Supply side economics and monetary policy
Speech by Jean-Claude Trichet,
President of the European Central Bank,
at the Institut der Deutschen Wirtschaft,
Kőln, 22 June 2004.
The notion of supply and demand in the context of price determination goes back to the economic writings of the Greek philosophers. But the economy’s supply side in particular gained attention with Adam Smith’s “Wealth of Nations”, published in 1776, where he railed against the restrictive, regulated, “mercantilist” system of his time and showed how the principles of free trade, competition and choice foster economic development and reduce poverty. More than two centuries later, the analysis of the supply side has lost none of its attraction to economists and politicians.
This seems to have mainly two reasons, one pleasant and one more sobering. The pleasant one is that economic theory can still contribute new ideas on how to improve the functioning of the supply side. The more sobering is that too many of these ideas have still found insufficient implementation, requiring continuous calls for more hearted progress with supply side reforms.
These calls are particularly audible in several European countries. Whereas over the last two decades, European countries have made considerable progress with product market reforms, including the creation of a Single Market as well as substantial reductions in entry barriers to network industries, reforms in several European labour markets have often been only very cautious and marginal. This also applies to the Single Market for services, where efforts for its creation need to be pursued.
Against this background, I would first like to outline the importance of an economy’s supply side for its ability to increase its potential growth path. Second, I would like to focus on the ways in which structural reforms that change an economy’s supply side affect the economic environment in which monetary policy is conducted. Third and finally, I would like to touch on how, in turn, the single monetary policy of the ECB supports non-inflationary growth in the euro area.
2. The importance of the supply side for potential growth
The supply side of an economy is responsible for mobilising resources to supply goods and services, entailing as a crucial part the supply of labour and capital. The supply side thus contributes to determining the economy’s potential growth path and the real income of its citizens. Any malfunctioning of the economy’s supply side is thus tantamount to leaving opportunities for raising the welfare of its citizens non-exploited. In this regard, the best economic measure for raising income opportunities is the implementation of policies, which help letting the supply side operate flexibly and efficiently. These policies include, among many others, education, research and development. For the euro area, the focus is increasingly shifting to how lasting impediments to the functioning of these policies can be removed with the help of structural reforms. Such well-designed structural reforms increase the mobility of production factors towards their most efficient use, thus raising factor productivity, opening up additional employment opportunities and allowing for lower prices of goods and services. By exploiting the opportunities of such a more efficient allocation of production factors, well-designed structural reforms allow the economy to reach a higher sustainable long-run growth path, higher employment, higher real incomes and thus a higher level of welfare.
Increasing the mobility of production factors between different uses and thus changing the economy’s production structure is normally a time-consuming process, and the beneficial effects of structural reforms often only materialise in the longer run. As a necessary although of course not sufficient condition, gaining support for the implementation of structural reforms requires highlighting the beneficial effects that reforms improving the functioning of economies’ supply sides have for potential growth and employment.
Let me therefore briefly draw attention to the US that successfully implemented structural reforms already towards the end of the 1970s and the beginning of the 1980s. The new direction of economic policy, the so-called “supply-side economics”, entailed a liberalisation of a number of network industries, previously heavily regulated, including air and surface transportation, natural gas pipelines as well as telecommunications. Furthermore, economic policy aimed at raising the incentives on the supply side as regards labour through a higher degree of labour market suppleness. Incentives to participate in the labour market were also enhanced by strongly reducing marginal income tax rates and by simplifying the income tax system. Overall, these policies contributed to the increase in economic activity and employment that the US witnessed in the following years.
In contrast to the reform efforts engaged in a number of industrialised countries towards the end of the 1970s and the beginning of the 1980s, several euro area countries started with structural reforms in labour, product and financial markets only more than one decade later. Some countries, in particular the Netherlands and Ireland, tended to act earlier and more decisively than others in the euro area. The success of the reforms undertaken in these countries is manifested in the low rates of unemployment compared to the average. In 2003, for example, unemployment in Ireland and the Netherlands amounted to 4.6% and 3.3% respectively, compared to more than 9% in Germany and France.
