Growth and jobs in Europe: Which way now?

Anis Chowdhury (United Nations Economic and Social Commissions for Asia and the Pacific) and Iyanatul Islam (International Labour Organization).

Whether it is EU28 or EA18, the European region has suffered two to three years of negative growth between 2008 and 2014. The projected recovery in 2015 is well below the rate of growth that is expected to be achieved by other advanced economies.1 Some argue that, even during the 1930s Great Depression, the pace and scale of European economic recovery was quicker than it is now.2

The lack of growth has understandably led to rather adverse labour market, employment and social outcomes. Today, more than 20% of young Europeans are out of work, while more than seven million young people are trapped in NEET (not in employment, education or training). Some of the key EU 2020 targets are under strain.3

Several leading economists attribute Europe’s economic malaise to inappropriate policy interventions, starting with the sharp turn to fiscal consolidation in 2010 and monetary policy settings by the ECB that erred in the direction of raising interest rates prematurely, such as the policy rate hike in July 2008 on the eve of the global recession, and two increases in the policy rate in 2011 when the European economic recovery was quite tepid.4

A number of analysts have found that the European fiscal consolidation was both synchronized and more aggressive than elsewhere.5 Given spill over effects and insufficient monetary policy accommodation, the result was a predictable drop in output and rise in unemployment. If left unresolved, cyclical changes in output and employment pave the way for hysteresis, where current conditions act as a drag on future growth and employment.6

Modelling exercises at the Directorate-General of Economic and Financial Affairs of the European Commission (DGECOFIN) suggest that, while a 1% fiscal consolidation reduces GDP by a maximum of 1%, the decline in GDP can be as much as 2.6% larger when there are spill over effects from synchronized fiscal consolidation as in the case of the EA18.7 Others find that the synchronized fiscal consolidation between 2011 and 2013 led to an estimated cumulative output loss of 14 to 20 per cent of annual baseline GDP. This is more than enough to explain the lack of growth in the Euro area.8

It was initially thought that ambitious fiscal consolidation would be ‘expansionary’ because decisive action against sovereign debt crises would instil private sector confidence and more than offset the contractionary consequences of fiscal consolidation.9 It was argued that long-run growth in the European region could only be unleashed through wide-ranging structural reforms that would make the European Union much more business-and consumer-friendly by breaking down the barriers to competition and boosting private sector growth. Some of the short-term pain of fiscal consolidation could be ameliorated through expansionary monetary policy that was eventually undertaken by the ECB following the rate rises of 2011. This led to the promulgation of the so-called ‘policy triangle’ entailing a combination of fiscal consolidation, monetary policy accommodation and structural reforms.10

In retrospect, and with the unravelling of the European economic recovery, it would be fair to say that the ‘policy triangle’ has not yielded the expected benefits. Monetary policy is caught in the grip of a ‘zero lower bound’ (ZLB) and ultra-low inflation rates that are well below the ECB’s inflation target.11 The risk of deflation cannot be dismissed. More importantly, despite fiscal consolidation, public debt-to-GDP ratios both in the EU28 and the EA18 have not only remained stubbornly high but have risen relative to the past and now significantly exceed Maastricht treaty norms, although in the majority of cases budget deficits are within the Maastricht criterion.12 In a number of cases, the public debt-to-GDP ratio exceeds 100%. Hence, it is legitimate to think in terms of alternatives to the ‘policy triangle’. Here, we will consider two such alternatives, one that represents a minor deviation from orthodoxy; another that represents a more ambitious approach complemented by additional measures. Of course, both approaches can be combined in a single framework.

Which way now?

A differentiated approach to fiscal policy

The minor deviation from the policy triangle would combine fiscal stimulus measures, such as increased capital expenditure in ‘surplus’ countries (such as Germany, Netherlands, Austria, Finland) in the Euro Area that have fiscal space to finance such measures and continued efforts to rein in public finances in ‘deficit’ countries (such as Greece, Portugal, France, Spain, Ireland and Italy)that are still suffering from the aftermath of sovereign debt crises along with those that are exposed to fiscal vulnerabilities. This differentiated approach to fiscal policy would be combined with Euro Area-level monetary policy accommodation and emphasis on structural reforms. Will this work?

Unfortunately, the aforementioned DGECOFIN modelling exercise suggests that the impact on GDP of a time-bound increase in public expenditure of 1% of GDP in the surplus countries would yield a modest boost to GDP of the deficit countries (just over 0.2% of GDP relative to the baseline).13 This is because the spills over effects of increased public expenditure in selected parts of Europe are not adequate enough to directly boost aggregate demand in the deficit countries. Hence, the evaluation rightly concludes that differentiated fiscal policy does not represent a ‘miracle cure’ for the deficit countries in Europe.

