It has been a terrible summer for the European economy as the Eurozone continued its slow but ineluctable slide towards deflation. The news that captured the attention of European commentators was the sudden and unexpected slowdown in Germany. Between April and June, none of the three largest Eurozone economies grew. The situation is particularly serious in Italy, which is back in recession. The OECD estimates that the Italian economy will shrink by 0.4 per cent in 2014. The recovery seems over already. Indeed, it had barely started. The bad news proves that relying almost exclusively on exports for growth exposes the economy to external shocks — the culprit for the slowdown in Germany, for example, is most probably the Ukrainian crisis.
European Central Bank president Mario Draghi seems increasingly aware of the risks related to looming deflation. The ECB has rightly been criticised in the past for being in denial about deflation. But since last June, it has embarked on a new round of long-term lending to financial institutions with the hope that this will restart the credit and spending cycle. The problem is that this is not going to lift the Eurozone economy out of deflation or recession. The main issue today is not credit availability. The ECB regularly conducts bank lending surveys, which, quarter after quarter, show depressed credit demand because of the unwillingness of consumers and firms to spend. Private spending will pick up once expectations change, once the economy resumes growth, once incomes and wages stop falling. At that point, it would be important that the increasing credit demand is met with adequate supply. Until then, boosting credit supply to prop up spending amounts to pulling on a string. It is not a surprise, then, that the ECB’s first offer of cheap four-year loans fell short of expectations — credit institutions are sitting on piles of cash, and mostly incapable of lending to reluctant households and firms. This state of affairs, while extremely rare, is not new. Economists term a situation in which money injected into the economy is hoarded and not used for consumption or investment a “liquidity trap”. In such a situation, monetary policy is ineffective and fiscal policy needs to take centrestage.
Draghi is aware that monetary policy is increasingly powerless. At the annual gathering of central bankers at Jackson Hole in August, he was, for the first time, expressly clear that we face a problem of insufficient aggregate demand and asked that monetary policy be accompanied by structural reforms and an accommodative fiscal policy to plug the investment gap that affects the Economic and Monetary Union of the European Union (EMU) economy.
Even new European Commission President Jean-Claude Juncker’s flagship proposal, a 300 billion euro public-private investment plan for the next three years, is meant to restart growth and develop new technologies. Today, investment is a trending topic in policy circles around Europe. This is welcome news because all European governments facing pressures on their finances have been reducing public investment since the early 1990s. The crisis further exacerbated this trend. And now, the shortfall of investment is widely acknowledged as the main problem of the European economy.
All is well then? Not exactly. European institutions and most governments aim to revive investment within the current fiscal framework, which leaves very little margin for significant action. The Juncker plan, for example, is worth, on a yearly basis, around 0.4 per cent of EMU GDP, some of which is supposed to come from private investors, who are not ready to rush into spending.
It is clear that the investment shortfall is too large to be addressed within the current framework. What is needed is a radical change of governance and policy. The EMU could adopt a fiscal rule similar to the one adopted in the UK by then chancellor of the exchequer Gordon Brown in the 1990s. The new rule would require countries to balance their current budget, while financing public capital accumulation with debt. This would make possible a reversal in the trend of decreasing levels of public investment. Even if it were politically feasible, such a radical change would need lengthy negotiations. The European economy cannot wait. The second-best solution would be for a group of countries to jointly announce that their next national budget laws would contain important (and coordinated) investment provisions and, therefore, temporarily break the 3 per cent deficit limit. France and Italy, which have lately been vocal in asking for a change in European policies, should show the way and include as many other governments as possible. This seems the only way to reverse the fiscal stance and move the Eurozone economy away from the deflation trap. It is safe to bet that even financial markets, faced with bold action by a large number of countries, would be ready to accept a temporary deterioration of public finances in exchange for prospects of that robust recovery that has eluded the Eurozone economy since 2008. It is hard to see how we could exit the crisis otherwise.
The writer teaches at Sciences Po, Paris, and at the Luiss School of European Political Economy, Rome