How to climb a mountain with both hands tied

Jean Pisani-Ferry

07 November 2014



Against the background of lacklustre global demand, economic growth in Europe has weakened again. In the Eurozone, a third recession in less than seven years is a distinct possibility. Yet economic policy looks powerless. On the monetary side, although the ECB may still embark on a genuine programme of quantitative easing, such action is unlikely to deliver a major boost because the benchmark 10-year government bonds already yield just 1%. On the budgetary side, fiscal space is scarce and the European discipline framework further reduces the leeway for action; moreover, those governments that could embark on a stimulus programme are reluctant to renege on their domestic promises to balance the budget in the near term. Overall, there is some room for a monetary and fiscal boost, but it is unlikely to suffice to address the risks of a triple-dip recession.

The effect of structural reforms when demand is weak

Alternatives must therefore be considered. The most popular one among European policymakers is structural reform. Since reforms, the reasoning goes, are needed to address high unemployment and slow productivity growth, they should be enacted without delay; their swift and comprehensive implementation would help to revive growth. The premise is indisputable, but the conclusion is largely flawed. Reforms, especially of the labour market, often hurt growth for several quarters before they start supporting it. In normal times, such short-term effects can be offset by monetary accommodation, but this is precisely what cannot be done in the current situation. Furthermore, many structural reforms result in efficiency gains that reduce inflation, which is normally good, but undesirable when year-on-year price increases are already perilously close to zero.

There are admittedly a few structural reforms that result in higher growth, higher inflation, or both. Simplifying administrative procedures is hardly harmful. Longer shop opening hours improve the service to consumers and create jobs, but they do not lower prices. Reforms that improve company access to finance increase investment and employment, but do not give rise to adverse short-term effects. Pension reforms that lead people to work longer improve their lifetime income and, to the extent that employees actually expect to have a job, lead them to consume more. As argued by the ECB’s Benoît Cœuré in a recent speech (Cœuré 2014), the same applies to reforms that improve future productivity and thereby raise expected income. So some reforms do good in both the long run and the short run. But the list is not long enough to ensure that even their comprehensive implementation would suffice to address growth weakness.

More generally, to increase aggregate supply or to strengthen the elasticity of supply when the feebleness of aggregate demand is already the binding constraint on growth is a disputable recipe. In an intriguing paper (Eggertsson and Krugman 2012), Gauti Eggertsson and Paul Krugman even argue that high public and private indebtedness could result in a ‘topsy-turvy’ economy where structural improvements actually hurt output, because lower prices increase the burden of debt and reduce aggregate demand instead of increasing it. This certainly does not apply to all Eurozone countries, but it may well apply to some.

The role of investment

This is where investment may fit in. In his first speech in front of parliament in July, the president of the European Commission, Jean-Claude Juncker, indicated his intention to support growth by launching a three-year investment package worth €300 billion. Investment, obviously, has the virtue of affecting both the demand and the supply sides. This is what makes it an attractive recipe. However, such a plan also raises questions: Why should companies invest if there is already excess supply? If it is governments that are expected to invest, where will they find the means for it? And is it desirable to increase supply any further? On second thought, investment may be a less attractive idea than it seems.

Incentivising environmentally friendly investment

There is however a way out of the conundrum. Suppose that the government had the power to discard the oldest part of the equipment used by companies in their production processes and to force them to substitute it with new, more efficient equipment. This would trigger new investment that would contribute to increasing demand without affecting supply. There would be both growth support in the short term and higher productivity in the medium term.

Governments in fact have such power. They can tinker tax legislation to incentivise capital replacement, and they can also legislate to eliminate inefficient capital. This is exactly what a tightening of emission standards does when applied to cars already in circulation – it forces car owners to discard their old, polluting vehicles and to replace them with new, more environment-friendly ones. In the process the number of cars in circulation does not change meaningfully, but the new fleet is eventually younger and more environmentally efficient.

Doing the same on a large scale would require setting higher environmental and energy efficiency standards (for instance for the insulation of buildings, for energy consumption, and for diesel emissions) and also ensuring that the price of carbon is high enough to incentivise investment in clean technologies. Such an initiative has been advocated for a long time by green activists.

Some words of caution

Naturally, precautions have to be taken. First, for such an action not to be a waste of resources socially, it would need to concentrate on fields where the old capital is gradually becoming obsolete anyway and where public action would merely speed up its replacement. It is always possible to dig holes, bury machines, and replace them with new ones, but any economist hesitates before recommending such action. Second, an acceleration of the renewal of the capital stock only makes sense if the new technologies are sufficiently mature. To trigger the replacement of 20th-century windows with more energy-efficient ones is one thing; to create a solar-panel bubble is another, which has been tried at high fiscal and social cost. Third, a depreciation of the existing capital would hurt the corporate sector’s profits. It can only be contemplated within limits because although big firms are awash with cash, many smaller ones are hardly profitable already.

The charm of regulation-triggered investment is that it does not rely on public spending, but this does not turn it into a magic bullet. There are obvious limits to what can be done in the short run to accelerate the transition to a more environmentally friendly economy and boost growth in the process. But together with public investment – where feasible – and the most growth-friendly reforms, such action should be used to help Europe escape from the trap it is at risk of falling into. It may not be sufficient to avoid a recession, but at least it has better chances of delivering growth support than inertia or an exclusive focus on structural reforms.       


Cœuré, B (2014), “Structural reforms: learning the right lessons from the crisis”, Keynote speech, Economic conference, Latvijas Banka, Riga, 17 October. 

Eggertsson, G B and P Krugman (2012), “Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach”, Quarterly Journal of Economics 127(3): 1469–1513. 

Juncker, J-C (2014), “A New Start for Europe: My Agenda for Jobs, Growth, Fairness and Democratic Change”, Political Guidelines for the next European Commission, Opening Statement in the European Parliament Plenary Session, Strasbourg, 15 July. 



Topics:  Environment EU policies Macroeconomic policy Microeconomic regulation

Tags:  Europe, eurozone, recession, stimulus, monetary policy, quantitative easing, fiscal policy, structural reforms, labour market reforms, liquidity trap, investment, Cash for clunkers, scrapping subsidies, environment, regulation, emissions standards

Professor, Hertie School of Governance; Commissioner-General for Policy Planning, Government of France