Last week was important may be decisive for the Euro Area. For the first time since the end of 2008, just after Lehman bankruptcy, government policies and monetary policy will both support economic activity on the same side. They will support internal demand in order to boost growth and employment.
This can be a game changer. Until now and since 2011 monetary strategy was accommodative but governments were committed to stabilize their public finance and their debt. This policy mix was compatible with an economic dynamic that requires fine tuning. This was not compatible with the drop of activity seen since spring 2011. The policy mix change seen last week reflects mainly a change in the European Commission policy as the EC forecasts a recession in 2013 after a recession in 2012. The situation does need a fine tuning but a deep change that recognizes that the Euro Area is still far from its potential trend and from full employment.
Last Thursday the ECB took a more accommodative trend (see here). The ECB main interest rate was dropped by 25bp to 0.5% and more importantly Mario Draghi has repeated that monetary policy stance will remain accommodative as long as it is needed. As the ECB will provide ample liquidity until at least summer 2014 we can expect that interest rates will remain low until this date. It will probably be longer. By these announcements the ECB wants to change investors’ mind on its monetary policy. In the recent past some interest rates hikes have been disturbing. Draghi wants to smooth investors’ expectations trying to force them to have a longer horizon.
Last Friday the European Commission has published its forecasts for 2013 and 2014. This latter year is in recovery but what is interesting is 2013 as it will be another year of recession after 2012. Reading the press release (read here) a change can be perceived on fiscal policy. Probably after the IMF pressure and after the controversy on public debt and growth (see here) the European Commission is becoming less tight on public finance convergence. Jose Manuel Barroso and Olli Rehn seem to have changed their mind on this issue. Read the title of paragraph 3 in the press release to see that may be something is new. Consistent with this paragraph title the Commission has allowed France and Spain to postpone by 2 years their public finance convergence. The delay is one year for the Netherlands. The convergence speed will be lower and that’s an important issue as internal demand will not have to be reduced as it has been in the last 2 years (see here)
The ECB is not too confident on the economic momentum, the European Commission forecasts a recession and recent surveys on economic activity have shown a that the second quarter has started on a very weak tone.
The change in the policy mix can be a support for internal demand and for a progressive recovery. This will feed growth and will help at the end to stabilize public finance. The fine tuning hypothesis did not require a hierarchy between policy targets. With the recognition of a deeper crisis it seems that the hierarchy seen after last week moves could put growth first (but still with a small margin). At the same time there is an opportunity as the inflation rate is low (1.2% in April) well below ECB target at 2%. There are no reasons to be tight on economic policies.
This does not mean that nothing will have to be done on structural reforms. The Euro situation is twofold.
- First most of Euro countries lack of growth autonomy. World trade is not strong enough to pull activity on the upside. This shows that the growth process is not efficient enough and not autonomous. That’s why structural reforms are needed. This will help to stabilize the long term framework which is necessary to create incentives for companies’ investment. This is a long lasting process that can be a little depressing in the short run.
- Second governments’ commitment to rapid public finance convergence was depressing reducing the possibility to make structural reforms.
These two options were not compatible. The change seen last week could be to ease convergence and at the end to facilitate structural reforms.
The main constraint for the Euro Area is low economic activity momentum and high unemployment. The change in economic policy hierarchy could be the good one to change this picture. The risk is that there will probably be a strong opposition to the soft option on fiscal policy. Nevertheless this is the only way to boost investment and employment. People in Europe are not ready to accept more unemployment and weaker economic conditions. This could favor extreme vote at elections. That’s the political signal that comes from every country in Europe. There is a choice to do and a softer policy mix is probably the good way to improve and save the Euro Area.