Does Europe face the prospect of a lost decade?

Christian Noyer of Banque De France asks this q in a recent speech.

He says lost decade could happen in Europe for two reasons (though adds it is not limited to Europe alone):

Questions about long-term growth are not limited to Europe. What we hear about our continent reflects a more general concern: the possibility of “secular stagnation” in advanced economies. Larry has launched this crucial debate. I don’t know whether he was thinking specifically about Europe, but, of course, this question is very relevant for us.

Secular stagnation rests on the assumption that the natural interest rate is negative. This may happen for two reasons:

  • In the short run, we may have a downward shock on demand and an increase in savings resulting from the deleveraging process. I have just explained how we are currently addressing this issue.
  • In the longer run, ageing and slower innovation may push up saving rates and bring down the return on capital. Therefore, the ultimate response to the risk of secular stagnation is to improve the return on investment, thus pushing the natural interest rate back into positive territory. Again, this is not only a European problem. But we do have difficulties in this regard. Structural reforms are not easy.

Many, however, are currently being implemented. Italy is abolishing its provinces, generating savings that will allow for a reduction in taxes and liberalising its labour market. France is on the same track and has reduced taxes on its labour costs as well as improving labour market flexibility.

He says opposite forces are hitting Europe:

Strangely, in the euro area, growth and inflation are moving in opposite directions. As growth accelerates, inflation keeps going down. This “disconnect” in the Philips curve is puzzling. We must look, then, at the broader picture. Euro area economies have attracted strong capital inflows over the recent months, with two opposite effects on financial conditions: first, easing through lower long-term interest rates. And, second, an appreciation of the euro exchange rate.

It’s not clear whether the overall effect is positive. While nominal conditions are more accommodating in euro area than in the US, real indicators point to a more restrictive stance. We may see a perverse feedback loop develop, with low inflation, increasing real rates, capital inflows and exchange rate appreciation mutually fuelling each other. The financial economy may be heading towards a bad equilibrium that would threaten the real economic recovery.

The situation called for an appropriate policy response and, as you know, the Governing Council has agreed last Thursday on a strong package of four significant measures

India just has an opposite problem. Despite slipping growth, inflation remains high.

What a mess we all are in…All basic macro conditions are all over the place.

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