Liviu Voinea: Europe - managing the upswing in uncertain times
Speech by Mr Liviu Voinea, Deputy Governor of the National Bank of Romania, at the Conference
CEPS-IMF Spring 2018 Regional Economic Outlook, Brussels, 15 May 2018.
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Dear Governor Smets,
Dear Director of the IMF's European Department Thomsen,
Dear CEPS Director Gros,
Thank you for having me here. It is an honor for me to speak at the launch of the IMF Regional
Economic Outlook for Europe. This report is remarkable in many respects: it is comprehensive,
well-documented and clearly written, with strong messages and judicious policy
recommendations. It comes in times of uncertainty, when the European economy is rebounding,
but challenges remain; in particular, the business and financial cycles of advanced economies
are so dissimilar to those of the new member states that a distinct analysis is warranted.
The first chapter of the report is entitled "Managing the upswing in uncertain times". The report
shows that growth has recovered in advanced European economies and even picked up in the
new member states, some of which are now having large positive output gaps. Moreover, growth
forecasts are strong in 2018, but growth is not taken advantage of to advance with fiscal
consolidation and structural reforms. This recovery has created more than 12 million jobs in the
EU since 2013, exceeding pre-crisis peaks. Consequently, unemployment fell by a total of 5
percentage points in NMS and 3 percentage points in EU-15 over the same period.
Uncertainty, however, does not mainly come from the economic environment; it comes from the
erosion of trust, based on an unbalanced distribution of globalization benefits, a long and slow
recovery, decentralization and fragmentation - as the IMF's First Deputy Managing Director
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David Lipton pointed out in a recent speech . The REO also speaks about the weakening
support for globalization, which affects global trade and long term growth prospects, a thesis
linked to the apparent retreat from cross-border integration and the move from multilateralism to
bilateralism.
And the report is right, in my view. After 3 decades of deregulation and liberalization, the
consensus is being threatened by the return to protectionism. East European countries, being at
the receiving end of capital movements, are the short term losers of what it looks like an exit from
globalization as we knew it. I call this exit from globalization "Glexit" - which is much more than
Brexit or any other individual exits. In the banking sector, Glexit means further deleveraging and
higher financial burden for already over indebted nations, companies and households.
We can do more, together, to rebuild trust in institutions, to improve the governance, and to make
sure that the economic upswing that we are now enjoying will be more evenly distributed, that it
will reach every household and company. While this is a long time-effort, we need to do more to
put our house in order now.
Jerome Powell, the chairman of the Federal Reserve, referring to the assessment of risks in
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emerging economies, said that three elements are important: first, the vulnerabilities in the
EMEs themselves; second, the evolution of advanced-economies monetary policies; and, third,
how markets might respond to that evolution. Emerging economies are takers in the global
markets; we cannot do much about the last two elements mentioned above, which are
exogenous. Our job, our duty, is to prevent the accumulation of domestic vulnerabilities, because
deterioration in a country's economic conditions makes it more vulnerable to adverse external
shocks.
High growth in emerging economies is good as long as it is sustainable. I would recall here a
famous answer from Henry Ford, the father of the car industry, when he was asked about his
preferred color for the new T-model: "Any color, as long as it's black". Any growth is good, as
long as it is sustainable and, I would add, fairly distributed. True, emerging economies need
higher growth rates to catch-up with the more advanced economies. True, potential GDP is a
non-observable variable, like many others such as inflation expectations, non-accelerating
inflation rate of unemployment, or the one to which it is directly linked - the structural deficit. New
Member States have probably higher potential growth rates than the ones we are now estimating,
and this estimation is subject to constant change, based on new information in the data series,
but also on improved endowment with and efficiency of labor and capital. Nevertheless, these
non-observable variables become visible, sooner or later, in two indicators that eventually
separate oil from water: the twin deficits.
Let me start with the case of Romania. In the aftermath of the global financial crisis, we had one
of the largest adjustments of the budget deficit in the EU: from 9.5% in 2009 to less than 1% in
2015. Romania exited the excessive deficit procedure in 2013 and also in 2013 reached the
Medium Term Objective of 1% of GDP structural deficit, down from 8.8% of GDP in 2009. Since I
was the Budget Minister in 2013 and for most of 2014, and I was responsible for the IMF and EC
negotiations, I can praise the role played by the IMF and the EC in the three successive
agreements (2009-2015). The current account adjustment was also impressive, from -13% in
2007 to just -1% in 2013-2015. However, in the last couple of years, the trend of fiscal
consolidation has been reversed. This has also impacted the current account, which has
deteriorated by 2.2% of GDP, of which 2.1% of GDP came from the budget deficit widening. The
main advantage of the country is its low level of public debt, but this can be reversed in the
medium term unless a prudent policy mix is implemented, including a gradual return to MTO.
