Paola Subacchi
Research Director, International Economics
Back from holiday European leaders are confronted with dysfunctional economies. In the south it is lack of growth and unemployment. In the north it is the imbalanced income distribution and exuberant property markets.
Mario Draghi, president of the European Central Bank (ECB) speaks beside Vitor Constancio, vice president of the European Central Bank, during a news conference to announce the bank's interest rate decision in Frankfurt, Germany 7 August 2014. Photo by MaMario Draghi, president of the European Central Bank (ECB) speaks beside Vitor Constancio, vice president of the European Central Bank, during a news conference to announce the bank's interest rate decision in Frankfurt, Germany 7 August 2014. Photo by Martin Leissl/Bloomberg/Getty Images.

The overall economic outlook is dispiriting and growth remains subdued. Oxford Economics expects the EU economy to expand at 1.4 per cent this year and at 1.8 per cent in 2015. The outlook for the eurozone is even more modest: 0.9 per cent in 2014 and 1.5 per cent the following year.

Some countries are now back in recession. The Italian economy, that according to the European Commission forecasts, was due to grow by 0.6 per cent this year, now looks likely to contract by almost 0.2 per cent (Oxford Economics). Same story for Greece. As for France, economic growth is now flat – the European Commission expected it to grow by 1 per cent this year.

It is difficult to map out future developments – and this is without even trying to factor in the impact from the extremely complex geopolitical outlook. On a number of occasions, over the last few years, the IMF has revised downward the sets of forecasts produced for the World Economic Outlook (WEO). In April 2012, the world GDP was expected to grow at 4.4 per cent in 2014. This was subsequently cut down by several basis points. It is currently 3.6 per cent, but it is likely to be revised downward in the next WEO to be published in October.

We live in a complex world where long-term structural change –  let’s call it the shift from west to east – intertwines with the legacy of the global financial crisis. Repairing the damage caused by the crisis is still work in progress. The policy mix that was put in place after the crisis has muted fiscal policy while it has relied too much on experimentation in monetary policies. In Europe, in particular, a myopic approach to crisis resolution back in 2011and 2012 – with too much focus on fiscal consolidation and too little on banking fragmentation –  has contributed to exacerbate the situation.

In the height of the euro crisis, the International Economics Department at Chatham House repeatedly made the point that addressing the crisis needed to be sequenced: emergency action to calm the markets, short-term demand-side measures to kickstart damaged economies, medium-term policies to mend the banking sector and long-term structural reforms to support growth. The first set of measures to deal with the emergency was delivered by the European Central Bank. As for the rest we had an incoherent set of fiscal austerity measures and a few structural reforms, with the burden of fiscal adjustment pushed on countries where economic growth was too weak to pull that adjustment. In the meantime the unemployment rate in southern Europe shot up from just over 19 per cent in 2011 to 26 per cent in 2013.

Where do we go from here? Focus should be on growth, ‘whatever it takes’. Some fiscal leeway should be created. And measures to stimulate domestic demand and restore confidence should be put in place. For example, a temporary reduction of the VAT rate should help consumption. Unlike a cash windfall – a measure recently introduced by the Italian government – a temporary VAT cut would have a clear impact on consumer demand as people need to consume in order to benefit from the measure.

Structural reforms, especially in the labour market, are necessary in many countries, and this predates the global financial crisis, as Germany, being the first country to focus on wage and productivity growth in the early 2000s, knows well. And structural reforms are needed to make Europe, and in particular its southern countries, resilient to the changing dynamics of the world economy. But they cannot be the fig leaf that covers Europe’s current policy impasse. Keeping fiscal policy muted risks pushing Europe on the brink of ‘Japan’s style stagnation’.

Mario Draghi, the president of the European Central Bank, is right. Monetary policy, especially unconventional measures, needs to go together with a more flexible approach to budget deficit and, of course, with structural reforms. The latter, however, should not take precedence over the former. As in 2012, policies need to be sequenced, and supporting growth is now paramount.

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