Yves Mersch: Policy needs, knowns and unknowns in the aftermath of
the crisis
Keynote speech by Mr Yves Mersch, Member of the Executive Board of the European
Central Bank, at UBS, Zurich, 4 February 2016.
* * *
I would like to thank Valerie Jarvis for her assistance in preparing this speech.
Ladies and Gentlemen,
I would like to thank Valerie Jarvis for her assistance in preparing this speech.
Coming out of a crisis, one of the biggest challenges that policymakers face is uncertainty
about the state of the economy. We can respond to this, of course, by looking at stylised
indicators, such as inflation or employment. But for a forward-looking monetary policy, that's
not sufficient. We need to know the strength of the inflation pressures building up over the
medium-term - that is, whether the economy is over-heating or under-cooking relative to its
underlying potential.
It is for that reason that central banks have traditionally used the concept of potential output -
the level of output consistent with price stability - to gauge inflationary pressures.1 If actual
output is above potential output, there is a positive "output gap" and we can expect upward
pressures on inflation. And if actual output is below potential, the opposite will be the case
and disinflation will follow.
In general terms, I see nothing wrong with this way of thinking. The economy is vastly
complex and we need simplifying frameworks for assessing "how it's doing" overall. In
particular, it's self-evident that central bankers need some way of judging the degree of slack
in the economy and its effect on prices. If there are either ample underused resources or
binding capacity constraints, monetary policy may need to respond pre-emptively.
But the concept of the output gap becomes less useful, in my view, if it morphs from being a
broad signpost for policy into a de facto intermediate target for policy. If policymakers start to
believe that they can steer the output gap towards zero - effectively, to "fine-tune" policy in
order to achieve that - they are liable to come unstuck. And our recent experience in the
euro area, coupled with my assessment of how the economy is evolving, only reinforces that
view. There are three main reasons why I say this.
The first is that estimating the output gap in real time is fraught with uncertainty, and the
misleading signals this can give to policymakers have been painfully exposed by the crisis.
In 2007, real time estimates from a range of international institutions - the European
Commission, the IMF, the OECD - envisaged the euro area output gap at that time to be in
the range of minus 0.6% to minus -0.2%. According to the most recent estimates, however,
we now think that the euro area output gap in 2007 was in the range of plus 2.6% to 3.3%.
This shows how wrong real-time estimates can be. Not only was the size of the output gap
significantly mis-measured - with real-time estimates subsequently revised up by some
3-4 percentage points - but, more importantly, even the sign of the gap was wrong.
This example is not just an aberration: large errors are inherent in the concept of the output
gap. And worse still, at the critical moments when policymakers need to understand what's
happening in the economy - in the build-up to and aftermath of crises - measures of output
gap are often at their least dependable.2
So that poor track record in the run up to the crisis is one reason why I'm sceptical of
finetuning. But there's also a second one: such difficulties are only likely to increase given
current trends in the economy and society - and not just in estimating potential output, but in
measuring actual output too.3
We're living through an era where the nature of production and consumption is changing
rapidly. And that has profound implications for our ability to understand the economy - or, at
least, our ability to adequately measure what is actually being produced and how efficiently
this is achieved.
Consider, for example, the difficulties that the digital economy creates for measuring labour
input. As highlighted in a recent statistical study, the growth of the "sharing economy" is
creating new opportunities for self-employment: people who work on a shift pattern in a retail
store might spend their off-days driving an Uber taxi. This kind of "micro" activity might be
less simple to measure than the services of traditional taxi firms, as it may be less likely to
show up in earnings data.4
Measuring investment in a digital economy is equally tricky, as much of it concerns intangible
capital. We have now started classifying R&D as investment, which is welcome, but it's only
the most tangible part, i.e. technological innovation, which is typically recorded. Business
model innovation is excluded. What's more, investment in organisational capital and human
capital are not recorded in national accounts, even though this will become ever more
important part of capital growth as more jobs become automated and skill premia rise.
