Editor’s note: This speech was delivered by Mateusz Szczurek, Minister of Finance of Poland, last night at the annual Bruegel dinner.
The Bruegel Institute is one of the most influential European think-tanks and the quality of its research is continuously increasing its impact on policymaking. It is therefore my honour and great privilege to be here and to address this exceptional audience.
Europe is at risk
We are meeting here at the time when Europe is facing a great threat. It is not the danger of sovereign debt crisis or of the collapse of the euro area. We have managed to decisively avert those risks through a coordinated effort at the European level. Unfortunately, neither is it the threat of the so-called “lost decade” because the “lost decade” is already Europe’s baseline scenario. Remember, six years have already passed since the start of the financial crisis and European GDP is still well below its pre-crisis level and around 10% below the level consistent with trend growth prior to the crisis. As a continent we are doing worse than Japan in the aftermath of the financial meltdown of the 80s and worse than during the Great Depression in the 30s. The timid recovery, which gave us so much hope, has recently stalled. Unemployment and the negative output gap are at record highs and we are on the verge of deflation. Even Poland, with its continuing economic expansion, still faces elevated unemployment and below-potential growth.
You may ask: what risk could be added to such a gloomy baseline? It is the threat of secular stagnation, the trap of permanently depressed demand and meagre long-term growth rates. It is also the threat of a lost generation: a generation of young people who will never find their way into quality employment and will never reach their full human and economic potential. To realize that such a gloomy scenario may already be unfolding, look no further than our labour market. Almost a quarter of all young people in Europe are without work. Persistent unemployment, inequality, and a debt burden increasing with each month of stagnant income and near-deflation not only threaten Europe’s economic development, but risk unravelling the entire social structure of the European Union. The radical parties are gaining strength, and as Europeans we should never forget that it was depression and deflation, and not hyperinflation, that brought to power the totalitarian regime that devastated our continent through the World War and unspeakable atrocities 75 years ago.
Europe needs concerted and decisive action
Europe is not doomed, but we do need concerted and decisive actions at both the national and European levels to close the output gap, create jobs and strengthen the long-term growth potential, all the while ensuring the sustainability of public finance and the stability of the financial sector.
Such actions, many of which we have already undertaken, span a wide spectrum of policies, reforms and regulatory changes. Much attention has already been devoted to three broad areas: structural reform, European monetary policy and national fiscal policies.
Structural reforms are essential to promote flexibility and increase long-term growth. We need labour market reforms, we have to cut red-tape and we must reduce the regulatory burden. Completing the Single Market is key to ensuring efficient allocation of resources; meanwhile, the European Banking Union should complement other reforms to promote financial stability. The crisis – despite its obvious costs – offers a tremendous opportunity to overhaul the ailing aspects of the European economy and to boost its potential.
The challenge looming on the horizon is deflation. This threat makes traditional monetary policy instruments inadequate or irrelevant. Reviving the recovery and reaching the inflation target therefore requires continued monetary expansion through unconventional measures. The recent announcement of President Draghi about possible QE operations in the near future is a source of optimism. However, this optimism should be qualified by the relative impotence of monetary policy at the zero bound: the situation when interest rates are already zero or very close to zero and cannot be reduced further.
The new European fiscal framework will be the foundation of public finance sustainability. Together with the ECB’s resolve, it has already restored confidence and averted a debt crisis. This is a great achievement. But to provide more growth momentum, we need smarter national fiscal consolidation strategies within the constraints of the Stability and Growth Pact (SGP). And I underline here the importance of the SGP rules as they represent necessary restraint and provide trust in our economic policy in Europe.
Europe needs investment
Ladies and gentlemen, while progress on each of these three fronts – structural reforms, monetary policy and public finance stability – is necessary, it is time to face the fact that it will not be sufficient. It will not be sufficient to overcome the fundamental problem holding back the European economy: depressed investment demand.
The economic crisis caused a historically unprecedented collapse in capital investment in the European Union. Six years after the beginning of the financial crisis, private investments are still almost one fifth below pre-crisis levels. Public investment also fell significantly. This has become the main target for fiscal consolidation in most of Europe, with cuts reaching 60% in some countries.
Investment is very low when it is needed more than ever. Higher capital expenditures could be a powerful way to boost economic recovery and close the output gap in the short term, as investment multipliers are particularly high in deep recessions. This is especially true during balance sheet recessions when the private sector is in the process of deleveraging, while interest rates are constrained by the zero lower bound, unable to balance saving and investment. Greater investment would also increase long-term productivity growth rates in Europe, further stimulating private capital expenditure. What is more, scaling-up of investments is also critical for achieving the vision of Europe 2020, the vision on which all member states agreed and which we all share.
