Mario Draghi: On the importance of policy alignment to fulfil our
economic potential
Text of the 5th Annual Tommaso Padoa-Schioppa Lecture by Mr Mario Draghi, President of
the European Central Bank, at the Brussels Economic Forum 2016, Brussels, 9 June 2016.
* * *
The Footnotes can be found at the end of the text.
In a speech in Vienna last week, I explained why monetary policy could deliver the appropriate
level of stimulus to the economy, even in a setting where interest rates are close to their
effective lower bound.[1] As inflation is ultimately a monetary phenomenon, a committed central
bank can always fulfil its mandate. And that is true independently of the stance of other
macroeconomic policies.
But monetary policy does not exist in a vacuum. The situation of central banks is better
described as independence in interdependence, since other policies matter a great deal. They
can buttress or dilute the effects of our policy. They can slow down or speed up the return to
stability. And they can determine whether stability is accompanied by prosperity, which is
directly relevant to the social cohesion of the euro area.
It is these interactions, and why they matter, that I would like to talk about today.
Policy interactions in stabilising the economy
The objective of the ECB is defined as delivering a rate of inflation below but close to 2% over
the medium term. But the medium term is not a fixed period of time. When faced with adverse
shocks, the pace at which monetary policy can bring inflation back to the objective depends
on two factors: the nature of the shock itself, and the conditions in which monetary policy
operates.
Some types of disturbance will inevitably depress inflation for longer than others and make the
return to the objective slower. The recent succession of global oil supply shocks is a prime
example. In that context, the job of monetary policy is not to fight short-term shocks to prices,
but to prevent them from feeding into longer-term inflation dynamics - or put another way, it is
to make sure that the effect of shocks on inflation is no more persistent than it needs to be. So
when we talk about returning inflation to our objective without undue delay, this is what we
mean. The return to price stability should take no longer than implied by the nature of the
shocks we are facing.
But this is not entirely dependent on our actions, due to the second factor - the conditions in
which we operate. Monetary policy can act decisively to support demand, to stabilise inflation
expectations and to avert second round effects on wages and prices, which is exactly what the
ECB has done over the past two years.[2] But the orientation of other policies also influences
the speed with which output returns to potential. So if other policies are not aligned with
monetary policy, inflation risks returning to our objective at a slower pace.
There are a number of policy areas that matter in this regard.
First, for monetary policy to stoke demand and inflation, it matters crucially whether the
financial system is able to relay our policy impulses efficiently to the economy. In the euro area
that transmission mechanism has been impeded repeatedly in the past, initially by rising risk
premia linked to unwarranted fears about the survival of the euro area, and later by widespread
bank deleveraging.[3] That has diluted the effectiveness of our stimulus and lengthened the
"long and variable" lags over which monetary policy works.
We have compensated for this by designing our measures to remove transmission blockages,
as well as including an asset quality review in the comprehensive assessment of bank balance
sheets that we launched in 2013. Both measures have helped ease financing conditions, as
we can see in our bank lending surveys. But bank balance sheets have not yet been fully
repaired, as illustrated by the high stock of non-performing loans in some parts of the euro
area. So more work-out of these non-performing assets will have to take place, and the
conditions for that will have to be put in place by the right policies and authorities.
Second, it matters for monetary policy whether fiscal policy is steering aggregate demand in
the same direction, and how strongly. Fiscal policy was contractionary for several years in the
euro area following the loss of confidence in sovereign credit in 2010, and the negative effect
on growth was exacerbated by the fact that consolidation in some countries was implemented
mainly through tax rises rather than current spending cuts.[4]
This placed the full burden of macroeconomic stabilisation on monetary policy. And in a context
of disrupted transmission, that has led to a slower return of output to potential than if fiscal
policy had been more supportive.
This is why the ECB has said many times that fiscal policy should work with not against
monetary policy, and the aggregate fiscal stance in the euro area is now slightly expansionary.
But supporting demand is not just a question of the budget balance, but also of its composition,
especially the tax burden and the share of public investment. So we should not see fiscal policy
as solely a macroeconomic tool, which is only available to countries with strong public finances.
We should also see it as a microeconomic policy tool that can enhance growth even when
public finances need to be consolidated.
Third, it matters for monetary policy whether the right structural policies are in place. Structural
reforms can help limit the depth and duration of shocks, which in turn supports the anchoring
of inflation expectations and keeps real interest rates low.[5] Such reforms can also reduce the
transmission lag of our measures, since a more flexible, more responsive economy is likely to
transmit monetary policy impulses faster.[6] And they produce higher potential growth, which
leads to higher investment and hence a higher equilibrium real rate. That creates the conditions
for the central bank to return to conventional interest rate policy as the means to deliver price
stability.
In the euro area, many structural reforms have been implemented in recent years, and
especially in those countries worst-hit by the crisis. The benefits can now be seen. But there
are many more benefits still to aim for, and so much more needs to be done.
