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Conditions for kick-starting the European economy

New year 2015 is a year to kick-start the European economy. Weaker euro exchange rate is good for exports and the decreased price of oil can help to boost Europe's economy as well. Europe needs more growth and jobs and this requires more investment, not least in knowledge and innovation.

It has been estimated that there is an investment gap of around 700 billion euro in the euro area. The European Commission’s 300 billion euro investment plan is a bold start in the right direction. But alone it is not enough. Publicly-supported investment must be well-targeted for growth and go hand-in-hand with economic reforms in the Member States.

Now the question is what kind of policy mix of monetary policy, fiscal policy and structural reforms can support stronger productive investment and more sustainable growth, within the strict fiscal constraints? This is related to the recent debate on ‘secular stagnation’, where competing theories exist to explain the sclerotic performance of advanced economies. For instance, there are serious concerns that the Eurozone could be stuck in cyclical stagnation graduating to secular stagnation.

Many underline demand-side weaknesses and the constraints low inflation creates for monetary policy to keep economic activity close to the potential. Others refer to supply-side barriers, due to demographics and weakening impact of technological change on total factor productivity.

While it is important to try and get the diagnosis right, we are likely to be in a situation where both factors are at play - both demand-side and supply-side factors. Their relative weight may vary, but it is nevertheless a reasonable policy stance to address both factors in parallel by aiming at increasing productive investment and pursuing economic reform.

Meanwhile, Member States should not create more public debt nor scrap the Stability and Growth Pact, as that would be counterproductive to sustainable growth. That’s why growth-enhancing conditionality is needed: the European investment fund should only fund projects in those member states that intensify structural reforms in line with the Council recommendations and whose budgetary plans have been approved by the Commission. That’s the way to combine boosting investment and ensuring sound public finances that are both needed for sustainable growth.

The quality of public finances has been an underrated subject in crisis economics, perhaps because it is politically so difficult and sensitive. Too often, fiscal consolidation has been done only or largely through tax increases and cuts in capital expenditure, which before long will start to damage or even suffocate growth. Take France and Italy, which suffer from the combination of sluggish growth and high public debt: instead of further tax increases, one should seek more growth-friendly ways of pursuing the necessary consolidation of public finances.

For instance, according to the OECD, the most compatible measures of consolidation with growth are: cut subsidies, reduce pension spending, increase property taxes. However, such economically preferable fiscal-structural reforms have been an uphill struggle, since across-the-board cuts are usually politically more palatable. In many countries, this has led to the crowding out of capital expenditure (= investment) by current expenditure (= social benefits, running costs), which has contributed to the squeeze of investment, and thus to the squeeze in economic growth and employment.

We must ensure the adequacy and sustainability of social protection systems while making them more supportive to growth. As the crisis has already hit public finances and population aging is advancing, the European societies in particular are currently facing a true stress test of their pension and social systems. To illustrate the policy urgency, there is a wave of reforms going on: in 23 out of 28 member states of the EU, significant pension reforms that link the retirement age to life expectancy have been decided in the recent years.

Watering down the reformed Stability and Growth Pact would erode fiscal sustainability, which has been essential for the stabilisation and still is for the fragile recovery in Europe. The fiscal rules are not there for nothing. If persistently high fiscal deficits and increasing public debt were a recipe for rapid economic growth, then France and Italy would be European champions in the field. Japan would be the world’s first economic power and Finland would be the Nordic champion of growth. But this is obviously not the case. What these countries have in common has been a persistent lack of willingness to carry out structural reforms.

Europe needs growth-enhancing structural reforms in order to become more attractive especially for private investments. Europe must be more competitive, flexible, future-oriented and innovative than today. Reforms are not least needed in the labour market, pensions and health care, requiring strong leadership to communicate its importance to those voters easily swayed by populist arguments.

The conditions for investment through the creation of an efficient internal market in capital, services and goods need to be improved. Additionally the EU must further strive for an ambitious external trade policy and for the opening up of foreign markets to boost growth.

Helping small and medium-sized enterprises to grow is crucial. We need to make regulation smarter and the rules simpler, cut red tape, and improve SME’s access to financing and Europe’s markets. SMEs provide two out of three private-sector jobs in the EU, and new jobs are primarily created by them.

Europe is highly dependent on energy from third countries, which has only increased during the last two decades. EU’s annual import bill for fossil fuels is hundreds of billions euro. Why wouldn’t we use a big slice of this money for developing our own green economy?

Bio-economy and renewable energy sources include enormous potential to tackle climate change, promote growth and jobs in Europe, decrease energy dependence on third countries, and make a major contribution to Europe’s energy security. All EU institutions and Member States must now work for the common goal of boosting growth and jobs. A 300 billion-euro investment programme must be well targeted for the same purpose.

One final note on the preconditions of stronger sustainable growth in Europe: once member states pursue reforms with drive, the ECB should go all the way to combat deflation, as it could then be reassured of the positive impact of its monetary stimulus. And Germany should then use its formidable fiscal space and boost investment so as to support domestic demand.

As the example of Japan has proven, there is no silver bullet — or single arrow — to bring higher and lasting growth. Instead you have to make all the relevant arrows fly, which in Europe means simultaneously boosting investment, pursuing reforms, consistently balancing public finances and executing a more expansionary monetary policy. That’s the real recipe for stronger, sustainable growth.

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