Even more complex is how to measure the value of digital innovations in terms of, say, the
time they save for consumers or for national output. How should we value the ability to
conduct banking via a smart phone? Or get directions through Google maps?5
This isn't just a question of the so-called "consumer surplus", which is about welfare. It's a
question of whether improvements in quality are being properly valued. And as more and
more services are provided in this intangible way, the likelihood of significant
mismeasurement of the full value of goods and services in our economies rises.
The flipside of digital services is that more activities that were previously part of the market
economy can now be produced at home. A person wanting to arrange a holiday, for
example, no longer needs to visit or phone a travel agent, but can research and book the
whole trip herself online. The sales of hotels and flights still contribute to GDP. But the work
formerly done by the travel agent, which has now effectively been outsourced to the
consumer, disappears. This also raises questions for how we measure productive activity.
These examples highlight the difficulties of understanding how the economy is developing -
let alone estimating its potential growth rate. To be sure, we should aim to rise to that
challenge and update our statistics to capture such changes. But clearly, as policymakers,
we also have to be humble about what can know. And in that context, imagining that we can
reliably hold the output gap around zero is simply hubris.
However, the fine-tuning mindset is not only a problem because we don't know exactly the
size of the output gap. It's also a problem because it sustains huge expectations about the
ability of monetary policy to steer the economy wherever it wants. And such expectations, in
my view, are becoming less and less appropriate given the environment we will likely face
coming out of the crisis.6
This is the third reason for my scepticism.
We may well be entering a world where established macroeconomic relationships no longer
hold with the regularity we once thought. We face an outlook of ageing populations, high
savings, persisting weak investment, increasingly interlinked economies at the global level
and, potentially, lower real equilibrium interest rates. In that environment, monetary policy
transmission may become less predictable, and monetary policy itself might end up stuck at
lower bound more often.7
Some go as far as pretending that unconventional policies might even end up becoming
conventional.
All this wouldn't necessarily make monetary policy ineffective. But it would make the way in
which it works less regular. And in that context, sustaining the belief that we can hold the
economy on a string - that if we introduce X amount of stimulus it will affect economic growth
by Y% and lead to Z% inflation - would likely backfire and damage our credibility. It would be
preferable, in my view, for policymakers to admit the uncertainties they face in this new
environment and be humble about what they can achieve within it.
The productivity challenge
Even if the economy is changing in ways that we do not yet fully grasp, there are certain
facts that remain immutable. Most importantly, we know that what ultimately matters for
longterm prosperity - and increases in standards of living - is productivity. That's the case in any
economy with limited resources. But it's even more important in an economy with
demographic challenges, where a shrinking workforce has to support a growing retired
population. And that is, of course, the case in the euro area today.
It's well documented that productivity growth in the euro area has long been lacklustre in an
international context. Since the early 1990s euro area labour productivity growth per person
employed has been falling behind the US, and that has continued during the crisis. Since
2008, euro area productivity has averaged only 0.2% per year, while US it has increased by
around 1.0% a year over the same period.8
In the US this is also seen as a low figure, and recently it's been debated there whether the
productivity slowdown seen in the US over recent years isn't simply the outcome of the
mismeasurement I highlighted earlier. This is based on the observation that the productivity
slowdown has been associated with marked declines in employment, whereas typically the
latter would tend to raise productivity.9
There may well be some truth in this. After all, it's well-known that the national accounts often
take a long time to fully count the effects of innovations in technology. For example, US
national accounts did not reflect the output from automobiles for nearly 15 years after the
Ford Model T was available.10
But even if we are mis-measuring productivity, we still need to raise it: the euro area is still
lagging considerably behind others. And worse still, we only seem to be able to achieve
productivity growth if it's traded-off against employment.
In recent years, much of the (meagre) productivity growth seen in the euro area has come
through labour shedding rather than from strong value added growth. And if those displaced
don't have the right skills to find another job, structural unemployment is likely to increase
further, or they will be forced to consider low productivity sectors, and then aggregate
productivity growth will stagnate once more. Neither scenario is desirable or sustainable.
