Only reform, not rate cuts, can solve the Eurozone's problems

Following the Swedish Riksbank's 50 bp rate cut on 21 June, there have been calls for the European Central Bank to do likewise. Edward Hugh at A fistful of Euros, for example, agrees with Bill Gross that “disinflationary forces are winning out” (hat tip: Brad DeLong).

While I expect the ECB will eventually follow suit, don't hold your breath - it won't be until current inflationary pressures have abated, which means at least several months away. Today's Lex column in the Financial Times (subscribers only) is even more sceptical about the prospect for Eurozone rate cuts:

In Germany pessimists still outnumber optimists, at least according to Monday's Ifo business confidence survey.

All over the eurozone, domestic demand is slow and investment intentions are weak. So it is unsurprising that, on interest rates, the optimists outnumber the pessimists. With the implied rate on the three-month Euribor December contract down 60 basis points since the end of March, markets are increasingly confident that the European Central Bank is on the verge of a cut.

Such optimism is a triumph of hope over experience. The ECB has made it clear it believes the risks to price stability are on the upside. These risks have increased. The 50 per cent rise in the oil price in euro terms this year is likely to add 0.5 percentage point to headline inflation. Meanwhile, another half a percentage point will come before long from the 10 per cent decrease in the euro's nominal effective exchange rate. Even if the ECB was not worried about inflationary pressures, its own research suggests that the impact on growth of even a 1 percentage point change in the policy-controlled interest rate is small a mere 0.34 per cent change in real gross domestic product in year one.

The ECB has consistently argued that the eurozone's lack of economic dynamism is due to structural, not monetary, factors. If it caved into political pressure to cut rates now, confidence might actually be damaged rather than encouraged. The rate optimists should unplug their ears.

Nonetheless, I hope the ECB eventually do cut rates. Even if the stimulus to growth proves to be modest, it can't hurt (likewise a weaker Euro). But of course what's really needed in Europe is structural reform of product and labour markets, greater competition and the extension of the single market to services.

This makes the findings of new research by OECD economists Romain Duval and Jorgen Elmeskov, delievered at a recent ECB conference, all the more disturbing. Their paper, The effects of EMU on structural reforms in labour and product markets (PDF), points to:

...the apparent slowdown in the reform process after the formal advent of the euro and by the limited ability of EMU countries – with the exception of few small ones and of reforms to retirement schemes – to carry out needed reforms in areas where political resistance is normally strong.

This is consistent with their finding that:

...the absence of monetary policy autonomy seems to be associated with lower structural reform activity in large, more closed economies.

...Obviously these simple findings should not be exaggerated. However, if additional testing suggests that they are robust it would point to a potentially problematic aspect of EMU. In particular, an effect of EMU in the direction of weakening the incentives for structural reform in the larger member countries would be a cause for concern.

Indeed. While these findings suggest that a more co-ordinated approach to structural reform in he Eurozone should be pursued, "this may be more complicated than it sounds." The authors conclude, somewhat despondently, that:

...there may be little alternative to soldiering on with the so-called open method of co-ordination - essentially based on jaw-boning and peer pressure - and trying to make that as effective as possible. It would be sad if structural reform were eventually driven by a factor that empirically is strongly correlated with reform: crisis.

(Hat tip to Ed at A fistful of Euros for the conference and paper links.)

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