Finally, uncertainty over the institutional stability of the euro area also matters for monetary
policy, since it too can slow down the transmission of monetary policy. Firms that lack sufficient
visibility over their operating environment over the years to come may understandably choose
to deter or even abandon investment plans. That is especially so when the return on those
investments depends strongly on the size and openness of the market provided by the euro
area and the European Union. This has been clear in the past when the future of the euro area
has been called into question.
And that sort of uncertainty not only impacts on firms that borrow to finance real investment. It
can also affect the saving rate of firms and households, as the perception of higher risk can
call for higher precautionary savings. This would obviously run against the efforts of monetary
policy to stimulate higher investment and consumption.
So I will only note once more the critical need to restore clarity and confidence on the
institutional setup of the euro area. We know that the current setup is incomplete. There is a
large degree of agreement on what its shortcomings are, and many proposals have been put
forward on how to overcome them. Progress in this field is necessary for the long-term, but it
is also relevant for the short-term because of its effect on investment. Indeed, perhaps the best
way to raise output today is to remove the drag on confidence that results from such
uncertainties.
Summing up, there is a large degree of interaction between monetary policy and other policies
that may in principle be geared towards different objectives. Such interactions do not prevent
a determined central bank from achieving its objective. But they do affect the time frame over
which we can do so. What this implies is that, for stabilisation to occur no more slowly than is
strictly necessary, all policy areas have a role to play.
And in fact, all policymakers should have a strong motivation to do so, because time matters.
A too-slow return of output to potential is far from innocuous. On the contrary, it has lasting
economic consequences, since it can ultimately lead to potential being eroded as well.
It is well-documented for instance that workers who remain unemployed for too long may suffer
the effects throughout their life, in the form of reduced employability, reduced productivity and
reduced income - so-called hysteresis.[7] That is particularly true for younger workers who are
unemployed during the all-important formative years of their careers and may suffer from
labour market "scarring".[8] In the euro area structural unemployment is estimated to have risen
during the crisis, while youth employment remains high.[9]
There is also emerging evidence that growing below potential for too long can erode that
potential through its effect on productivity growth. When uncertainty is high, a "wait-and-see"
attitude can cause the most productive firms not to expand as much as they would otherwise,
and the least productive firms not to contract as much as they should.[10] In other words - and
contrary to what is often claimed - too-weak demand can slow down "creative destruction",
whereas stronger demand can accelerate it. And there are signs of such effects in the euro
area, too.[11]
The cost of delay, then, is that labour and productivity suffer, and the output gap closes in the
"wrong way" - instead of output rising towards potential, it is potential that falls towards current
output.
So it is in fact in everybody's interest to act without undue delay. For the ECB, this means that
we do not let inflation undershoot our objective for longer than is avoidable given the nature of
the shocks we face. For others, it means devoting every effort to ensuring that output is
returned to potential before subpar growth causes lasting damage. And given the harm that
has already occurred to potential growth during the crisis, it also means acting decisively to
raise potential.
While keeping output close to potential is about the right policy mix, raising potential is above
all about structural reforms. This ultimately comes down to two factors - employment and
productivity. And in both areas there is considerable scope for the euro area to raise output
with determined reform efforts.
Raising potential growth
In terms of employment, we know that the euro area faces a long-term drag from its
unfavourable demographics. But even accounting for that, I see substantial leeway to lift output
in the euro area by exploiting the other margins which determine employment: first, by reducing
the trend unemployment rate, which remains too high in many countries; and second, by
raising participation rates, which are still short of international norms in several jurisdictions.
Reducing trend unemployment is in part about reversing the hysteresis effects I described
above. But it is important to remember that the crisis only added to an already troubling picture:
structural unemployment in the euro area was estimated at around 9% even going into the
crisis, compared with just 5% in the US. This is a consequence of structural features of euro
area labour markets which have been "ratcheting up" unemployment over successive cycles.[12]
And it implies that there is a large, latent potential in the euro area labour force which can be
unleashed with appropriate labour market and activation policies - and more so than in other
advanced economies.
Experience during the crisis has demonstrated how such reforms can work. Reforms
implemented by Portugal under its adjustment programme are estimated to have reduced the
unemployment rate by around 3 percentage points over the 2011-2014 period.[13] Likewise, the
Spanish labour market reform in 2012 has been a factor supporting employment growth since
then.[14] This should give encouragement to reforming countries to continue their efforts - and
in particular those where high unemployment has persisted for so long that it has been allowed
to become a social norm.