So our aim must be to achieve high productivity growth at full employment. But how can that
be achieved? Essentially, there are two channels towards higher productivity growth, and to
combine productivity growth with full employment we need to employ both.
The first is within-firm productivity growth, which is about investing in or adopting new
technology. There's quite some debate, led by scholars like Robert Gordon, as to whether
the great waves of technological innovation are now behind us.11
But whether or not that's the case, I don't see it as a barrier to productivity growth in the euro
area. In fact, we still have a long way to go to capitalise on the last wave of innovation - the
ICT revolution - which many firms have not yet incorporated into their business models.
Indeed, a large part of the difference in productivity performance between the US and the
euro area can be attributed to the fact that US firms have invested more in ICT capital, and
crucially, in the human and organisational capital necessary to full reap the benefits of it.12
There's a lot of scope for European firms to catch-up in terms of improving management
quality, to make the organisational changes required by new technologies, and in terms of
improving ICT skills, so that workers can operate those technologies effectively.13
But looking further ahead, it's clear we need to reflect on what types of skills will be needed
for the next phase of the ICT revolution: the replacement of routine service occupations by
robotics.14
There will obviously have to be larger human capital investment in people who will design
robots. But greater upskilling and professional polyvalence will also be needed in the people
who use them: those who work in automated warehouses, for example, may have to have
10
http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/2016/01/13/090224b08405ea05/
2_0/Rendered/PDF/World0developm0000digital0dividends.pdf. Similarly, Diane Coyle notes that the UK's
Statistical Abstract for 1871-85 - in retrospect, the height of the industrial revolution - devoted just 12 of the
200 pages on the economy's output and trade to manufacturing and transport "Commentary: Modernising
Economic Statistics: Why It Matters," National Institute Economic Review, No. 234 (November 2015).
11
Robert J. Gordon, The Rise and Fall of American Growth (Princeton UP; 2016). See also: Juan F. Jimeno,
Frank Smets and Jonathan Yiangou, "Secular stagnation: A view from the Eurozone," Secular Stagnation:
Facts, Causes and Cures, ed . Coen Teulings and Richard Baldwin (CEPR, 2014).
12
Bart van Ark, Mary O'Mahony and Marcel P. Timmer, "The Productivity Gap between Europe and the United
States: Trends and Causes", The Journal of Economic Perspectives, Vol. 22, No. 1 (Winter, 2008), pp. 25-44.
13
Carol Corrado, Jonathan Haskel, Cecilia Jona-Lasinio and Massi miliano Iommi , Innovation and intangible
investment in Europe, Japan, and the United States, Oxford Review of Economic Policy, Vol: 29 (Oxford,
2012), pp. 261-6.
14
Carl Frey and Michael Osborne, The Future of Employment: How susceptible are jobs to computerisation?
(Oxford, September 2013).
skills in logistics, (re-)programming, and routine or basic maintenance. Are our education
systems ready for that challenge?
Moreover, what will happen to those who are displaced by new technologies?
Economic theory tells us that technological gains raise disposable income and hence create
new demand somewhere in the economy. But as the literature on "hollowing out" has shown,
technological advances may lead to a polarisation of jobs - at the expense of the
middleskilled.15
And this seems to be evident also in recent employment growth seen in the euro area, with
the bulk of the recent employment growth seen concentrated in the lower productivity
sectors.16 So the risk is that the one effect offsets the other: technological advances in some
sectors are neutralised by gains in employment in other, lower productivity ones. That might
be damaging for social cohesion.
This is why the second channel is crucial: across-firm productivity growth.17
To combine productivity growth with full employment, it's essential that labour can flow to the
most productive firms, rather than being bottled up in the least productive. That in turn
requires that the most productive firms are able to grow and create new jobs. And it requires
that workers have the incentives, skills and means to move to them. In an average mature
economy, around 50% of productivity growth comes from such reallocation.
When people think about reallocation, they tend to think in terms of people moving across
sectors. But typically, that only accounts for a small share of productivity growth.18
What's more important for mature economies is within-sector reallocation, which means
shifting resources towards the most productive firms within each sector of the economy.
