We are becoming accustomed to European policy makers’ schizophrenia, so when yesterday during his press conference Mario Draghi mentioned the consolidating recovery while announcing further easing in December, nobody winced. Draghi’s call for expansionary fiscal policies was instead noticed, and appreciated. I suggest some caution. Let’s look at Draghi’s words:
Fiscal policies should support the economic recovery, while remaining in compliance with the EU’s fiscal rules. Full and consistent implementation of the Stability and Growth Pact is crucial for confidence in our fiscal framework. At the same time, all countries should strive for a growth-friendly composition of fiscal policies.
During the Q&A, the first question was on precisely this point:
Question: If I could ask you to develop the last point that you made. Governor Nowotny last week said that monetary policy may be coming up to its limits and perhaps it was up to fiscal policy to loosen a little bit to provide a bit of accommodation. Could you share your thoughts on this and perhaps even touch on the Italian budget?
(Here is the link to Austrian Central Bank Governor Nowotny making a strong statement in favour of expansionary fiscal policy). Draghi simply did not answer on fiscal policy (nor on the Italian budget, by the way). The quote is long but worth reading
Draghi: On the first issue, I’m really commenting only on monetary policy, and as we said in the last part of the introductory statement, monetary policy shouldn’t be the only game in town, but this can be viewed in a variety of ways, one of which is the way in which our colleague actually explored in examining the situation, but there are other ways. Like, for example, as we’ve said several times, the structural reforms are essential. Monetary policy is focused on maintaining price stability over the medium term, and its accommodative monetary stance supports economic activity. However, in order to reap the full benefits of our monetary policy measures, other policy areas must contribute decisively. So here we stress the high structural unemployment and the low potential output growth in the euro area as the main situations which we have to address. The ongoing cyclical recovery should be supported by effective structural policies. But there may be other points of view on this. The point is that monetary policy can support and is actually supporting a cyclical economic recovery. We have to address also the structural components of this recovery, so that we can actually move from a cyclical recovery to a structural recovery. Let’s not forget that even before the financial crisis, unemployment has been traditionally very high in the euro area and many of the structural weaknesses have been there before.
Carefully avoiding to mention fiscal policy, when answering a question on fiscal policy, speaks for itself. In fact, saying that “Fiscal policies should support the economic recovery, while remaining in compliance with the EU’s fiscal rules” and putting forward for the n-th time the confidence fairy, amounts to a substantial approval of the policies followed by EMU countries so far. We should stop fooling ourselves: Within the existing rules there is no margin for a meaningful fiscal expansion of the kind invoked by Governor Nowotny. If we look at headline deficit, forecast to be at 2% in 2015, the Maastricht limits leave room for a global fiscal expansion of 1% of GDP, decent but not a game changer (without mentioning the fiscal space of individual countries, very unevenly distributed). And if we look at the main indicator of fiscal effort put forward by the fiscal compact, the cyclical adjusted deficit, the eurozone as a whole should keep its fiscal consolidation effort going, to bring the deficit down from its current level of 0.9% of GDP to the target of 0.5%.
It is no surprise then that the new Italian budget (on which Mario Draghi carefully avoided to comment) is hailed (or decried) as expansionary simply because it slows a little (and just a little) the pace of fiscal consolidation. Within the rules forcefully defended by Draghi, this is the best countries can do. As a side note, I blame the Italian (and the French) government for deciding to play within the existing framework. Bargaining a decimal of deficit here and there will not lift our economies out of their disappointing growth; and more importantly, on a longer term perspective, it will not help advance the debate on the appropriate governance of the eurozone.
In spite of widespread recognition that aggregate demand is too low, Mario Draghi did not move an inch from his previous beliefs: the key for growth is structural reforms, and structural reforms alone. He keeps embracing the Berlin View. The only substantial difference between Draghi and ECB hawks is his belief that, in the current cyclical position, structural reforms should be eased by accommodating monetary policy. This is the only rationale for QE. Is this enough to define him a dove?
I was puzzled by Daniel Gros’ recent Project Syndicate piece, in which he claims that Germany’s dominance of the EMU may be coming to an end. Gros’ argument is based on two facts. The first is the slowing growth rate of Germany, that seems to be heading towards the pre-crisis “normal” of slow growth (Germany grew less than EMU average for most of the period 1999-2007). The second, more geo-political, is the lack of willingness (or of capacity) to manage, the crises that face the EU (in particular the refugees crisis).
