The Blanchard Touch

April 15, 2015 6 comments

Yesterday I commented on the intriguing box in which the IMF staff challenges one of the tenets of the Washington consensus, the link between labour market reform and economic performance.
But the IMF is not new to these reassessments. In fact over the past three years research coming from the fund has increasingly challenged the orthodoxy that still shapes European policy making:

  1. First, there was the widely discussed mea culpa in the October 2012 World Economic Outlook, when the IMF staff basically disavowed their own previous estimates of the size of multipliers, and in doing so they certified that austerity could not, and would not work (of course this led EU leaders to immediately rush to do more of the same).
  2. Then, the Fund tackled the issue of income inequality, and broke another taboo, i.e. the dichotomy  between  fairness and efficiency. Turns out that unequal societies tend to perform less well, and IMF staff research reached the same conclusion. And once the gates opened, it did not stop. The paper by Berg and Ostry was widely read. Then we had Ball et al on the distributional effects of fiscal consolidation (surprise, it increases inequality). Another paper investigated the channels for this link, highlighting how consolidation leads to increased inequality mostly via unemployment. And just last week I assisted to a presentation by IMF economists showing how austerity and inequality are positively related with political instability.
  3. On labour markets, before yesterday’s box 3.5, the Fund had disseminated research linking increased inequality with the decline in unionization.
  4. Then, of course, the “public Investment is a free lunch” chapter three of the World Economic Outlook, in the fall 2014.
  5. In between, they demolished another building block of the Washington Consensus: free capital movements may sometimes be destabilizing…

These results are not surprising per se. All of these issues are highly controversial, so it is obvious that research does not find unequivocal support for a particular view. All the more so if that view, like the Washington Consensus, is pretty much an ideological construction. Yet, the fact that research coming from the center of the empire acknowledges that the world is complex, and interactions among agents goes well beyond the working of efficient markets, is in my opinion quite something.

What does this mass (yes, now it can be called a mass) of work tells us? Three things, I would say. First, fiscal policy is back. it really is. The Washington Consensus does not exist anymore, at least in Washington. Be it because the multipliers are large, or because it has an impact on income distribution (and on economic efficiency); or again because public investment boosts growth, fiscal policy has a role to play both in dampening business cycle fluctuations and in facilitating stable and balanced long term growth. The fact that a large institution like the IMF has lent its support to this revival of consideration for fiscal policy, makes me hope that discussions about macroeconomic policy will be less ideological, even once the crisis will have passed.

The second thing I learn is that the IMF research department proves to be populated of true researchers, who continuously challenge and test their own views, and are not afraid of u-turns if their own research dictates them. I am sure it has always been the case. What is different from the past is that now they have a chief economist who seems more interested in understanding where the world goes than in preaching a doctrine.

The third remark is more problematic. If I write a paper saying that austerity will not be costly because multipliers are 0.5, and 2 years later retract my previous statement and argue that austerity is in fact self defeating, the impact on the world is zero. If the IMF does the same, during the two years huge suffering will be needlessly inflicted to masses of people. This poses a problem, as research by definition may be falsified. In the past an institution like the IMF would never have admitted a mistake. And we certainly do not want to go back there. Today they do admit the mistakes, but the suffering remains. The only way out to this problem is that the “new” IMF should learn to be cautious in its policy prescriptions, and always remember that any policy recommendation is bound to be sooner or later proven inappropriate by new data and research. We don’t live in a black and white world. Adopting a more prudent stance in dictating policies  would be wise (in Brussels as well, it goes without saying). And of course, the disconnect between the army and the general is also a problem.

What Structural Reforms?

April 14, 2015 2 comments

I am ready to bet that the latest IMF World Economic Outlook, that was presented today in Washington, will make a certain buzz for a box. It is box 3.5, at page 36 of chapter 3, which has been available on the website for a few days now. In that box, the IMF staff presents lack of evidence on the relationship between structural reforms and total factor productivity, the proxy for long term growth and competitiveness. (Interestingly enough people at the IMF tend to put their most controversial findings in boxes, as if they wanted to bind them).