Looking at the euro area as a whole, some important structural reforms have taken place. Among the outcomes of these structural reforms were a higher level of competition in product markets due to the Single Market programme, a lower level of state aid and regulatory reform in network industries that resulted in price reductions and increased activity. Furthermore, since the introduction of the euro and in anticipation of it, reforms of the euro area capital markets have been stepped up, in particular through the Financial Services Action Plan initiated by the European Commission in 1999. As far as labour market reforms are concerned, these included, for example, improvements in countries’ job mediation systems as well as policies raising the efficiency of tax and benefit systems. These policies seem to have contributed to the strong employment growth and to the considerable decline in unemployment during the cyclical upswing between 1997 and 2000.
However, the high rate of unemployment in the euro area, which amounted to 8.9% in 2003, signals a still insufficient flexibility of the euro area and thus the necessity of further substantial efforts with structural reforms in labour markets in particular. In this regard, a cause for particular concern is that the level of euro area unemployment of young people aged 15-24 still amounted to 15.8% in 2002, despite a significant decline since the mid-1990s. This seems to reveal continued difficulties of this group to grow into work. This is all the more problematic as youth unemployment signals a particularly mediocre functioning of that segment of the labour market. A malfunctioning youth labour market negatively affects labour and product market performance immediately but also in the future because it has long-term consequences as regards the quality of the full body of the labour force.
The implementation of well-designed structural reforms in labour, product and capital markets and reforms aiming at increasing innovation, research and development is decisive at the euro area’s current juncture. The available conjunctural indicators suggest that the recovery of real economic activity in the euro area has continued into 2004, and it can be expected that this gradual recovery will continue and will strengthen over time. The economic recovery is likely to be stronger and more sustained, if ambitious well-designed structural reforms are implemented that improve the microeconomic fundamentals of the euro area. In this respect, a convincing commitment to the implementation of structural reforms and a successful communication of their economic benefits to the general public is crucial for raising consumer confidence, private consumption and ultimately growth and employment. In contrast, inactivity where reforms are necessary, piecemeal reform approaches or a lack of vision would hamper the economic recovery.
One last remark: In my view, there is no lack of knowledge why structural reforms are necessary. We all agree in Europe on the Lisbon diagnosis and the Lisbon agenda: the Heads of States and governments, the Commission, the ECB and the Eurosystem. There is more difficulty on how to convince households, to persuade our fellow citizens about their necessity. It is therefore very important to improve the communication on the substantial benefits well-designed structural reforms entail for all and particularly for the unemployed.
3. The impact of supply side policies on the conduct of monetary policy and financial stability
Let me now turn to the discussion of the implications that supply side policies like those I have just described may have for the conduct of monetary policy and for financial stability in the euro area.
In general, more competitive product and labour markets would increase firms’ productivity as well as aggregate demand and employment and, as a consequence, social welfare. Furthermore, a diversified, competitive, deep and well-integrated financial market structure increases the efficiency of both intertemporal consumption decisions and savings allocation. Following on from the above, it is not surprising that the ECB has always stressed the importance of a swift implementation of “supply side” policies, as those embodied in the Lisbon agenda, across the euro area.
