I have just read Mario Draghi’s opening remarks at the Brookings Institution. Nothing very new with respect to Jackson Hole and his audition at the European Parliament. But one sentence deserves commenting; when discussing how to use fiscal policy, Draghi says that:
Especially for those [countries] without fiscal space, fiscal policy can still support demand by altering the composition of the budget – in particular by simultaneously cutting distortionary taxes and unproductive expenditure.
So, “restoring fiscal policy” should happen, at least in countries in trouble, through a simultaneous reduction of taxes and expenditure. Well, that sounds reasonable. So reasonable that it is exactly the strategy chosen by the French government since the famous Jean-Baptiste Hollande press conference, last January.
Oh, wait. What was that story of balanced budgets and multipliers? I am sure Mario Draghi remembers it from Economics 101. Every euro of expenditure cuts, put in the pockets of consumers and firms, will not be entirely spent, but partially saved. This means that the short term impact on aggregate demand of a balanced budget expenditure reduction is negative. Just to put it differently, we are told that the risk of deflation is real, that fiscal policy should be used, but that this would have to happen in a contractionary way. Am I the only one to see a problem here?
But Mario Draghi is a fine economist, many will say; and his careful use of adjectives makes the balanced budget multiplier irrelevant. He talks about distortionary taxes. Who would be so foolish as not to want to remove distortions? And he talks about unproductive expenditure. Again, who is the criminal mind who does not want to cut useless expenditure? Well, the problem is that, no matter how smart the expenditure reduction is, it will remain a reduction. Similarly, even the smartest tax reduction will most likely not be entirely spent; especially at a time when firms’ and households’ uncertainty about the future is at an all-times high. So, carefully choosing the adjectives may hide, but not eliminate, the substance of the matter: A tax cut financed with a reduction in public spending is recessionary, at least in the short run.
To be fair there may be a case in which a balanced budget contraction may turn out to be expansionary. Suppose that when the government makes one step backwards, this triggers a sudden burst of optimism so that private spending rushes to fill the gap. It is the confidence fairy in all of its splendor. But then, Mario Draghi (and many others, unfortunately) should explain why it should work now, after having been invoked in vain for seven years.
Truth is that behind the smoke screen of Draghinomics and of its supposed comprehensive approach we are left with the same old supply side reforms that did not lift the eurozone out of its dire situation. It’ s the narrative, stupid!
Update (9/30): Eurostat just released the September figures for inflation: Headline: 0.3%, Core, 0.7%
Hans Werner Sinn did it again. In the Financial Times he violently attacks Mario Draghi and the ECB. To summarize his argument (but read it, it is beyond imagination):
- The ECB gave too much liquidity to banks in peripheral EMU countries since 2008, thus fueling a spending boom.
- Then, with the SMP and the OMT programs it “lowered the interest rates at which overstretched eurozone members could obtain credit and reversed the losses of their foreign creditors, triggering another borrowing binge”
- Finally, “The ECB’s plan to purchase [private borrower's] debt could end up transferring dozens if not hundreds of billions of euros from eurozone taxpayers to the creditors of these hapless individuals and companies.”
- Last (but not least!!) he claims that deflation is necessary in EMU peripheral countries to restore competitiveness
I am shocked. Let me start from the last point. Even assuming that competitiveness only had a cost dimension, what would be required is that the differential with Germany and core countries were negative. Deflation in the periphery is therefore only necessary because Germany stubbornly refuses to accept higher inflation at home. And no, the two things are not equivalent, because deflation in a highly leveraged economy increases the burden of debt, and triggers a vicious circle deflation-high debt burden-consumption drop-deflation. I refuse to believe that a respected economist like Hans Werner Sinn does not see such a trivial point…
As for the rest, the spending binge in peripheral countries began much earlier than in 2008, and it is safe to assume that it was fueled by excess savings in the core much more than by expansionary monetary policies.
Further, does Sinn know what a lender of last resort is? Does he know what is “too big to fail”? Where was he when European authorities were designing institutions incapable of managing the business cycle, while forgetting to put in place a decent regulatory framework for banks and financial institutions?
