REFORM ALONE IS NO SOLUTION FOR THE EUROZONE / THE FINANCIAL TIMES COMMENT AND ANALYSIS

October 21, 2014 6:59 pm

Reform alone is no solution for the eurozone

Martin Wolf

 

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A policy that may work for Germany alone cannot work for an economy more than three times as big

 

 

 

Might the policies of the eurozone result in a robust recovery? My answer is: no. Since the eurozone generated 17 per cent of world output in 2013 (at market prices), that answer has global significance.

 

It is Germany that set the economic strategy of the eurozone. It consists of three elements: structural reform; fiscal discipline; and monetary accommodation. So far, this set of policies has failed to generate adequate demand: in the second quarter of 2014, real demand in the eurozone was 5 per cent smaller than it was in the first quarter of 2008.

 

Both France and Italy are being encouraged to accelerate “structural reforms” as a way to reignite growth in their own economies and so, given their importance, also in the eurozone.

 

These two countries generate 38 per cent of eurozone gross domestic product, against 28 per cent for Germany alone. In both economies, the recommended programmes involve liberalising the labour market. They are both being encouraged to follow Germany’s “Hartz reforms”, introduced between 2003 and 2005, to which the country’s relatively good recent labour market performance is often attributed.

 

Yet the one thing those reforms did not do is create dynamic aggregate demand. Between the second quarter of 2004 and the second quarter of 2014, Germany’s real domestic demand grew 11.2 per cent, a compound annual rate of 1 per cent. It could have been worse. But this is hardly the performance of a “locomotive” (see chart below).

Examination of Germany’s sectoral financial balances – the differences between income and spending of the government, private sector and foreigners – strengthens this point. The response of the German private sector to the reforms of the early 2000s was to increase financial surpluses massively: that is, to spend far less than their incomes. Since the fiscal deficit also shrank, the capital outflow soared. This is striking and significant. In brief, the response of the private sector to the labour market reforms and fiscal tightening was to become increasingly frugal and so accumulate large quantities of (often poor-quality) foreign assets.

In terms of raising private domestic demand, reforms achieved little. On the contrary, Germany became heavily dependent on foreign demand. Similarly, fiscal tightening did not unleash stronger private spending. Expecting similar labour-market reforms to promote demand in France and Italy is likely to prove highly over-optimistic.

 

 

 

 

This does not mean reforms achieved nothing. Germany has low unemployment despite quite weak growth. The UK also has relatively low unemployment despite still weaker post-crisis economic growth. In both cases, the labour reforms encouraged the sharing of a large negative shock across the population via stagnant or even falling real earnings. A symptom of this form of an adjustment is weak productivity. In German industry, productivity has not risen since 2007. Productivity performance has also been poor in the UK. But German unemployment was 4.9 per cent in July and the UK’s only 6 per cent against 10.4 per cent in France.

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