What is certainly going to stir controversy is the finding that while long term growth is negatively affected by product market regulation, excessive labour market regulation does not hamper long term performance.

It is not the first time that the IMF surprises us with interesting analysis that goes against its own previous conventional wisdom. I will write more about this shortly. Here I just want to remark how these findings are relevant for our old continent.

The austerity imposed to embraced by eurozone crisis countries has taken the shape of expenditure cuts and labour market deregulation, whose magic effects on growth and competitiveness have been sold to reluctant and exhausted populations as the path to a bright future. I already noted, two years ago, that the short-run pain was slowly evolving into long-run pain as well, and that the gain of structural reforms was nowhere to be seen. The IMF tells us, today, that this was to be expected.

The guy who should be happy is Alexis Tsipras; he has been resisting since January pressure from his peers (and the Troika, that includes IMF staff!) to further curb labour market regulations, and recently presented a list of reforms that mostly pledges to reduce crony capitalism, tax evasion and product market rigidities. Exactly what the IMF shows to be effective in boosting growth. Of course, at the opposite, those who spent their political capital to implement labour market reforms are most probably not rejoicing at the IMF findings.

This happens in Washington. Problem is, Greece, and Europe at large, seem to be light years away from the IMF research department. We already saw, for example with the mea culpa on multipliers, that IMF staff in program countries does not necessarily read what is written at home. Let’s see whether the discussion on Greece’s reforms will mark a realignment between the Fund’s research work and the prescriptions they implement/suggest/impose on the ground.

Sand Fiscal Foundations

April 11, 2015 6 comments

Simon Wren-Lewis has an interesting piece on structural deficits. He has issues with Pisani-Ferry’s plea for more stable  structural deficit targets for EU countries. While Pisani-Ferry has a point in invoking more certainty for EU government action, Wren-Lewis argues, rightly so, that stable targets risk creating straitjackets for countries, and that the problem is mostly in the excessively short time horizon of structural deficit targets.

The fact that both Pisani and Wren-Lewis have a point highlights what is in my opinion a structural flaw of EU fiscal governance, namely its reliance on the slippery concept of structural government deficit.

To explain this simply, the idea underlying structural deficit targets is that  not all deficit were created equal. if the government runs a deficit because of adverse cyclical conditions (low growth yields lower tax revenues and larger welfare payements), this deficit is “healthy” because it supports economic activity, and bound to disappear when the economy recovers. As such, governments should not be required to target cyclical deficit, but only  the structural (or cyclically adjusted) deficit, which is precisely the deficit “cleaned” of its cyclical component.

The EU fiscal rule, the Stability Pact and its hardened Fiscal Compact extension, recognizes this distinction, and imposes that governments balance their budget over the cycle, which is yet another definition of structural deficit. This may seem a sensible approach, recognizing, as I just said, that not all deficits were created equal. But in fact sensible it is not.

The problem lies precisely in the word “cleaned” I used above . How do we clean headline deficit from its cyclical component, to compute the structural deficit that should be targeted by governments? This is how we should do it: We compute “potential output”, i.e. the capacity of production of the economy. From that we can obtain the output gap, i.e. the distance of actual output from its potential level; finally, by applying an estimate of how the deficit responds to the output gap, we can clean headline deficit from its cyclical component. Simple, right? Yes, in theory. In practice, we have no way to do it in a sufficiently precise way.

Just consider what the Commission itself states in the page dedicated to its own methodology for measuring potential output. (Their most recent methodological paper can be found here).

Any meaningful analysis of cyclical developments, of medium term growth prospects or of the stance of fiscal and monetary policies are all predicated on either an implicit or explicit assumption concerning the rate of potential output growth. Given the importance of the concept, the measurement of potential output is the subject of contentious and sustained research interest.

