The most recent data shows that the euro-zone economy is currently in a period of strong expansion. With economic growth of nearly 2 percent, two million new jobs and falling – although still high – unemployment of 9.2 percent, 2017 could well be the bloc’s best year since the financial crisis. The upward trend applies to all the countries in the currency union and is increasingly driven by domestic demand, making it more stable.
Of course, it is questionable how long the upswing will last. A great deal will depend on developments in the United States and China, because there are risks for the euro zone in both of these economic regions. There could be a slowdown in Europe too, for example, if Brexit negotiations fail or old debt problems of certain southern European countries become acute again. None of this is predictable – all of it is possible. And economic policy is not well prepared for such risks.
In many countries, finance ministers have little scope for expansive measures because sovereign debt has continued to increase in recent years. And as the interest rates of the European Central Bank are still below zero, monetary policy could only intervene with unconventional measures, the effects of which are highly questionable.
That is why it would now be a good idea to make anticyclical adjustments to economic policy and remove existing economic stimuli. The euro-zone member countries should use cyclical tax windfalls, which we have had in Germany for years, to reduce their budget deficits and not succumb to the political temptation of increasing expenditure.
The upswing gives the ECB the opportunity to normalize its monetary policy.
However, up to now, there is little sign of such preventative policies. Savings were made immediately following the financial crisis in particular and, as a matter of necessity, as a reaction to the euro debt crisis. But it had more of a procyclical effect and reduced demand even further. In the last three years the reduction of structural deficits has slowed down again considerably. The only savings made by governments have been due to lower interest burdens which have mainly been a result of monetary policy.
Countries such as France, Spain and Italy still have high deficits although the economic situation there has clearly improved. The European Commission, the EU’s executive arm, should exert strong pressure now to make them reduce their borrowing. That would create scope to maneuver in the next economic downturn.
The economic environment for the ECB’s monetary policy has also changed. It still seems entangled in the paradigm of the financial crisis and is hesitant to change its ultra-expansive policy. “Patience and consistency” are the mantra of the bank, which still has doubts about the strength of the upswing and thinks inflation is too low.
The ECB will certainly have good reasons for pointing to remaining risks with regard to the sustainability of the upswing and its reasons for a very cautious exit strategy from an unconventional monetary policy. But it cannot just continue to fuel the economic climate in an environment of recovering economies and prices. And that is how the ECB’s continuing bond purchases and retention of negative interest rates have to be interpreted.
A strategy like this creates not just risks – for example, exaggerated valuations on the financial markets – it also severely narrows the scope the central bank will then have to stimulate the economy in the case of a downturn in the economic climate.
Of course, there are also risks involved in forsaking the highly expansive monetary policy, for example, soaring returns on the capital market. But if the ECB sticks to its usual good communications policy the increase in returns should be kept within limits and shouldn’t be dramatized in terms of its effects on the economic climate.
Even if interest rates on the euro-zone’s capital markets were to double, they would still be well below the nominal growth tempo of the economy, which is the long-term yardstick for a neutral interest rate level. In the euro zone this growth tempo was around 3 percent in the last two years. Interest rate levels significantly below this figure create expansive impulses for the economy.
So there is scope for interest rates to rise without being restrictive. The upswing gives the ECB the opportunity to normalize its monetary policy. And for the governments of the euro zone it provides the opportunity to make real progress with debt reduction – an opportunity they should take now.
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