Mario Draghi: Structural Reforms, inflation and monetary policy
Introductory speech by Mr Mario Draghi, President of the European Central Bank, at the ECB
Forum on Central Banking, Sintra, Portugal, 22 May 2015.
* * *
Accompanying charts can be found at the end of the speech.
Summary
Structural and cyclical policies - including monetary policy - are heavily independent.
Structural reforms increase both potential output and the resilience of the economy to
shocks. This makes structural reforms relevant for any central bank, but especially in a
monetary union.
For members of monetary union resilience is crucial to avoid that shocks lead to consistently
higher unemployment, and over time, permanent economic divergence. It therefore has
direct implications for price stability, and is no less relevant for the integrity of the euro area.
This is why the ECB has frequently called for stronger common governance of structural
reforms that would make resilience part of our common DNA.
Structural reforms are equally important for their effect on growth. Potential growth is today
estimated to be below 1% in the euro area and is projected to remain well below pre-crisis
growth rates. This would mean that a significant share of the economic losses in the crisis
would become permanent, with structural unemployment staying above 10% and youth
unemployment elevated. It would also make it harder to work through the debt overhang still
present in some countries. Finally, low potential growth can have a direct impact on the tools
available to monetary policy, as it increases the likelihood that the central bank runs into the
lower bound and has to resort recurrently to unconventional policies to meet its mandate.
The euro area's weak long-term performance also provides an opportunity. Since many
economies are distant from the frontier of best practice, the gains from structural reforms are
easier to achieve and the potential magnitude of those gains is greater. There is a large
untapped potential in the euro area for substantially higher output, employment and welfare.
And the fact that monetary policy is today at the lower bound, and the recovery still fragile, is
not, as some argue, a reason for reforms to be delayed.
This is because the short-term costs and benefits of reforms depend critically on how they
are implemented. If structural reforms are credible, their positive effects can be felt quickly
even in a weak demand environment. The same is true if the type of reforms is carefully
chosen. And our accommodative monetary policy means that the benefits of reforms will
materialise faster, creating the ideal conditions for them to succeed. It is the combination of
these demand and supply policies that will deliver lasting stability and prosperity.
* * *
In every press conference since I became ECB President, I have ended the introductory
statement with a call to accelerate structural reforms in Europe. The same message was also
conveyed repeatedly by my predecessors, in three quarters of all press conferences since
the introduction of the euro. The term "structural reforms" is actually mentioned in
approximately one third of all speeches by various members of the ECB Executive Board. By
comparison, it features in only about 2% of speeches by governors of the Federal Reserve.
Our strong focus on structural reforms is not because they have been ignored in recent
years. On the contrary, a great deal has been achieved and we have praised progress where
it has taken place, including here in Portugal. Rather, if we talk often about structural reforms
it is because we know that our ability to bring about a lasting return of stability and prosperity
does not rely only on cyclical policies - including monetary policy - but also on structural
policies. The two are heavily interdependent.
So what I would like to do today in opening our annual discussions in Sintra is, first, to
explain what we mean by structural reforms and why the central bank has a pressing and
legitimate interest in their implementation. And second, to underline why being in the early
phases of a cyclical recovery is not a reason to postpone structural reforms; it is in fact an
opportunity to accelerate them.
The importance of structural reform
Structural reforms are, in my view, best defined as policies that permanently and positively
alter the supply-side of the economy. This means that they have two key effects.
First, they lift the path of potential output, either by raising the inputs to production - the
supply and quality of labour and the amount of capital per worker - or by ensuring that those
inputs are used more efficiently, i.e. by raising total factor productivity (TFP). And second,
they make economies more resilient to economic shocks by facilitating price and wage
flexibility and the swift reallocation of resources within and across sectors.
These two effects are complementary. An economy that rebounds faster after a shock is an
economy that grows more over time, as it suffers from lower hysteresis effects. And the
same structural reforms will often increase both short-term flexibility and long-term growth.