Gros concludes that this loss of influence is dangerous, because Germany will not be able to resist the changes in policies that are pushed by peripheral countries and by the ECB. Of course, implicit in this statement, is Gros’ belief that these policies were necessary and useful.
I welcome the recognition that Germany has steered the EMU since the beginning of the crisis. Those of us talking about the Germanification of Europe have been decried until very recently. Yet, I do not share, not at all, Gros view.
True, Germany’s growth is slowing down. These are the risks of an export-led growth model: countries are not masters of their own fate. Germany stayed clear from the peripheral countries’ crisis (that it contributed to create) by turning to the US and to emerging economies as markets for its exports. But now that these countries are also having problems, the limits of jumping on other countries’ shoulders to grow, become evident. I am surprised by Gros’ surprise, as this was evident from the very beginning.
But here I do not want to reiterate my criticisms of the export-led model, starting from the fallacy of composition. Instead, I would like to challenge Gros’ argument that Germany influence is waning. I would say on the contrary that the Germanification of the eurozone is almost complete.
I took a few macroeconomic variables, and contrasted Germany with the remaining 11 EMU members. Let’s start with (missing) domestic demand, a defining characteristic of the export-led growth model:
Since 2007, the yellow line (EMU11) and the red line (Germany) converged, mostly because domestic demand in the rest of the EMU was reduced. This led of course to an increased reliance of the EMU as a whole on exports. The EMU as a whole had an overall balanced external position in 2007, while it has a substantial current account surplus today (the EMU12 went from 0.5% to 3.4 projected for 2016. Germany went from 7% to 7.7%). In other words, the EMU11 joined Germany on the shoulders of the rest of the world.
Austerity has of course much to be blamed for this compression of domestic demand: Just look at government balances (net of interest payments):
True, the difference between Germany and the rest of EMU is today larger than in 2007. But since Germany and the Troika took the driving seat in 2010, government balances of the EMU11 have been steadily converging to surplus, and they are not going to stop in the foreseeable horizon (the Commission forecasts go until 2016).
Finally, if we look at one of the main drivers of growth, investment, the picture is the same.
Be it private or public, the EMU11 Gross Fixed Capital Formation has been converging towards the (excessively low) German level (I did not draw the differences, not to clutter the figure).
And of course, there are labour costs, for which convergence to Germany was brutal, even if the latter, rather than EMU peripheral countries, were the outlier. To summarize, during the crisis the difference between Germany and the rest of the EMU was substantially reduced, and will continue to be in the next years:
The difference was reduced for all variables, except for government deficit. Self-defeating austerity slowed down the convergence. But private expenditure, in particular investment, more than compensated.
So, if I were Gros, I would not worry too much. The Germanification of Europe is well on its way. If Germany does not go to the EMU11 (it definitely does not!), the EMU11 keeps going to Germany.
But as I am not Gros, I worry a lot.
Thanks to the invaluable Economist’s View, I have read with lots of interest the speech that newly appointed Federal Reserve Board Member Lael Brainard gave last Monday. The speech is a plea for holding on rate rises, and uses a number of convincing arguments. Much has been said on the issue (give a look at comments by Tim Duy and Paul Krugman). I have little to add, were it not for the point I made a number of times, that the extraordinarily difficult task of central bankers would be made substantially easier if fiscal policy were used more actively.
What I’d like to express here is my jealousy for the discussions (and the confrontation) that we observe in the US. These discussions are a sideproduct, a very positive one if you ask me, of the institutional design of the Fed. I just returned from a series of engaging policy meetings on central bank policy in Costa Rica, facilitated by the local ILO office, where I pleaded for the introduction of a dual mandate.
I wrote a background paper (that can be seen here) in which my main argument is that a central bank following a dual mandate will always be able to take an aggressive stance on inflation, if it deems it necessary to do so. Appropriate choice of the weights given to employment and inflation would allow incorporation of any combination of the two objectives. A good case in point are the United States, where the Federal Reserve under Chairman Volcker embarked on a bold disinflation program in the early 1980s when the country had just adopted the dual mandate. No choice of weights, on the other hand, would allow a central bank following an inflation targeting mandate to explicitly target employment as well. Thus, the dual mandate can embed inflation targeting strategies, while the converse is not true. In terms of policy effectiveness, therefore, the dual mandate is a superior institutional arrangement.
