Time for Germany to step up

The economic performance of the eurozone since the crisis has disappointed, with forecasts downgraded year after year. Consumer spending is stuck at its 2009 level, unemployment is too high and the burden of government debt continues to pile up. Inflation is now running well below the 2 per cent target of the European Central Bank (ECB) and is likely to remain so for some time.

The persistent disappointments have worrying underlying causes. Can policymakers get the eurozone economy into higher gear? Or will millions remain unemployed, with consumption stagnant, and investors lacking worthy choices? At the heart of the eurozone’s poor growth is weak demand. Consumers, businesses and governments are reluctant to spend. Whereas some countries with significant debt, such as Spain or Ireland, needed consumers and government to retrench, other economies with strong balance sheets—Germany, Austria—have also chosen to keep government spending down.

The period of sluggish investment has reduced the growth potential of many countries in the eurozone and deep-seated problems of policy and performance weigh on their economies. Restrictive regulations that hinder competition and innovation, and labour market policies that lead to high unemployment and make it hard for people to switch jobs are hard to change in such a dour economic climate, and restrain current and future economic performance.

There is a debate about how much of the eurozone’s weak performance is about demand and how much is supply. These are two sides of the same coin. Firms won’t invest if they don’t see a supportive business environment. On the other hand, if there is little consumer demand, it does not matter how favourable the investment climate is. Concerns about the medium-term future are particularly damaging to confidence in some countries, notably France and Italy.

Without stronger action by policymakers, the eurozone will continue its lacklustre performance—or worsen. The Organisation for Economic Cooperation and Development (OECD) recently published its “Economic Outlook,” which  projects a shallow recovery, with GDP growing by only 1.1 per cent in 2015 and 1.7 per cent in 2016. This is far slower than what the eurozone should be able to achieve, and did achieve on average during the eight years running up to the financial crisis. More worryingly, just a small bad shock could tip the eurozone into a zero growth, zero inflation scenario, with unemployment remaining above 11 per cent. The risks of a renewed recession and deflation are thus significant.

This downside scenario for the eurozone is bad for the global economy. Even with the rising share of Asian economies, the eurozone still accounts for more than one-fifth of global GDP, and with its non-euro neighbours, fully one-third of global GDP and even more of global trade. The strong trade and financial links with the UK and central and eastern Europe puts their recent better economic performance at risk. They would be knocked back if the eurozone were to weaken significantly. So what can be done to get the eurozone recovery in gear? Policymakers have failed to kick-start weak demand or improve the eurozone’s supply-side performance. Fiscal and monetary policy in the United States and UK, and to a lesser extent Japan, has sought to address these problems, but those in the eurozone have been constrained. It’s often been too little, too late; or even too much in the wrong direction.

To get out of a cycle of weak demand and structural problems, a united policy response needs to be crafted with the ECB and individual countries working in the same direction. Monetary policy, fiscal policy and structural policies are complementary strategies. These policies are three legs of a stool, and Europe needs all three legs for the stool to stand.

The ECB has already made positive moves to ease credit conditions since the summer, but weak demand and the risks of deflation call for further action. This should include a commitment to continue stimulating the economy—including via the purchase of sovereign debt, as part of a quantitative easing programme—until inflation is back on target.

All fiscal space should be used to support demand. The EU fiscal rules are important, but discretion is possible. If an economy slows more than expected and this pushes up the budget deficit, this should be tolerated. Ultimately, the best solution to high public debt in the eurozone must be a return to growth. Some countries on the European periphery have taken difficult actions to make their labour markets work better and foster competition. Others have done little. Encouragingly, Italy and now France have begun facing the challenge of implementing reforms. It is time for Germany to step up and encourage domestic investment, undertake domestic reforms in services and thereby boost its underlying growth potential.

It is time for everyone in Europe to begin moving toward the same objective of faster growth. The world economy needs the eurozone to recover. Whether that happens will depend on whether European policymakers deliver the boost that is needed to get the recovery into gear.