For example, reforms aimed at encouraging reallocation will not only support faster
adjustment, but also higher productivity through raising allocative efficiency.1 Reforms aimed
at strengthening competition will not just encourage greater price flexibility, but also higher
investment as young firms are able to enter new markets and expand more quickly.2
A comprehensive package of structural reforms will therefore tend to increase both resilience
and growth. These are clearly issues in which any central bank has a keen interest. But this
is especially true for the central bank of a monetary union - and even more so in the
conditions we face today. Let me explain why.
Increasing resilience to shocks
In terms of resilience, the ability of each economy in a monetary union to adjust quickly to
shocks is essential for price stability and, over time, for the long-term viability of the union.
This is because, faced with a negative demand shock, a more flexible economy will tend to
react by immediately lowering prices, but agents will then expect inflation to rise again as the
shock fades, ensuring a firm anchoring of inflation expectations. By contrast, an inflexible
economy is more likely to adjust through higher unemployment, which exerts a more
prolonged downward pressure on inflation and is therefore more likely to weigh on inflation
expectations. This in turn can lead to higher real interest rates and compound the effect of
the shock.
Whereas in a single country setting the central bank could respond directly to such a
contractionary effect, in a monetary union monetary policy cannot be tailored to
developments in particular countries. There are also no large-scale fiscal transfers across
countries in the euro area to play a compensating role in supporting demand. This implies
that economies with insufficient flexibility risk more prolonged disinflation, consistently higher
unemployment, and over time, permanent economic divergence.
The way different euro area economies have reacted to the crisis bears this point out. Labour
and product market rigidities contributed to a more painful adjustment process in the
stressed economies, which was initially driven more by compression of demand than by a
reduction of costs relative to other economies, albeit with differences across countries based
on their initial degree of flexibility (Chart 1).3 As a result, we now face a situation of significant
divergence in unemployment across the euro area (Chart 2).
This has direct implications for price stability: slow adjustment has contributed to the
protracted disinflation we have witnessed since 2011 and to making inflation expectations
more fragile. But it is also directly relevant for the ECB through its effect on the integrity of
the currency. Like any political union, the cohesion of the euro area depends on the fact that
each country is permanently better off within the union than without. Convergence is
therefore essential to bind the union together, while permanent divergence caused by
structural heterogeneity has the opposite effect.
For this reason, that every national economy is sufficiently flexible should be accepted as a
part of our common DNA. It has to be a permanent economic feature that comes with
participation in the euro area, in the same way that the Copenhagen Criteria are permanent
political features of membership of the EU.
And this is why, as I have said many times, I believe there is a strong case for governance of
structural reforms to be exercised jointly at the euro area level: to help each country to
achieve the necessary level of resilience; and to ensure that they maintain that resilience
permanently.4 Since structural reforms in any euro area country are a legitimate interest of
the whole union, there needs to be stronger ownership of reforms not just at the national
level, but at the European level as well.
Several countries have however made significant progress with structural reforms during the
crisis, and we can already see how this has altered the relationship between inflation and
unemployment. Various estimates of the euro area Phillips curve show that, while the slope
has varied over time, it has steepened in recent years. In particular, there is evidence that
inflation has become increasingly responsive to cyclical conditions in countries that have
reformed their product and labour markets, such as Spain5 and Italy6.
Raising potential growth
Besides this issue of resilience, as the central bank of the euro area we also have another,
equally direct interest in structural reforms. This is related to their effect on growth - or more
specifically, the challenges posed by a period of low potential growth.
International institutions currently estimate potential growth to be below 1% in the euro area,
compared with above 2% in the US (Chart 3).7 This is in part a result of the effects of the
crisis on investment and, via hysteresis, structural unemployment. But it also reflects weak
underlying trends in productivity growth and labour supply. Consequently, while some of the
effects of the crisis on investment and employment are expected to unwind, potential growth
is projected to remain well below pre-crisis growth rates.
This is problematic for at least three reasons.
