ECB Needs To Talk About Slack And Not Structural Reforms

by: Antonio Fatas

In yesterday's Financial Times, Matteo Renzi, Italy's prime minister defends the pace of Italian reforms. In doing so he responds to comments by Mario Draghi last week that the pace of structural reform in Italy was responsible for the low GDP growth figures. From the FT interview:

I agree with Draghi when he says that Italy needs to make reforms but how we are going to do them.

So no disagreement between Draghi and Renzi on the need for structural reforms in Italy. The fact that improvements in regulation, labor markets, competition can increase growth rates in Europe is undisputed. The real debate is about the right timing and speed of those reforms. Here Renzi disagrees with Draghi.

"I will decide, not the Troika, not the ECB, not the European Commission," he said. "I will do the reforms myself because Italy does not need someone else to explain what to do."

But beyond the question of who decides on what are the appropriate reforms and at what pace they should be done, I find that there is a more fundamental problem with the dialogue between central banks and governments about the need of reforms. Why do central bankers need to remind governments of the need to do reforms? The only reason I can think of is because they feel too much pressure to lift growth rates and they want to explain to the public at large that the low economic performance is not really their fault but the fault of governments' failure to reform. But I find that the way the argument is being made creates unnecessary confusion and leads to a behavior of the central bank that sounds defensive and a justification for inaction.

Clearly, during any period of low growth there is a debate about the extent to which this is due to cyclical conditions or structural ones. What I expect the central bank to communicate is their view on how close the economy is to potential output, how much slack there is in the economy and how they plan to use their economic tools to address that gap. In the ECB press conference last Thursday, Draghi acknowledged that some of the low growth in Italy (and Europe) is due to demand/cyclical factors. But then he immediately brought up the need for structural reforms. And when he had to compare the importance of the two arguments in the case of Italy, he said that "it's mostly the lack of structural reforms" instead of low expected demand that is keeping investment low. I would find more reassuring if Draghi provided a stronger and more quantitative statement on the perceived slack in the economy (or the deviations of inflation from its target) and what the ECB plans to do about it than trying to guess the potential effects of structural reform.

The contrast between the ECB and the US Fed is, as usual, very interesting. The statements from the FOMC in the US tend to focus on their views about the current slack in the labor market and the potential effects of monetary policy actions to address this slack. There can be an occasional (justified) comment on how fiscal policy conditions are affecting the cyclical position of the US economy. No mention on the potential role of other long-term growth-enhancing policies that could be undertaken in the US government, as it should be.