Eurozone structural policy: Game changer, or game over?

Implement structural policy, or structural reform, and you will solve the problem of stagnant growth in the Eurozone! At least that’s the impression created by the September 2014 Geneva Report on deleveraging (see Figure 3A.3, page 31). And no one has argued the case more forcefully than European Central Bank President Mario Draghi, who took office in November 2011 when Greece was in a meltdown, Italian sovereign 10-year bond yields had crossed the psychological threshold of seven percent, and investors were concerned about the very survival of the euro.

As set out in his May 2015 speech on structural reforms, inflation and monetary policy, the goals of structural reform for Draghi are to raise potential growth by creating a climate for higher capital accumulation (increasing capital-labor ratios) and faster total factor productivity (TFP) growth; and to enhance resilience thereby minimizing output losses following adverse shocks. Further, he argues that there is no excuse for procrastination because the ECB’s accommodative monetary policy, consisting of policy interest rates at the zero lower bound (ZLB) and quantitative easing (sovereign bond quantitative easing was started in March 2015), should facilitate structural reform by increasing the payoff in terms of faster growth and investment benefits. However, there are serious problems with Draghi’s position.

First, the goals of structural reform are defined, but what is structural reform? Draghi mentions only “best practice across labor and product markets, tax policy and pensions.” Learning from the emerging market experience, structural reform is everything that is left after macroeconomic stabilization and “getting the prices right,” or foreign trade liberalization. It grew out of the recognition in the 1980s that the latter two were not enough to put countries on faster growth paths: property and creditor rights, competition policy, a good legal and regulatory framework, flexible labor markets, and credible fiscal and financial institutions were also necessary. But surely, Eurozone countries being mostly advanced economies, or developed markets, already have the necessary institutions and structural policies in place? Not quite, as I shall discuss.

Second, Draghi argues that accommodative monetary policy should facilitate structural reform by increasing the payoff to structural reform through quick wins on investment and growth. But consider the opposite angle: that excessive leverage and a debt overhang in the Eurozone have compelled an accommodative monetary policy. This is a critical point from the emerging market perspective because structural reform tends to be disruptive, involving both winners and losers, and often with large upfront costs in terms of output, which are difficult to absorb in the presence of a debt overhang.

Examples: Poland which from 1990 to 1991, suffered a cumulative 18 percent decline in gross domestic product (GDP), but which has registered positive growth ever since, and was the only country in the EU to grow in 2009; or India, which implemented far-reaching reforms after its 1991 balance-of-payments crisis, but suffered a big deterioration in its government debt dynamics before growth took off in 2003. It is hard to implement structural reform when a debt overhang is present and debt dynamics are unsustainable at normal interest rates: the difficult structural reforms Poland implemented in 1990 were facilitated by the 50 percent debt write-off it received from the Paris Club.

The Centre for Economic Policy Research report on Eurozone debt argues that monetary policy has reached its limits in the Eurozone, and that growth is anemic because of its debt overhang, which must therefore be eliminated. The report proposes several options, including securitizing a part of future tax revenues or even seigniorage to bring government debt-to-GDP levels below 95 percent of GDP. The quid pro quo would be a reform in fiscal governance and the official bailout mechanism to make the tattered so-called no bailout clause credible. However, none of the debt restructuring proposals argues for a reduction in the net present value (NPV) of outstanding debt claims, without which it is hard to see how the debt overhang can be resolved.

Third, the idea that structural reform would increase resilience and allow quick recoveries from adverse shocks raises the topic of the timing of the reform. If it is to possess a countercyclical property, it needs to be implemented in good times, as with countercyclical fiscal policy. Fiscal cushions, sound banks, strong balance sheets—these are the foundations of resilience, enabling shocks to be absorbed and permitting quick rebounds after a recession; but these need to be in place before the adverse shock hits.

This last point is reinforced by the 2003 Sapir Report (see also Aghion and Durlauf (2007)) which attributed the stop in the convergence of per capita Eurozone GDP to US levels in the mid-1970s to a competition policy that focused on incumbents as opposed to new entry. Once again, the Polish experience, which involved uncompromisingly hard budget constraints for incumbent firms and banks, is instructive. Incumbent firms were subject to the threat of bankruptcy if they could not adapt to a market economy. Together with competition from imports, this forced enterprise restructuring and asset reallocation that permanently strengthened the microeconomic foundations for growth. But as noted already, this approach had large upfront output costs and was cushioned by Poland’s debt write-down. In the Eurozone today, zero interest rates if anything serve as a blanket soft budget constraint to keep over-leveraged governments afloat.

The debt overhang in the Eurozone will have to be resolved before one can think of benefits accruing from structural reform. Such reform entails upfront costs and it is difficult to absorb these when a debt overhang is present. Besides, with potential growth having been reduced to just 1 percent in the Eurozone, it is unlikely to grow out of its debt problem even at the ZLB. Finally, there is also the thorny issue of the timing of structural reform. The growth performance bifurcation between the USA and the Eurozone has become even more pronounced after the Global Financial Crisis. The implication is clear: Good structural policies must be in place before a crisis hits. Indeed, even fiscal and financial institutions remain incomplete in the Eurozone. In these circumstances, to see structural policy as the missing piece of the growth puzzle is mere wishful thinking.

Brian Pinto was at the World Bank from 1984-2013 followed by two years as chief economist, Emerging Markets, at GLG in London. This column is based on his chapter in
Boosting European Competitiveness: The Role of the CESEE Countries, Edward Elgar, forthcoming, autumn 2016. This volume captures the proceedings of a conference on the Future of the European Economy jointly sponsored by
Narodowy Bank Polski and Oesterreichische National Bank
in October 2015. Brian holds a PhD in Economics from the University of Pennsylvania, USA. His papers have appeared in top economic journals, and
his second book, 

How Does My Country Grow? Economic Advice Through Story-Telling

, was published by Oxford University Press in 2014.