The economic and geopolitical situation is by no means easy as we face overlapping crises caused both by various internal vulnerabilities and numerous exogenous shocks. An important characteristic is their long-term effect, which is valid both if we think about the changes in economic mechanisms induced by the COVID pandemic (still ongoing, including according to the WHO), and the rethinking of economic and commercial dependencies (not only from the perspective of added value chains) imposed by Russia’s aggression on Ukraine.
By Leonardo Badea, Deputy Governor of the National Bank of Romania
Forced by these realities that will make it difficult for many years to fully return to the economic ties specific to the peak period of globalization, economic decision-makers are forced to manage risks more strictly, through a different strategic approach to the national economic potential, seeking to develop a wider range of local economic sectors, even where in reality there is no clear competitive advantage, but their strategic importance for the overall functioning of the economy and society no longer allows dependence on imports from areas with potential geo-political or social risk.
From a certain perspective, in the short term (1-3 years), this paradigm shift in policies to stimulate the economy leaves room for (or cannot completely eliminate) inflationary pressures, being obvious that in those sectors where locally produced raw materials without competitive advantages are used for supply, they will be more expensive, implicitly the production cost will be higher and therefore the consumer will pay more or benefit from a lower quality compared to what it would be paid in conditions of peace and normality, for a perfectly substitutable import product.
Also in this register, it should be mentioned that including stricter risk management in the normal flow of production (for example the need to maintain larger stocks, the need to implement health protection measures for workers, the introduction of IT and technological systems resilient to cyber risks, reducing the impact on the environment, etc.) inevitably implies a higher production cost, therefore, in the absence of an increase in productivity, it indirectly exerts upward pressure on final prices.
From another perspective, however, this response of economic policies to the aforementioned effects of overlapping crises, costly in the short term (not only from the perspective of inflation but also of budget expenditures, etc.), has in the medium and long term the indisputable advantage of favoring the consolidation of the national economy from the perspective of jobs, increasing the well-being of households, increasing the accumulation of domestic capital, improving the solvency of companies and the population, therefore implicitly increasing the bankable demand for loans and the advance of financial intermediation, therefore further strengthening the banking system and, not least, improving the perennial vulnerabilities of public finances and the deficit resulting from international trade (at least on the side of reducing imports).
The list of benefits over time of some structural policies to develop the supply of goods and services is much wider and is not limited to economic ones, as it is natural because a larger economy generates more public revenues that can be directed to the development of education, of local culture, to the improvement of health and public safety services, defense, etc; in fewer words, towards a more evolved society and a more consolidated and internationally influential state. And all these benefits, as in a veritable virtuous circle, then return to the economy through a more stable and sustainable long-term aggregate demand, a healthier, more competent workforce, more adapted to new technologies, therefore, more productive and competitive globally, as well as by increasing local investment resources, both in the public and private sectors.
An absolutely necessary nuance: as it is very clear from the nature of the previously inserted arguments, the plea is not for embracing the intensely contested economic theory of supply (“supply side economics” or “supply side fiscal policy”) whether we refer to its best known form (based on the “Laffer Curve” theory – 1974) or subsequent adjustments (Lucas, 1990). Even though it is an approach supported by many well-known economists (e.g. Robert Mundell, 1970) and it has been the basis of the economic strategies of some US presidents (e.g. that implemented by the Reagan administration in the 1980s), it is as clear as it can be that such an approach would not work in Romania now, when the need for budget consolidation leaves no room for tax reduction. Moreover, from a strictly academic point of view, as is very clear from the above, many of the arguments previously invoked actually have their basis in the Keynesian theory of the stimulation of demand (1930), for example investment in education, with the effect of reducing inequalities between social categories. Therefore, the focus is not on the fiscal stimulation of supply, but on public policy support for the structural reforms needed to reduce current vulnerabilities, which can lead to economic growth and the reduction of inflation.
It is a widely accepted economic principle that demand generates supply. But, in the context of the last 2-3 years at least, we cannot ignore the questions “where and what kind of offer is generated by the demand stimulated by internal economic policies?”. An answer of the type “we stimulate the external offer, coming from remote regions and characterized by considerable geo-political and social risks, the internal offer being less competitive in terms of price” I don’t think can be accepted by anyone today. We therefore see that, gradually, among the criteria for optimizing the decision to allocate resources and capital, considerations of long-term sustainability and risk could make their way, not just those of the price/quality ratio in classical economics.