Broadening our perspective, all EU countries have adjusted their budget deficits over the last 10
years. Most of them also adjusted their current account deficits. In fact, the downsizing of current
accounts can be attributed to both public and private sectors. This means that aggregate
demand was affected for a longer period, and measures to stimulate it, when the economies
experienced negative output gaps, were needed. Despite very low interest rates, credit was not a
main driver of the recovery; and public investments, as the report outlines, are on average 2
percentage points of GDP lower than their pre-crisis levels.
Although it is nowadays a demand-led recovery, we do not have sufficient demand-push inflation,
with the notable exception of countries that have closed the output gap - and these are the New
Member States. This justifies the report recommendation of further accommodative policies from
the ECB. However, as Mr. Thomsen highlighted in his presentation, policymakers need to seize
the good times to advance further with fiscal consolidation and structural reforms. But the low
rate environment and the strong sovereign-bank nexus are feeding the beasts and provide the
wrong incentives for reforms.
This is where policy trade-offs step in. Monetary policy has been overburdened in times of crisis,
trying to address the market failures and the pro-cyclical fiscal policy. Yet, monetary policy is not
a universal medicine, and it cannot work in isolation. Jens Weidmann, the President of
Bundesbank, once made an analogy between monetary policy and Coca-Cola's all-round
curative properties: monetary policy is also currently being branded as a cure for assorted ills. As
well as its own actual mandate of keeping prices stable, some people seem to be under the
impression that it should be used to strengthen growth, lower unemployment, safeguard the
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financial system and guarantee citizens adequate interest rates" . Yet, monetary policy can only
buy time for structural reforms in the short run, while tensions are accumulating in the
background.
One major source of tensions refers to the wage policy. Chapter 2 of REO discusses in much
detail the "European wage dynamics and labour market integration". The main messages of this
part can be summarized as follows: a) in EU 15 wages are subdued because they respond very
slowly to changes in unemployment and are closely related to inflation and inflation expectations,
which are unusually low; b) in NMS wage growth responds very quickly to changes in
unemployment, and inflation expectations play a lesser role; c.) average wage increases in NMS
were much higher since 2012 than in EU-15; d.) about one quarter of wage growth in Europe can
be explained by EU-wide and group-level factors; e.) there was a decrease in unemployment, but
also an increase in involuntary part-time employment; f) migration plays a role in the faster
increase in wages in the countries of origin.
One hot debate topic in Europe these days -reflected in the report- is the flattening of the Philips
curve. Subdued wage growth, together with subdued inflation, are presented among the risks in
the euro-area - while the divergent wage growth trends between euro area and emerging Europe
are considered to reflect differences in labor market slack. Alternative explanations provided by
recent international literature for the disappearance of the Philips curve refer to under-measuring
the amount of spare capacity (slack) in the labour market; a lower natural rate of unemployment;
lower or more anchored inflation expectations; and changes in expectations of real pay growth.
The IMF' REO presents an innovative econometric model reshaping the wage Philips curve
against a measure of unemployment gaps. This shows that the Philips curve is flatter in the euro
area than in the NMS, but that in general it still works. However, caution in interpreting the results
is needed because this model splits the EU countries into three distinctive groups (Germany a
group of its own, some euro-area countries and some NMS countries including euro and
noneuro area, but excluding Romania and Bulgaria - probably because, in particular for these 2
countries, any measure of unemployment should be regarded prudently given the large
emigration and underground economy).
Let us remember that catching-up is an inflationary process in itself, as postulated by
BalassaSamuelson. Maybe not much convergence is taking place between North and South, but
catching-up has continued throughout the crisis between East and West - as Daniel Gros
recently concluded in a CEPS study. Migration has led to upward pressures on wages in the
emerging Europe and to downward pressures in the advanced EU. The contribution of net
emigration to the middle income trap for emerging economies should also be further studied.
