Christine Lagarde: The future of the euro area economy Sspeech by Ms Christine Lagarde, President of the European Central Bank, at the Frankfurt European Banking Congress, Frankfurt am Main, 22 November 2019. * * * It is a pleasure to be speaking here this morning at the European Banking Congress. This is my first opportunity to meet the mayor and Frankfurt’s financial community – and I am sure it will be the first of many. T.S. Eliot said that “every moment is a fresh beginning” and it certainly feels that way for me today. But in many respects it feels that way for Europe, too. The theme of this year’s programme is “Europe: New Approaches”, and that seems very fitting. The idea of European renewal may, for some, elicit feelings of cynicism. We have heard it many times before: “Europe is at a crossroads”; “now is Europe’s moment”. Often that has not proven to be the case. But this time does in fact seem different. Turnout at the latest European elections was the highest in a quarter of a century. A new Commission is about to begin its term with an agenda to strengthen Europe in areas like environmental policies, digitalisation and defence. Discussions are moving forward on completing banking union and building a capital markets union. This is essential because, all the while, the world around us does not stand still. In recent years, the global environment has been transformed in ways that none of us could have imagined. We have seen the post-war global order fracturing, the rise of new – and some old – powers, rapid changes in technology, and an uncertain outlook for global trade and finance. Uncertainty abounds and conventional wisdom is being challenged, in politics, in diplomacy and in economics. And, unavoidably, this calls on Europe to consider its place in the world and reset its ambitions. In my remarks, I would like to focus on the economic dimension of this question. As the global economy evolves, how can Europe best position itself? Challenges in the global economy This question is prompted by two main challenges in the global economy today. The first relates to the changing nature of world trade, which has multiple causes. Ongoing trade tensions and geopolitical uncertainties are contributing to a slowdown in world trade growth, which has more than halved since last year. This has in turn depressed global growth to its lowest level since the great financial crisis. These uncertainties have proven to be more persistent than expected, and this is clearly impacting on the euro area. Growth is expected to be 1.1% this year, i.e. 0.7 percentage points lower than we projected a year ago.1 At the same time, there are also changes of a more structural nature. We are starting to see a global shift – driven mainly by emerging markets – from external demand to domestic demand, from investment to consumption and from manufacturing to services.2 In parallel, world trade is being reordered as new technologies disrupt conventional supply chains and workplace organisation, and as potential new risks emerge from climate change. 1/5 BIS central bankers' speeches All this obviously has implications for our external sector, not least because the euro area’s exports are intense in capital and intermediate goods. It suggests that Europe needs to innovate and invest to respond to these challenges and preserve its competitiveness in the longer run. But it also suggests that the high rates of trade growth that we are used to seeing are no longer an absolute certainty. The second challenge relates to domestic growth in advanced economies. Advanced economies are in the midst of a long-term deceleration in growth rates, which have roughly halved since the late 1980s. This is reflected in the long-term decline of global interest rates. As growth rates are a fundamental driver of interest rates, even countries that have tried to raise interest rates have gradually lowered them again. Supply-side factors, such as productivity and demographics, are clearly one driver behind this. Labour productivity growth has fallen by almost two-thirds in advanced economies since the early 1990s. In 2015, there were four working-age people for every person over the age of 65 in advanced economies. By 2050, that ratio will be less than two to one. But there is evidence that demand-side factors are playing a role as well. In the euro area, domestic demand has contributed to the recovery, helping to create 11.4 million new jobs since mid-2013. But over the past ten years, domestic demand growth has been almost 2 percentage points lower on average than it was in the decade before the crisis, and it has been slower than that of our main trading partners.3 This is reflected in the shift in our current account position, which has moved from being broadly balanced before the crisis to showing a surplus since, as well as in the relatively subdued performance of underlying inflation. So, these twin external and domestic challenges call on us to consider – as Europeans – how we should respond to the new environment. The answer lies in converting the world’s second largest economy into one that is open to the world but confident in itself – an economy that makes