An interesting parallel can be drawn here between the changes in economic decision algorithms brought about by sustainability factors, on the one hand by the need to preserve the environment and on the other hand by the real threats to globalization, such as those discussed here. I think that, as in the decisions to allocate investments in the capital markets, it initially started from the Markowitz criterion of optimization between return and risk (1969) and later evolved towards multi-criteria formulas that today are completed in the approach of some institutional investors with criteria regarding supporting green investments (Alessi et al., 2021; Bolton and Kacperczyk, 2021; Pedersen et al., 2021; Krueger et al., 2020; UBS, 2020), likewise in state economic policies there is room for a better balance between the stimulation of domestic demand and the conditions for the evolution of domestic or regional supply (e.g. in the European Union).
In any modern economy there are interconditionalities between demand and supply, which influence price levels, but also the speed with which they converge back to equilibrium after the manifestation of shocks that induce tensions on economic mechanisms. Therefore, the plea could not be to completely change the approach and focus economic policies exclusively on the stimulation of supply, but rather to restore a normality in which the national supply of goods and services once again receives the attention and support it deserves from the economic policies and public resources allocated. Finally, the success of supply-side structural reforms translates into favorable stimuli for domestic demand, for which support through established public policy instruments certainly exists and is important to be maintained.
Structural reforms based on the development needs of the local economy must be oriented with priority to those areas of activity that are the main source of external imbalances, but also to the consolidation of the performing sectors of the economy, taking into account at the same time the areas of strategic importance, the need for rapid adoption of new technologies, the European objectives regarding the digital transition and the reduction of the environmental footprint, as well as the acute need to combat inequalities and promote inclusion.
We currently have a large-scale and impactful instrument for stimulating supply in key economic areas, which largely overlap with the European Union’s multiannual objectives, so it does not create controversy at the community level from the perspective of unjustified state advantages, as some might be tempted to object. On the contrary, the extremely important sums allocated to Romania (as well as to all other European states) based on the National Recovery and Resilience Plan can be allocated to objectives that stimulate the development of productive capacities at the national level, at the same time fulfilling important environmental, digitalization, and infrastructure objectives. Moreover, the investments in the Romanian economy made through the financing offered by the European funds are largely devoid of inflationary effect, and the grants (very consistent) do not contribute to the increase of the nominal level of the debt either. These are the objective reasons why many voices from the administrative structures, the entrepreneurial area, and the local economic and financial community insist on the importance of efforts to absorb as quickly and as completely as possible these resources released from the community budget. In addition, the investment from European funds is today, by the very way in which the European Facility for Recovery and Resilience was conceived, among the few that can really exert an anti-cyclical action in this period.
Ensuring a robust and sustainable fiscal framework but at the same time favorable to fair and balanced economic and social development has an important role. Fiscal predictability has always represented one of the first requirements of the business environment vis-à-vis the public administration, and the sustainability of public finances is implicitly a key factor for the development of the private sector, because it builds the risk premia that influence the cost of financing on the capital market, also having broad, direct, and indirect effects on the general macroeconomic equilibria.
Reaching a situation where the counter-cyclical nature of economic policies can be preserved in the long term is important to mitigate the volatility of economic cycles and vulnerabilities to external shocks. Today, unfortunately, we are not in such a favorable position, so that in many ways economic policy actions are forced to act pro-cyclically as a result of the narrowing of the room for maneuver in the context of the ample resources used to counter the overlapping crises of recent years and of imbalances accumulated prior to their manifestation. But we must continue to seek the best balance of the mix of corrective measures and create, step by step, the necessary space to stimulate economic growth, which can be done including through qualitative measures and structural changes, not only through the allocation of financial resources. The quality of the measures taken is at least as important as the extent of their financial support. It is also necessary to avoid the excessive overlapping of corrective measures with a procyclical, depressive effect on the economy, which can be attained through a multi-criteria, difficult, and complex, but possible “balancing act”, between stimulating demand, implementing structural reforms, fiscal consolidation, and combating inflation, through a gradual approach and good synchronization between all components of the economic policy mix.