But the challenge is not just moving people from unemployment into employment, it is also
raising the size of the workforce - which is where participation comes in. Though the euro area
fares quite well in international comparisons, participation rates in some Member States remain
relatively low, with a roughly 15 percentage point difference between the best and worst
performers. This implies that there is also a latent potential to raise employment on this margin
with the right structural policies. For example, we have seen participation rates of older workers
grow strongly during the crisis, due in part to pension reforms adopted in many euro area
countries.[15]
Still, despite this untapped reserve for accelerating employment growth, we cannot avoid the
fact that, over time, the inherent speed limits resulting from the euro area's unfavourable
demographics will start to bite. The euro area's working age population is projected to start
gradually decreasing in the next decade. In that context, employment growth is likely to start
decelerating in the not-too-distant future, even with determined structural reforms, as a higher
share of people in work will no longer be able to offset the fall in working age population. Even
higher expected migration is unlikely to be able to fully offset this natural population decline.[16]
Public policy can certainly help temper these effects through its role in receiving and integrating
migrants. But since policy cannot do much to alter long run demographic trends, the implication
is that raising long-term growth will require a complement - namely, raising productivity.
Raising productivity is difficult. It requires a broader set of reforms, and those reforms typically
encounter greater resistance from vested interests. That is why many countries have found it
easier to reform the labour market than other areas during the crisis, and indeed repeated
attempts since the turn of century to make the Europe "the most competitive and dynamic
knowledge-based economy in the world" have produced only meagre results.[17] Given the weak
outlook for euro area growth, however, tackling the productivity challenge can no longer be
delayed.
Broadly speaking, productivity growth comes through two channels. The first is within-firm
growth, which depends on the generation and diffusion of new innovations and management
techniques. The second is across-firm growth, which depends on the movement of resources
from the least to the most productive firms. The euro area's comparatively weak performance
derives from both.
Indicators on research and development suggest that the euro area is lagging behind in terms
of innovative capacity, and particularly in the services sector. Indeed, the diffusion of
information and communication technology appears to have contributed much less to services
productivity growth than in the US, and this accounts for much of the weaker productivity
performance of the euro area since the mid-1990s.[18]
At the same time, employment in euro area is undergoing a secular shift from manufacturing
to services, and this has only been exacerbated by the patterns of job creation since the
crisis.[19] Such shifts are of course taking place in all advanced economies. But since
productivity growth in the services sector is often lower in the euro area, it constrains our
aggregate productivity more.
Yet this picture is not necessarily a cause for pessimism.
For a start, it suggests that there is quite some scope for productivity catch-up through adopting
digital technologies. So the debate that is currently raging among US economists about
whether the great waves of technological innovation are now over is, for the time being, less
relevant.[20] For the euro area the key question is how to create the conditions for more firms to
move towards the productivity frontier.
What is more, the secular shift from manufacturing to services can be consistent with higher
productivity if resources are well allocated. In fact, there are very large differences between
the most and least productive firms within each sector, even more so than across sectors.[21]
This implies that, even in a services-oriented economy, aggregate productivity can still be
improved.
So the euro area faces a twin policy challenge: to get more firms in each sector to the
productivity frontier, and to get more labour and capital to those productive firms. And crucially,
this would not only boost output, but also employment and wage equality, since labour would
be concentrating in firms that are both growing and demanding higher value skills.
To achieve this there are, in my view, three policy priorities.
First is addressing the structural barriers to knowledge diffusion within Europe. This has many
facets, but critical are policies that increase trade openness and facilitate firms' participation in
value chains, as well as a competitive business environment that favours the adoption of
superior managerial practices and organisational structures.[22] The most powerful "quick win"
we could make here would be to complete the single market, especially in services, since that
would automatically accelerate diffusion from the European frontier where we already have
many world leading industries.[23]
For firms to integrate effectively into the single market, however, they need to be able to scale,
which is why the second priority is to create the conditions for the most productive firms to
expand quickly and attract resources. This depends on well-functioning product and labour
markets, a financial system that channels capital to dynamic firms, and policies that prevent
resources from becoming trapped in unproductive firms, such as efficient judicial systems and
bankruptcy laws. Change of that nature creates opportunities, but it can also be perceived as
threatening for individual workers. So adequate social safety nets have to be in place, too.
That is also why the third priority is improving human capital. This would benefit workers who
would gain higher pay due to better-matched skills. And it would benefit productive firms by
reducing the skill mismatch that constrains their growth.[24] Making progress in this area comes
down primarily to education, but labour market reforms, such as lifelong learning schemes and
removing labour market dualities, could also make an important contribution - for instance, by
providing greater opportunities for both younger and mature workers to gain experience and
access training, both of which help raise their individual productivity.
Ultimately, investing in human capital is the key ingredient in making growth both stronger and
more inclusive. And over time such investment would help the euro area not just to converge
to the productivity frontier, but also to shift it out.
Each country of course has its own challenges. But few euro area countries are displaying high
productivity growth, so there is little doubt that progress could be made almost everywhere.
