Structural reforms and monetary policy revisited

Paolo Pesenti

07 September 2015



“In the midst of this turmoil, we cannot stop to make reflections; but Renzo, causing disturbance at night in another person's house, and holding the master of it besieged in an inner room, has all the appearance of an oppressor; when in fact he was the oppressed. Don Abbondio, assaulted in his own house, while he was tranquilly attending to his affairs, appeared the victim; when, in fact, it was he who had inflicted the injury. Thus goes the world, or rather, thus it went in the seventeenth century”

– Alessandro Manzoni, The Betrothed.

In a volume devoted to the assessment of the roots and causes of the European crisis, it may come as a surprise to find a contribution focused on the interaction between structural reforms and monetary accommodation. That is what this essay will do – concentrate on the policy recipes prescribed on both supply-side and demand-side to jump-start economic recovery and reduce the extent and spillovers of the crisis itself. But, in the complex and murky reality of the European crisis, what typically would have been part of the solution has been highlighted as part of the problem by a large and vocal group of critics.

The above citation - probably quite familiar to many Italian high-school students - nicely conveys a similar sense of confusion and disorientation, whereas the distinction between oppressors and victims, diseases and treatments, problems and solutions gets blurred and uneasy. Beyond the audience of Manzoni acolytes, for a lower-brow reference one may want to think of the Eurozone as ‘Bizarro world’ – an alternate place where fast is slow, good is bad, and structural reforms and monetary policy (the super-heroes under ‘normal’ circumstances) reappear under disfigured and distorted semblances as the villains of the situation.1

Competing views, polar extremes

To be fair, not many observers are willing to take the extreme view that economic policy tout-court is at the root of the European crisis and both supply-side and demand-side policies are jointly co-culprits. Most critics seem happy to highlight that reforms and monetary policy are not on the same level, praising one side of the coin for its contribution to improving macroeconomic conditions and blaming the other side for its unnecessarily contractionary or not sufficiently growth-oriented effects. Problem is, there is no universal agreement on which one of the two is actually the good side.

  • One extreme view is that structural reform, considered as the progressive elimination of distortions and frictions in labour, product and financial markets, is all that matters.

Eliminate microeconomic attrition and institutional inefficiencies, the argument goes, and markets will do their magic, in terms of restoring firms to their lost competitiveness.

Of course it is easy to think of monetary accommodation according to this view as unnecessary and ineffective, perhaps as an additional source of randomness and volatility. But things get worse – monetary policy is deemed to be counterproductive even when it is effective and predictable. It is counterproductive because it is effective and predictable. In fact, reforms tend to be undertaken only when governments are under general pressure and can afford to overlook specific lobbying efforts by special interest groups.

If monetary policy effectively provides some macroeconomic breathing space that reduces this urgency, it then jeopardizes the social cohesion and electoral consensus required to push forward unpopular reforms. Also, an injection of liquidity that lowers the cost of money is bound to keep alive unprofitable firms that would otherwise be restructured or disappear, thus preventing the survival of the fittest, upholding a sectoral composition skewed toward low average productivity, and condemning the economy to a limbo of inefficient stagnation.

The bottom line, according to this view, is that monetary stimulus is paradoxically criticized not because it is ineffective or inconsistent, but because it ends up delaying and destroying the very incentives for market adjustment.

A second extreme view is to some extent the polar opposite of the first. Societies are predominantly present-oriented and discount the future heavily.

  • In an environment in which in the long run we are all dead and we want it fast and we want it now, structural efficiency is bound to be just an abstract tendency – an ideal for the very long term whose policy relevance is always subordinated to the more immediate search for cyclical stabilisation.

Yes, it is understood that reforms may end up enhancing potential growth and reduce labour market frictions tomorrow, but it is output and employment today that matter. Which means, reform is given a narrow time span to flaunt its promised benefits. As soon as the cyclical costs of structural adjustment become obvious, reform ceases to be a key element of a growth-oriented strategy and metamorphoses into hideous austerity. And when adjustment is perceived (correctly or not) as imposed from outside as part of a conditionality programme of doubtful coherence and effectiveness, rather than an internal decision undertaken by a democratic society with full control of its own destiny, popular support vanishes and political fatigue ensues, leaving short-term stimulus – if and when available - as the only game in town to restore full employment and provide insurance against the tail risks of deflation.

Less extreme views

Less extreme views of course tend to mix and match elements of these polar approaches. They end up recognising the relevance of both supply-side reforms that promote high and sustainable growth trends, and countercyclical policies that smooth consumption, incomes and employment around these trends.

As the 2015 Sintra speech by Mario Draghi - quite obviously an excellent starting point for any conversation on the interdependence between reforms and monetary policy – makes clear, the not so hard truth is that both structural reforms and monetary accommodation are imperfect, costly, and uncertain tools of growth-oriented policy (Draghi 2015). Firms and households in the European periphery have long shunned an excessively naïve reliance on the confidence-boosting effects of expected gains from structural adjustment, but are the first in line to emphasise that muddling through with patches and patches of short-term stimulus is not exactly a panacea for sustainable performance over time.