All the available methods have “pros” and “cons” and none can unequivocally be declared better than the alternatives in all cases. Thus, what matters is to have a method adapted to the problem under analysis, with well defined limits and, in international comparisons, one that deals identically with all countries. (emphasis is mine)

There is nothing wrong with recognizing that potential output estimates are “contentious”. Contrary to what some Talebans persist to argue, economics is a social science, subject to all the uncertainties, mismeasurements, and ambiguities that are inherently linked to human and social interactions.

Where we have a problem is in using a contentious concept as the foundation for rules in which a zeropointsomething deviation from the target may lead to sanctions and public disapproval by the EU community, with all the potential financial market disruptions associated with it.

This makes the rule non credible, because the contentious estimate may be questioned. More importantly, it leads to what Wren-Lewis fears: countries imposing harsh sacrifices to their people that may turn out to be unwarranted when the estimate is revised.

I am not clear about what fiscal rule we should have in the EU. I actually am not even convinced that we really would need one. What is certain is that two necessary conditions for any rule to be effective, credible, and reasonable are that it is not short -termist (I rejoin Wren-Lewis), and that it is based on indicators that are quantitatively as precise as possible.

The current rule fails on both ground (and don’t get me started on how crazily complicated and arbitrary it grew over time). EU fiscal governance remains founded on sand. And of course, a serious debate on its reform is nowhere to be seen in European policy circles.

The Confidence Witch

March 25, 2015 3 comments

Remember the old times? Here is a quote from ECB President Jean-Claude Trichet, September 2nd, 2010:

[Fiscal Consolidation] is a prerequisite for maintaining confidence in the credibility of governments’ fiscal targets. Positive effects on confidence can compensate for the reduction in demand stemming from fiscal consolidation, when fiscal adjustment strategies are perceived as credible, ambitious and focused on the expenditure side. The conditions for such positive effects are particularly favourable in the current environment of macroeconomic uncertainty.

And just in case it was not clear, on September 3rd, 2010:

We encourage all countries to be absolutely determined to go back to a sustainable mode for their fiscal policies,” Trichet said, speaking after the ECB rate decision on Thursday. “Our message is the same for all, and we trust that it is absolutely decisive not only for each country individually, but for prosperity of all.”

“Not because it is an elementary recommendation to care for your sons and daughter and not overburden them, but because it is good for confidence, consumption and investment today”.

Well, think again. Here is the abstract of ECB Working Paper no 1770, March 2015:

We explore how fiscal consolidations affect private sector confidence, a possible channel for the fiscal transmission that has received particular attention recently as a result of governments embarking on austerity trajectories in the aftermath of the crisis. Panel regressions based on the action-based datasets of De Vries et al. (2011) and Alesina et al. (2014) show that consolidations, and in particular their unanticipated components affect confidence negatively. The effects are stronger for revenue-based measures and when institutional arrangements, such as fiscal rules, are weak. To obtain a more accurate picture of how consolidations affect confidence, we co nstruct a monthly dataset of consolidation announcements based on the aforementioned datasets, so that we can study the confidence effects in real time using an event study. Consumer confidence falls around announcements of consolidation measures, an effect driven by revenue-based measures. Moreover, the effects are most relevant for European countries with weak institutional arrangements, as measured by the tightness of fiscal rules or budgetary transparency. The effects on producer confidence are generally similar, but weaker than for consumer confidence.

The confidence fairy seems to have turned into a confidence witch. One more victim of the crisis. But this one will not be missed.

It is not shameful to change opinion. Rather the contrary, it is a sign of intellectual courage. Two years ago, the IMF famously surprised commentators worldwide with a rather substantial U-turn on the impact of austerity. Revised calculations on the size of multipliers led them to acknowledge that they had underestimated the impact of austerity on economic activity.