Those who fear that secular stagnation is already our reality point to a particularly worrying combination: an investment shortfall coincides with historically low interest rates. Cheap and plentiful savings are not being transformed into productive capital for three reasons. First, the private sector lacks confidence in future demand for its products; second, the real interest rate cannot turn negative due to the deflationary environment; and third, in most EU member states the public sector lacks fiscal space to scale up investment operations. Meanwhile, necessary structural reforms will take time to bear fruit, and often have only an indirect influence over the crucial saving-investment balance.
Time for action at the European level
I believe that to overcome these constraints, we need a decisive public investment initiative at the European level. I propose that we take advantage of the favourable financial market conditions right now in order to undertake strategic public investment projects across Europe and in line with the rules underpinning the Stability and Growth Pact. It will aid our growth in the long term, while at the same time helping us escape the current economic weakness and avert the danger of a generation-long stagnation.
We estimate, based on conservative assumptions about the size of the current output gap and fiscal multipliers, that closing the output gap in the medium term requires phased-in European public investment spending of around 5.5% of European Union GDP, or 700 billion euros (see Analytical Note).
The capital spending would start at 0.5% of European GDP in 2015, peak at 2% in 2017, and be gradually phased out afterwards. This path is proposed as large-scale public investment projects are likely to take time to get started. It also gives policymakers time to react and adjust the size of the initiative if economic conditions change in the coming years.
The proposed initiative should ensure that infrastructure critical to the long-term growth of Europe is put in place, in line with estimates given by the European Commission. The additional resources should supplement - not replace - European Investment Bank financing and the multiple functions of the EU budget.
How to mobilise such considerable investments? We propose to establish the European Fund for Investments, preferably operating as a special purpose vehicle under the umbrella of the European Investment Bank Group. The capital of the Fund would be leveraged by borrowing in the financial market and directly invested in the selected infrastructure projects because Europe needs actual capital expenditures, not merely extra funding. Even in Poland and Germany, investment credit demand remains subdued.
Direct public sector participation would bring in private investors, who are currently chasing a relatively small number of potentially “bankable” projects, because they tend to consider large-scale infrastructure projects too risky in terms of future demand, regulatory environment and profitability. The assets created through these investments would eventually be privatised, generating revenues for the Fund. However, the logic of the excess savings at the zero lower bound, as well as the experience of other balance sheet recessions should make us prepared for prolonged ownership of newly created assets.
The Fund’s size, its direct investment in infrastructure and long-term investing horizon would be the key differences with the existing European Investment Fund, which has only 4.5 billion euros of capital and facilitates SME’s access to finance through intermediary institutions with a shorter investment horizon.
To start operating, the new vehicle would require a gradual injection of paid-in capital and guarantees by all EU member states in a similar way and on a similar scale as was done for the European Stability Mechanism (ESM). This would be necessary to ensure its triple-A rating. The contributions of member states to the capitalisation of the Fund would be excluded from the calculation of the budget deficit and its borrowing on financial markets would be recorded as EFI debt, and not re-routed to the member states. This treatment would be exactly the same, as it is the case under the ESM, and in line with the rules underpinning the Stability and Growth Pact. It is important that all EU member states take part in the initiative to prevent free-riding.
The Fund would facilitate directing currently idle private savings towards large-scale, pan-European infrastructure projects, with a particular focus on energy, transportation and ICT. These sectors have long been defined as priority areas for long-term sustainable growth in Europe, and the principle of subsidiarity justifies taking the action at the European level. These investment projects would contribute to energy interconnectedness, independence and security, also known as energy union, reduction of carbon emissions, promotion of trade, investment and mobility among member states, and shifting Europe towards digital union and a knowledge-based model of growth.
At the same time, investment projects in the most depressed economies, as measured by output gaps, should be prioritised through front-loading. The Fund must not become another income redistribution tool. It should not promote economic laggards whose inadequate growth is simply a result of their structural weakness. But it will be a mechanism for synchronising the business cycle, it will combat intra-European imbalances and reduce the pressure on labour migrations and on macro-prudential regulation. Moreover, it will result in member states competing in reforms to increase potential output.
Many of you will be asking yourselves if Europe can afford to take on such an additional financial burden at the current juncture. The question is whether we can afford not to take it on. Before you answer that question, consider the present market conditions. Consider the historically low interest rates. Consider the potentially large multipliers generated by investment spending in a depressed economy. Consider the stimulus to demand and the uptick in long-term growth rates. Consider the additional publicly owned capital stock. Consider the evidence that public investment may actually reduce debt in the medium term and strengthen long-term sustainability. And consider the alternative: the risk of secular stagnation, which may already be with us. Do we really have a choice?