full use of Europe’s potential to unleash higher rates of domestic demand and long-term growth. There are two reasons why this would be beneficial: resilience and rebalancing. Resilience and rebalancing Resilience rests on two pillars. It relies on having firms that are competitive globally and can export to the world when domestic growth falls; and it relies on having a strong internal economy which can sustain demand when the global economy weakens. Open trade is therefore a platform for resilience, as we saw clearly during the sovereign debt crisis. From 2010 to 2013, the share of extra-euro area goods exports in GDP increased by about 20%, while the share of intra-euro area exports grew by just 5%. The global competitiveness of many euro area firms was a vital shock absorber in that period, and the benefits were spread across the monetary union via value chain linkages. Without a strong export sector, our crisis would plainly have been worse. At the same time, it is also clear that stronger domestic demand puts economies in better position to withstand swings in the global business cycle and disruptions in world trade – like those we are seeing at the moment – and to keep their growth trajectories on course. 2/5 BIS central bankers' speeches One sign of this can be found by looking at the correlation between global growth and domestic growth over the past 40 years for countries with different trade exposures, as captured by their current account positions. It turns out that the group of surplus countries tends to grow faster than the world economy during periods of global upswings, but also to contract more sharply during periods of global downturns. For the group of deficit countries, the opposite is the case.4 And when global growth falls, stronger internal demand can help protect jobs, too. This is because domestic demand is linked more to services – which are more labour-intensive – while external demand is linked more to manufacturing, which is less labour-intensive.5 We are seeing that shield in action in the euro area today: the resilience of services is the key reason why employment has not yet been affected by the global manufacturing slowdown.6 But there is also a second benefit to strengthening the domestic economy, which is that it facilitates rebalancing. More dynamic internal growth offers a way to improve the functioning of the euro area and to accelerate crisis recovery. Since countries in a monetary union do not have their own exchange rates, they have to adjust to crises through prices. This is easier to achieve when growth is strong at the euro area level and inflation is in line with the ECB’s objective. Adjusting countries can quickly improve their relative prices and export more to other members of the union. But if internal demand is too weak and inflation too low, such rebalancing across countries obviously becomes harder. And to some extent, this is what we saw in the euro area after the crisis. As demand was stronger in our trading partners, vulnerable countries had to reverse their imbalances mainly by increasing net exports outside the euro area. Importantly, strengthening internal growth is fully consistent with all countries maintaining their competitiveness. If countries boost growth by investing in productive areas of the economy, it not only lifts demand in the short run. It also provides the ingredients for maintaining competitiveness in the face of long-run global challenges. So the question is, what can public policies do to further develop our domestic demand and growth potential, while also encouraging dynamic and globally competitive firms? Policies to boost internal growth In my view, since our challenges are common ones, we must meet them with a common response. This involves moving towards a new European policy mix, which has a number of key elements. The first is monetary policy, which I start with because it is my area of responsibility and which will undergo a strategic review due to begin in the near future. The ECB’s accommodative policy stance has been a key driver of domestic demand during the recovery, and that stance remains in place. As laid out in the ECB’s forward guidance, monetary policy will continue to support the economy and respond to future risks in line with our price stability mandate. And we will continuously monitor the side effects of our policies. But it is clear that monetary policy could achieve its goal faster and with fewer side effects if other policies were supporting growth alongside it. One key element here is euro area fiscal policy, which is not just about the aggregate stance of public spending, but also its composition. Investment is a particularly important part of the 3/5 BIS central bankers' speeches response to today’s challenges, because it is both today’s demand and tomorrow’s supply. While investment needs are of course country-specific, there is today a cross-cutting case for investment in a common future that is more productive, more digital and greener. Public investment in the euro area remains some way below its pre-crisis levels. The share of productive expenditure in total primary expenditure – which in addition to