I also cited evidence showing, and here we come at my jealousy for the Fed, that inflation targeting central banks, like the ECB, de facto target the output gap, but timidly and without explicitly saying so. This leads to low reactivity and opaque communication, that hamper the capacity of central banks to manage expectations and effectively steer the economy. I am sure that those who followed the EMU policy debate in the past few years will know what I am talking about.
One may argue that the cacophony currently characterizing the Federal Reserve Board is hardly positive for the economy, and that in terms of managing expectations, lately, the Fed did not excel. This is undeniable, and is the result of the Fed groping its way out of unprecedented policy measures. The difference with the ECB is that for the Fed the opacity results from an ongoing debate on how to best attain an objective that is clear and shared. We are not there yet, but the debate will eventually lead to an unambiguous (and hopefully appropriate) policy choice. The ECB opacity, is intrinsically linked to the confusion between its mandate and its actual action, and as such it cannot lead to any meaningful discussion, but just to legalistic disputes on the definition of price stability, of how medium is the medium term and the like.
And I can now come to my final point: a dual mandate has the merit to let the political nature of monetary policy emerge without ambiguities. It is indeed true that monetary policy with a dual mandate requires hard choices, as the ones that are debater these days, and hence is political in nature. The point is, that so is monetary policy with a simple inflation targeting objective. The level of inflation targeted, and the choice of the instruments to attain it, are all but neutral in terms of their consequences on the economy, most notably on the distribution of resources among market participants. Thus, an inflation targeting central bank is as political in its actions as a bank following a dual mandate, the only difference being that In the former case the political nature of monetary policy is concealed behind a technocratic curtain.
The deep justification of exclusive focus on price stability can only lie in the acceptance of a neoclassical platonic world in which powerless governments need to make no choice. Once we dismiss that platonic view, monetary policy acquires a political role, regardless of the mandate it is given. A dual mandate has the merit of making this choice explicit, and hence to dispel the technocratic illusion.
I am not saying there would be no issues with the adoption of a dual mandate. The institutional design should be carefully crafted, in order to ensure that independence is maintained, and accountability (currently very low indeed) is enhanced. What I am saying is that after seven years (and counting) of dismal economic performance, and faced with strong arguments in favour of a broader central bank mandate, EMU policy makers should be engaged in discussions at least as lively as the ones of their counterparts in Washington. And yet, all is quiet on this side of the ocean… Circulez y a rien à voir
I was asked to write a piece on whether we should continue to study the EMU (my answer is yes. In case you wonder, this is called vested interest). One section of it can be a stand-alone blog post: Here it is, with just a few edits:
While in the late 1980s the consensus among economists and policy makers was that the EMU was not an optimal currency area (De Grauwe, 2006), the choice was made to proceed with the single currency for two essentially opposed reasons: The first, stemming from the Berlin-Brussels Consensus, saw monetary integration, together with the establishment of institutions limiting fiscal and monetary policy activism, as an incentive for pursuing structural reforms and converging towards market efficiency: as the role of macroeconomic management was believed to be limited, giving up monetary policy would impose negligible costs to countries while forcing them, through competition, to remove growth-stifling obstacles to markets.
Another group of academics and policy makers, while not necessarily subscribing to the Consensus, highlighted the political economy of the single currency: Adopting the euro in a non-optimal currency area would have created the incentives for completing it with a political union: a federation, endowed with a common fiscal policy and capable of implementing the fiscal transfers that are required to avoid divergence. In other words a non-optimal euro was seen as just an intermediate step towards a real United States of Europe. A key argument of the proponents of a federal Europe was, and still is, that fiscal transfers seem unavoidable to ensure economic convergence. A seminal paper by Sala-i-Martin and Sachs (1991) shows that even in the United States, where market flexibility is substantially larger than in the EMU, transfers from booming states to states in crisis account for almost 50% of the reaction to asymmetric shocks.
