In Europe, as in the global economy more generally, growth has been too slow for too long. In Europe, unlike elsewhere, this is setting up an existential crisis. Restoring growth now, on a basis that directly addresses the social discontent fuelling the rise of political fringe parties, has become mission-critical to sustaining the experiment.
Many solutions have been tried or proposed. Nothing has worked well, and nothing will unless the European economy is shifted from its current bad equilibrium of stagnant growth and deflationary pressures. This so-called stag-deflation is the mirror image of the stagflation (slow growth and high inflation) faced by the industrialized world in the 1970s.
The solution to stagflation was to switch from demand management to supply-side policies. The logic was powerful: The only way to achieve lower prices and higher output was to make economies more productive. This prescription would still be effective if today’s problems were those of the 1970s. But they are the reverse: Demand is depressed. To exit stag-deflation requires a break with current economic orthodoxy.
There is no shortage of examples of such breaks: Roosevelt’s New Deal, the creation of the Bretton Woods system, the break from Bretton Woods, Russia’s post-Soviet privatization and marketization, and China’s opening-up policy.
Europe has arrived at such a moment. A new and functional equilibrium requires appreciating how current policies are reinforcing the bad equilibrium. The key factor is the relationship between wage rates and interest rates.
Since the supply-side revolution, monetary policy has assumed the main responsibility for macroeconomic stabilization. But lowering interest rates to engineer a recovery by boosting interest-sensitive expenditure and investment also distorts the pricing of factors of production.
