Standard Life Investments

Weekly Economic Briefing


Liberté, égalité…flexibilité?


Eurozone growth keeps surprising to the upside. Indeed, consensus expectations for 2017 GDP growth have risen from 1.4% at the turn of the year to a robust 1.9% at present. However, while the cyclical upswing has seen actual Eurozone growth firing on all cylinders, underlying potential GDP growth is estimated to be rather more modest in the currency union. The European Commission estimates potential growth at a sluggish 1.2% in 2017, which helps explain why the robust activity of late has been successful in eating into spare capacity. With potential growth rates low, there remains significant room for improvement (see Chart 5). European Central Bank President Draghi has been outspoken about the need for labour and product market reforms that broaden labour-market participation and competition in the corporate sector to help boost productivity and potential growth.

Much improved, much to do Different measures of potential

Spain provides a useful case study of reform in action. In 2012, the Spanish government enacted reforms to improve labour- market flexibility by reorientating collective bargaining from industry level to company level, while also increasing labour flexibility around hiring, firing and working conditions at the company level. Since then, potential growth estimates have risen (albeit not back to pre-crisis levels) and hiring has picked up sharply. However, these reforms have not been warmly received by all, with workers citing heightened job insecurity and lower quality jobs available. Fast forward to 2017: the election of Emmanuel Macron to the presidency in France may see similar reforms unfold. French potential growth sits around the average at 1.2%, with a highly inflexible labour market frequently cited as a key factor holding the French economy back. Macron’s policy proposals echo the Spanish reform programme, with a focus on giving the power back to corporates on issues like hiring, firing and hours worked. While this would allow firms more flexibility, the President will – and already has – come up against substantial opposition from workers and unions, which suggest his path to reform will be a difficult one.

Why does potential growth matter? Generally speaking, it provides an important benchmark of the structural growth potential of an economy, helping fiscal and monetary policy makers calibrate policy appropriately. In the Eurozone, potential growth helps determine country compliance with the stability and growth pact – which is assessed using the structural budget balance expressed as a percentage of potential GDP.  However, the use of this measure is not without controversy: estimating potential growth is a notoriously thorny endeavour given that it cannot be directly observed. Therefore, wide confidence intervals are needed around any point estimate. Indeed, while the EC and OECD provide estimates using production function models, the IMF approach varies between combinations of statistical smoothing models and production functions depending on the country. Even the EC and OECD differ in approach and lead to quite different views on potential (see Chart 6). This ambiguity over potential naturally causes headaches for policymakers in the tricky area of fiscal policy adherence, with targets set based on assumptions in economists’ models. Indeed, it is not a surprise to see countries protest or even renege on these targets.

Stephanie Kelly, Political Economist