Jean-Claude Trichet and his colleagues at the European Central Bank have clearly learned the wisdom of Paul Volcker: without first establishing anti-inflationary credibility, all is lost. The question now is whether they should learn the wisdom of Alan Greenspan – that the economy’s speed limit can change and that policy may have to be adapted accordingly.
Developing this insight and acting upon it were arguably Greenspan’s greatest achievements. In a series of speeches starting in 1995 that many observers initially dismissed as an effort to evade questions of policy, the Maestro raised the possibility that the sustainable rate of economic growth had increased due to the productivity-enhancing effects of new information and communications technologies. From January 1996 through June 1999, the Fed did not raise interest rates despite strong economic growth that, under other circumstances, would have fanned fears of inflation. Monetary policy did not choke off the expansion. Continued strong investment supported the deployment of the new productivity-enhancing infrastructure.
Strikingly, Greenspan made this judgment in advance of hard evidence. Subsequent experience supported his conclusion, but the case when he made it was based mainly on intuition, indirect evidence from the stock market, and fragmentary data.
The question for Trichet and his colleagues is whether Europe is undergoing a similar shift and whether the ECB should display analogous restraint. The fact that growth is currently accelerating tells us nothing about the answer, since this could simply be a cyclical phenomenon. More relevant is evidence of structural change with real economic consequences. European firms are forging production networks with their counterparts in Central and Eastern Europe, allowing even activities where proximity to the final user is important to be outsourced at lower cost. Labour market restrictions are being relaxed. Nationwide collective bargaining is being decentralised. Wages are becoming more flexible. Financial markets are being remade. These changes create more opportunity for deploying new information technologies in retailing, financial services, and manufacturing alike. All this, together with the improved performance of Germany, is taken as evidence that the scope for non-inflationary growth has increased.
But there are two reasons to pause before concluding that Europe’s speed limit has been raised. First, Germany is not Europe. Reform in the continent’s other large economies has lagged. Much of the reform that has taken place elsewhere has been partial and creates as many problems as it solves. For example, wage flexibility has been enhanced by creating a two-tier labour market in which new workers, mostly young people, hired on short-term contracts can be paid less and do not enjoy security of employment. The majority of new job creation in France and Spain has taken this form. The problem is that employers have an incentive not to renew those contracts, for temporary workers would then become permanent, raising social charges. This encourages churning in the labour market. It reduces the incentive to invest in productivity-enhancing skills. In Germany, a decade of high unemployment and chronic fiscal problems following reunification broke down resistance to comprehensive reform. As the French elections remind us, no analogous transformation is evident elsewhere.
Second, economic reform can have a disturbing tendency to depress productivity growth before raising it. The European economic and social model is a system of interlocking parts, none of which can be changed without disrupting the operation of the others. A simple caricature of that model is one in which patient banks provide long-term finance to firms working together through cohesive employers associations to provide vocational and apprenticeship training to their workers, all with the goal of producing world-class precision manufactures. This model worked well so long as economic growth in Europe depended on importing known technologies from the United States, adapting them to local conditions, and improving them in modest ways. It was ideally suited to conditions where Europe remained far from the technological frontier defined by the United States and where the task for growth was to import existing technologies and improve them incrementally rather than to develop new ones out of whole cloth – which is precisely why Europe elaborated this particular constellation of institutions following World War II.
But these arrangements are less well suited to today’s circumstances, when Europe has approached the technological frontier and growth depends on the economy’s capacity to innovate. This is why Europe now needs more flexible labour markets, securities markets to take bets on competing technologies, and more emphasis on university education than vocational training.
The problem is that progress is faster in some of these areas than others. In financial markets, adaptation is proceeding rapidly. The share of bank loans in total financing has declined from 74, 80, and 75 % in 1989 in France, Germany and Italy, respectively, to 42, 52, and 47 % at the beginning of the 21st century in the face of growing competition from global capital markets. Banks are merging. Europe’s securities markets are consolidating. Everywhere one looks in the realm of finance, change is in the air. By comparison, labour market reform is slower. And, in areas like university education, where efficient provision requires public-private competition, change is barely visible at all.
And, so long as some parts of the mechanism are replaced without replacing the others, the efficiency of the overall system is negatively affected. This is evident, for example, in the effects of labour market reform. Labour market reforms have resulted in “job-rich growth,” which has allowed Europe to boost employment even faster than output. But in the absence of education reform and new ways of fostering skill formation, this has mainly meant adding unskilled workers and unskilled jobs. In the short-run, this has depressed productivity growth rather than raising it.
The reality is that there is no higher power – certainly not the European Commission – with the capacity to mandate simultaneous change in all the relevant areas. And there is no radical shock akin to World War II forcing European society to simultaneously overhaul all of the components of the model. Inevitably, change will be uneven. It will proceed more rapidly in some areas than in others. The result is likely to be a slowdown in productivity growth in the short-run, even if there are prospects for an increase subsequently.
If Germany’s speed limit has been raised but the rest of Europe’s has not, then tight ECB policy is likely to raise hackles in Germany, where wage growth has been restrained and there is still little evidence of inflation pressure. This is the cost of European Monetary Union, where a one-size-fits-all monetary policy is not a comfortable fit for a diverse set of member states. Europe may have better times ahead, but for the ECB, a Greenspan-like gamble on growth would still be premature.