Mario Vella, Governor, Central Bank of Malta
Monetary policy and structural reforms in the Euro area
Malta, 5 April 2017
As we all know, the euro system continues to maintain a highly accommodative monetary policy stance. The governing council has kept key ECB interest rates fixed at low and even negative levels, and has reinforced its monetary policy stance through a variety of non-standard measures, including the various asset purchase programmes. This policy stance appears to be bearing fruit. The economic recovery in the euro area that has been underway since the middle of 2013 is proceeding steadily, driven mainly by private consumption. Following a double-dip recession triggered by the global financial crisis and then the sovereign debt crisis, real GDP levels finally surpassed the pre crisis peak in 2015. The outlook is fair. The ECB projections released last month foresee real GDP growth at rates of between 1.6% and 1.8% in the coming three years.
As the economy has recovered, labour market conditions have improved. Unemployment in the euro area, which had risen to more than 12% in the first half of 2013, has now dropped to around 9.5%. The latest projections see unemployment falling by another percentage point. Nevertheless, while real GDP is comfortably above its pre-crisis level, unemployment remains above the corresponding pre-crisis rate. It seems, therefore, that a considerable amount of slack persists in the labour market. This may be one factor behind the weakness of wage and price pressures in the euro area today. Indeed, after stripping out the effects of volatile components, such as energy and food, inflation in the euro area has not yet exceeded 1%. Bearing this in mind, the governing council is determined to maintain its monetary policy stance until it can be sure that inflation in the euro area as a whole returns, durably and sustainably, to a rate that is consistent with the ECB’s objective of below but close to 2%.
Persistent high unemployment rates in the euro area imply a loss of income, weak purchasing power and human and social costs that affect a significant proportion of the population. Moreover, apart from high unemployment, especially amongst the young, the euro area also records high levels of under-employed workers. From a purely technical perspective, the waste of resources that unemployment embodies points to an economy that is failing to generate enough growth. Indeed, not only is unemployment above its pre-crisis level, investment is also below the share of GDP seen before 2008. Additionally, the consistent surplus of the current account of the euro area’s balance of payments points to an economy that is saving more than investing. Unutilised labour and subdued investment lead to weak potential growth. In fact, potential growth in the euro area has slowed down substantially. According to the Commission, potential growth is expected to average around 1.2% annually between 2015 and 2018, against an average of 1.8% between 2003 and 2007.
Why is this slowdown in potential output important? Potential output can be thought of as the rate of economic growth that can be achieved in the long run without generating undue price pressures. The lower the rate of potential output, the lower expected future incomes will be. This also entails stiffer challenges to ensure that debt, whether public or private, is sustainable. Lower potential growth also means that price pressures begin to build up sooner rather than later, and this evidently impacts on monetary policy stance.
I hope I have shown that rate of growth and potential output, and hence the output gap, are variables of key importance for central bankers. However, monetary policy has only a limited, if any, impact on them or any other real economic variable – output, employment and interest rates – in the long run. In the short run, monetary policy need not be neutral. In a cyclical downturn, an accommodative monetary policy still sustains economic activity. In so doing, it can help prevent a cyclical drop in output and unemployment from becoming entrenched. For example, a reduction in borrowing costs stimulates investment, which boosts current demand as well as future supply. In addition, by supporting aggregate demand, accommodative monetary policy sustains employment. This could also support potential growth, if it lessens long-term unemployment, which may lead to workers dropping out of the labour market altogether. The long-run neutrality of money implies that other policy actors have to play their parts in securing high levels of sustainable growth.
Raising long-run potential growth requires either an increase in the supply of factors of production, or an increase in the productive efficiency. Looking first at capital stock, there is clearly a role for fiscal policy in ensuring that physical infrastructure is maintained and upgraded. Although not all euro area countries enjoy the necessary fiscal space to be able to increase capital spending, those that can do so should, while those that do not enjoy sufficient fiscal space should consider reorientating their expenditures to this end. At European level, there is also scope for action to increase investment, including through the EU budget, the European Fund for Strategic Investments, and the Juncker plan. The efficient deployment of capital also relies on well-functioning financial systems, which points to the relevance of completing the CMU and the Banking Union as soon as possible. Policymakers need to ensure that small firms can also benefit from access to non-bank sources of finance. Given their role in the European financial system, however, strengthening banks will remain critical.
Investment in human capital is also important, and will become increasingly so as Europe faces the challenges posed by an aging population. We need to allocate more resources more efficiently towards education, training and retraining with an emphasis on outcomes rather than just expenditures. Measures to raise labour force participation, including that of women and other workers, are also necessary. The picture throughout the Union is certainly not homogenous. At the same time, policymakers should act to reduce structural unemployment by facilitating job mobility, flexibility and reduction of wage mark-ups.
Talking about my country, our own experience with labour market reforms show that this is possible. Since 2012, Malta’s employment rate has risen by nearly 7%. Its female employment rate is converging rapidly with EU average, and unemployment has fallen to historic lows. In part, this reflects the increase available labour generated by a buoyant service-driven economy, but balanced with a fair factor of export-oriented production. However, it also stems from concrete measures designed to entice people into work. For example, we have raised the retirement age, and introduced incentives for people to work longer, and it is working. We have introduced free childcare, allowing parents with young children into work, and this working too. We have begun tapering welfare benefits to avoid an abrupt loss of benefits once the unemployed take up work, and that is working too.
In the current climate, with the UK leaving the EU and with the global commitment to free trade under attack, it is especially important to maintain open access to markets. This is of special concern to us, one of the smallest and most open economies in the world. Increased protectionism can be seen as the antithesis of the structural reforms we need. Raising trade barriers implies increasing inefficiencies, lowering potential output and raising costs and prices. Though it appeals to particular interests, it leaves the population at large worse off.
Finally, structural reforms of the sort I have just outlined increase the resilience and flexibility of an economy. This is especially important in a monetary union, where the member states have chosen to give up an independent monetary and exchange rate policy, in favour of a single currency. As the economy recovers and this monetary policy remains supportive, I would argue that now is the time to pursue the reforms needed to foster sustainable growth and jobs.