Insufficient home-assignments from the European Semester

Policy contribution - 'Does the European Semester deliver the right policy advice?'

The backbone of the EU’s economic policy coordination is the European Semester. In each year, it starts with the setting of the main priorities by the European Commission, followed by the submission and assessment of EU member states’ economic, fiscal and structural plans, and concludes with country-specific recommendations and recommendations for the euro area as a whole.

Does the European Semester deliver the right policy advice to the euro area? This was the question we tried to answer with Erkki Vihriälä in a briefing paper we wrote for the European Parliament. Unfortunately, we found the recommendations disappointing, for a number of reasons.

First, the recommendations to the euro area as whole are not really reflected by the country-specific recommendations. An example is that while the euro area recommendations call for addressing national distortions to saving and investment in both current account deficit and surplus countries, but Germany and the Netherlands (two major surplus countries) have not received specific recommendations to this end. Their large current account surpluses are not even mentioned in the recommendations. In terms of wage growth, Germany was advised to “Sustain conditions that enable wage growth to support domestic demand.”, which sounds promising, but the details on how to do this waters down the headline proposal: beyond reducing high taxes and social security contributions for low-wage earners, the second key channel is raising the educational achievement of disadvantaged people, which of course has to be a major goal, but it is unlikely to contribute in a significant way to wage growth. Also, three additional sentences call for increasing employment, which is again important, but in a country which is close to full employment (rather high labour force participation rate and low unemployment rate), it won’t deliver much.

And symmetric intra-euro area adjustments would be necessary not just for rebalancing price-competitiveness between euro-area deficit and surplus countries, but also for public debt sustainability. Competitiveness adjustment in deficit countries requires persistently lower inflation than in major trading partners, but low inflation worsens public debt sustainability. When inflation in surplus countries is low (eg below two percent), inflation has to be even lower in southern Europe, undermining debt sustainability, as I argued in another paper we published earlier this month. Interestingly, Daniel Gros and Cinzia Alcidi from CEPS also wrote a paper on the very same topic recently.

Second, demand is not important according to the recommendations, despite the still weak cyclical position of the euro-area economy. Investment is not a priority, even in countries with healthy public and private balance sheets and very low investment rates, like Germany.

Third, the concept of the “aggregate fiscal stance of the euro area” is a largely empty concept – even though it is emphasised in the euro area recommendations. The ideal aggregate fiscal stance of the euro area is not specified, and consequently not allocated between countries. Instead, the fiscal strategy continues to reflect a consolidation bias, which is not consistent with the economic situation of the euro area. The issue is not a return to ‘failed old debt-making policies’ in highly indebted countries (in these countries fiscal consolidation was necessary and has to continue at an appropriate pace), but to ensure fiscal stabilisation at the euro-area level as long as private demand is weak.

Fourth, the suggestions for financial sector repair go in the right direction, but remain too timid. Although the euro-area recommendations include a call to limit national supervisory incentives for re-nationalisation of bank assets and liabilities, this is absent from the country-specific recommendations. Another issue that is not properly addressed is the general undercapitalisation of the European banking system, which extends to the core countries.

The most comprehensive recommendations are on structural reforms aimed at improving the functioning of labour and product markets and making the business environment more growth-friendly, and on improving public finance management.

Therefore, and not very surprisingly, the recommendations very much reflect the general view on economic policies of the European Commission and Germany, placing strong emphasis on structural reforms and almost no emphasis on demand. Even the straitjacket of the European economic governance framework is not exploited sufficiently. I 100% agree that structural reforms are essential, but they can help at best in the medium- to long-term, while lack of growth in the short-term will have harmful impact on long-term growth too, as I argued here. Have the EU’s economic policies been successful so far, as claimed by several policymakers recently? Well, many people think they have not, as it was nicely summarised by this week’s Bruegel Blog review.

Policy contribution - 'Does the European Semester deliver the right policy advice?'