Even at that time it started with a technical paper. But significantly, that paper was coauthored by Olivier Blanchard, IMF Chief Economist. It then served as the basis for a progress report on Greece, in June 2013, that de facto disavowed the first bailout program arguing that austerity had proven to be self-defeating.

Let us just hope that in the ECB new building communication between the research department and the top guys is more effective than in the old one…

Ps
I am glad to give credit for the title to Merijn Knibbe, from Real-World Economics Review Blog, who used the term in a comment to my last post.

Raise Fed Rates Now?

March 23, 2015 4 comments

A quick note on the US and the Fed. Pressure for rate rises never really stopped, but lately it has intensified. Today I read on the FT that James Bullard, Saint Louis Fed head, urges Janet Yellen to raise rates as soon as possible, to avoid “devastating asset bubbles”. Just a few months ago we learned that QE was dangerous because, once again through asset price inflation, it led to increasing inequality. Not to mention the inflationistas (thanks PK for the great name!) who since 2009 have been predicting Weimar-type inflation because of irresponsible Fed behaviour (a very similar pattern can be found in the EMU). Let’s play the game, for the sake of argument. After all, asset price inflation, and distortions in general are not unlikely in the current environment. So let’s assume that the Fed suddenly were convinced by its critics, and turned its policy stance to restrictive (hopefully this is just a thought experiment). I have two related questions to rate-raisers (the same two questions apply to QE opponents in the EMU):

  1. Do they think that private expenditure is healthy enough to grow and to sustain economic activity without the oxygen tent of monetary policy?
  2. If not, would they be willing to accept that monetary restriction is accompanied by a fiscal expansion?

I am afraid we all know the answer, at least to the second of these questions. Just yesterday, on Italian daily Il Corriere della Sera, Alberto Alesina and Francesco Giavazzi called for public expenditure cuts, invoking the confidence fairy and expansionary austerity (yes, you have read well. Check for yourself if you understand Italian. And check the date, it is 2015, not 2007) What Fed (and ECB) bashers tend to forget, in conclusion, is that central bankers are at the center of the stage, reluctantly, because they have to fill the void left, for different reasons, by fiscal policy.  Look at the fiscal stance for the US: 2015_03_Fiscal_Impulse_1 Fiscal impulse, the discretionary stance of the US government, was positive only in 2008-2009, and has been restrictive since then. In other words, while the US were experiencing the worse crisis since the 1930s, while recovery was sluggish and jobless, the US government was pushing the brake. We all know why: political blockage and systematic boycott, by one side of Congress, of each and every one of the measures proposed by the administration (that was a bit too timid, if I may say so). Whatever the reasons, the fact remains that fiscal policy was of very limited help during the crisis. What do Fed bashers have to say about this? What would have happened if, faced with procyclical fiscal policy, the Fed had not stepped in with QE? I am afraid their answer would once again turn around confidence fairies… The EMU is pretty much in the same situation. The following figure shows the cumulative fiscal impulse since 2008 for a number of countries: 2015_03_Fiscal_Impulse_2   The figure speaks for itself. With the exception of Japan (thanks Abenomics!) governments overall acted as brakes for the economy (Alesina and Giavazzi should look at the data for Italy, by the way). Central banks had to act in the thunderous silence of fiscal policy. So I repeat my question once again: who would be willing to exchange a normalization of monetary policy with a radical change in the fiscal stance? To conclude, yes, monetary policy has been very proactive (even Mario Draghi’s ECB); yes, this led us in unchartered lands, and we do not fully grasp what will be the long term effects of QEs and unconventional monetary policies; yes, some distortions are potentially dangerous.  But central bankers had no choice. We are in a liquidity trap, and the main tool to be used should be fiscal policy. Monetary policy could and should be normalized, if only fiscal policy would finally take the witness, and the burden to lift the economy out of its woes; if fiscal policy finally tackled the increasing inequality that is choking the economy. If fiscal policy did its job, in other words.