infrastructure includes R&D and education – has also dropped in nearly all euro area economies since the crisis.7 And new investment needs are emerging. Both national policies and European programmes like InvestEU have a role to play. And the Budgetary Instrument for Convergence and Competitiveness is also a good start. This tool acknowledges that, even when governments need to consolidate their finances, we have a common interest in maintaining sufficient levels of public investment. But a stronger domestic economy also rests on higher business investment, and for that raising productivity is equally important. Firms need to be confident in future growth if they are to commit long-range capital. Though all advanced economies are facing a growth challenge, the euro area has been slower to embrace innovation and capitalise on the digital age than others such as the United States. This is also reflected in differences in total factor productivity growth, which has risen by only half as much in the euro area as it has in the United States since 2000. To help us close this gap, we have a very potent tool at our disposal: empowering our internal market. The private sector calls it: scale. Completing the digital single market, the capital markets union and the single market in services can provide the impetus Europe needs to launch new and innovative firms and to spread new technologies faster around the union. These are the building blocks of the European economy of the future. And the projected gains are significant: new studies find that the full implementation of the Services Directive would lead to gains in the order of €380 billion8, while completing the digital single market would yield annual benefits of more than €170 billion.9 This growth dividend would in turn help close the circle with public investment by ensuring that public debt is sustainable. Finally, empowering our internal market also means completing our Economic and Monetary Union. The design of EMU – and in particular the balance between risk reduction and risk sharing – is closely linked to the propensity to save and spend in Europe. On the one hand, a monetary union focused too much on risk sharing is likely to produce moral hazard and too little saving, which harms the union as a whole. But on the other hand, prioritising risk reduction alone is likely to lead to the opposite problem: excess saving and fragile growth as countries are forced to self-insure by running persistent surpluses. The solution to the famous “paradox of thrift” is institutions. Good institutions exist to ensure that people are not forced into actions that are rational at the individual level but self-defeating collectively. So, completing EMU is about finding the right trade-off: enough protection against moral hazard to discourage under-saving, but enough mutual insurance to prevent over-saving. In this way, we could tap into new sources of growth that would otherwise be suppressed. And, in the spirit of this conference, that would truly represent a “new approach” for Europe. 4/5 BIS central bankers' speeches Conclusion Let me conclude. We face a global environment that is marked by uncertainty. But I believe that, if we approach this challenge in the right way, it can also be a moment of opportunity. We have a unique possibility to respond to a changing and challenging world by investing in our future, strengthening our common institutions and empowering the world’s second largest economy. All of this would be a game changer, not just for our own stability and prosperity, but for that of the global economy, too. It does require us to think differently about Europe. It will almost certainly not be easy. But as St Francis of Assisi once said, “Start by doing what’s necessary; then do what’s possible; and suddenly you are doing the impossible”. 1 September 2019 ECB staff projections. 2 See ECB (2017), “China’s economic growth and rebalancing and the implications for the global and euro areaeconomies”, Economic Bulletin, Issue 7. 3 Since the onset of the financial crisis, domestic demand growth in the euro area has averaged 0.5%, compared with average growth of 2.3% in the decade before 2008. 4 Internal ECB analysis. 5 See Anderton, R., Aranki, T., Bonthuis, B. and Jarvis, V. (2014), “Disaggregating Okun’s law − Decomposing the impact of the expenditure components of GDP on euro area unemployment”, Working Paper Series, No 1747, ECB, Frankfurt am Main, December. 6 See Lane, P. (2019), “Europe’s role in a changing global economy”, presentation at the European Commission’s Annual Research Conference in Brussels, 15 November. 7 European Fiscal Board (2019), “Assessment of the EU fiscal rules with a focus on the six and two-pack legislation”, August. 8 Pelkmans, J. (2019), “Contribution to Growth: The Single Market for Services”, study prepared for the European Parliament’s Committee on the Internal Market and Consumer Protection. 9 Scott Marcus, J., Petropoulos, G. and Yeung, T. (2019), “Contribution to Growth: The European Digital Single Market”, study prepared for the European Parliament’s Committee on the Internal Market and Consumer Protection. 5/5 BIS central bankers' speeches