The Euro Area Can Return to a Stable Economic Growth Path

Dr Ivanovitch - MSI Global
Dr. Michael Ivanovitch

A strong recovery from the monetary union’s deep recession in the middle of last year has generated very little price inflation in labor and product markets. That now makes it possible to withdraw an exceptionally large monetary stimulus without compromising a gradual return to growth rates that are compatible with the economy’s long-term noninflationary potential.

About one-half of the euro area’s 3% inflation in the year to August came from surging energy prices, while labor costs -- the main underlying inflation drivers -- in major member country economies were either declining or remaining virtually flat in annual comparisons.

Apart from that, the area’s labor market slack is still considerable. At the end of July, 12.3 million people – 7.6% of the labor force – were out of work, with 2.3 million of young people (under the age of 25) struggling to get a job and a meaningful future.

Those are important monetary policy markers at a time when huge public debt and budget deficits offer no space for fiscal support to economic activity and employment creation.

The current patterns of demand for money in the euro area’s private sector also reflect a number of weak points in real economy.

Lending to households, for example, has been growing at a sluggish annual rate of 4% in June and July. That is consistent with largely flat retail trade volumes since the beginning of the year, and the fact that private consumption is far from firing up rising inflation pressures.

More worrying is a paltry 1.7% annual increase in euro area’s corporate loans over the last few months – an ominous sign that borrowing to finance business investments has virtually collapsed. Corporations apparently don’t feel the need to expand factory floors to meet expected sales – because the weak demand can be readily served with existing production capacities.

Summing it all up, the euro area’s total lending to the private sector in June and July has been growing at a lackluster annual rate of 3.5%. That partly explains why the growth of the broad monetary aggregate, M3, has been nearly halved since the beginning of this year to 7.6%.

So, where is all the money going?

The overwhelming majority of bank lending in the euro area goes to the public sector. Last June and July, loans to general government were growing at a hefty annual rate of 12.8%. And, on current evidence, there are no indications that the strong government loan demand is crowding out the financing needs of euro area’s households and non-financial corporations.

The way forward, therefore, is clear. The euro area monetary policy needs to support the economy to settle on a steady and sustainable growth path.

How likely is that?

Such a monetary policy setting is unambiguously indicated by a weak private sector demand, difficult labor market conditions and large government financing requirements.

A more important question here is that governments should not be dumping their economic mismanagement on the monetary policy. As a rule, the monetary policy should never bear the entire burden of economic stabilization.

An effective and politically responsible economic policy mix should consist of sound fiscal policies, structural reforms aiming at flexible and balanced labor and product markets – and a monetary policy focusing on price stability.

Some people may argue that “this time it’s different:” We now have conditions of an exceptional crisis that call for urgent and extraordinary measures of economic policy.

It’s true that the euro area economies have been hit by an unexpectedly violent pandemic shock. But it is also clear that member countries of a profoundly integrated economic and monetary union have been left to individually deal with intractable sanitary conditions, crashing economic activity, and rising unemployment and poverty rates.

That, of course, is not the way it should be. And, surprisingly, the EU moved fast to adopt an epochal recovery package of €750 billion proposed by Germany and France in May 2020.

Since then, however, the EU Commission has only managed to schedule an €80 billion disbursement by the end of this year.

And there is worse. The entire process of EU’s urgent economic recovery management has been bogged down in “rule-of-law” disputes with Europe’s “illiberal democracies” -- even though those €750 billion were meant to support programs for a “greener, more digital and resilient” European economy.

So, here again, we have a classic case where governments are dumping their economic mismanagement on money printing operators.

The euro area monetary authorities will now have to manage alone the delicate transition of a cyclical upswing toward a steady and sustainable growth path. Luckily, odds are that they will succeed because they will be operating in an environment of relatively stable costs and prices.