The DGECOFIN paper recognizes the importance of public investment in facilitating European economic recovery, given the sharp decline in such investment in recent years.14 The paper notes that: “…(I)n the drive to consolidate public finances, government investment has been reduced, with major infrastructure investment plans scrapped and backlogs in deferred investment building up. Instead, low interest rates could have been locked in to finance an increase in public spending, by bringing forward public infrastructure projects which should, even if debt-financed, have a higher rate of return.”15

The recent behaviour of public investment in a core part of Europe is not unusual as the global and historical evidence suggests that there is a close association between fiscal adjustments and the decline in public investment across both developed and developing countries.16 This begs the question: how should one respond to the sharp decline in public investment witnessed in EA18?

An ambitious approach to public investment or a ‘Marshall Plan 2.0’ as part of an ‘investment new deal’ for Europe17

What matters is the scale and scope of the proposed increase in public investment and the manner in which it ought to be financed. This is where a Euro Area-wide, or even an EU-wide approach, rather than regional selectivity might be most important.

Some important voices within Europe have called for such an ambitious approach.

The new President of the European Commission has called for the need to “…mobilise up to (300 billion Euros) in additional public and private investment in the real economy over three years.”18 This proposal has been approvingly cited by the President of ECB who regards ‘a large scale public investment programme’ as an essential element of a ‘growth-friendly fiscal policy’ stance.19 There also seems to be considerable political support for this proposal among member states of the EU.

The Chair of the Committee on Employment and Social Affairs in the European Parliament has suggested that “What Europe needs is a Marshall Plan 2.0.”20 The Secretary-General of the European Trade Union Confederation (ETUC) has proposed a public investment package of 2% of EU GDP per year for 2014-2019.21 The Director of a European think-tank proposes that:

“A two-year 400 billion (Euros) public investment program, financed with European Investment Bank (EIB) bonds, would be the best way to overcome Europe’s malaise”.22 Complementing this proposal, the Polish Finance Minister has argued the case for a European Investment Fund equivalent to 5.5% of the EU’s GDP to support a major, region-wide investment push.23

In terms of absolute size, these proposals are about three times bigger (in current prices) than the famous Marshall Plan that resuscitated a Europe ravaged by the Second World War. Such a level of ambition is appropriate as Europe today is much more populous and prosperous than it was in the late 1940s and 1951 when the Marshall Plan was implemented.

What about monetary policy in this framework? The ECB could support this investment push by buying European Investment Bank (EIB) bonds. This approach has certain advantages. Cash-strapped national governments in the Eurozone can rely on a financing window that would otherwise not be available. The contentious arguments pertaining to monetary policy accommodation by the ECB using ‘quantitative easing’ that has to rely on buying sovereign bonds in multiple Eurozone member states can be bypassed.24

It is, of course, being assumed here that a major increase in public investment will bring about much needed growth and jobs. Will it do so?

The most recent empirical evidence compiled by the IMF supports this optimism. The study covers both advanced and developing countries.25 In the case of the former, the evaluation finds that:

  • There has been a secular decline in both the stock of public capital and public investment as  share of GDP
  • There are growing concerns about deteriorating quality of infrastructure in at least some advanced countries
  • A significant increase in public investment leads to both short-term and medium-term increase in output
  • Debt-financed public investment yields the biggest growth impact under current conditions that prevail in the advanced economies
  • Public debt-to-GDP ratio declines, at least in the short-run
  • Private investment rises in tandem with the increase in public investment.26

The aforementioned evaluation does not discuss the job creation impact of increased public investment. Table 1 provides some examples of model-based estimates of the impact of a public-investment led growth strategy in Europe. As can be seen, the numbers vary, with the cumulative impact on employment ranging from 6 million to 11 million, depending on the size of the investment package.

Table 1.

Size of investment package  Likely cumulative impact on employment  Source
420 billion Euros for 2014 to 2020 5.0 million new jobs Foundation for European Progressive Studies (FEPs) based on macroeconomic model27
2% of GDP per year for 2014-2019 11 million new jobs ETUC based on macroeconomic model28

Still, this only goes some way towards the goal of promoting full employment, given that more than 17 million good jobs would be needed to promote full and product employment in EA18.29 At the same time, in terms of the impact of a single intervention, this is probably more effective than other targeted interventions.

