## Praising the Bundesbank

I am puzzled by Wolfgang Münchau’s latest piece in the Financial Times. Let me start by quoting the end:

[...] The ECB should have started large-scale asset purchase a year ago. It certainly should do so now. The EU should allow governments to overshoot their deficit targets this year, and suspend the fiscal compact, which will result in further fiscal pain from 2016.

Even a casual reader of this blog will quickly realize that it would be hard for me to agree more with these statements. The macroeconomic stance at the EMU level has been seriously inappropriate since 2010, with fiscal policy globally restrictive (thank you austerity), and monetary policy way too timid.
So, what is the problem? The problem is the first part of Münchau’s editorial, in which he attacks the Bundesbank for its plea in favour of faster wage growth in Germany (the Buba asked for an average wage increase of 3%).
This is frankly hard to understand. The eurozone problems, and it’s flirting with deflation, stem from the victory of the Berlin View, that laid the burden of adjustment on the shoulders of peripheral countries alone.
The call for wage increases in Germany signals, and it was about time, that even conservative German institutions are beginning to realize the obvious: there will be no rebalancing, and therefore no robust recovery, unless German domestic demand recovers. This means a fiscal expansion, as well as private expenditure recovery. Unsurprisingly, the Buba rules out the former, but it is nice to see that at least the latter has become an objective. Faster wage growth may not make a huge difference in quantitative terms, but it still marks an important change of attitude. This is a huge step away from the low-wage-high-productivity-export-led model that the Bundesbank and the German government have been preaching (and imposing to their partners).
Münchau is right in calling for a different policy mix in the EMU. But this is complementary, not alternative, to a change in the German growth model. I would have expected him to applaud a small but potentially important change in attitude. Instead I have read a virulent attack. Puzzled, puzzled…

Categories: EMU Crisis

## ECB: Great Expectations

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…

## Marginal Productivity? Think Again

I am writing  a paper on inequality and the crisis,  for which I used Piketty and Saez ‘s World Top Income Database to try to understand whether the distributional effect changed over time. Unfortunately their data cover 2012 only for a handful of countries, among which are the United States; waiting for new data here is the evolution of income percentiles, including capital gains, from 2007 to 2009 (yellow bars), and from 2009 to 2012 (red bars):

The financial crisis of 2007-2008 mainly hit asset prices, thus having a major impact on the richest layers of the income distribution. In fact, the top 0.1% to 0.01% (a handful of people) lost more than 40% of their income in real terms, while average income of the bottom 90% dropped of around 10%. This was short-lasted, nevertheless, as the prolonged recession, and the jobless recovery that followed, quickly restored, and further deepened the distance between the rich on one side and the middle and lower classes on the other.  Since 2009 average income of the bottom 95% stagnated (for the bottom 90% it kept decreasing). Nothing really new, here. The iAGS 2014 report, to which I (marginally) contributed, reaches similar conclusions. But I thought it would be interesting to share it.

And while we are at it, here are the ratios of average income of those at the very top, with respect to income of the bottom 90% (from the same dataset):

The top 0.1%-0.01%, the same handful of people as before, has an average income that is 120 times the average income of the bottom 90%. This is also barely breaking news…

Now, as we all know, the traditional view on income distribution states that  factors of production are paid according to their contribution to the production process (their “marginal productivity”). Within this traditional view, the recent steep increase of inequality would be explained by skill-biased technical progress and increased competition in the globalized labor market: the entrance in the global labor market of low-skilled workers from emerging and developing economies lowered the average marginal productivity of labor, thus reducing its share of national income. Increasing inequality would then be an ineluctable process that policy is not supposed to address, if not at the price of reduced efficiency and growth. Is this a caricature? Not so much. in his recent Project Syndicate comment on Piketty, Kenneth Rogoff proposes once again the old tradeoff between inequality and growth that the crisis seemed to have buried once and for all (just look at the widely cited IMF discussion paper  by Ostry et al). The traditional view is alive and kicking, and those who oppose it are dangerous liberal extremists! After all, Rogoff tells us, the tide raises all boats…

The bottom line is that if a top executive makes on average 120 times the wage of his or her employee, well, this means that he or she is 120 times more productive. Rent seeking and political capture play no role in explaining the difference in pay. Circulez, il n’y a rien à voir…

Nothing new under the sky, I guess. But it is important, from time to time, to send out reminders.