I don’t know why, but I have the feeling that Janet Yellen and Mario Draghi would not completely disagree.

Push Greece Off the Cliff?

February 5, 2015 18 comments

Yesterday, like many, I was appalled by the ECB announcement that it would stop accepting Greek bonds as collateral for loans. The timing, right after Greek finance minister Varoufakis met Draghi, but before he met German finance minister Schauble, seemed a clear signal: the ECB sides with Germany and EU institutions, and the only possible outcome it expects is a complete rolling back of Syriza electoral promises, and a renewed Greek commitment to austerity and troika-style structural reforms (privatizations plus labour market reform, to say it simply). This would of course be terrible news for Europe (these recipes simply did not work, this is acknowledge  everywhere from the IMF to the White House, passing by Downing Street). And terrible news for democracy as well. The signal to voters would be “Enjoy your day at the polls. Then we decide in Brussels, Frankfurt and Berlin”.

Appalling, I said. This morning I have read a different, very interesting interpretation by Frances Coppola.  Please read the piece. Is wonderfully written. In a few sentences, it says that the ECB move may not be pressure just on Greece, but on both sides involved, i.e. on Germany as well. In a sort of mega game of chess, by weakening Greece, by pushing it closer to the edge of the cliff, the ECB forces both sides to actively look for a deal, in order to avoid the catastrophic effect of Grexit. Coppola mentions the principle of “coercive deficiency” (famously applied to nuclear deterrence): a weaker Greece makes it run out of options, and hence a deal unavoidable.

Boy, I hope Frances is right! The alternative interpretation, United Creditors Against Greece, would mean the end of the Euro. And it is true that the practical implications of yesterday’s decision are in the end limited.  But I remain worried, for at least two reasons.

  1. The first is that if the ECB were trying (in a convoluted way) to set the stage for a deal, it should push Greece closer to the cliff, while at the same time showing at least some willingness to negotiate. Now, it seems that the ECB is not willing even to grant an extension of maturities. This is at odds with the interpretation of the ECB as setting the ground for a deal
  2.  Second, even assuming the ECB were in fact trying to crate the conditions for a deal, the game would be dangerous indeed, because it relies on Germany’s leaders to be good chess players! Leaving metaphors aside, it seems that Angela Merkel and Wolfgang Schauble are trapped in their own narrative of debt as a morality tale, in which punishment of the sinners is by definition impossible. So the question becomes whether they would recognize that pushing Greece off the cliff would entail huge costs for the EU at large. And even if they recognize it, they may be willing to pay the price “to teach the sinners a lesson”

Difficult times ahead. I am not optimist

Who are the Radicals in Europe?

January 25, 2015 4 comments

As I write the Greek people are voting.  I was puzzled in the past weeks by the fear (more in the media than in markets, actually) of a “radical” left win. Puzzled, because the radical and ideological policy makers do not seem to live in Greece, today. On January 20 I wrote a piece for the Greek website Macropolis, where I claimed that we should not expect an Armageddon if Syriza wins, but rather some welcome fresh air.  I reproduce the piece here:

It is most likely that from the elections of January 25 will emerge a Syriza-led government, the main uncertainty being how large a coalition Alexis Tsipras will have to gather to obtain a comfortable parliamentary majority. This is seen with a fair deal of preoccupation in Europe. A preoccupation that does not seem warranted. Syriza is no longer the radical party of the beginning, which called for the exit from the euro and for a default on Greek public debt. Today it is party whose program can hardly be defined revolutionary, and whose label of “radical” left is justified mostly by the drifting of other social democratic party in Europe  (for example in Italy and in France) towards the center of the political spectrum, and towards a de facto acceptance of the European macroeconomic orthodoxy. Syriza’s leader, Tsipras, as the prospects of victory become more concrete, has further softened his tones and is already actively negotiating with the Commission and with the major countries, in view of a compromise on the key points of his program. However, some of the media and some political leaders around Europe continue to present the Greek elections as an incoming Armageddon, and the possibility of a Syriza victory as the beginning of the end for the monetary union.