Long-term policy innovations in monetary and fiscal policy

Two policy innovations for the longer term might be considered that might facilitate and sustain European economic recovery. One is a review of the currently low inflation target that guides monetary policy of the ECB. The other is the invocation of a ‘golden rule’ to guide fiscal policy.

There is a growing consensus among several leading economists that the adoption of a 2% inflation rate (or just below it as the ECB formulation suggests) might be too low and makes advanced economies susceptible to the ZLB. Conventional monetary policy instruments then become ineffective in coping with a large-scale demand shock, while the risk of deflationary tendencies become quite significant. If, on the other hand, the target inflation rate is set at 4% for advanced economies, the risk of a ZLB is substantially reduced and monetary policy regains its usual potency in fighting demand shocks.30 One study on the US experience suggests that, had the US Fed explicitly adopted a 4% inflation target prior to the 2008-2009 global recession, it would have restored full employment significantly faster than is likely to be the case.31

As far as fiscal policy is concerned, the invocation of the ‘golden rule’ might be considered. It seeks to preserve the fiscal balance in terms of current expenditure and revenue, but protects capital expenditure from fiscal consolidation.32 There is some evidence that the decline in public investment was lower in some countries that adopted the golden rule in the past.33

Income support for the unemployed and living wages for low-paid workers to boost consumer demand

The Directorate-General for Employment, Social Affairs and Inclusion of the European Commission recognizes that automatic stabilizers that protect consumer demand during downturns have been impaired in recent years. It suggests that “basic European unemployment insurance” could be introduced to supplement national schemes. If adopted, any Euro Area country in the future “..facing a cyclical downturn would receive a limited fiscal transfer to support the cost of short-term unemployment.” Hence, this might alleviate country-specific fiscal pressures caused by downturns while protecting consumer demand.34

Inadequate consumer demand in Europe also stems from a significant incidence of low pay and in-work poverty in quite a few countries. In the OECD, for example, it has been estimated that just over 16% of the work-force do not earn a ‘living wage’.35 Granting living wages to all low-paid workers would be a fiscally smart strategy as it would lead to higher tax receipts and lower government expenditure on benefits that are used to support low- paid workers. It might also lead to more motivated and productive workers.36

The challenge is how to enact such an approach in circumstances in which wage moderation policies are seen as essential elements of a structural reform agenda. The European Commission recognizes this challenge when it observes that minimum wage setting processes should not be exclusively driven by concerns about competitiveness but also by considerations pertaining to the alleviation of in-work poverty, job quality and sustaining consumer demand, particularly during a recession.37

Apart from reviewing minimum wage setting processes, what else can governments do? One approach that the UK has taken is to enable the development of a ‘living wage movement’ led by civil society organizations. Civic activism has led to voluntary living wage commitments by more than 800 British employers. This number is poised to increase substantially soon. Furthermore, there are promising signs that local governments would support the voluntary ‘living wage movement’ through fiscal incentives.38

Concluding summary

The unravelling of European economic recovery in the aftermath of the last global recession represents a major challenge to political and social cohesion. The combination of fiscal consolidation, monetary policy accommodation and structural reforms has not delivered the expected benefits. Alternative approaches will have to be considered. Targeted policies are useful, but in the absence of growth and buoyant aggregate labour market conditions, are unlikely to make a major difference to the European employment crisis, especially among young people.

A modest alternative to the status quo is to aim for differentiated fiscal policy in which surplus countries undertake a temporary fiscal stimulus, while fiscal consolidation continues elsewhere. Modelling exercises undertaken under the auspices of the European Commission suggests that the impact on GDP and employment is likely to be rather marginal.

A more ambitious approach to public investment in infrastructure – akin to a ‘Marshall Plan 2.0’ and a “new investment deal” – might deliver a significant boost to both GDP and employment.39 In general, there is now a good deal of evidence from a wide range of advanced economies that well designed and debt-financed public investment in infrastructure under current conditions can be ‘self-financing’, that is, this intervention can engender significantly higher output, more jobs and lower debt-GDP ratios while “crowding in” private investment.

Additional policy innovations might be considered. These include the adoption of a new and higher inflation target that can stave off the risks of ZLB and deflationary tendencies in the future. ‘Golden rules’ that simultaneously aim for maintaining fiscal balance in terms of current expenditure and current revenues while protecting capital expenditure during downturns might also be useful.

