A version of this article originally appeared in the Financial Times on July 29, 2014.
It has been two years since Mario Draghi, the president of the ECB¹, made his seminal pledge to save the euro. The intervention, followed by pronounced if belated accommodative monetary policy, has put the question of the euro’s survival out of play for now, but the lacklustre economic performance of the euro zone betrays the challenges that remain.
While the US and UK recoveries reach “escape velocity”, the euro zone is dogged by the spectre of deflation eerily reminiscent of 1990s Japan. Whatever the ultimate fate of “Abenomics” in Japan, policy makers in Europe would do well to develop their own three arrows to put the euro zone back on target for sustainable recovery.
Accommodative monetary policy
As with Abenomics, Europe’s first arrow needs to be the continuation of accommodative monetary policy. The ECB has already gone too far for some by effectively transferring wealth from savers to debtors. This action is necessary, however, to stave off Japanese-style deflation and could even intensify in the absence of cohesive political leadership among euro-area nations. Political inertia could oblige the ECB to focus on minimum inflation targets just as it has emphasised upper thresholds in the past.
The euro-zone’s second arrow needs to be a more concerted round of pension, labour market and tax reforms.
While the crisis precipitated a round of pension reforms in Greece, Spain and Italy, the sheer scale of the issues facing many European countries has not been adequately addressed. Pension expenditure in the majority of euro-zone countries already stands at more than 10 per cent of GDP² compared with around 4, 5 and 8 per cent in Australia, the US and UK, respectively.
These pressures will increase as people live longer and the ratio of retirees to workers rises sharply. In Western Europe, the OAD³ is set to rise from 28 per cent in 2010 to near 50 per cent by 2050. Yet France, for instance, retains various early retirement options that mean the effective retirement age is only 60. Meanwhile Germany, where the OAD is projected to almost double to 60 per cent by 2050, is sending the wrong signal by lowering the statutory age of retirement for long-term insured from 65 to 63. Increasing the effective retirement age is a critical policy challenge.
More labour reforms are also essential to boost dismally low growth and counter stubbornly high unemployment, which remains above 11 per cent. In particular, policy makers need to address the impact of excessive protection for workers on entrepreneurs and the unemployed. While large companies in countries like France, Italy and Spain continue to do well, startups and companies more dependent on local employees are understandably cautious about taking on new staff.
Taxation measures are also required to reduce inequality and create higher consumer demand. Most of the public discourse has focused on higher taxes for the rich, but more could be achieved with greater emphasis on lowering taxation, especially in countries like Germany, which has the greatest fiscal room for manoeuvre.
It is little wonder that Germany’s private-household consumption is so anaemic, when one considers that its low-to-middle- income workers are among the hardest hit in terms of total taxation. According to the OECD4, the tax wedge for German workers earning two-thirds of the median national wage is 45 per cent, second only to Belgium. This beggars belief; removing what are, in effect, regressive taxes would ease the burden on lower-to-middle incomes and boost consumer demand.
The euro-zone’s third arrow should be a programme of investment, particularly in infrastructure. This has been talked about in a number of countries, most recently in France, but the scale and realisation of such investment still falls short. As with taxation, Germany has the scope and the justification to do the most.
Reunification led to massive capital investment in the east of the country at the expense of investment in the west. Annual government capital investment in Germany has declined steadily from around 4 per cent of GDP in the 1970s to an average of just 1.6 per cent since 2000, even less than in the US and UK. Indeed, a study by the German Institute of Economic Research pointed to a chronic lack of investment in infrastructure, education and factories, which risks undermining the country’s long-term competitiveness and growth.
So, while the urgency of the crisis has abated, the euro zone has much more to do to propel itself out of the doldrums. Contrary to the received wisdom that the policy focus should be on troubled periphery countries, the euro zone would benefit more from three arrows that are targeted as well on the core.