First, it would mean that the output gap would close at a notably lower level of output, at
which point monetary policy would have to return to a more neutral stance (Chart 4). A
significant share of the economic losses suffered across countries would therefore become
permanent. Structural unemployment would stay around 10%. Youth unemployment would
also remain elevated, with devastating effects for individuals in terms of labour market
"scarring".8 And this would ultimately affect society as a whole as, given our demographics,
realising the potential of the young and their capacity for innovation is essential for long-term
sustainability.
Second, a situation of persistently low potential growth would make it even harder to work
through the debt overhang that still exists in parts of the euro area. For firms that took on
debt based on pre-crisis growth expectations, low potential growth acts as a major barrier to
new investment, as any profits generated will likely be absorbed by servicing existing debt.
And we do see signs that this effect has been operative in euro area: there is a clear
negative correlation between corporate debt-to-GDP levels in different countries at the
beginning of the crisis and the evolution of business investment since.
Third, low potential growth can have a direct impact on the tools available to monetary policy
to deliver its mandate. The reason is that low potential growth implies a lower equilibrium real
interest rate, which in turn means that, faced with a negative output gap, nominal policy rates
need to go lower still to steer output back to potential. This materially increases the likelihood
that central bank policy runs into the constraint set by the effective lower bound for interest
rates, which is not far below zero. It therefore also increases the likelihood that we have to
resort recurrently to unconventional policies to meet our mandate.
When in 2003 we clarified our objective to keep inflation below but close to 2%, we assumed
an equilibrium real interest rate of 2% on average.9 The probability of hitting the effective
lower bound under this assumption was very low. Today, imperfect indicators of the
equilibrium real rate, such as real forward rates at long horizons, suggest that it may have
fallen to much lower levels. In this context, higher potential growth would facilitate the
stabilisation task of monetary policy by allowing the equilibrium real rate to rise.
The untapped potential of the euro area
For all these reasons, structural reforms that reverse the downward drift in potential growth
are now vital for the euro area, which is why I believe, as the guardian of the currency, we
have a legitimate interest in talking about them. But we should recognise that our weak
longterm performance also provides an opportunity. Since many economies are distant from the
frontier of best practice in at least some policy areas, the gains from structural reforms are
easier to achieve and the potential magnitude of such gains is greater.
To give just one example, research by the OECD suggests that committed convergence
towards best practice across labour and product markets, tax policy and pensions would
raise GDP per capita by about 11% after ten years for the average EU country. In the US,
which starts from a more favourable position, the benefit would be under 5%.10
And it is not difficult to understand why the benefits of reform could be so high in the euro
area. High levels of structural unemployment, compounded by high numbers of
underemployed and discouraged workers, imply a latent potential in our economies for a
major positive shock to labour supply (Chart 5). We also have scope for a large catching-up
in terms of productivity growth. TFP has increased by only 1.5% between 2000 and 2014 in
the euro area, far below the 10.9% increase in the US over the same period (Chart 6).
The type of policies that could release this upward shock to potential growth are not just
those focused on price flexibility. They include, on the labour supply side, policies aimed at
providing job search support for the long-term unemployed and requalification for the low
skilled. And on the TFP side, policies that encourage the reallocation of resources - which
could be powerful in the euro area given the wide and skewed distribution between the least
and most productive firms11 (Chart 7) - and policies that accelerate the diffusion of new
technology, where the euro area on the whole lags some way behind the US (Chart 8).
There are many other examples one could give. The important point, however, is that in the
euro area today structural reforms are not about creating minor efficiencies or marginal
gains. They are about unleashing an untapped potential for substantially higher output,
employment and welfare. And in the current environment, this would play a crucial role in
ensuring that the ongoing cyclical recovery becomes a stronger, structural recovery.
Structural reform in a fragile demand environment
This discussion on the importance of structural reforms leads in principle to only one
conclusion: the earlier they take place, the better.
