Opening remarks by Ilmārs Rimšēvičs, Governor of Latvijas Banka, at the Eurofi high level seminar; Riga, 22 April 2015
The euro area economic growth outlook for this year has been revised slightly up recently as the collapse of the oil price and the strength of the US dollar appear to outweigh negative effects such as increasing geopolitical uncertainty. However, growth in the euro area remains slow and fragile, the negative output gap remains sizeable and unemployment rates in many countries are unacceptably high. What does Europe have to do to revive growth?
The Asset Quality Review by the ECB and the stress tests by EBA followed by recapitalization requirements for some of the European banks as well as an alphabet soup of increasingly accommodative monetary policy measures (TLTROs, ABSPP, CBPP to give some of the more recent examples) and now the so-called Quantitative Easing by the European Central Bank have been significant steps aimed at reigniting lending and supporting demand in Europe. However, recapitalization of the banking sector and monetary policy accommodation alone cannot make Europe return to vibrant growth.
It has often been said that Europe needs more fiscal stimulus in the short run and fiscal consolidation in the medium term. This argument has been around for at least five years now, while deficits in many countries are still above the 3% of GDP threshold, debt burdens keep growing, but economic growth remains anemic. Five years are not the short run. The short run is already long over, the medium term is here. Member states need to return to responsible fiscal management today. There is a body of academic research including work by Alberto Alesina from Harvard that indicates: in order not to harm economic growth, fiscal consolidation needs to be expenditure based. In practice, however, it often tends to be revenue based. The reason for that is clear – expenditure cuts are more likely to draw opposition from powerful interest groups and are thus politically more difficult to implement than tax rises.
Investment in Europe in recent years has been below its long-term trend. Jumpstarting investment would boost demand and create additional jobs now and raise the long term growth potential of the European economy. However, even with the banking sector returned to health and ready to lend again, we cannot expect companies to borrow and invest if the state of the public finances combined with political resistance to expenditure cuts signals that the tax burden is likely to rise in the future. Research has also shown that policy uncertainty more generally is a key factor hampering investment. Contrary to geopolitical uncertainty that I mentioned earlier and which is often determined by factors beyond our control, policy uncertainty is something that is created by indecisiveness and inaction of policymakers.
In addition to accommodating monetary policy and responsible fiscal management, economic growth also needs to be supported by structural changes. Member states need to implement structural reforms in goods, service and labour markets to remove barriers to growth. At the European level, rapid completion of initiatives to further integrate the European capital, energy and services markets, including the market of digital services, are key to generating new investment and employment opportunities and helping to jumpstart growth.
It is a known fact that individuals and companies as well as governments and societies often put together their best efforts at times of severe crisis. We in Latvia faced such a crisis in 2009, which led us to carry out substantial fiscal and structural reforms. Latvia did not devalue its currency, opting instead for measures which are sometimes referred to as "expansionary consolidation". This is an expression we like in our country. In Latvia, it is no longer viewed as a contradiction in terms. As a result of the reform effort, Latvia saw economic growth return two years after the onset of the crisis; it was the fastest growing economy in the EU for several years, and already in 2013, it surpassed the pre-crisis peak level of output per capita.
Let me briefly explain what the formula that worked so well was. Speed was one of its key elements. Latvia saw a fiscal adjustment of 14.7% of GDP throughout 2009 and 2010, adding just an additional 2.8% by 2012. In addition, the rapid consolidation came largely on the side of budget expenditure and was based on structural reforms. Two thirds of the total consolidation was generated by cutting expenditure and only one third came from additional revenue, mainly in the form of raising the VAT rate. Another important element was ownership. The set of measures for overcoming the crisis was drafted by Latvian authorities and was not dictated or imposed from outside – either by the European Commission or the IMF. For instance, even though the IMF considered outright devaluation to be the right approach in dealing with the crisis, Latvian authorities insisted on massive consolidation as the only viable option. Commitment by the public at large could be mostly attributed to active communication by authorities explaining the causes of the crisis, the alternative courses of action and the selected option. The final element in the formula was solidarity. Expenditure cuts were applied to all branches of government. The wage and benefit cuts in the public sector were an important part of the common effort and also crucial to help close the wage-productivity gap which had opened during the boom years. Overall, however, the path selected by Latvia resulted in pre-crisis imbalances to a significant extent being resolved by pushing the economy towards higher productivity rather than lower wages.
The euro area is currently not facing a severe crisis. Moreover, things are gradually getting better. Now, does that mean that further reforms are to be put on hold? Are substantial reforms possible only when facing an existential threat? It should not be so. A while ago I read a story about a large multinational company that was doing quite well when the two top managers conducted the following thought experiment:
This is what they did and the company is still prospering today, although this conversation took place several decades ago.
I would now like us to do a similar thought experiment. I will not ask you to leave the room and then come back in, though, as this might create too much of a commotion. But let us imagine that we are all newly appointed. Our mandate is, of course, to act in the long term interests of our societies, similarly as the mandate of a company's management is to act in the long term interests of its shareholders and other stakeholders. With this in mind, let us agree on the next steps needed to revive sustainable growth in Europe. And even more importantly, let us act now and not wait for the next crisis.