And finally, does Mr Sinn remember what was the situation in the summer of 2012? Does he remember the complete paralysis of European governments that were paralyzed in front of speculative attacks to two large Eurozone economies? Does he realize that were it not for the OMT and the “whatever it takes”, today Spain and Italy would not be in the Euro anymore? Which means that probably the single currency today would not exist? Maybe he does, and he decided to join the AfD…
Yesterday I quickly commented the disappointing growth data for Germany and for the EMU as a whole, whose GDP Eurostat splendidly defines “stable”. This is bad, because the recovery is not one, and because we are increasingly dependent on the rest of the world for that growth that we should be able to generate domestically.
Having said that, the real bad news did not come from Eurostat, but from the August 2014 issue of the ECB monthly bulletin, published on Wednesday. Thanks to Ambrose Evans-Pritchard I noticed the following chart ( page 53):
The interesting part of the chart is the blue dotted line, showing that the forecasters’ consensus on longer term inflation sees more than a ten points drop of the probability that inflation will stay at 2% or above. Ten points in just a year. And yet, just a few pages above we can read:
According to Eurostat’s flash estimate, euro area annual HICP inflation was 0.4% in July 2014, after 0.5% in June. This reflects primarily lower energy price inflation, while the annual rates of change of the other main components of the HICP remained broadly unchanged. On the basis of current information, annual HICP inflation is expected to remain at low levels over the coming months, before increasing gradually during 2015 and 2016. Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with the aim of maintaining inflation rates below, but close to, 2% (p. 42, emphasis added)
The ECB is hiding its head in the sand, but expectations, the last bastion against deflation, are obviously not firmly anchored. This can only mean that private expenditure will keep tumbling down in the next quarters. It would be foolish to hope otherwise.
So we are left with good old macroeconomic policy. I did not change my mind since my latest piece on the ECB. Even if the ECB inertia is appalling, even if their stubbornness in claiming that everything is fine (see above) is more than annoying, even if announcing mild QE measures in 2015 at the earliest is borderline criminal, it remains that I have no big faith in the capacity of monetary policy to trigger decent growth. The latest issue of the ECB bulletin also reports the results of the latest Eurozone Bank Lending Survey. They show a slow easing of credit conditions, that proceed in parallel with a pickup of credit demand from firms and households. While for some countries credit constraints may play a role in keeping private expenditure down (for example, in Italy), the overall picture for the EMU is of demand and supply proceeding in parallel. Lifting constraints to lending, in this situation, does not seem likely to boost credit and spending. It’s the liquidity trap, stupid!
The solution seems to be one, and only one: expansionary fiscal policy, meaning strong increase in government expenditure (above all for investment) in countries that can afford it (Germany, to begin with); and delayed consolidation for countries with struggling public finances. Monetary policy should accompany this fiscal boost with the commitment to maintain an expansionary stance until inflation has overshot the 2% target.
For the moment this remains a mid-summer dream…
After the latest disappointing data on growth and
indeflation in the Eurozone, all eyes are on today’s ECB meeting. Politicians and commentators speculate about the shape that QE, Eurozone edition, will take. A bold move to contrast lowflation would be welcome news, but a close look at the data suggests that the messianic expectation of the next “whatever it takes” may be misplaced.