From the monetary policymaker’s point of view, “supply side” reforms have an additional positive effect, as they tend to facilitate monetary policy and increase its effectiveness. To be sure, a more flexible economic environment would not insulate labour, product and financial markets from unforeseeable shocks that eventually hit the economy but it would smooth the process of adjustment to those shocks. In such a flexible economic environment, policy actions will be more efficient and feed through the economy more quickly. Furthermore, one notable consequence of reforms should be to lower inflation persistence. For example, more flexible labour markets may imply that negative supply shocks (e.g. oil price increases) are absorbed with a smaller increase in inflationary pressures, as second round effects are appropriately subdued. This, in turn, would allow monetary policy to react less strongly to such shocks. As another, similar, example one could think of the case when an economy open to international trade has to face the consequences of the appearance on the world stage of a new, eventually large, competitor country. Endowed with sufficiently flexible labour and product markets this economy will be able to undergo the necessary structural re-adjustment while at the same time maintaining low output volatility and enjoying the benefits of lower import prices. As a consequence, domestic inflationary pressures will remain muted and monetary policy is facilitated.
In this context, reforms aiming at developing the financial sector would strengthen the effect of “supply side reforms” on the economy and on the effectiveness of monetary policy. In particular, well developed financial markets will enhance the transmission of monetary policy impulses to the rest of the economy due to wealth and income channels that will complement the classic effect that an interest rate change has on aggregate demand.
In summary, a flexible economic environment will make it easier for monetary policy to maintain price stability, while at the same time it should also help to keep the volatility of output and unemployment lower.
From a different, but certainly related, perspective, policies aiming at the creation of an integrated, deep and competitive financial market in order to improve its resilience to shocks are important for the maintenance of financial stability, which, in turn, ensures a smooth functioning of the economy and supports macroeconomic stability. In extreme cases, the inability of the financial system to withstand unforeseeable shocks – which is one possible definition of financial instability - gives way to cumulative processes that hinder both the normal allocation process of savings towards investment and the functioning of the payment systems. In this context, the finalisation of the process of integration of the euro area’s financial system will provide investors and financial institutions with the opportunity to diversify away the “regional” risk arising from asymmetric shocks eventually hitting any single country or region within the euro area. As a consequence, financial institutions which have diversified loan and assets portfolios across the euro area will be better able to absorb the losses resulting from region specific developments, thus contributing to minimise overall macroeconomic volatility while maintaining the proper functioning of the monetary policy transmission mechanism.
Everything just said provides strong justifications for central banks’ interest in the implementation of structural reforms that increase the flexibility of the economy in which monetary policy operates. However, the impact of supply side policies, and structural changes more generally, on both the supply potential of the economy and the transmission mechanism of monetary policy calls for the monetary policy-maker to deepen its understanding of the dynamics of the economy. I shall try, now, to elaborate on this more in detail.
In the pursuit of their own objectives, modern central banks recognise that the economic environment in which they operate changes continuously and in ways that are extremely difficult to precisely identify in real time. As a consequence, when assessing their monetary policy stance central banks cannot rely on mechanical deterministic rules whereby a simple, reduced-form system of equations provides a unique and never changing mapping of economic developments into interest rates. Quite to the contrary, modern central banks need to adopt the broadest possible perspective when assessing the wealth of information that is available at the time the policy decision has to be taken. It is against this background that central banks need to assess the consequences for the conduct of monetary policy over time of possible changes in the supply potential and the structure of the economy.
In theory, central banks need to assess the impact of structural changes on the production potential of the economy and on the determination of the “equilibrium” real interest rate - which is often defined as the real short-term interest rate that is consistent with output at its potential level and a stable rate of inflation. For illustrative purposes, let me assume for the time being that potential output and the real equilibrium interest rate can be estimated with a high degree of precision. Under this, admittedly, simplifying (– and unrealistic –) assumption, the central bank, in a first step, would distinguish between changes in the level of potential output and changes of the long-run growth rates of potential output. For example, supply-side policies leading to a one-off increase in the level of potential output will only have a temporary effect on the economy and will not change the long-run equilibrium real interest rate. In a different situation, when the central bank comes to the conclusion that it is potential output growth that increases, the return on capital will also increase and the equilibrium real interest rate will follow.