Ladies and Gentlemen, Europe’s road to recovery requires us to show determination in reaching our goals and courage in taking difficult decisions. Steps undertaken to counteract the recent crisis prove that, despite our sometimes divergent views, member states can find mutually beneficial solutions to our shared problems. The future of the European Union depends on our determination to implement an ambitious agenda of reforms and on our capacity to adjust to new challenges.
At this juncture, boosting European investments is, in my view, the most important, but a perfectly achievable, economic policy challenge. This evening I have outlined an effective and fiscally responsible economic and institutional answer to this challenge. I am looking forward to working with all our European friends to develop it in full detail, and to implementing it as promptly as possible.
In conclusion, let me make one thing absolutely clear. I am happy and proud that Poland was the only country in Europe that never stopped growing throughout the crisis. However, we cannot afford to be complacent. As Europeans, we can sustainably meet our growth aspirations only within a strong and growing Europe. The responsibility for ending the lost decade and avoiding the lost generation is on all the EU member states, and the European Fund for Investments is the way to achieve this goal. This is why I can confirm without any hesitation that I would like to see Poland as its founding member.
I am counting on your support and cooperation.
Thank you very much
Analytical Note to accompany Minister Mateusz Szczurek’s keynote address at the Bruegel Institute’s 2014 Annual Meeting.
September 4th, 2014
Introduction: The European Fund for Investments
In his keynote address at the 2014 Bruegel Institute annual dinner, Poland’s Minister of Finance Mr. Mateusz Szczurek laid out a proposal for jumpstarting the EU economy, avoiding a prolonged stagnation and building solid foundations for long run growth. This proposal is based on a European-level program of scaling up public investment by around 5.5% of European Union GDP or 700 billion euros within the next 5 years. The capital spending would start at 0.5% of European GDP in 2015, peak at 2% in 2017, and be gradually phased out afterwards (Figure 1). The gradual path reflects the nature of large-scale public investment projects and gives policymakers time to react and adjust the size of the program to changing economic conditions. In order to mobilize such considerable investments, a European Fund for Investments (EFI) would be established. A gradual injection of paid-in capital and guarantees by all EU Member States would be leveraged by borrowing in the financial market. The Fund capital would be directly invested in selected infrastructure projects, with a particular focus on energy, transportation and ICT.
This note presents the background calculations of the program’s potential effects on EU GDP and justifies its proposed size of 5.5% of EU-28 GDP.
Figure 1. Proposed path of EU-28 public investment under the EFI
Uncertainty about the sources of low growth and the size of output gap
The weak economic recovery across Europe and the risk of so-called secular stagnation are the key motivations behind the proposal. Nearly six years since the beginning of the financial crisis, European GDP is still well below its pre-crisis level and around 10% below the level consistent with trend growth prior to the crisis. Figure 2 summarizes this situation. It shows three curves. The solid line is the evolution of actual real GDP of the 28 EU economies since 2002. The dashed line is an extrapolation of the average 2% trend-growth prior to the financial crisis; this is the EU’s potential output if no permanent underlying stagnation occurred. The dotted segment, on the other hand, is an extrapolation based on the meager average growth of 0.8% since the trough in 2009. The EU economy is now about 10% below where it could be if the pre-crisis trends were maintained. If the current slow growth continues, it will be 16% below in 2019.
Figure 2. Losing ground after the crisis
There are two polar ways to interpret the current (and projected) economic weakness.
- The EU economy is only suffering from depressed demand in the aftermath of the global financial crisis and sovereign debt troubles in Europe. In this scenario, EU could and should return to the pre-crisis potential growth path (dashed line). Expansionary macroeconomic policies are needed in order to achieve this goal.
- The EU has entered a prolonged period of slow or non-existent growth, which fully explains the current output size. In this scenario, the EU’s potential growth is permanently lowered due to productivity slowdown, regulatory burden and demographic changes, and deep structural reforms are needed to boost long-run growth.
The truth lies somewhere inbetween, and uncertainty over the nature of the current economic weakness complicates the proper policy response to the current situation. If deficient demand is to blame, relying exclusively on structural reforms is likely to be insufficient. Such reforms take a long time to affect growth, and in the meantime a prolonged recession (due to deficit of demand) may turn into structural problems (stagnation of potential GDP) through the so-called hysteresis effects, e.g. because of the loss of skills and labour-force attachment of the long-term unemployed, forgone investment in physical and human capital and innovation (DeLong and Summers 2012). If underlying problems are of a structural nature, stimulating macro policies will be ineffective and risk overheating the economy, but this risk can be easily managed as discussed below.