Let’s see what are the reasons for concern. Regarding Europe, Syriza’s agenda has two key elements. First, in case of victory Tsipras would ask to renegotiate a substantial chunk of Greece’s unbearable public debt, that today is mostly (for around 80%) in the hands of official creditors. Of course, this would mean a loss for creditors to absorb. But, as the Financial Times noted as well,  it is difficult to imagine a durable exit from the crisis that has choked Europe since 2008,  if at least a part of the debt burden that is stifling the recovery is not removed. The French finance minister has agreed yesterday that some compromise on Greek debt will be have to be found, even if some northern countries are at least as of now inflexible. What seems increasingly evident, in fact is that with the European economy back into deflation the costs, for creditor countries as well as for debtors,  of a long stagnation, seem far more important than the loss associated with the debt restructuring. The second key point of Syriza’s electoral agenda is the abandonment of austerity that, albeit less stringent than in previous years, continues to characterize European economic policy   In other words, Syriza asks to address the problem of unsustainable debt, so far hidden under the rug, and to finally acknowledge the need for a comprehensive plan to restart the European economy, that goes well beyond the accounting tricks of the Juncker plan. Syriza may seem radical to some German economist. But it is in good company of other well-known extremists such as Paul De Grauwe, the IMF, the US government, and much of the Anglo-Saxon press. The European economy is unbalanced and stuck in a deflationary  liquidity trap, Mario Draghi’s faces fierce political opposition, and his arrows are increasingly ineffective; it is therefore increasingly clear that only fiscal policy will be able to get us out of trouble.

On closer inspection, it seems far more radical the position of those who, despite having grossly underestimated the negative effects of austerity, ask for more of the same; of those who insist on advocating supply-side reforms to cope with a chronic lack of demand; and of those who boast having achieved a balanced budget one year ahead of forecasts, when Europe would benefit from a recovery of domestic demand in Germany.

What will happen then, if “radical” Syriza will win the election? Actually not much. Tsipras, comforted by opinion polls among his fellow citizens, does not consider the Grexit option. He will sit at the negotiating table to try to obtain for his country a substantial restructuring of debt, and for Europe change towards a more Keynesian policy. If on the latter objective it is hard to imagine that substantial progress will be made, debt restructuring in some form will probably happen. First, because as we said above, it seems to be an unavoidable event, just waiting for the political conditions to be reunited. And second, because Greece will negotiate from a position of strength.  Its primary budget surplus (a proof, if needed, that contrary to widespread beliefs Greece actually did its homework; and painfully so), and the low share of debt held by private investors, around 15%, would allow it not to be subject to market pressures in case of exit and default.

And contrary to some declarations that resemble to pre-electoral tactics (the Greek election game is played in the European arena as well), Greece’s exit from the euro would not arrange its European partners either. First, because it would be accompanied by default, and losses for creditors would be significantly larger than in the case of restructuring. Then, probably more important, because Grexit would have unpredictable contagion effects on other peripheral economies, which not hazardously today look with concern to the increasingly harsh tones used in particular by the German Government. In case of a Syriza victory Angela Merkel will most probably soften the tone and agree to negotiate. It is hard to imagine that orthodoxy will go as far as to push Greece out of the euro.

It goes without saying that the negotiation will be harsh, and that tensions will emerge. But today the ECB is more active in assisting countries in difficulty, and its program OMT, which recently received preliminary clearance by the European Court of Justice, is a good protection against speculative attacks.

To conclude, Europeans should stop worrying and let democracy play its role. A Syriza-led government (possibly forming an alliance with George Papandreou’s To Kinima) would not cause an earthquake. Rather the contrary, it could help stirring things up, and bring within the European debate discussion about measures the need for which is now obvious to all except to those who will not see.