Boosting weak consumer demand as part of an overall strategy to facilitate European economic and employment recovery is essential.  One possibility is to implement, as suggested by the European Commission, Euro Area-wide unemployment insurance scheme that would supplement national schemes and thus provide a limited fiscal transfer to member states during cyclical downturns. Yet another measure is to encourage voluntary compliance by the private sector to a ‘living wage movement’ to complement any review of minimum wage setting mechanisms. It is also a fiscally smart strategy. The UK experience suggests that civic activism together with support from local governments that engenders employer-led commitments to payment of living wages is a promising development that can reinforce minimum wage policies.

Authors' note: Iyanatul Islam is Chief, Employment and Labour Market Policies Branch, Employment Policy Department, ILO, Geneva; Anis Chowdhury is Director, Statistics Division, UN-ESCAP. This is an edited version of a longer paper that one of the authors (Islam) presented at a ‘Youth Employment Event’ hosted by the European Youth Forum and National Youth Council of Italy in Rome, 13-14 November, 2014. See http://www.it2014youth.eu/wp/Draft_Agenda_Youth_Employment_Event.pdf

Footnotes

1 IMF (2014) World Economic Outlook (WEO), October, Table 1.1, page 2.

2 Krugman, P (2013) ‘Europe’s Remarkable Achievement’, November 14, http://krugman.blogs.nytimes.com/2013/11/14/europes-remarkable-achievement/

3 European Commission, Directorate-General for Employment, Social Affairs and Inclusion (2014) Employment Policy Beyond the Crisis, Social Europe Guide, Vol.8, September, p.13.

4 Fitoussi, J-P and Saraceno, F (2013) ‘European Economic Governance : The Berlin-Washington Consensus’, Cambridge Journal of Economics, Vol.37(3): 479-496,

5 Mazzolini, G and Mody, A (2014) ‘Austerity Tales : the Netherlands and Italy’, Brugel, October 3, http://www.bruegel.org/nc/blog/detail/article/1449-austerity-tales-the-n... Holland, D and Portes, R (2012) ‘Self-defeating Fiscal Austerity’, National Institute Economic Review, November 1,

6 European Commission, Directorate-General for Employment, Social Affairs and Inclusion (2014) Employment Policy Beyond the Crisis, Social Europe Guide, Vol.8, September, p.1.

7 t’Veld, J (2013) ‘Fiscal Consolidations and Spillovers in the Euro Area Periphery and the Core’, Economic Papers 506, October, Directorate-General for Economic and Social Affairs, European Commission

8 Rannenberg, A, Schoder, C and Stratsky, J (2014) ‘The Macroeconomic Effects of the European Monetary Union’s Fiscal Consolidation from 2011 to 2013: A Quantitative Assessment’, September 25, mimeo, IMK, Vienna University of Economics and Business and OECD, https://editorialexpress.com/cgi-bin/conference/download.cgi?db_name=MMF...

9 Alesina, A (2010) ‘Fiscal Adjustments: Lessons from History’, http://scholar.harvard.edu/alesina/publications/fiscal-adjustments-lesso.... This was presented to an ECOFIN meeting in Madrid. For a critique, see Islam, I and Chowdhury, A (2012) ‘The Debate on Expansionary Fiscal Consolidation: How Robust is the Evidence’, The Economic and Labour Relations Review, Vol.23, No.3,

10 The policy triangle is discussed in Islam, I and Kucera, D (2014) Beyond Macroeconomic Stability: Structural Transformation and Inclusive Development, ILO and Palgrave Macmillan, chapter 1

11 In a ZLB, the nominal interest rate is effectively close to zero and cannot go any lower thus setting a limit to the capacity of the monetary authorities to conduct monetary policy using conventional instruments.

12 http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-23102014-AP/EN/2-231....

The debt-GDP ratio of six countries fall within the Maastricht criterion, while seven countries exceed this criterion in terms of budget deficits. See Draghi, M (2014) ‘Economic Situation in the Euro Area’, Euro Summit, 24 October, slide 9. https://www.ecb.europa.eu/press/key/date/2014/html/sp141024_1.en.html

13 t’Veld, J (2013), op cit

14 Inflation-adjusted public investment in EU18 is now at least 23% lower today relative to 2008. See Draghi, M (2014) ‘Economic Situation in the Euro Area’, Euro Summit, 24 October, slide 4.

