I have been silent on Greece, because scores of excellent economists from all sides commented at length and in real time on the developments of negotiation, and most has been said.
But last week has transformed in certainty what had been a fear since the beginning. The troika, backed by the quasi totality of EU governments, were not interested in finding a solution that would allow Greece to recover while embarking in a fiscally sustainable path. No, they were interested in a complete and public defeat of the “radical” Greek government.
The negotiation has not been one. The two sides were very far in January, as it is and it should be, if two radically different views about the engines of growth confront each other. Syriza wanted the end of austerity, that was much harsher on the country than expected, while failing to bring the promised benefits, even in terms of public finances’ sustainability. And it wanted the burden of debt to be lifted The troika wanted get its money back (well, not all of it; the IMF has always been open to debt restructuring), and more of the policies imposed to Greece since 2010, because, well, “eventually they will work”. (no need for me to remind with whom I have been siding).
But there was a common ground that, had the negotiation been real, could have allowed to reach an agreement, in just a few weeks of discussion. Both sides agreed that the Greek economy is broken, and that it needs radical reform. While Syriza focused on reorganisation of the State, on putting together a functioning tax collection system, at cloosing ineficiency loopholes, the troika demands were more “classic” and somewhat ideological: pension cuts, labour market reform, and the like. A continuation of the memorandum, in fact.
If we look at the economics of it, Sequencing is crucial: implementing structural reforms in bad times, when the economy is not able to absorb the short run costs of such reforms, imposes excessive disruption and risks hampering the potential long run benefits. This is why the joint implementation of austerity and structural reforms is particularly pernicious. Their short run contractionary effects reinforce each other and may be self-defeating, leading to no improvement in productivity or in public finances’ health. The dire state of Greece’s economy stands as a reminder that such an outcome is all but impossible. Troika reforms and cuts to public spending were doomed to fail since the beginning.
What happened since then? Well, contrary to what is heard in European circles, most of the concessions came from the Greek government. On retirement age, on the size of budget surplus (yes, the Greek government gave up its intention to stop austerity, and just obtained to soften it), on VAT, on privatizations, we are today much closer to the Troika initial positions than to the initial Greek position. Much closer.
The point that the Greek government made repeatedly is that some reforms, like improving the tax collection capacity, actually demanded an increase of resources, and hence of public spending. Reforms need to be disconnected from austerity, to maximize their chance to work. Syriza, precisely like the Papandreou government in 2010 asked for time and possibly money. It got neither.
Tsipras had only two red lines it would and it could not cross: Trying to increase taxes on the rich (most notably large coroporations), and not agreeing to further cuts to low pensions. if he crossed those lines, he would become virtually indistinguishable from Samaras and from the policies that led Greece to be a broken State.
What the past week made clear is that this, and only this was the objective of the creditors. This has been since the beginning about politics. Creditors cannot afford that an alternative to policies followed since 2010 in Greece and in the rest of the Eurozone materializes.
Austerity and structural reforms need to be the only way to go. Otherwise people could start asking questions; a risk you don’t want to run a few months before Spanish elections. Syriza needed to be made an example. You cannot survive in Europe, if you don’t embrace the Brussels-Berlin Consensus. Tsipras, like Papandreou, was left with the only option too ask for the Greek people’s opinion, because there has been no negotiation, just a huge smoke screen. Those of us who were discussing pros and cons of the different options on the table, well, we were wasting our time.
And if Greece needs to go down to prove it, so be it. If we transform the euro in a club in which countries come and go, so be it.
The darkest moment for the EU
Some comments, and endless twitter discussions on my Blanchard Touch post call for a couple of clarifications.
The first has to do to the most common reaction, that has been: “the IMF may well have made advances in its analysis, but the policy prescriptions are remarkably unchanged. So what good is it?” After all, isn’t the IMF considered an hardliner in the current
Troika Institutions‘ negotiation with Greece? No Blanchard touch, there.
These objections are of course justified, but in my opinion they miss an important point: Blanchard is not the IMF executive director. Nor the representative of a major country. He is “only” the head of the research department, and as such his job is to provide analyses, not to decide the use of these analyses made by a process that (luckily) is political in nature. Does this mean that what Blanchard and his staff do is irrelevant? Of course not. I do think that making the debate evolve is a fundamental task for public figures like Blanchard. One of the strength of the Washington Consensus has been the narrative that accompanied it, the market efficiency hypothesis that laid the theoretical foundations of supply side policies. This is why I believe that the fact that the narrative is crumbling, among other things thanks to the IMF own research, is of paramount importance. The change in narrative is a precondition for a policy change. The hiatus between the Fund’s actions and words will be increasingly visible, and eventually, I hope, it will lead to a change of policies. I cannot believe that the narrative is irrelevant; otherwise I would have chosen a different job.
The second clarification concerns the end of my post:
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)
By this I surely did not mean that the IMF should refrain from giving policy advice. Nor that governments should follow their guts instead of informed analysis, as one reader very clearly put it. I meant that the first and most important achievement for a policy adviser is to abandon dogmatism, and acknowledge that however robust we believe our knowledge to be, there always is a chance that it will be proved wrong. With such an attitude, policy advice would become “cautious” in the sense of being aware of possible unintended consequences of policies; policies that should therefore be implemented with in mind alternative scenarios. Just to make an example, the IMF could have suggested, as it did, to implement austerity based on the belief that the multiplier was low. But it should have asked governments to do it gradually, in order to be ready to reverse course in case the estimated multipliers would prove (as it did) to be larger. In a sentence, being cautious means avoiding advising for extreme behaviors that could prove to be extremely costly and hard to unwind. Especially in crisis situations, policy makers should look east and cross the river by feeling the stones.
I would also like to add that in the case of the Washington Consensus, we had already, in the past decade, a number of episodes when its prescriptions turned out to be catastrophic. Thus, caution would have been even wiser. But hey, dogmatism is by definition unwise…
Paul Krugman raises the very important issue of the impact of monetary policy on financial stability. He starts with the well-known observation that, contrary to the predictions of some, expansionary monetary policy did not lead to inflation during the current crisis. He then continues arguing that tighter monetary policy would not necessarily guarantee financial stability either. If the Fed were to revert to a more standard Taylor rule, financial stability would not follow. As Krugman aptly argues, “That rule was devised to produce stable inflation; it would be a miracle, a benefaction from the gods, if that rule just happened to also be exactly what we need to avoid bubbles.“
Krugman in fact takes position against the “conventional wisdom”, which has been widespread in academic and policy circles alike, that a link exists between financial and price stability; therefore the central bank can always keep in check financial instability by setting an appropriate inflation target.
The global financial crisis is a clear example of the fallacy of this conventional wisdom, as financial instability built up in a period of great moderation. A recent analysis by Blot et al shows that the crisis is no exception, as over the past few decades, in the US and the Eurozone, the link between price and financial stability has been unclear and moreover unstable over time, as shown on the following figure.
We therefore subscribe to Krugman’s view that financial stability should be targeted by combining macro- and micro-prudential policies, and that inflation targeting is largely insufficient. In another work, Blot et al argue that the ECB should be endowed with a triple mandate for financial and macroeconomic stability, along with price stability. They further argue that the ECB should be given the instruments to effectively pursue these three, sometimes conflicting objectives.
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:
- 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).
- 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.
- On labour markets, before yesterday’s box 3.5, the Fund had disseminated research linking increased inequality with the decline in unionization.
- Then, of course, the “public Investment is a free lunch” chapter three of the World Economic Outlook, in the fall 2014.
- 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.
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.
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.
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.
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.