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Ultra-accommodative policies by central banks have helped support growth and inflation dynamics both in the UK following the shock EU referendum result and in the Eurozone. 

But the beneficial effects of unconventional monetary policy are starting to recede. As they do, concrete government policies for productivity growth are essential if the UK is to overcome the challenges of Brexit – and other European countries are to avoid being overwhelmed by their levels of public debt.

Analyst: Antonio García Pascual - MD, Chief European Economist, Barclays

Unconventional monetary policy has saved the day…

  • The Bank of England’s decision to cut the bank base rate to 0.25% and introduce a package of stimulus measures a week after the EU referendum vote was forceful and decisive. 
  • These policies were instrumental in helping market volatility to recede and allay negative market and corporate sentiment.
  • Extra flexibility created by a weaker pound also eased the risk of sudden current account deterioration.
  • In the Eurozone, ultra-accommodative monetary policy has pushed funding costs to historic lows.
  • QE-driven growth has helped to reduce public-debt-to-GDP ratios.
  • Growth and inflation since 2015 have been 1.3% and 0.9% higher than we would estimate under conventional monetary policies.

…but it can’t last forever

But ultra-accommodative monetary policies by central banks have also taken the pressure off governments to enact specific policies for growth. At the same time they have created capacity for highly indebted sovereigns to spend more.

Our concern now is the beneficial effects of expansionary monetary policy being overwhelmed by these less positive effects:

  • In the UK, underinvestment and the squeeze in real pay growth will likely cause growth to continue to trend lower regardless of lower borrowing costs for companies. This will add another headwind to Brexit-specific risks, given Prime Minister Theresa May's confirmation that the government intends to leave the EU's single market and the customs union, which poses some downside for UK business.
  • QE has discouraged fiscal consolidation including in countries where it is urgently needed as well as reducing the pace of supply-side reforms. Public sector leverage could become unsustainable in some countries, unless GDP rates improve, and concerns about sovereign solvency could resurface sharply.

But why isn’t monetary policy enough to stimulate growth?

QE and ultra-low interest rates are designed to support growth and bring inflation back to target. But monetary policy cannot boost long-term productivity and growth. It can only provide support and buy the time needed for governments to implement fiscal and supply-side structural reforms. It is up to governments to use wisely the space that central banks can provide. 

Why productivity growth is the best antidote to public debt

Reduces debt to GDP ratio – enabling a country to pay its debts without taking on more debt.

Improves the fiscal balance – the balance of government revenues vs government spending.

Pushes up per capita incomes – improving consumption and reducing reliance on state spending – especially as inflation increasingly squeezes real pay growth.

Debt rises as productivity flatlines in Europe

As in the UK, productivity growth in Europe has been very disappointing. In the mid-1990s, productivity growth was 2% year on year in the Eurozone. Now it is below 0.5%, well behind the US and the majority of advanced and developing markets. Without better productivity dynamics, it is hard to see how those Eurozone countries with elevated debt will be able to pay it back – especially if and when the benefits of QE recede.

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Total Factor Productivity (index, 2010=100)

Source: European Commission

Public Debt/GDP, in percent

Source: Eurostat IMF

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So, what’s the answer?

Supply-side reforms by national governments are urgently needed to address three key needs.

1.  Raise productivity growth
  • In the UK, this would ideally mean implementing structural policies that incentivise saving over consumption and investment in innovation over investment in real estate. 
  • Opportunities to redeploy public spending will also arise as the post-Brexit government takes over spending currently managed by the EU.
  • In the European Union, reforms that could make a major difference to productivity and growth include:

    • Completing the Single Market, which is particularly relevant to improving productivity diffusion in the service sector.

    • Completing the Capital Markets and Banking Union to reduce the likelihood of future financial crises and more efficiently allocate credit to firms and households.

    • Reducing duality in labour markets and structural unemployment. These problems are particularly acute in Southern European countries.
2.  Mitigate sovereign solvency concerns
  • With the exception of Germany, all large European countries have failed to materially reduce their very high debt/GDP ratios. 
  • In theory, high debts do not necessarily imply that a sovereign crisis is around the corner, especially if governments spend fiscal resources wisely and collect taxes efficiently. 
  •  But if governments don’t act prudently, solvency concerns could re-emerge, sovereign interest rates quickly rise above the average funding costs and the adverse 2010-11 market dynamics could return.
3. Raise per capita incomes in Europe
  • Even in major European economies like Germany, GDP per capita (purchasing power adjusted) continues to lag behind the US and several other OECD economies.
  • Given adverse population dynamics (aging populations), differences in GDP per capita are highly likely to widen in Europe unless productivity is enhanced and labour market reforms are implemented to reduce structural unemployment.
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Read the full report

Authorised clients of Barclays Investment Bank can log in to read more on EU referendum follow-up #9: Government forced down the parliamentary routeEU referendum follow-up #8: Unplug and play and subscribe to#brexit and #europeanelections on Barclays Live.

For further information about the Barclays Research offering, please contact barclayslive@barclays.com.

 

About the analysts

Fabrice Montagné is Chief UK Economist at Barclays. Previously, he was a Senior European economist responsible for French, Greek and euro area macroeconomics. Mr. Montagné joined Barclays in January 2012 from the Dutch Central Bank where he was responsible for balance sheet, asset/liability management and strategic asset allocation decisions in the Financial Market division. Prior to that, he worked at the French Treasury and Fonds de Reserves pour les Retraites. Mr. Montagné graduated from Ecole Polytechnique, has an MSc in Economics and Statistics from ENSAE, and also holds an MSc in Economic Analysis and Policy from the Paris School of Economics.

Antonio García Pascual is a Managing Director and Chief European Economist at Barclays, based in London. Prior to joining Barclays in June 2010, Mr. Garcia Pascual was a senior economist at the monetary and capital markets department of the International Monetary Fund (IMF), which he represented at the Basel Committee on stress testing issues. Prior to the IMF, Mr. Garcia Pascual taught International Finance and Econometrics at the University of Munich. He has published extensively, including in academic journals such as the Journal of International Money and Finance, Oxford Economic Papers, and the Review of International Economics. Mr. Garcia Pascual graduated with a PhD in Economics from the University of California and a BA in Quantitative Economics from Universidad Complutense.

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