Faced with mounting deflationary pressures, policy makers rely on the probable loosening of the monetary stance. While necessary and welcome, such loosening may not allow embarking the Eurozone on a robust growth path. The April 2014 ECB survey on bank lending confirms that, since 2011, demand for credit has been stagnant at least as much as credit conditions have been tight. Easing monetary policy may increase the supply for credit, but as long as demand remains anemic, the transmission of monetary policy to the real economy will remain limited. Since the beginning of the crisis, central banks (including the ECB) have been very effective in preventing the meltdown of the financial sector. The ECB was also pivotal, with the OMT, in providing an insurance mechanism for troubled sovereigns in 2012. But the impact of monetary policy on growth, on both sides of the Atlantic, is more controversial. This should not be a surprise, as balance sheet recessions increase the propensity to hoard of households, firms and financial institutions. We know since Keynes that in a liquidity trap monetary policy loses traction. Today, a depressed economy, stagnant income, high unemployment, uncertainty about the future, all contribute to compress private spending and demand for credit across the Eurozone, while they increase the appetite for liquidity. At the end of 2013, private spending in consumption and investment was 7% lower than in 2008 (a figure that reaches a staggering 18% for peripheral countries). Granted, radical ECB moves, like announcing a higher inflation target, could have an impact on expectations, and trigger increased spending; but these are politically unfeasible. It is not improbable, therefore, that a “simple” quantitative easing program may amount to pushing on a string. The ECB had already accomplished half a miracle, stretching its mandate to become de facto a Lender of Last Resort, and defusing speculation. It can’t be asked to do much more than this.
While monetary policy is given almost obsessive attention, there is virtually no discussion about the instrument that in a liquidity trap should be given priority: fiscal policy. The main task of countercyclical fiscal policy should be to step in to sustain economic activity when, for whatever reason, private spending falters. This is what happened in 2009, before the hasty and disastrous fiscal stance reversal that followed the Greek crisis. The result of austerity is that while in every single year since 2009 the output gap was negative, discretionary policy (defined as change in government deficit net of cyclical factors and interest payment) was restrictive. In truth, a similar pattern can be observed in the US, where nevertheless private spending recovered and hence sustained fiscal expansion was less needed. Only in Japan, fiscal policy was frankly countercyclical in the past five years.
As Larry Summers recently argued, with interest rates at all times low, the expected return of investment in infrastructures for the United States is particularly high. This is even truer for the Eurozone where, with debt at 92%, sustainability is a non-issue. Ideally the EMU should launch a vast public investment plan, for example in energetic transition projects, jointly financed by some sort of Eurobond. This is not going to happen for the opposition of Germany and a handful of other countries. A second best solution would then be for a group of countries to jointly announce that the next national budget laws will contain important (and coordinated) investment provisions , and therefore temporarily break the 3% deficit limit. France and Italy, which lately have been vocal in asking for a change in European policies, should open the way and federate as many other governments as possible. Public investment seems the only way to reverse the fiscal stance and move the Eurozone economy away from the lowflation trap. It is safe to bet that even financial markets, faced with bold action by a large number of countries, would be ready to accept a temporary deterioration of public finances in exchange for the prospects of that robust recovery that eluded the Eurozone economy since 2008. A change in fiscal policy, more than further action by the ECB, would be the real game changer for the EMU. But unfortunately, fiscal policy has become a ghost. A ghost that is haunting Europe…
Eurostat just released its flash estimate for inflation in the Eurozone: 0.5% headline, and 0.8% core. We now await comments from ECB officials, ahead of next Thursday’s meeting, saying that everything is under control.
Just this morning, Wolfgang Münchau in the Financial Times rightly said that EU central bankers should talk less and act more. Münchau also argues that quantitative easing is the only option. A bold one, I would add in light of todays’
deflation inflation data. Just a few months ago, in September 2013, Bruegel estimated the ECB interest rate to be broadly in line with Eurozone average macroeconomic conditions (though, interestingly, they also highlighted that it was unfit to most countries taken individually).
In just a few months, things changed drastically. While unemployment remained more or less constant since last July, inflation kept decelerating until today’s very worrisome levels. I very quickly extended the Bruegel exercise to encompass the latest data (they stopped at July 2013). I computed the target rate as they do as
(if you don’t like the choice of parameters, go ask the Bruegel guys. I have no problem with these). The computation gives the following:
Using headline inflation, as the ECB often claims to be doing, would of course give even lower target rates. As official data on unemployment stop at January 2014, the two last points are computed with alternative hypotheses of unemployment: either at its January rate (12.6%) or at the average 2013 rate (12%). But these are just details…
So, in addition to being unfit for individual countries, the ECB stance is now unfit to the Eurozone as a whole. And of course, a negative target rate can only mean, as Münchau forcefully argues, that the ECB needs to get its act together and put together a credible and significant quantitative easing program.