A common ingredient of all ‘intermediate’ approaches is the idea that the natural real interest rate in (parts of) Europe is persistently lower than in earlier decades. The natural rate is associated by definition with the equilibrium between saving and investment at full employment. A vast literature discusses in detail the potential drivers of a lower natural rate in Europe, whether related to demographic factors, globalisation trends, deleveraging, reduced risk appetite, diminished expectations about income growth and employment prospects, higher investments costs of investment, or quite simply catatonic animal spirits. As Draghi mentions in his Sintra speech, a lower natural real interest rate means that, faced with a negative output gap, nominal policy rates need to go lower still to steer output back to potential. This materially increases the likelihood that central bank policy runs into the constraint set by the zero (or effective) lower bound. It therefore also increases the likelihood that the central bank has to resort to unconventional policies of unknown or doubtful efficacy to meet its mandate.

Two stories as to how intermediate solutions work

There are probably two different but related ways to articulate an ‘intermediate’ view. In both cases, there are substantial long-term benefits from structural reform. But whether expected long-term benefits translate into short-term gains depends on the extent to which monetary policy can operate effectively.

  • Story 1 – as highlighted in recent research work on the subject (see Cacciatore et al. 2013 and Eggertsson et al. 2014) structural reforms that reduce the income and competitiveness gap between core and periphery may well be contractionary during crisis episodes that push the nominal interest rate to its zero lower bound.

In normal times, reforms reduce prices in labour and product markets, increasing agents' permanent real income and stimulating consumption. With falling aggregate prices, the central bank is able to lower nominal interest rate and the economy exhibits a cyclical expansion as well as a sustainable higher rate of long-term growth (see Bayoumi et al. 2004).

Things are different, however, in crisis times when the central bank's nominal interest rate is at the zero lower bound. In this case reforms are contractionary, as expectations of prolonged deflation increase the real interest rate well above its natural rate and depress consumption. In the literature, the short-run output losses associated with the ZLB constraint are increasing with the magnitude of the reforms and become particularly large when reform efforts are half-hearted. When you are stuck in the zero lower band quicksand, energetic ‘structural’ efforts to get out of the doldrums often make things worse, and provide no guarantee to getting out alive.

  • Story 2 – take the previous story, but now replace the intertemporal dimension with a geographic one.

Think of structural reform as being implemented in one specific region but not in the whole of the Eurozone.

As the region has no control on its monetary policy and cannot rely on exchange rate adjustment, no expenditure switching effects arise to redirect system-wide aggregate demand toward the goods and services produced in the region. Lack of exchange rate flexibility plays at the intratemporal level the same role that the zero lower bound plays at the intertemporal level. It is a constraint on the ability of monetary policy to offset the deflationary effects of structural reform.

A narrative of the Eurozone crisis

It is straightforward to combine the two stories above into a narrative of the European crisis, to understand how the hero becomes the villain. At the onset, there is a series of shocks to the natural rate of the periphery countries. To offset these effects and raise the natural rate, structural reforms would be welcome as harbingers of higher productivity growth. But monetary policy is at the zero lower bound, so there is no intertemporal escape. And the periphery is part of a currency union, so there is no intratemporal expenditure switch through exchange rate depreciation. So structural reform makes things worse, and insisting on structural reform as the only way out of the crisis contributes to a vicious circle of disinflation, low demand and low activity, low expected demand and further disinflation. 

Ways forward

This is not terribly comforting. Is it actually possible to engineer a strategy to escape such vicious circle, besides sheer luck? Maybe, provided one is willing to reconsider the case for structural reform and think outside the ‘competitiveness’ box.

When policymakers stress the competitiveness gains of structural adjustment, implicitly or explicitly they consider reforms as a reduction in the degree of monopoly power in the product or labour markets, and therefore a reduction in markups – the same result that one would obtain by increasing the elasticity of substitution between varieties produced under conditions of monopolistic competition.

In fairness, this is precisely how reforms are modelled in standard dynamic stochastic general equilibrium models such as, say, Bayoumi-Laxton-Pesenti (2004) or Eggertsson-Ferrero-Raffo (2014). The expected effect is an expansion in economic activity and an increase in the amount of resources available for consumption by domestic and international households. Or, as you like it, more competitive firms dump their excess output in their export markets at lower international prices. The external and internal terms of trade are bound to deteriorate, as either the relative price of imports or the relative price of leisure or both increase.

A similar scenario arises in the context of what international macroeconomists would refer to as a variant of the transfer problem (Corsetti et al. 2005). The so-called transfer problem has a long intellectual history which goes back to Keynes' classic criticism of German international obligations after World War I. He stressed that the macroeconomic costs of war reparations – the ‘primary burden’ of a transfer - were magnified by deteriorating terms of trade – the ‘secondary burden’ or ‘double punishment’.

Arguably, the transfer problem is the intellectual matrix of any meaningful analysis of current account rebalancing, or adjustment between a debtor country and its creditors. The basic mechanism of adjustment requires transfer of real resources from debtor countries such as the US or the European periphery to surplus countries such as China or Germany, with a decrease in domestic spending relative to production in the debtor countries. To the extent that adjustment requires a significant reversal in cost-competitiveness among trading partners, one can immediately recognise the links with the analysis of structural reforms.