15 t’Veld, J (2013), op cit, p. 15

16 Serven, L (2007) ‘Fiscal Rules, Public Investment, and Growth’, November, World Bank Working Paper No. 4382,

17 The notion of the ‘investment new deal’ is developed in Dervis and Saraceno (2014)

18 Juncker, Jean-Claude (2014) A New Start for Europe: My Agenda for Jobs, Growth, Fairness and Democratic Change’, 15 July, p.4, http://ec.europa.eu/about/juncker-commission/docs/pg_en.pdf. This was part of Juncker’s ‘campaign speech’ and has been endorsed by EU leaders.

19 Draghi, M (2014) ‘Unemployment in the Euro Area’, Speech by Mario Draghi, President of the ECB, Annual Central Bank Symposium in Jackson Hole, 22 August, http://www.ecb.europa.eu/press/key/date/2014/html/sp140822.en.html

20 European Commission, Directorate-General for Employment, Social Affairs and Inclusion (2014), op cit, p.71

21 European Commission, Directorate-General for Employment, Social Affairs and Inclusion (2014) op cit, p.74

22 Wolff, G (2014) ‘Europe’s Fiscal Wormhole’, November 3, http://www.project- syndicate.org/commentary/fiscally-responsible-eurozone-stimulus-by-guntram-b--wolff-2014-10. Others who have made a strong case for public investment-led growth in Europe include Grauwe, P (2014) ‘Stop Structural Reforms and Start Public Investment’, 17 September.. See also Hancke, R (2014) ‘Why The Eurozone is Once Again Staring into the Abyss’, 31 October.

23 http://blogs.wsj.com/brussels/2014/09/04/polish-finance-minister-calls-for-e500-billion-investment-fund/. This was proposed at an annual dinner hosted by Bruegel on September 4, 2014.

24 Wolff, G (2014), op cit

25 IMF (2014) World Economic Outlook (WEO), October, chapter 3.

26 The results of the study are in line with the ‘self-financing’ thesis of De Long, B and Summers, L (2012)’Fiscal Policy in a Depressed Economy’, Brookings Paper on Economic Activity, Spring

The authors argue that when several conditions in place (‘ZLB’, ultra-low interest rates, large-scale economic slack that breeds ‘hystereses’), debt-financed fiscal expansion is ‘self-financing’: it delivers higher output, higher employment and lower debt-GDP ratios.

27 Cozzi, G and Griffith-Jones, S (2014) ‘Bringing Europe Back to Life Using Investment, Economic Policy Viewpoint, No.4, July

28 ETUC (2013) A New Path for Europe: ETUC Plan for Investment, Sustainable Growth and Quality Jobs, November 7, 

29 Currently, 18.4 million in the EU18 are unemployed representing an aggregate unemployment rate of 11.5%. In 2007, on the eve of the last global financial and economic crisis, the unemployment rate was just over 7% which was the best performance since 2000. Assuming 7% to be NAIRU for EU18, just over 17 million productive jobs would need to be created to absorb the unemployed. The unemployment statistics are from Eurostat, http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-31102014-BP/EN/3-311... For the EU28, the relevant number is 23 million.

30 Blanchard et al (2010) ‘Rethinking Macroeconomic Policy’, IMF Staff Position Paper, SPN/10/03;

Blanchard, O (2014) ‘Where Danger Lurks’, Vol.51, No.3, Finance and Development; Krugman, P (2014) ‘Inflation Targets Reconsidered’, Paper for ECB Forum on Central Banking, May, https://www.ecbforum.eu/up/artigos-bin_paper_pdf_0134658001400681089-957...

31 Ball, L (2013) ‘The Case for Four% Inflation’, April, p.6. Prepared for Central Bank of Turkey, 

32 Dervis, K and Saraceno, F (2014) ‘An Investment New Deal for Europe’, September 3.

33 IMF (2014) World Economic Outlook (WEO), October, chapter 3.

34 European Commission Directorate-General for Employment, Social Affairs and Inclusion (2014), op cit

35 See http://www.oecd.org/employment/onlineoecdemploymentdatabase.htm#earndisp, Table N.

36 Islam, I (2014) ‘Minimum and Living wages in Times of Cuts’, 17 October.

37 European Commission, Directorate-General for Employment, Social Affairs and Inclusion (2014), op cit

38 http://www.theguardian.com/society/2014/nov/05/brent-council-living-wage-first-firms-incentive

39 In early 2009, the UN Secretary-General proposed a Global Green New Deal (GGND) to accelerate economic recovery and job creation while addressing sustainable development, climate change and food security challenges by front-loading massive, multilaterally cross-subsidized public investments in developing countries in renewable energy and small-holder food agriculture to induce complementary private investments.