However, while most of us might agree with this statement in normal times, the fact that
interest rates have reached the effective lower bound, coupled with the still fragile cyclical
situation, makes the situation less straightforward. In particular, the question has been raised
as to whether implementing structural reforms when the economy is still weak would be
counterproductive, in the sense that it would make it harder to achieve our mandate by
further reducing short-term demand.
One argument that has been put forward in this context is that, if reforms lead to a credible
increase in aggregate supply, they will exert downward pressure on inflation expectations.
And if nominal interest rates cannot fall because monetary policy is at the lower bound, real
interest rates will then rise, creating contractionary short-term effects.12
A parallel argument in favour of postponing structural reforms relates to their short-term
effects on employment. The reasoning is that reforms implemented at the trough of the cycle
or too early in the recovery may increase job insecurity among workers, which may in turn
result in a rise in precautionary savings and thereby reduce consumption. Factors such as a
depressed housing market would also exacerbate these effects by hindering geographical
mobility and the reallocation of resources.13
There is some empirical foundation to these concerns. For example, research suggests that
reforms that increase employment flexibility, such as reducing employment protection, are
more likely to depress demand during downturns.14 I would however reject the conclusion
that this means all structural reforms should be postponed.
The reason is that the short-term impact of structural reforms does not just depend on when
they are implemented, but how - namely, the credibility of reforms, the type of reforms and
their interaction with other policy measures. And if structural reforms are well-designed along
these parameters, they can in fact have a largely neutral, if not positive impact on short-term
demand - and even in adverse cyclical conditions.
Credibility of reforms
First, if reforms are credible their positive effects on short-term demand, via confidence, can
more than compensate for any negative effects on inflation via increased supply.
This is because, for firms, an upward shift in potential growth implies higher expected
revenues and higher future profitability, which should in turn encourage them to bring forward
investment into the present. And investment, remember, raises both supply tomorrow and
demand today. It can therefore in no way be construed as being detrimental to our monetary
policy objective.
A similar logic applies to households and their life-cycle income. Reforms that raise
expectations of life-cycle income should immediately support current consumption. To give
just one example of this effect, an extension of the retirement age should lift not only
medium-term supply - by expanding the active population - but also short-term demand, by
reducing the need for precautionary savings ahead of retirement.
But credibility is crucial in determining how quickly these positive effects materialise. If there
is uncertainty about the timeline over which reforms will be implemented, or about the
commitment of successive governments to maintaining them, it will take longer for firms and
households to adjust their expectations and the benefits of reforms will be delayed.15
Moreover, if reforms are not perceived to be sustainable under a wide variety of conditions
Moreover, if reforms are not perceived to be sustainable under a wide variety of conditions -
for example, if a pension reform is unrealistic over the longer-term - agents will anticipate a
reversal in the future and refrain from adjusting their behaviour today.- for example, if a
pension reform is unrealistic over the longer-term - agents will anticipate a reversal in the
future and refrain from adjusting their behaviour today.
We have used our Euro Area and Global Economy (EAGLE)16 model to analyse for a
medium-sized euro area country the effect of credibility and timely implementation17 - in this
13
Andrews, D., A. Caldera Sanchez, and A. Johansson (2011), "Housing Markets and Structural Policies in
OECD Countries." OECD Working Papers, No. 836, January 2011.
14
Gnocchi, S., A. Lagerborg, and E. Pappa (2014), "Do labor market institutions matter for business cycles?",
Journal of Economic Dynamics and Control, vol. 51, February 2015.
15
Giavazzi, F., and M. McMahon (2008), "Policy Uncertainty and Precautionary Savings." NBER Working
Papers 13911, National Bureau of Economic Research.
16
Gomes, S., P. Jacquinot, and M. Pisani (2010), "The EAGLE. A model for policy analysis of macroeconomic
interdependence in the euro area." ECB Working Paper Series No. 1195, May 2010.