The key question concerns the role played by relative prices in the adjustment process. Building on Keynes' approach to the transfer problem, one is tempted to acknowledge that large real depreciations in debtor country are needed to close current account imbalances, either through currency fluctuations or through significant ‘internal’ real devaluations. So substantial currency flexibility (or alternatively, wage flexibility and deflation) is seen as a precondition for adjustment.

However, over the time horizon relevant for adjustment, the baskets of tradable and non-tradable goods in consumption and production are bound to change and there is substantial entry and exit of firms across sectors and countries. New product varieties are created or destroyed as a consequence of shifts in world aggregate demand. Now, if a large fraction of adjustment occurs through changes in quantities at the extensive margin, the trade gap is closed by producing and exporting new tradable goods to the rest of the world. International prices of new varieties need not fall, and a large real exchange depreciation is neither a sufficient nor a necessary condition for resolving global and regional imbalances.

There is an intriguing application to intra-European imbalances. The conventional therapy for the structural ills of the countries in the European periphery prescribes real depreciations - possibly fostered by policies and reforms accelerating large-scale wage and price disinflations - with the goal of regaining cost competitiveness and closing trade gaps. If the reforms-cum-internal-devaluation plan does not work, then one can bring this view to its extreme consequences and claim that, for crisis countries there may be no alternative to abandoning the Eurozone, and adjusting relative prices via large nominal depreciations.

In contrast, a slightly refocused (and unconventional?) approach would suggest that to foster European adjustment, policy and reforms should target obstacles to firms' entry, start-up costs, and the incentives for product differentiation, not to achieve a narrow objective of cost-competitiveness but to expand the net array of tradable varieties of goods and services. Of course, this story does not deny that some real depreciation (internal or external) may be needed to facilitate the adjustment process. But the main message is that structural reforms focusing on market liberalisation and reduction of inefficient barriers to entry may not require deflationary pressures – and the associated contractionary effects - as dramatic as some observers claim is unavoidable.

If this unconventional view is correct or appropriate, then the link between structural reforms and monetary policy may be consistently reassessed. Setting up firms and new production lines is costly and typically requires financial resources. Structural reform cannot succeed without appropriate policies that address tight credit constraints on investment and firms' activity due to liquidity and balance sheet problems hitting banks. We no longer have a dichotomy between costly reforms and anti-recessionary monetary policy, but rather an integrated and perhaps coordinated vision of ‘whatever it takes’ to restore growth.

Needless to say, there is no easy and straightforward strategy. How to guarantee that entrepreneurship is rewarded and the appropriate resources flow to the right sectors? How to provide incentives to achieve the desired allocative efficiency without falling in the trap of directed credit? Who assesses (and according to what metrics) which sectors will flourish and which sectors will decline? There are no obvious answers, but this need not imply that there are no answers. The alternative option, i.e. continuing reliance on deflationary adjustment in a currency union stuck at the zero lower bound, is probably unlikely to convince anyone that structural reforms and monetary policy are back to being part of the solution and no longer being part of the problem. Thus goes the world, or rather, thus it goes in the twenty-first century.

Disclaimer and acknowledgments: A preliminary version of these notes were presented at the CompNet conference ‘Enhancing competitiveness and fostering sustainable growth: methodological issues and empirical results’, European Central Bank, Frankfurt am Main, 25 - 26 June 2015. I thank Filippo di Mauro, Jamie McAndrews, Jonathan McCarthy and Athanasios Orphanides for helpful comments and suggestions. The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.


Action Comics (1960) 1(263-264), April–May.

Draghi, M (2015) “Structural Reforms, Inflation and Monetary Policy”, introductory speech, ECB Forum on Central Banking, Sintra, 22 May, available at

Cacciatore, M, G Fiori and F Ghironi (2013), “Market Deregulation and Optimal Monetary Policy in a Monetary Union”, CEPR Discussion Papers 9742.

Eggertsson, G, A Ferrero and A Raffo (2014), “Can structural reforms help Europe?”, Journal of Monetary Economics 61(C): 2-22.

Bayoumi, T, D Laxton and P Pesenti (2004), “Benefits and Spillovers of Greater Competition in Europe: A Macroeconomic Assessment”, CEPR Discussion Papers 4481.

Corsetti, G, P Martin and P Pesenti (2013), “Varieties and the Transfer Problem”, Journal of International Economics 89(1), January.

Corsetti, G, P Martin and P Pesenti (2013), “Current-Account Rebalancing and International Transfers (Immaculate or Not)”, VoxEU, 31 January.


1 The Bizarro world appears in Action Comics (1960) as a cube-shaped planet called Htrae (Earth spelled backwards). One wonders to what extent Bizarro used the duplication ray on fiscal policy in the Enozorue.



Topics:  Macroeconomic policy

Tags:  monetary policy, Eurozone crisis

Senior Vice President and Monetary Policy Advisor, Federal Reserve Bank of New York and CEPR Research Fellow