Daniel Gros writes:  The mantra in Brussels and throughout Europe nowadays is that investment holds the key to economic recovery. The lynchpin of the new European Commission’s economic strategy is its recently unveiled plan to increase investment by €315 billion ($390 billion) over the next three years.

The Commission’s plan, the signature initiative of President Jean-Claude Juncker at the start of his term, comes as no surprise. With the eurozone stuck in a seemingly never-ending recession, the idea that growth-enhancing investment is crucial for a sustainable recovery has become deeply entrenched in public discourse.

European Union authorities (and many others) argue that Europe – particularly the eurozone – suffers from an “investment gap.” The smoking gun is supposedly the €400 billion annual shortfall relative to 2007.

But the comparison is misleading, because 2007 was the peak of a credit bubble that led to a lot of wasteful investment. The Commission recognizes this in its supporting documentation for the Juncker package, in which it argues that the pre-credit-boom years should be used as the benchmark for desirable investment levels today. According to that measure, the investment gap is only half as large.

The pre-boom years are not a good guide for today’s European economy, because something fundamental has changed more quickly than is typically recognized: Europe’s demographic trends.

The eurozone’s working-age population had been growing until 2005, but it will fall from 2015 onward. Given that productivity has not been picking up, fewer workers mean significantly lower potential growth rates. And a lower growth rate implies that less investment is needed to maintain the capital/output ratio.

If the eurozone maintained its investment rate at the level of the pre-boom years, there would soon be much more capital relative to the size of the economy.

An ever-increasing capital stock relative to output means ever-lower returns to capital and thus ever more non-performing loans in the banking sector over time.

What can the Juncker plan do to have a positive short-run impact on aggregate investment?

At present, there is no shortage of funding available in most of the EU. The countries on the eurozone periphery, where credit might still be scarce, account for less than one-quarter of Europe’s economy. So a lack of funding is not the reason that investment remains weak.

The Juncker plan is supposed to unlock, with €21 billion in EU funding, projects worth 15 times as much (€315 billion). That sounds far-fetched. Europe’s banking system already has more than €1 trillion in capital. The addition of €21 billion, in the form of guarantees from the EU budget, is unlikely to have a significant impact on banks’ willingness to finance investment.

The Juncker plan targets, in particular, infrastructure projects, which are often riskier than other investments. But these risks usually are not financial; they reflect potential political and regulatory barriers at the national level. These problems cannot be solved by a guarantee from the EU budget.

The reason why there still is no good interconnection between the Spanish and French power grids is not a lack of financing, but the unwillingness of monopolies on both sides of the border to open their markets. Many rail and road projects are also proceeding slowly, owing to local opposition, not a lack of financing.
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Economic performance in the United States and the United Kingdom holds an important lesson for the eurozone. Both economies’ recoveries have been driven largely by a pickup in consumption on the back of stronger household balance sheets, especially in the US. Is consumption the answer?

Barry Eichenreen writes:  The European Central Bank is moving, hesitantly but ineluctably, toward quantitative easing. The threat of deflation and the ineffectiveness of its previous measures leaves it no choice. The question is whether the ECB will be able to move quickly enough.

The ECB has already attempted to ease credit conditions by purchasing high-quality asset-backed securities. It has bought securities backed by cash flows from private-sector mortgages, so-called covered bonds, and it has floated the idea of buying corporate bonds and multilateral securities issued by the European Investment Bank.

But it is clear that this will not be enough. Supplies of private-sector securities are limited, reflecting the dominance of bank lending in Europe and depressed sentiment in securitization markets. Augmenting the supply of such securities will take too much time.

For all these reasons, purchasing private-sector securities alone will not enable the ECB to achieve its stated goal of expanding its balance sheet by €1 trillion ($1.2 trillion). Unable to vanquish the specter of deflation, ECB President Mario Draghi will need to continue working to build a consensus in the bank’s governing board for purchases of government bonds.

But Draghi and his colleagues will proceed in small steps, given fears in Germany that quantitative easing is just another name for runaway inflation. Initially, the ECB will buy a small volume of government bonds; when this fails to produce economic Armageddon, it will begin to scale up its purchases.

The problem is that this kind of incrementalism will not work.  When deflationary expectations are entrenched, as they are in Europe today, consumers and investors delay spending on the ground that prices and costs will be lower tomorrow. Those expectations become self-fulfilling.

Dramatic measures are needed to convince households and firms that the future will be different from the past. The central bank needs to convince them that it will do whatever it takes  to jolt the economy out of its deflationary lethargy.

That is what the Bank of Japan, under Governor Haruhiko Kuroda, is attempting to do.

Opponents of quantitative easing worry that it augurs inflation. They worry that securities purchases will sow the seeds of another financial bubble and bust. The most influential objection to quantitative easing is that it will relieve the pressure on European governments to reform.

Under current conditions, with the inflation rate dangerously close to zero, governments are reluctant to do anything that increases the risk of deflation. And structural reform and fiscal consolidation are both deflationary in the short run.

Structural reform that increases the flexibility of labor and product markets is deflationary as well. Enhancing wage flexibility in an environment in which unemployment exceeds 11% will allow firms to cut wages, and lower labor costs will permit them to cut prices in an effort to gain market share. Deregulation that intensifies product-market competition will similarly lead to lower prices (that being what competition does).

Europe does stand to reap significant benefits from fiscal consolidation and structural reform – but in the long run, not in the short run, when the problem is deflation. And European governments know it.

It follows that the best thing the ECB could do to encourage fiscal consolidation and structural reform is to banish the specter of deflation. Only full-bore quantitative easing can do that.