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Still, I would like to share with you some preliminary results of a work in progress that I am
undertaking on the relationship between wage growth and inflation. If we think in terms of stocks
instead of flows, we can introduce the concepts of wage gap and inflation gap (just like the IMF's
REO discusses about unemployment gap, and the classical theory has the output gap). Wage
gap refers to the cumulated gap between current wage and a peak reference wage value in the
past. The permanent income hypothesis is fundamentally flawed in times of crisis, because of
uncertainty of future income. The only certain reference value lies in the past, not in the future:
and that is why current consumption is influenced by past income. A recession is a game -
changer. In a crisis, the reference is not ahead of us, but it is rather in the past. Retirement
savings and linear employment prospects are uncertain. People relate to their peak gains in the
not so distant past rather than to uncertain future gains. Inflation gap refers to the cumulated
deviation of present inflation from the target inflation or, in the absence of such, from its long-time
average. We also allow for the wage Philips Curve to be non-stationary: it moves over time, and
it is absolutely normal to do so. Reference wage values, social preferences, jobs'
characteristics, skill endowments and even Central Banks' targets, they all change over time -
hence, the impact of wage gaps on inflation cannot be the same in different time periods. The
preliminary finding of our model is that inflation does not increase close to or above its target level
until the wage gap is closed. For Philips Curve to work, the loss of welfare from a negative wage
gap has to be fully compensated first - as a stock measure, not as a flow. The policy
recommendation from here is that countries which closed their wage gap should be much more
prudent in further wage increases - because they will be seen in inflation much faster and larger
than in the recent past. And for countries which have not closed their wage gap the implication is
that inflation will remain subdued until this happens.
I fully agree with the IMF's recommendation that central banks in NMS with their own currencies
should be alert to the inflation risks of higher wage growth, while bearing in mind that raising
policy rates could trigger capital inflows and exchange rate appreciation - which could further
deepen current account imbalances. While the real monetary policy stance may differ between
euroarea and emerging Europe, there is broad heterogeneity even among emerging Europe. This
is why it is important not to give the wrong incentives to capital flows.
This reminds me of my days as a child when, being asked what I want to become when I grow
up, I confessed that I wanted to be a firefighter. It turns out that I am now a central banker, which
is not far from being a firefighter in these uncertain times.
National Bank of Romania has started the tightening cycle of the monetary policy, to contain the
higher inflation and inflation expectations. Although most of it is supply-side and temporary, and
fighting fiscal loosening with monetary tightening is a sub-optimal policy mix, we considered that
the 3 rate hikes we implemented this year were warranted to preserve a hard-fought public good:
price stability.
Coming to an end of my intervention, I would like to express a few thoughts on one of the most
important remarks of the REO. It states that "the recovery provides an opportunity to move faster
to deepen the Economic and Monetary Union". The report details three lines of action in this
regard: completing the Banking Union, creating a central fiscal capacity, and advancing with the
Capital Union.
Too much financial innovation, deregulation and the blind, theological belief in self-regulating
markets have brought us here, back to the era of re-regulation; but coordination is needed for
that, and Glexit is threatening this coordination.
It is however undeniable that the completion of the Banking Union is of paramount importance.
However, there is still no consensus on operationalizing the EDIS, on debt mutualization, on
setting the minimum requirement for own funds and eligible liabilities, on the features of the fiscal
union, and the list could go on. I think that the Union should also clarify the fine balance between
the consolidated microprudential supervision of banks and national accountability in terms of
resolution. The home-host issue has not been dealt with yet. Moreover, the European financial
architecture is populated with unfinished, incomplete, or untested mechanisms created after the
crisis. Even so, my message on the reform of the European financial sector is twofold. First, the
reform is fundamental for the success of the European project. Romania welcomes all the
European Commission's initiatives aimed at enhancing supervision, consolidation, and
accountability in this area, and we will do our best to help reach a consensus on these proposals
during our incoming EU Presidency. Second, it is also fundamental for the integrity of the
European project that euro-area should not be ring-fenced; the reform should still make it
possible for non-euro countries to join euro, when they will be ready, on a level playfield.
Price stability and financial stability are two sides of the same coin. You can't have one without
the other - this is a lesson that history has recently taught us. And none of them is possible
without credible public policies.
1.
Lipton, David (2018), "Trust and the Future of Multilateralism", Introductory Remarks for the
Eurofi High Level Seminar, Sofia, Bulgaria, April 30, 2018.
2.
Powell, Jerome H. (2017), "Prospects for Emerging Market Economies in a Normalizing
Global Economy," speech delivered at the 2017 Annual Membership Meeting of the Institute of
International Finance, Washington, October 12.
3.
Weidmann, Jens (2017), "Monetary policy and the architecture of the euro area", speech at
the Deutsche Bundesbank's Capital City Reception, Berlin, 29 May 2017
. Voinea, L. (2018), "Explaining the Post-Crisis Philips Curve: Wage Gap Matters for Inflation",
manuscript