17
Under full credibility, firms anticipate the full amount of the implied long-run increase in output, which leads to
an immediate increase in asset prices and, hence, firms' net worth, triggering more investment already in the
short term. Similarly, households anticipate an increase in real wages and, hence, life-cycle income which in
turn supports current consumption. In the case of imperfect credibility, firms and households instead partially
case for a structural reform in the services sector - and we find the benefits of reforms are
clearly brought forward, even in a situation where monetary policy is constrained by the zero
lower bound (Chart 11). This provides a strong rationale to implement reforms in a way that
is committed, credible and consistent.18 And such an approach is in fact And such an
approach is in fact even more important for reforms to yield short-term benefits in the special
environment we face today.
Following seven years of crisis marked by several false dawns, firms and households have
become more hesitant about taking on economic risk. This is mirrored in the fact that
medium-term growth expectations among forecasters have not only shifted downwards in
that period, but the distribution of possible outcomes has also widened (Chart 9). In this
uncertain context credibility is key, as the strength of the reform signal has an even stronger
determination over the magnitude of the short-term benefits.
Type of reforms
Those short-term benefits can also be maximised, however, if the type of reforms is carefully
chosen. How structural reforms affect the economy is of course complex, but the evidence
suggests that the short run gains can be amplified if reforms are well designed, packaged
and sequenced19, with a focus on measures that minimise short-term costs.
For example, the experience of Germany during the crisis suggests that reforms aimed at
adjustment through the intensive margin - that is, working hours and wages - are less likely
to have negative short-term effects than reforms that operate through the extensive margin -
i.e. dismissals.20 This is supported by new micro level research from the Eurosystem which
shows that, for a larger sample of countries, firms with flexibility at the plant-level have
reduced employment less during the crisis than those bound by centralised wage bargaining
agreements, partly because they have been more able to adjust wages to economic
conditions.21
Moreover, if reforms are targeted specifically at frictions that hold back investment demand,
their short-term effects should be largely positive, even at the bottom of the cycle. For
instance, reforms directed at sectors with large pent-up demand, such as professional
services and retail trade, could be expected to elicit a rapid investment response.22 Indeed,
our EAGLE simulations show that the short-term benefits from structural reform in the service
sector arise mainly via a strong reaction of investment.
adjust over time their knowledge of the favourable long-run effects. The analysis also captures the notion that
credibility is endogenous and adversely affected by delaying reform implementation.
18
For more on the importance of front-loading structural reforms see speech by Coeuré, B., on "Structural
reforms: learning the right lessons from the crisis", at the Bank of Latvia Economic Conference 2014, Riga,
17 October 2014.
19
Blanchard, O., and F. Giavazzi (2003), "Macroeconomic Effects of Regulation and Deregulation in Goods and
Labor Markets." Quarterly Journal of Economics, Vol. 118, February 2001.
20
See for example Burda, M., and J. Hunt (2011), "What Explains the German Labour Market Miracle in the
Great Recession?" NBER Working Papers No. 17187, June 2011; and Brenke, K., U. Rinne, and
F. Zimmermann (2013), "Short-Time Work: The German Answer to the Great Recession." International Labour
Review Vol. 152, Issue 2, June 2011.
21
Di Mauro, F., and M. Ronchi (2015), "Centralisation of wage bargaining and firms' adjustment to the great
recession: A micro-based analysis." CompNet Policy Brief, No. 8. May 2015.
22
See for example Forni, L., A. Gerali, and M. Pisani (2010) "Macreconomic Effects of Greater Competition in
the Service Sector: the case of Italy." Macroeconomic Dynamics, 2010; or Faini, R., J. Haskel, G. Navaretti,
C. Scarpa and C. Wey (2006), "Contrasting Europe's Decline: Do Product Market Reforms Help?" in Boeri,
T., M. Castanheira, R. Faini, and V. Galasso (eds.), Structural Reforms Without Prejudices, Oxford University
Press.
