Flash Economics. The attempts to save Keynesianism in the euro zone are tiresome. 25 January

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5 January 17-19 The attempts to save Keynesianism in the euro zone are tiresome Keynesian economists are now trying to save Keynesianism for the euro zone with arguments that are constantly repeated and yet fail to convince: It is said there is a growth shortfall in the euro zone. But actual growth in the euro zone is higher than potential growth, and the gap between the two is higher than that in the United States; It is also said that the fiscal multiplier is high. But when we look at the effect of the domestic demand stimulus provided by the fall in oil prices between 1 and 16, we see that a very large portion was lost to imports and the effect on euro-zone GDP was small; The need for public investment is touted over and over. But there is already the Juncker Plan, which seems to meet the borrowing requirement for efficient investment. There is also no link across OECD countries between the level of public investment and medium-term growth. So is it not time to give up trying to save Keynesianism? Patrick Artus Tel. (33 1) 58 55 15 patrick.artus@natixis.com @PatrickArtus www.research.natixis.com CORPORATE & INVESTMENT BANKING INVESTMENT SOLUTIONS & INSURANCE SPECIALIZED FINANCIAL SERVICES Distribution of this report in the United States. See important disclosures at the end of this report..

A return to Keynesianism is being strongly urged in the euro zone International institutions, a number of governments and many economists in Europe advocate a return to using more expansionary fiscal policy in the euro zone (Chart 1). Chart 1 Euro zone: Fiscal deficit (as % of nominal GDP) -1-3 - -5-1 -3 - -5 Sources: Datastream, Natixis forecasts -7-7 3 5 6 7 8 9 1 11 1 13 1 15 16 17 The arguments in favour of returning to Keynesian policies are well known. It is argued that: - The fiscal austerity in the euro zone is one of the causes of its weak growth; - The fiscal multiplier is high; - There is a need for more public investment. We think that these arguments, repeated incessantly, are not at all convincing. In reality, growth is not weak in the euro zone To judge whether there is a need to stimulate demand, it is not growth in absolute terms that matters but the comparison between actual growth and potential growth. Demand needs to be stimulated if growth is low relative to potential growth. Chart A shows that since the end of 13, euro-zone growth has been higher than potential growth; Chart B shows that the gap between growth and potential growth is higher than that observed in the United States.

Chart A Euro zone: Real GDP and potential growth (Y/Y as %) Chart B Spread between real GDP and potential growth (Y/Y as %) 6 Real GDP Potential growth 6 United States Euro zone (*) Per capita productivity - smoothed over the past 5 years + labour force Sources: Datastream, Eurostat, Natixis 3 5 6 7 8 9 1 11 1 13 1 15 16 17 - - Sources: Datastream, Natixis -8 3 5 6 7 8 9 1 11 1 13 1 15 16 17 - -8 This shows that a real economic recovery has been underway in the euro zone, which disproves the argument that demand needs to be stimulated. The fiscal multiplier is probably not high Many conflicting empirical studies have looked at the level of the fiscal multiplier depending on the stage of the economic cycle, whether the change concerns public spending or the tax burden, the monetary policy stance, etc. These studies do not lead to an unambiguous conclusion. But one can also look at recent experience in the euro zone. The increase in domestic demand due to the fall in the oil price from 1 to 16 led to a sharp increase in imports. For every euro that domestic demand increased, 8 euro cents went to an increase in imports and 5 euro cents to an increase in GDP (Charts 3A and B). Chart 3A Euro zone: Domestic demand, GDP and imports (in volume terms, 1:1 = 1) Chart 3B Euro zone: Imports excl. intra-zone trade (in volume terms, as % of domestic demand) 11 18 Domestic demand GDP Imports excl. intra-zone trade 11 18 6 6 16 16 1 1 1 1 1 1 Sources: Datastream, Eurostat, Natixis 98 98 Mar-1 Sep-1 Mar-15 Sep-15 Mar-16 Sep-16 Mar-17 18 Sources: Datastream, Eurostat, Natixis 16 3 5 6 7 8 9 1 11 1 13 1 15 16 17 18 16 This is incompatible with a high fiscal multiplier, given the extent of the loss to imports (half of the domestic demand stimulus). Is there a real need for public investment? It is true that public investment in the euro zone has fallen since the 89 crisis (Chart ). 3

3.8 Chart Euro zone: Public investment (as % of nominal GDP) 3.8 3.6 3.6 3. 3. 3. 3. 3. 3..8.8 Sources: Datastream, AMECO, Natixis.6.6 3 5 6 7 8 9 1 11 1 13 1 15 16 But there are a lot of inefficient components of public investment: inefficient transport infrastructure, oversized public buildings, etc. It is not certain that there is a real need to increase public investment in the euro zone: - The Juncker Plan (Table 1) is comfortably financing efficient public investments; - When we compare OECD countries, we see no link between public investment and medium-term growth (Chart 5), which probably stems from the heterogeneity of public investment and the difficulty in identifying the components of public investment that actually have a positive effect on long-term growth. Table 1: Juncker plan (December 16) EFSI investment by sector Energy % Small enterprises 31% Research and discovery 1% Digital 1% Transport 8% Environment and resource efficiency % Social Infrastructure % Total investment related to EFSI approval 163.9 EUR bn EFSI approved financing 3.6 EUR bn* EIB:. EIF: 8.1 *Of which 17 EUR bn signed Sources: European Commission, Natixis

Real GDP (Y/Y as %) 3.5 3..5. Chart 5 Real GDP and public investment (16 average) UK SW AU 1.5 BG OE ES FN 1. GE NL FR.5 DK JP PT IT. GR Sources: OECD, Natixis -.5..3.6.9 3. 3.5 3.8.1..7 NZ US CN Public investment (as % of nominal GDP) SD Conclusion: Disingenuous pro-keynesian activism? We have major doubts about: - The need to stimulate demand in the euro zone, as growth is markedly higher than potential growth; - The presence of a high fiscal multiplier, because of how much of domestic demand stimulus in the euro zone is lost to imports; - The need to increase public investment in the euro zone, given the financing of efficient investments by the Juncker Plan and considering the absence of any link among OECD countries between the level of public investment and growth. Unfortunately, the constant flow of pro-keynesian propaganda is scientifically dubious. 5

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