Staying in this fictitious “thinking experience” a bit longer, economic theory would prescribe that once the, possibly, new “equilibrium” interest rate and potential output growth are estimated, the central bank takes into consideration a large set of other indicators, including the short-term interactions of aggregate demand and supply. This is needed because it is quite unlikely that supply side policies will affect aggregate demand and potential output growth at the same time and by the same magnitude.
However, as I already alluded to, these considerations oversimplify the issue. Reality is much more complex than described by this discussion. In real life, monetary policy cannot rest on the assumption that the level of the equilibrium interest rate, the natural rate of unemployment or potential output can be observed or estimated with a sufficient degree of confidence. The difficulty of producing reliable estimates of these indicators calls for appropriate decision-making in an uncertain environment. In a world where the degree of uncertainty about the structure of economic agents’ preferences and the relations among economic variables is very high, monetary policy is well advised to attach a relatively small weight to indicators or equilibrium concepts that can only be estimated with a high degree of uncertainty.
The design of the ECB’s monetary policy strategy takes into account such problems, thus facilitating robust decision-making in an economic environment characterised by high uncertainty. In our approach, the assessment of risks to price stability relies on a comprehensive economic analysis based on a large set of information and models. We do not give any privilege to a particular equation, set of equations or algorithm. We cross check this economic analysis with a monetary analysis in a medium and long-term perspective. In so doing, and by cross-checking all the available information, the central bank needs always to carefully consider the possibility of structural breaks in historical relationships as well as the signals sent by different models in the context of various types of approaches.
4. Monetary policy and long-term economic growth –The contribution of the ECB
I would now like to provide an answer to the opposite question, namely how the ECB’s monetary policy supports the non-inflationary growth of the euro area economy. In doing so, I want to start by emphasising again that on the basis of decades of economic research and central banking practice a widespread consensus view has by now consolidated on what monetary policy can and cannot do to foster long-term economic growth. According to this consensus view the changes in money supply eventually engineered by the central bank will, in the long run, only have a permanent effect on the general price level, not on economic growth.
However, this does not mean that monetary policy is irrelevant for long-term economic growth. Quite the contrary, by maintaining price stability and anchoring long-term expectations to a low and stable inflation level, the central bank reduces uncertainty in the economy and thereby contributes in the most effective way to support long-term growth and job creation. Needless to say, this is not necessarily an easy job to perform. In order to keep long-term inflation uncertainty low, the central bank needs to be credible, that is to say it must ensure that its behaviour is always fully consistent with the maintenance of price stability, and must be able to communicate its economic assessment and, eventually, its policy actions to the public in an open and transparent way.
By successfully preserving price stability the central bank will enhance the transparency of the price mechanism and remove certain distortions, thus allowing economic agents to take the most efficient consumption, saving and investment decisions. The outcome is an efficient allocation of resources that enhances the supply potential of the economy. In particular, price stability makes it easier for people to identify changes in relative prices, since such changes are not obscured by fluctuations in the overall price level. This allows households to decide upon their consumption on the basis of the right signals, while at the same time enabling a more efficient allocation of resources as both workers and firms are in a better condition to assess the developments in their own markets and, thus, take the appropriate decisions concerning production, employment and wages. Furthermore, in an environment of low and stable inflation the transaction costs associated with both frequent changes in the final prices, the so-called “menu costs”, and with people’s holding of a sub-optimal level of cash (“shoe leather” costs), will be smaller.
Moreover, price stability helps to avoid the arbitrary redistribution of wealth and income that arises in inflationary as well as deflationary environments.
In addition, price stability allows the economy to fully exploit its supply potential through other important channels. In a low and stable inflation environment, inflation uncertainty is minimised and this, in turn, reduces risk premia in financial asset prices and fosters investment by lowering the costs of financing for firms. It is one of the main benefit that the euro area currently enjoys that long-term interest rates all over the maturity spectrum are very low – reflecting the high level of credibility of the ECB in preserving price stability in continuity with the best performances observed in Europe before the setting up of the euro.
I thank you for your attention.