guarantee public debt. That’s one of the basements of the Quantitative Easing mechanism. This is not the case for the ECB. Draghi said that this has helped the US and the UK to exit from the crisis. By saying that, he implicitly asks for Eurobonds. But this has to be related to a specific institutional framework with one fiscal policy for the Euro Area).
He asks for a more active role for the fiscal policy which has to be a support for internal demand. In the Euro Area, the fiscal policy hasn’t played the role it has had in the US and UK. With an active fiscal policy there is a possibility for a stronger demand that would reduce the risk of deflation. (he takes the opposite route that led to austerity policies)
He mentioned 4 points on fiscal policy: he wants to use all the possibilities that exist within the current framework (growth and stability pact); he wants a change in its composition to improve its efficiency (reducing the tax burden and certain types of expenditures); to have a fiscal policy at the Euro Area level and not country by country; to put in place a strategy to boost public investment that could then create an impulse on private investment. This last point is essential to improve mid to long-term growth.
What to keep in mind?
Demand is too weak and the current monetary policy only strategy will not be sufficient to deeply improve its trajectory. A proactive fiscal policy could help. Having more coordinated and more accommodative policies could boost demand and reduce the deflation risk.
This is in opposition to what was already accepted. The current scenario is one in which every country has to be in a balanced situation. The aggregation of local equilibrium is the source of a stronger economy in the Euro Area. This was consistent with austerity policies that ask to converge rapidly to a balanced budget. This strategy was consistent with the commitment between Angela Merkel and Nicolas Sarkozy at the Elysée Palace meeting on August the 16th, 2011.
Draghi’s position is for a more centralized fiscal policy that would not necessarily try to reach a balance situation for each country.
In that case, the fiscal policy is a global strategy that can be compared to the monetary policy managed by the ECB. That would be a complete change in the institutional framework; less power to countries and probably a convergence to a kind of federalism.
The structural unemployment rate in the Euro Area is 9% according to Mario Draghi. It is too high. Measures have to be taken to improve competitiveness and to increase the autonomy of the growth process.
One way to see the necessity of these reforms is the following: before when there was a negative shock, growth dropped in negative territory for a limited period of time. Then there was a rebound and growth rate converged to its former trend. This is not currently the case. After two years of negative growth (2012 and 2013), GDP will increase by less than 1% in the Euro Area. This reflects the lack of capacity to reach a strong profile. Adjustments have to be done, that the role of structural reforms.
Draghi has mentioned two types of structural reforms
1 – The first is to improve the allocation of resources and of employment. In other words, what works well after a recession is not what worked well before it. To improve the situation there is a need to hasten the re-allocation of resources. This is a way to reduce rigidities
2 – To converge to a stronger growth profile, there is a need for innovation and higher human capital. This has to be improved. This goes through formation and investment (public investment mentioned above must push private investment to catch up what has not been done since 2007) to improve potential growth.
Five points to keep in mind
- The current situation is weak in the Euro Area and the probability of deflation is not null
- To fight this risk, monetary policy alone is not sufficient.
- There is a need for a stronger and proactive fiscal policy at the Euro Area scale. It is no more a country by country discussion but fiscal policy must be at a larger scale
- Monetary and fiscal policies will support demand to reduce the risk of weak economic outlook in the short run
- In the mid-term horizon structural reforms are needed to improve long-term growth prospects and create conditions for a higher potential trajectory
These propositions by Mario Draghi are changing the current picture as he thinks that the regulation must be done at the Euro Area level and not country by country. This must lead to a new institutional framework than could converge to federalism. A real break but surely the necessary change to save the Euro Area