Similarly, reforms designed to reduce bottlenecks to new investment that come from onerous
business conditions should also have mainly benefits in the short-term. This would include
measures such as reducing the administrative burden on young firms, or speeding up
insolvency proceedings that raise the opportunity cost of investment by tying up capital for
years longer than initially assumed. For many euro area countries there are several "low
hanging fruit" that can still be picked in this area (Chart 10).
The EAGLE simulations show that if reforms are also well coordinated across the euro area,
the short-term benefits for a medium-sized country can be further maximised, especially in
terms of limiting the downward effects on inflation (Chart 12). This reinforces what I have
said about the need for stronger common governance of structural reforms in the euro area:
if all countries reform together, then all countries benefit more. And these findings hold even
under the assumption that monetary policy is constrained.
Interaction with other policy measures
But it is also important to underline that this assumption is in fact inaccurate for the euro area
today. Contrary to models in the literature, monetary policy is not constrained because we
have reached the lower bound. Rather, as I laid out in a recent speech in Washington, I think
we have demonstrated in recent months how effective monetary policy can be when it has to
resort to unconventional measures.23
The difference this makes in terms of the short-term effects of reforms is clearly visible in our
EAGLE simulations. With monetary policy able to respond to any negative inflation shocks
consumer price inflation is barely affected (Chart 13).
What has been constrained in the euro area in recent years is fiscal policy, as some
countries faced a loss or near loss of market access. But we should remember that, in these
circumstances, structural reforms are in fact crucial to support fiscal stabilisation. Insofar as
they raise expectations of future government revenue, they make public debt more
sustainable, lessen the constraint of market discipline, and thereby reopen fiscal space.
In any event, demand is today being meaningfully buttressed in the short-term by monetary
policy, and the stance of fiscal policy is broadly neutral. The arguments for postponing
structural reform therefore become less convincing still. Any reforms undertaken now will in
fact have an improved interaction with macroeconomic stabilisation policies. And I would go
even further: I would argue that our current monetary stance in fact makes accelerating
structural reforms desirable, because it brings forward their positive demand effects.
For example, the literature suggests that a well-functioning banking sector is key to reap the
short-term benefits of reforms, as it ensures that funds flow quickly to the new investment
opportunities they create.24 In this context, the combination of our interest rate and credit
easing policy, together with the recently completed Comprehensive Assessment of bank
balance sheets, can be seen as creating the ideal conditions for reforms to succeed.
By bringing real interest rates well below the medium-term growth rate, this policy package is
creating strong price incentives to invest. And by improving the transmission of those low real
rates into actual borrowing conditions, it ensures that the financial sector can quickly
reallocate finance to firms that capitalise on those incentives.
In this way, accommodative monetary policy supports structural reform by ensuring that the
investment and employment benefits materialise faster. And structural reform, by reducing
uncertainty about the future macro- and microeconomic outlook, supports monetary policy by
releasing the pent-up investment demand that accommodative policy creates.
It should therefore be clear that the argument that accommodative monetary policy
constitutes an excuse for governments and parliaments to postpone their reform efforts is
incorrect. In fact, I would submit it actually makes reforms less socially and politically costly,
as it reduces the time it takes for reforms to produce positive effects. All this confirms my
main contention that the current environment, per se, creates no reason for delay.
Conclusion
Let me conclude.
The economic outlook for the euro area is brighter today than it has been for seven long
years. Monetary policy is working its way through the economy. Growth is picking up. And
inflation expectations have recovered from their trough.
This is by no means the end of our challenges, and a cyclical recovery alone does not solve
all of Europe's problems. It does not eliminate the debt overhang that affects parts of the
Union. It does not eliminate the high level of structural unemployment that haunts too many
countries. And it does not eliminate the need for perfecting the institutional set-up of our
monetary union.
But what the cyclical recovery does achieve is to provide near perfect conditions for
governments to engage more systematically in the structural reforms that will anchor the
return to growth. Monetary policy can steer the economy back to its potential. Structural
reform can raise that potential. And it is the combination of these demand and supply policies
that will deliver lasting stability and prosperity.

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