How to Climb a Mountain with Both Hands Tied

Against the background of lackluster global demand, economic growth in Europe has weakened again. In the eurozone, a third recession in less than seven years is a distinct possibility. Yet economic policy looks powerless. On the monetary side, although the European Central Bank (ECB) may still embark on a genuine quantitative easing, such action is unlikely to deliver a major boost because the benchmark 10-years government bond rates already only yield 1 per cent. On the budgetary side, fiscal space is scarce and the European discipline framework further reduces the leeway for action. Moreover, those governments that could embark on a stimulus are reluctant to renege on their domestic promises to balance the budget in the near term. Overall, there is some room for a monetary and fiscal boost, but it is unlikely to suffice to address the risks of a triple-dip.

Alternatives must therefore be considered. The most popular among European policymakers is structural reform. Since reforms, the reasoning goes, are needed to address high unemployment and slow productivity growth, they should be enacted without delay. Their swift and comprehensive implementation would help to revive growth. While the premise is undisputable, however, the conclusion is largely flawed. Reforms, especially of the labor market, often hurt growth for several quarters before they start supporting it. In normal times, such short-term effects can be offset by monetary accommodation, but this is precisely what cannot be done in the current situation. Furthermore, many structural reforms result in efficiency gains that lower inflation, which is normally good but undesirable when year-on-year price increases are already perilously close to zero.

There are admittedly a few structural reforms that result in higher growth, higher inflation or both. Simplifying administrative procedures is hardly harmful. Longer shop opening hours improve the service to consumers and create jobs, but they do not lower prices. Reforms that improve company access to finance increase investment and employment but do not give rise to adverse short-term effects. Pension reforms that lead people to work longer improve their lifetime income and to the extent that employees actually expect to have a job, lead them to consume more. As argued by the ECB's Benoit Coeuré in a recent speech, the same applies to reforms that improve future productivity and thereby raise expected incomes. So some reforms do good both in the long and in the short run. But the list is not long enough to ensure that even their comprehensive implementation would suffice to address growth weakness.

More generally, to increase aggregate supply or to strengthen the elasticity of supply when the feebleness of aggregate demand is already the binding constraint on growth is a disputable recipe. In an intriguing paper, Gauti Eggertsson and Paul Krugman even argue that high public and private indebtedness could result in a "topsy turvy" economy where structural improvements actually hurt output because lower prices increase the burden of debt and reduce aggregate demand instead of increasing it. This certainly does not apply to all euro area countries, but it may well apply to some.

This is where investment may fit in. In his first speech in front of parliament in July, the president of the European Commission, Jean-Claude Juncker, indicated his intention to support growth through launching a three-year investment package worth 300 billion euros. Investment, obviously, has the virtue of affecting both the demand and the supply sides. This is what makes it an attractive recipe. However, such a plan also raises questions: Why should companies invest if there is already excess supply? If it is governments that are expected to invest, where will they find the means for it? And is it desirable to increase supply any further? On second thought, investment may be a less attractive idea than it seems.

There is, however, a way out of the conundrum. Suppose that the government had the power to discard some of the oldest equipment used by companies in their production process and to force them to substitute it with new, more efficient equipment. This would trigger new investment that would contribute to increasing demand without affecting supply. There would be both growth support in the short term and higher productivity in the medium term.

Governments in fact have such power. They can tinker tax legislation to incentivize capital replacement and they can also legislate to eliminate inefficient capital. This is exactly what a tightening of emission standards does when applied to cars already in circulation: it forces car owners to discard their old, polluting vehicles and to replace them by new, more environment friendly ones. In the process the number of cars in circulation does not change meaningfully, but the new fleet is eventually younger and more efficient environmentally.

Doing the same on a large scale would require setting higher environmental and energy efficiency standards (for instance for the insulation of buildings, for energy consumption and for diesel emissions) and also ensuring that the price of carbon is high enough to incentivize investment in clean technologies. Such an initiative has been advocated for a long time by green activists.

Naturally, precautions have to be taken. First, for such an action not to be a waste of resources socially, it would need to concentrate on fields where the old capital is gradually becoming obsolete anyway and where public action would merely speed up its replacement. It is always possible to dig holes, bury machines and replace them with new ones, but any economist hesitates before recommending such action. Second, an acceleration of the renewal of the capital stock only makes sense if the new technologies are sufficiently mature. To trigger the replacement of old windows with more energy-efficient ones is one thing, but to create a solar panel bubble is another one, which has been tried at high cost fiscally and socially. Third, a depreciation of the existing capital would hurt the corporate sector's profits. It can only be contemplated within limits because whereas big firms are awash with cash, many smaller ones are hardly profitable.

The charm of regulation-triggered investment is that it does not rely on public spending, but this does not turn it into a magic bullet. There are obvious limits to what can be done in the short run to accelerate the transition to a more environmentally friendly economy and boost growth in the process. But together with public investment – where feasible – and the most growth-friendly reforms, such action should be used to help Europe escape from the trap it is at risk falling into. It may not be sufficient to avoid a recession, but at least it has a better chance of delivering growth support than inertia or an exclusive focus on structural reforms.

Jean Pisani-Ferry teaches at the Hertie School of Governance in Berlin and serves as commissioner-general for Policy Planning in Paris. He is a former director of Bruegel, the Brussels-based economic think tank