That is one reason why the recent Five Presidents' Report called for a new convergence
process among euro area countries, which would move all countries towards best practices on
structural reforms.[25] What is now crucial is that we move towards a common consensus on
what the necessary reforms are, how countries should implement them, and then, that the
process starts.
Conclusion
There are many understandable political reasons to delay structural reform, but there are few
good economic ones. The cost of delay is simply too high.
Given the interactions between policies that I have described, it is in everyone's interest that
the various strands of policy buttress each other - if only because that would shorten the time
it takes for each to produce its effects. And that would mean that we can bring growth back to
potential before potential itself becomes damaged.
Of all the ways to accelerate the realisation of our economic potential, perhaps the simplest is
to remove the uncertainties that hamper long-term decisions and hold back investment. And
speaking here in Brussels, I can only underline in this context the costs of postponing the
reform of EU and euro area governance that all agree is necessary, and by the same token,
the boost to prosperity and stability that would result from removing those uncertainties, without
undue delay.
1
Draghi, M. (2016), "Delivering a symmetric mandate with asymmetric tools: monetary policy in a context of low
interest rates", speech at the ceremony to mark the 200th anniversary of the Oesterreichische
Nationalbank, Vienna, 2 June 2016.
2
For a fuller explanation of this point see Praet, P. (2016), "The ECB's fight against low inflation: reasons and
consequences", speech by at LUISS School of European Political Economy, Rome, 4 April 2016.
3
For evidence on disruptions in monetary transmission see Ciccarelli, M., Maddaloni, A., and Peydró, J.-L.
(2013), "Heterogeneous transmission mechanism: monetary policy and financial fragility in the Eurozone",
Economic Policy vol. 28, issue 75, July 2013.
4
For evidence on the impact of the composition of fiscal adjustment on output see Alesina, A., Favero, C., and
Giavazzi, F. (2014), "The output effect of fiscal consolidation plans", Journal of International Economics,
forthcoming.
5
For an elaboration of this argument see Coeuré, B. (2014), "Structural reforms: learning the right lessons from
the crisis", speech at the Bank of Latvia Economic Conference 2014, Riga, 17 October 2014.
6
For more on this point see Draghi, M. (2015), "Structural reforms, inflation, and monetary policy", introductory
speech at the ECB Forum on Central Banking, 22 May 2015.
7
For more on this phenomenon see Ball, L. (2009), "Hysteresis in unemployment: old and new evidence", NBER
working paper 14818, March 2009.
8
See for example Arulampalam, W., Gregg, P., and Gregory M. (2001), "Unemployment scarring", The Economic
Journal, vol. 111, November 2001.
9
The European Commission estimates euro area structural unemployment to be 9.7% in 2016.
10
See for example Riley, R., Rosazza-Bondibene, C. and Young, G. (2015), "The UK productivity puzzle 2008-
13: evidence from British businesses", Bank of England Staff Working Paper 531. See also Bloom, N., Floetotto,
M., Jaimovich, N., Saporta-Eksten I., and Terry, S.J. (2014) "Really Uncertain Business Cycles", Stanford
University mimeo.
11
Gamberoni E., Giordano, C., and Lopez-Garcia, P. (2016), "Capital and labour (mis)allocation in the euro area:
some stylised facts and possible determinants", mimeo, ECB.
12
See Anderton, B. et al (2015), "Comparisons and contrasts of the impact of the crisis on euro area labour
markets", ECB Occasional Paper Series, No. 159, February 2015. This phenomenon had already been noted
in Blanchard, Olivier, and Justin Wolfers (1999), "The role of shocks and institutions in the rise of European
unemployment: the aggregate evidence", NBER Working Paper 7282.
13
Vansteenkiste, I. (2016), "Did the Crisis permanently Scar the Portuguese Labour Market?: Evidence from a
Markov-Switching Beveridge Curve Analysis", forthcoming.
14
OECD (2013), "The 2012 Labour Market Reform in Spain: A Preliminary Assessment".
15
See Anderton, B. et al (2015), ibid.
16
European Commission (2015), The 2015 Ageing Report.
17
Lisbon European Council, 23-24 March 2000, Presidency Conclusions.
18
Bloom, Sadun, and Van Reenen (2012), "Americans do IT better", American Economic Review, 102,1.
19
ECB (2015), "What is behind the recent rebound in euro area employment?", Economic Bulletin, Issue 8/2015.
20
See for example Gordon, R.J. (2016), "The Rise and Fall of American Growth: The U.S. Standard of Living since
the Civil War", Princeton U.P.
21
Syverson, C., (2011), "What Determines Productivity?", Journal of Economic Literature, 49(2): 326-65.
22
OECD (2015), The Future of Productivity.
23
Coeuré, B. (2014), ibid.
Anderton, B. et al (2015), ibid.
25
Juncker, J.-C. et al, "Completing Europe's Economic and Monetary Union", June 2015.