It is interesting to notice how the hopes of both views were dashed by subsequent events. As the theory of optimal currency areas correctly predicted, the inception of the euro without sufficiently strong correction mechanisms, triggered a divergence between a core, characterized by excess savings and export-led growth, and a periphery that sustained the Eurozone growth through debt-driven (public and private) consumption and investment.
Even before the crisis the federal project failed to make it into the political agenda. The euro came to be seen by the political elites not, as the federalists hoped, as an intermediate step towards closer integration, but rather as the endpoint of the process initiated by Jean Monnet and Robert Schuman in 1950. The crisis further deepened economic divergence and recrimination, highlighting national self-interest as the driving force of policy makers, and making solidarity an empty word. As we write, the Greek crisis management, the refugee emergency, the centrifugal forces shaking Europe, are seen as a potential threat to the Union, rather than a push for further integration as it happened in the past (Rachman, 2015).
The Consensus partisans won the policy debate. The EMU institutions, banning discretionary policy, reflect their intellectual framework; and the policies followed (more or less willingly) by EMU countries, especially since the crisis, are the logical consequences of the consensus: austerity and structural reforms aimed at increasing competitiveness and reducing the weight of the State in the economy. But while they can rejoice of their victory, Consensus proponents have to deal with the failure of their policies: five years of Berlin View therapy has nearly killed the patient. Peripheral countries’ debt is still unsustainable, growth is nowhere to be seen (including in successful Germany), and social hardship is reaching unbearable levels (Kentikelenis et al., 2014). Coupling austerity with reforms proved to be self-defeating, as the short term recessionary impact on the economy was much larger than expected (Blanchard and Leigh, 2013), and as a consequence the long run benefits failed to materialize (Eggertsson et al., 2014). It is then no surprise that in spite of austerity and reforms, divergence between the core and the periphery of the Eurozone is even larger today than it was in 2007.
The dire state of the Eurozone economy is in some sense the revenge of optimal currency areas theory, with a twist. It appears evident today, but it was clear two decades ago, that market flexibility alone would never suffice to ensure convergence (rather the opposite), so that the Consensus faces a potentially fatal challenge. On the other hand, the federalist project, that was already faltering, seems to have received a fatal blow from the crisis.
The conclusion I draw from these somewhat trivial considerations is that the EMU is walking a fine line. If the federalist project is dead, and if Consensus policies are killing the EMU, what have we left, besides a dissolution of the euro?
I conclude the paper by arguing that two pillars of a new EMU governance/policy are necessary (neither of them in isolation would suffice):
- Putting in place any possible surrogate of fiscal transfers, like for example a EU wide unemployment benefit, making sure that it is designed to be politically feasible (i.e. no country is net contributor on average), eurobonds, etc.
- Scrapping the Consensus together with its foundation, the efficient market hypothesis, and head towards real, flexible coordination of (imperfect) macroeconomic policies in order to deal with (imperfect) markets. Government by the rules only works in the ideal neoclassical world.
I know, more easily said than done. But I see no other possibility.
Jared Bernstein has a very interesting piece on the lessons we
(did not) learn from the great crisis. He basically makes two points:
First, the attitude towards lenders, while somewhat schizophrenic (Bear Sterns, up; Lehman, down. Why? We still don’t know), was forgiving to say the least. in his words, ” Borrowers get austerity, joblessness, and poverty. Lenders get bailouts when credit is scarce and bribes not to lend when it’s too plentiful”. He then argues that both letting lenders fail and bailing them out has large costs, that should be avoided ex ante through better regulation (and we are not there, yet).
Bernstein is perfectly right, but he neglects mentioning a third option, that was advocated at the time, for example by Joe Stiglitz: temporary bank nationalization. The Swedish experience of 1992 proves, according to many (1, 2), that this would have been as effective, while the cost for the taxpayer would have been greatly reduced if not completely eliminated. Public control over the main financial institutions would have guaranteed that the necessary healing could happen without the rents and bonuses that actually went to the very same people who had caused the trouble in the first place. Temporary nationalization, in other words, would have avoided the “Heads I win Tail you lose” feature of financial sector bailouts.