Two more remarks:
- A minor one (back of the envelope) remark is that given a core inflation level of 0.8%, the current ECB rate of 0.25%, is compatible with an unemployment gap of 1.95%. Meaning that the current ECB rate would be appropriate if natural/structural unemployment was 10.65% (for the calculation above I took the value of 9.1% from the OECD), or if current unemployment was 11.5%.
- The second, somewhat related but more important to my sense, is that it is hard to accept as “natural” an unemployment rate of 9-10%. If the target unemployment rate were at 6-7%, everything we read and discuss on the ECB excessively restrictive stance would be significantly more appropriate. And if the problem is too low potential growth, well then let’s find a way to increase it…
I just read an interesting piece by Nicolò Cavalli on the ECB and deflationary risks in the eurozone. The piece is in Italian, but here is a quick summary:
- Persisting high unemployment, coupled with inflation well below the 2% target, put deflation at the top of the list of ECB priorities.
- Mario Draghi was adamant that monetary policy will remain loose for the foreseeable horizon.
- As we are in a liquidity trap, the effect of quantitative easing on economic activity has been limited (in the US, UK and EMU alike).
- Then Nicolò quotes studies on quantitative easing in the UK, and notices that, like the Bank of England, the ECB faces additional difficulties, linked to the distributive effects of accommodating monetary policy:
- Liquidity injections inflate asset prices, thus increasing financial wealth, and the value of large public companies.
- Higher asset prices increase the opportunity costs of lending for financial institutions, that find it more convenient to invest on stock markets. This perpetuates the credit crunch.
- Finally, low economic activity and asset price inflation depress investment, productivity and wages, thus feeding the vicious circle of deflation.
Nicolò concludes that debt monetization seems to be the only way out for the ECB. I agree, but I don’t want to focus on this. Read more
The Financial Times highlights one of the most striking conclusions of the latest ECB Financial Stability Report (full document here). The ECB, using FT’s words, “issued a stark warning over the threat posed by the scaling back of US monetary stimulus, calling on eurozone policy makers to do more to prepare for the market shocks from Federal Reserve tapering.“
There are of course many reasons why a change of policy of the largest world economy is closely monitored because of its potential impact. The ECB statements nevertheless are striking to me, because they are further confirmation of the small country syndrome that I pointed out in the past.
Quantitative Easing has been pivotal in ensuring that the hasty reversal of the fiscal stance in the United States did not dip their economy into a new recession. One may argue that today’s US economy is not sufficiently robust for exiting monetary stimulus. But it is sooner or later going to happen. The rest of the world has been free riding on Fed’s policies. In particular, the eurozone has benefited from QE in a context of sharp and pro-cyclical austerity, and very timid monetary policy.
Here is the statement I would have expected from the ECB: “The eurozone, the second largest economy of the world, has benefited from exceptional measures implemented by the Fed. This helped our economies and our financial markets in the context of a difficult consolidation process. Domestic factors in the United States will most likely cause a reversal of these policies. It is time European policy makers stand on their legs. As our economies persist in a state of chronic weakness, the ECB will consider its own quantitative easing program, to compensate for tapering in the United States, and provide to the European economy the environment it needs to rebound“
Such a statement, that I would find reasonable and balanced (maybe even too prudent), is nevertheless revolutionary nonsense in European policy circles. Instead we had the same old “copy-and-paste” demand to EMU countries of structural reforms and stable macroeconomic policies (read austerity). Not a single hint of even remotely possible non orthodox policies here at home. The sad truth is that we are structurally incapable of finding within our economy and our institutions the instruments to ensure growth and prosperity. We are structurally free riders. We siphon aggregate demand from the rest of the world running increasing current account balances, and we are not capable of implementing an autonomous monetary policy.
The world’s second largest economic area remains a parasite of the global economy, and it is incapable of living up to its responsibilities. Nothing good can come out of this.