In turbulent times we tend to be overwhelmed by the most recent events and indicators. Let me therefore start by taking stock of the current situation and the outlook, in an effort to put things in perspective.
- For years, before 2001, all forecasters talked about the risk of a hard landing of the U.S. economy. It was felt, particularly outside the stock exchanges, that stock prices defied gravity. Over-investment and indebtedness in the corporate sector, about household spending and borrowing on the back of inflated asset prices, etc. were recurrent themes.
A hard landing in the U.S. was thought to be onerous, something possibly quite destabilising for the global economy, not only the financial markets.
But when the long-awaited correction in the U.S. economy finally appeared, there was an initial sense of shock, followed by a brief spell of wishful thinking (the sharp V). In Europe there was no anticipation of great spillovers. This changed, as forecasts were repeatedly adjusted down. But again, with some encouraging U.S. numbers at the start of this year (2002), optimism about a rapid takeoff returned.
Now we are disappointed about the second quarter, and disappointed about what we antici-pate about the third quarter, both for the U.S. and for Europe. Gloom is spreading again.
We tend to be overwhelmed by the latest twists and turns in the indicator flow – by what economists call noise.
Let me therefore offer the following, perhaps equally biased opinion: What we now see unfolding is, at least so far, really a milder version of the hard landing scenario that we originally thought most likely for the U.S. economy. Common sense told us then, and should tell us now, that in any economy, once households and companies get overextended, at some stage confidence dissipates and collective consolidation takes over. We always knew that consolidating balance sheets is a lengthy process, which by definition takes place in a slower than anticipated growth environment. Of course, we have not seen everything yet, but what we have seen so far is not, in terms of past cyclical behaviour in the U.S. and in Europe, quite as dramatic as the hard landing, at least so far, and in view of the "bubble".
Real adjustment and balance sheet consolidation go hand in hand. They are needed and necessary, and they take time. These realities we cannot and should not try to eliminate, by means of short-term economic policy tuning or otherwise. Adjustment may be facilitated, perhaps, but it has to take place.
All this is obvious. Why, then, state it again?
It is because with some frequency there are calls for expansionary macro-economic policy, either fiscal expansion or monetary easing, in order to get the economy to recover. One variation of the theme is the suggestion that macro policy adjustments provide a "signal" that would have an impact on the confidence of consumers and companies, therefore on domestic demand.
Signals about what? The jargon of "signalling" has been taken over from a different context, i.e. communicating policy intention or policy nuances to financial markets. What we are dealing with now, in Europe, is real adjustment and structural problems. I must say that I am personally increasingly sceptical about the virtue of such virtual policies.
The fact is that macro-economic policies cannot eliminate the need for real adjustment. Not only the U.S., but also and perhaps in particular the European economy, is facing a process of inevitable adjustment. Of course, the deterioration in the outlook for the European economy is to a great extent a reflection and consequence of adjustment in the Unites States, but this is not the whole story; the European economy has serious structural problems of its own. In any case, we can no longer say that the European economy would live a separate life. Europe is not separate from but part of the global economy, with the U.S. economy being the anchor, both in product markets and in money and capital markets. European companies are, so to speak, also part of the Unites States economy – directly, not only via trade flows, and, the same has applied for a long time to U.S. corporate involvement in Europe. Looking at trade flows alone gives a misleading impression of separate economies. – In other words, adjustment processes in the United States economy become part of Europe's own forecast. But the even more important point is that the European economy is beset by all manner of structural rigidities that limit its growth potential both in and beyond the current phase of the cycle.
This being the case, macro-economic signalling and encouragement do not address the issues at hand. Virtual policies are not enough. They are likely to be harmful to the extent that they deflect policy makers and the public away from the structural issues that really are the key and which need to be addressed.
Expansionary macro-economic policy makes things worse, if it is a substitute for structural measures, and if it comes on top of missed public sector consolidation opportunities of recent years. For the future, we need stronger public sectors, even if we were not taking into account the ageing of the population, something that of course makes the consolidation requirement even stronger. Confidence in the sustainability of the public sector finances is important. Also for interest rates.
Nor should we want to endanger long-term monetary stability by "comforting" households and corporations with literally excessive liquidity – liquidity that they do not have any use for and the use of which might in a consolidation phase merely feed into various asset markets or have other undesirable effects. Let me also remind you of the fact that in any developed financial system a central bank has only one interest rate at its disposal, namely its policy rate, not the yield curve nor the credit spreads. In times of diverging credit quality, interest rate policy would not in any case be of much consolation to those companies squeezed by increasing credit spreads.
Summing it up: We should not look to fiscal and monetary expansion as a means to help the economy avoid or postpone real adjustment.
Accepting the reality of business cycles and the inability of macro policy to compensate for the swings, of course does not mean that Europe would be condemned to inferior economic performance. The recipe is to bring flexibility and strong incentives into a stable macro-economic environment. Global integration deepens all the time, even in the absence of institutional arrangements that may serve to accelerate it, such as the EU, WTO, etc. Knowledge and technology are the fundamental drivers in the background. Economic growth will increasingly take the shape of structural change. The pressures in that direction will in all likelihood intensify. This is a good thing in the long term. (EU enlargement is likely to help.)
Higher growth and employment levels will be seen wherever resources, i.e. capital and labour, move easily from low productivity to high productivity sectors, in a continuous never-ending process. – As an aside, I should say that this is not equivalent to more insecurity in society, rather the contrary.
The European economy is still very compartmentalised. The diversity of institutions, the sheer mass of large differences and small nuances in norms and procedures, and in market access, make an enormous difference. The market is fragmented. Even within the EMU, with a common currency as a unifying factor, we can still observe price differentiation to an amazing extent in product markets. The rigidity of the labour markets is widely acknowledged. Even today, with the monetary union firmly in a place, we can still not speak about a unified financial market; this we shall see only with greater corporate cross-border integration in the financial sector, and with a harmonisation of the legal and institutional framework determining the usability and availability of financial assets and services cross-border.
All the challenges of bringing mobility and flexibility into the European economy are well recognised. This is what the Financial Services Action Plan, Risk Capital Action Plan, etc. and perhaps in particular the Lisbon initiative are all about. The Lisbon initiative adopted by the heads of state, as you will be aware, aims at nothing less than transforming the EU into the most dynamic and competitive, knowledge based economy by 2010, capable of an average annual growth rate of 3 % per annum. – With the starting point we now have, this is extremely ambitious.
Are we making progress? – We are making slow progress, in the financial markets and in other areas. But what about mobility and flexibility in the labour markets? Our labour markets are not efficient. An efficient labour market is one that produces a high rate of employment, not the high rate of unemployment that we seem to face as a permanent phenomenon in Europe, regardless of the cyclical situations. Clearly, in the European welfare state context, the so-called labour market partners cannot alone bring about such efficiency in the labour market. The performance of the labour markets is probably more fundamentally determined by the norms and the design of social support systems and by the tax system.
Labour market flexibility is both politically and technically a challenging area of policy, precisely because of the link to the design of support systems. Maybe there is no politically correct way to achieve results. Nevertheless, we might bear in mind comparisons between U.S. and European performance also as regards labour markets: Superior U.S. performance in terms of gdp per capita in the 90's is only in part due to more efficient absorption of new technology. Superior U.S. performance also reflects superior absorption of labour.