The second point Bernstein makes is that regardless of the strategy chosen to save the financial sector, fiscal policy should have been much more aggressive in fighting the downturn. A quote, again:
But here’s what I do know. Neither bailouts nor allowing insolvent banks to fail will work if, when private sector demand is subsequently tanking, we undercut the use of fiscal policy to make up the difference. In this regard, the clearest lesson of Lehman is not simply that we must regulate financial markets, which is true, nor is it that we must always preserve private credit flows by fully bailing out irresponsible lenders, which contributes to inequality and economic unfairness.
It’s that it takes both monetary and fiscal policy working together to get back to full employment. Restored credit flows alone won’t get people back to work. That’s pure supply-side thinking.
Well, he says it all. What drives me nuts, is that the he complains about the US, THE US, where the Fed showed incredible activism, where the Obama administration voted and implemented a huge stimulus package (the American Recovery and Reinvestment Act) just weeks after been sworn in office, while it took us 7 years, to decide to adopt a cumbersome investment plan that will make little or no difference.
Without even mentioning the fact that the whole Greek crisis, since 2010, has been managed with an eye to (mostly German and French) lenders’ needs, rather than to the well-being of European (and in particular Greek) taxpayers.
I really would like to know what would Bernstein say, were he to comment the EMU lessons from the crisis…
So, Mario Draghi is disappointed by eurozone growth, and is ready to step up the ECB quantitative easing program. The monetary expansion apparently is not working out as planned.
Big surprise. I am afraid some people do not have access to Wikipedia. If they had, they would read, under “liquidity trap“, the following:
A liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.
In a liquidity trap the propensity to hoard of the private sector becomes virtually unlimited, so that monetary policy (be it conventional or unconventional) loses traction. It is true that the age of great moderation, and three decades of almighty central bankers had made the concept fade into oblivion. But, since 2008 we were forced to reconsider the effectiveness of monetary policy at the so-called zero lower bound.
Or at least we should have…
So, had policy makers taken the time to look at the history of the great depression, or at least to open the Wikipedia entry, they should have learnt that when monetary policy loses traction, the witness in lifting the economy out of the recession, needs to be taken by fiscal policy. In a liquidity trap the winner is fiscal policy. Or at least it should be. Here is a measure of the fiscal stance, computed as the change in government balance once we exclude cyclical components and interest payments.
The vast majority of E
MU countries undertook a strong fiscal tightening, regardless of the actual health of their public finances. This generalized austerity, an offspring of the Berlin View, led to our double dip recession, and to further divergence in the eurozone, that would have needed coordinated, not synchronized fiscal policies. Well done guys…
And yet, Mario Draghi is surprised by the impact of QE.
A new Occasional Paper details the new methodology adopted by the Bank of Italy for calculating an index of price competitiveness, and applies it to the four largest eurozone economies.
I took the time to copy the numbers of table 3 in an excel file (let’s hope for the best), and to look at what happened since 2009. Here is the evolution of price competitiveness (a decrease means improved competitiveness):
I find this intriguing. We have been sold the story of Spain as the success story for EMU austerity as, contrary to other countries, it restored its external balance through internal devaluation. Well, apparently not. Since 2008 its price competitiveness improved, but less so than in the three other major EMU countries.
The reason must be that the rebalancing was internal to the eurozone, so that the figure does not in fact go against austerity nor internal devaluation. For sure, within eurozone price competitiveness improved for Spain. Well, think again…
This is indeed puzzling, and goes against anedoctical evidence. We’ll have to wait for the new methodology to be scrutinized by other researchers before making too much of this. But as it stands, it tells a different story from what we read all over the places. Spain’s current account improvement can hardly be related to an improvement in its price competitiveness. Likewise, by looking at France’s evolution, it is hard to argue that its current account problems are determined by price dynamics.
Without wanting to draw too much from a couple of time series, I would say that reforms in crisis countries should focus on boosting non-price competitiveness, rather than on reducing costs (in particular labour costs). And the thing is, some of these reforms may actually need increased public spending, for example in infrastructures, or in enhancing public administration’s efficiency. To accompany these reforms there is more to macroeconomic policy than just reducing taxes and at the same time cutting expenditure.
Since 2010 it ha been taken for granted that reforms and austerity should go hand in hand. This is one of the reasons for the policy disaster we lived. We really need to better understand the relationship between supply side policies and macroeconomic management. I see little or no debate on this, and I find it worrisome.