That's encouraging because expecting, say, steel workers to become bankers is not realistic.
But expecting them to move to better firms within their sector is.
For this to happen, however, the structural conditions have to be right. Product markets have
to allow market entry, to challenge unproductive firms; they have to support firm growth, so
that the most productive can reach their optimal size; and they have to facilitate quick
bankruptcy, so that the weakest firms can exit. Similarly, labour markets have to set
incentives for mobility; support retraining and upskilling where needed; and allow wages to
match productivity at the firm level, creating proper market signals.
Clearly, for firms to prosper in this environment, they need to be agile. Increased agility
would enable firms to switch production towards the higher quality, distinctive, more
customised goods and services increasingly demanded by ever more sophisticated
customers, which has long been the strategy of Europe's leading exporters.19 And since such
goods and services typically command a price premium in the market, that would in turn lift
the value of output, raise national income and secure and expand employment.
15
David Autor and David Dorn, The Growth of Low-Skill Service Jobs and the Polarization of the US Labor
Market, American Economic Review, 2013, 103(5): 1553-1597.
16
See the article entitled, "What is behind the recent rebound in euro area employment?", ECB Economic
Bulletin, No. 8 (December 2015).
17
Ulf Lewrickb, Lukas Mohlera and Rolf Weder, When firms and industries matter: understanding the sources of
productivity growth, BIS Working Papers No 469 (October 2014).
18
Among several other papers, see e.g. Krizan, C.J., Foster, L. and Haltiwanger, J.C. (2006), "Market selection,
Reallocation, and Restructuring in the U.S. Retail Trade Sector in the 1990s", The Review of Economics and
Statistics, MIT Press, Vol. 88(4), pp. 748-758, November.
19
Valerie Jarvis and S.J. Prais, "The Quality of Manufactured Products in Britain and Germany," International
Review of Applied Economics, Vol. 11:3 (1997), 421-438.
Indeed, even with the technological advances at our disposal, advanced economies such as
the euro area cannot afford to try to out-compete the lower cost producers on price - not if
we want to maintain the benefits of our welfare states and less precarious patterns of
employment. Competing against lower cost producers would require either wages having to
fall to the levels of the least-cost producers or some substitution of higher-cost labour with
capital. Both effects would have adverse consequences for euro area workers.
This is not to say that cost containment is not a necessary condition for competitiveness.
Rather it is saying that cost considerations should not be the only element on which we
should aim to rebuild our economy in the aftermath of a severe crisis. All this raises many
questions for policy makers: what kinds of investments do we need for future growth? What
are the implications for workforce skills? How can we increase the degree of
entrepreneurship to realise innovative activity?
At the same time, policymakers cannot lose sight of the social consequences of such
changes. A world where jobs are being created and destroyed with ever greater speed, and
where people are expected to move regularly between them, is a world of greater insecurity.
So we need also to consider the readiness of our societies to cope with these changes, and
ask what type of new social models we will need to adapt to them. And crucially, so as not to
lose more time, we need to start today.
Conclusion
We are experiencing a period a transition.
Economically, we haven't recovered fully from the after-pains of the crisis.
Technologically, the jury is still out on whether the IT-driven transformation of work has
ended or will continue, and what this means in terms of productivity. What is clear however is
that we have to overhaul our traditional ways of measuring, assessing and reacting to
productivity and welfare indicators.
Socially, uncertainty will weigh heavily on people's shoulders in the years to come amid
these structural changes.
How should policymakers react? The fact that our established gauges have lost their
assumed precision does not mean that we have become clueless. In spite of the elevated
uncertainty, it is still possible to grasp the obvious.
Potential output may not the most reliable benchmark in the current environment. Moreover,
perhaps it misses the broader structural changes, which are of paramount importance in the
longer run pursuit of improvements in standards of living.
So it is crucial that policy makers pay heed to broad and thorough analyses, coupled with an
understanding of the limitations to our understanding we face at this time. In this way,
modest judgment and prudent action will provide the indispensable preconditions for
policymakers to live up to their responsibilities.