## Wrong Debates

May 9, 2014 1 comment

Paul Krugman has a short post on the Eurozone, today (I’d like him to write more about us; he has been too America-centered lately), pointing out that the myth of fiscal profligacy is, well, just a myth. in fact, he argues, the only fiscally irresponsible country, in the years 2000 was Greece. It is maybe worth reposting here a figure that from an old piece of this blog, that since then made it into all my classes on the Euro crisis:
The figure shows the situation of public finances in 2007, against the Maastricht benchmark (3% deficit and 60% debt) before the crisis hit. As Krugman says, only one country of the so-called PIIGS  (the red dots) is clearly out of line, Greece. Portugal is virtually like France, and Spain and Ireland way better than most countries, including Germany. Italy has a stock of old debt, but its deficit in 2007 is under control.

So Krugman is right in reminding us that fiscal policy per se was not a problem before the crisis; And yet, what he calls fiscal myths, have shaped policies in the EMU, with a disproportionate emphasis on austerity. And even today, when economists overwhelmingly discuss unconventional measures available to the ECB to contrast deflation, fiscal policy is virtually absent from the debate and continued fiscal consolidation is taken for granted. I will write more on this in the next days, but it is striking how we aim at the wrong target.

## Reforming Europe

I just finished editing a collective volume, in English and in French, on possible ways to reform Europe. Here is the blog post that presents it:

What Reforms for Europe?

From May 22 to May 25, Europeans will vote to elect the 751 Members of the European Parliament. These elections will take place in a context of strong mistrust for European institutions. While the crisis of confidence is not specifically European, in the Old Continent it is coupled with the hardest crisis since the Great Depression, and with a political crisis that shows the incapacity of European institutions to reach decisions. The issues at stake in the next European elections, therefore, have multiple dimensions that require a multidisciplinary approach. The latest issue of the Debates and Policies Revue de l’OFCE series (published in French and in English), gathers European affairs specialists – economists, law scholars, political scientists – who starting from the debate within their own discipline, share their vision on the reforms that are needed to give new life to the European project. Our goal is to feed the public debate through short policy briefs containing specific policy recommendations. Our target are obviously the candidates to the European elections, but also unions, entrepreneurs, civil society at large and, above all, citizens interested by European issues.

In the context of the current crisis, the debate leading to the next European elections seems to be hostage of two opposing views. On one side a sort of self-complacency that borders denial about the crisis that is still choking the Eurozone and Europe at large. According to this view, the survival of the euro should be reason enough to be satisfied with the policies followed so far, and the European institutions evolved in the right direction in order to better face future challenges.

At the opposite, the eurosceptic view puts forward the fundamental flaws of the single currency, arguing that the only way out of the crisis would be a return to national currencies. The different contributions of this volume aim at going beyond these polar views. The crisis highlighted the shortcomings of EU institutions, and the inadequacy of economic policies centered on fiscal discipline alone. True, some reforms have been implemented; but they are not enough, when they do not go in the wrong direction altogether. We refuse nevertheless to conclude that no meaningful reform can be implemented, and that the European project has no future.

The debate on Europe’s future and on a better and more democratic Union needs to be revived. We need to discuss ways to implement more efficient governance, and public policies adapted to the challenges we face. The reader nevertheless will not find, in this volume, a coherent project; rather, we offer eclectic and sometimes even contradictory views on the direction Europe should take. This diversity witnesses the necessity of a public debate that we wish to go beyond academic circles and involves policy makers and citizens. Our ambition is to provide keys to interpret the current stakes of the European debate, and to form an opinion on the direction that our common project should take.

## ECB: One Size Fits None

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

$Target=1+1.5\pi_{core}-1(u-\overline{u})$.

(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