Europe needs investment stimulus
While the output gap persists, conventional policy choices for the EU are severely restricted. Expansionary monetary policy is limited by the zero lower bound while expansionary fiscal policies are constrained by fiscal discipline induced by the SGP.
The situation calls for a new policy approach. The fact that the economic crisis caused a historically unprecedented collapse in capital investment in the EU (Figure 3) and the current historically low level of long-term interest rates suggest that cheap and plentiful savings are not being transformed into much-needed productive capital by the private sector. Boosting public investment – which is the goal of the EFI – seems to offer an attractive and viable option for such a new policy approach. It would address both the lack of demand and the slowdown of potential growth in an environment where the risk of crowding out of private investment is extremely low.
Figure 3. The collapse of the EU investment rate
Quantifying the impact and sizing the EFI
The impact of the investment boost on economy and its optimal size depend on two considerations:
First, as discussed above, they depend on the economy’s current output gap. Given the uncertainty over this variable discussed earlier, the ‘naïve’ but reasonable approach is to target closing about half of the 16% gap between the low-growth projection and the pre-crisis trend that is expected to occur in 2019 in the absence of the EFI.
Second, the effect of the additional public spending of EU-28 GDP depends on the size of the multiplier, so quantifying the effects of EFI program and deriving its size are based on the latest research on the size of output multipliers associated with government expenditure. Namely, we adopt a multiplier of 1.5, which is consistent with recent estimates from the IMF (Blanchard and Leigh, 2013) and is somewhat conservative, taking into account the depressed state of economy, which tends to increase multipliers (Auerbach and Gorodnichenko 2013).
Figure 4 illustrates the impact of the EFI public investment of 5.5% of GDP on the EU-28 economy under these assumptions. The extra investment boosts average growth over 2015-19 from 0.8% to 2.3%, reducing the gap in 2019 between current output and the path of uninterrupted 2% growth from almost 16% to 8.9%.
Figure 4. Effects of the EFI program on EU-28 GDP
The objective illustrated in Figure 4 seems to be prudent given the uncertainty about the size of the output gap. It is also quite robust.
In the case that true potential is indeed represented by the pre-crisis trend (and thus the output gap is very large), the multipliers will likely prove to be larger than those used here. It is now commonly accepted that the magnitude of the effect is likely much greater in a depressed economy where interest rates are close to the zero lower bound and when spending is directed towards productive public capital. Specifically, in an important recent contribution, Auerbach and Gorodnichenko (2013) point to large and persistent effects of government investment in a depressed economy. The impact of the EFI would then probably be higher if the output gap was bigger than assumed here.
The policy itself also offers some important flexibility. If the EU economy continues to experience low inflation and stagnant labor markets as growth rates of GDP pick up, indicating that the output gap remains substantial, the scale of the EFI project should be increased and its duration extended.
In the case that the true potential is much below the pre-crisis growth path (dashed line), there is a concern that a stimulus like the EFI could lead to overheating of the economy and a surge of inflation. This is unlikely to be a serious issue for the EFI for several reasons. First, the latest research demonstrates that the effects of the fiscal expansion in an economy that is not in a recession are much more modest. Thus if the output gap isn’t very large to start with, the policy will have much less potential to overheat the economy (Auerbach and Gorodnichenko 2013). Second, the inherent asymmetry of the zero lower bound helps to contain any downside risk to inflation. While it is hard for the ECB to stimulate the economy further with interest rates already at or close to their minimum, it would find no difficulty cooling the economy by raising them, should that be required. Additionally, given the gradual scaling up of investment over the five years, policymakers would have ample time for course-correction should the stimulus prove excessive.
Long-run benefits of the EFI
One of the crucial aspects of our proposal is that the investment boost is directed at large-scale infrastructure projects in energy, transportation and ICT. Such projects will not only add to the economy’s capital stock and mobilize idle saving. They will also increase the economy’s long-term potential growth rate. Thus, if we are seriously concerned about the slowdown in potential growth of the EU economy, we should embrace this idea even more wholeheartedly. Given the current economic weakness and dire forecast, doing too little seems like a greater danger than doing too much.
Auerbach, A J and Y Gorodnichenko (2012), “Measuring the Output Responses to Fiscal Policy”, American Economic Journal: Economic Policy, 4(2): 1–27.
Blanchard, O and D Leigh (2013), “Growth Forecast Errors and Fiscal Multipliers”, IMF Working Paper, January.
DeLong, B and L Summers (2012), “Fiscal Policy in a Depressed Economy”, Brookings Papers on Economic Activity, Spring.
Woodford, M (2011), “Simple Analytics of the Government Expenditure Multiplier”, American Economic Journal: Macroeconomics, 3(1): 1–35.