Smoke Screens

October 14, 2014 Leave a comment Go to comments

I have just read Mario Draghi’s opening remarks at the Brookings Institution. Nothing very new with respect to Jackson Hole and his audition at the European Parliament. But one sentence deserves commenting; when discussing how to use fiscal policy, Draghi says that:

Especially for those [countries] without fiscal space, fiscal policy can still support demand by altering the composition of the budget – in particular by simultaneously cutting distortionary taxes and unproductive expenditure.

So, “restoring fiscal policy” should happen, at least in countries in trouble, through a simultaneous reduction of taxes and expenditure. Well, that sounds reasonable. So reasonable that it is exactly the strategy chosen by the French government since the famous Jean-Baptiste Hollande press conference, last January.

Oh, wait. What was that story of balanced budgets and multipliers? I am sure Mario Draghi remembers it from Economics 101. Every euro of expenditure cuts, put in the pockets of consumers and firms, will not be entirely spent, but partially saved. This means that the short term impact on aggregate demand of a balanced budget expenditure reduction is negative. Just to put it differently, we are told that the risk of deflation is real, that fiscal policy should be used, but that this would have to happen in a contractionary way. Am I the only one to see a problem here?

But Mario Draghi is a fine economist, many will say; and his careful use of adjectives makes the balanced budget multiplier irrelevant. He talks about distortionary taxes. Who would be so foolish as not to want to remove distortions? And he talks about unproductive expenditure. Again, who is the criminal mind who does not want to cut useless expenditure? Well, the problem is that, no matter how smart the expenditure reduction is, it will remain a reduction. Similarly, even the smartest tax reduction will most likely not be entirely spent; especially at a time when firms’ and households’ uncertainty about the future is at an all-times high. So, carefully choosing the adjectives may hide, but not eliminate, the substance of the matter: A tax cut financed with a reduction in public spending is recessionary, at least in the short run.

To be fair there may be a case in which a balanced budget contraction may turn out to be expansionary. Suppose that when the government makes one step backwards, this triggers a sudden burst of optimism so that private spending rushes to fill the gap. It is the confidence fairy in all of  its splendor. But then, Mario Draghi (and many others, unfortunately) should explain why it should work now, after having been invoked in vain for seven years.

Truth is that behind the smoke screen of Draghinomics and of its supposed comprehensive approach we are left with the same old supply side reforms that did not lift the eurozone out of its dire situation. It’ s the narrative, stupid!


  1. October 14, 2014 at 6:46 am

    never fear – austerity will cause extreme right wing parties to take power and they won’t play that game. Then we can safely accept fiscal stimulus because the police state will prevent a rise in wages!

  2. October 14, 2014 at 7:36 am

    Reblogged this on Arjen polku and commented:
    ‘Truth is that behind the smoke screen of Draghinomics and of its supposed comprehensive approach we are left with the same old supply side reforms that did not lift the eurozone out of its dire situation. It’ s the narrative, stupid!’
    This is exactly one of the things I hope to research in the near future: how even labour unions became in engaged in (at the very least not opposing) this kind of economics.

  3. Patrick VB
    October 14, 2014 at 11:51 am

    The real and big problem is that there is in fact only one EU member state that has sufficient “fiscal space” and is large enough to be able to affect the euro economy: Germany. But even if Germany were now to engage in significant counter-cyclical (supportive) fiscal policy, say 2 – 4% of German GDP one-off, this would provide a temporary boost to euro area GDP of at most 0.7 – 1.4%. This might provide short-term export support to other EU MS, but the main problem of an overall, long run tight fiscal stance remains in the EU (the SGP), as does the fact that Germany’s economic model is export-based. Debt ratios in the EU are still rising, and the common currency plus Fiscal Compact offer just one possible way out of the current weakness: the ECB will have to engage in implicit fiscal support and buy euro area sovereign debt, until the euro area’s real economy picks up and debt ratios begin to decline. The alternative will be a new bout of “euro crisis” and renewed speculation about the break-up of the euro area.

  4. October 14, 2014 at 1:06 pm

    Exactly my thoughts. There is not much fiscal space left and not all countries can devaluate at the same time. Someone should ask Draghi how aggregate demand can be boosted. Maybe EIB would be a solution Germany would allow to happen?

    • Patrick VB
      October 14, 2014 at 3:04 pm

      In principle, the EIB does only co-financing, meaning that as long as private sector banks are unwilling to lend, or entrepreneurs aren’t asking for credit to fund investment, these funds remain unused. The EIB’s current total capital is about 2.5% of euro area GDP, to be used for long term financing. If it were all used in 1 year, it would be a big boost, but spread over the usual 5-10 years of investment projects, it’s not a big amount.

  5. José Araújo
    October 14, 2014 at 1:18 pm

    I think Draghi is genuine in his concerned about Italy, so probably he has put his supply side views on hold for a while.

    We have experienced in the past years a strong tax increase on consumption and income, and I hope that’s what Draghi is talking when he refers the “distortionary taxes”. I’m Portuguese and I can tell you from my experience, that IMHO we are well behind the laffer point on this taxes (and well behind on the wealth taxes) especially on the VAT levels.

    Vat is an extremely distortionary taxes, because it promotes imports and penalizes heavily labor in our own country. In Europe you basically have to pay VAT in any job you create….

    High level income taxes, also are distortionary because it diverts the consumption to basic goods, and in a society that produces high level goods and services (fine dining, health, car maintenance, etc) by contracting this demand, you are destroying jobs in your economy in favor of jobs in other countries that produce the basic goods you consume (energy, food, etc)

    From what we have experienced in Portugal by relaxing a bit this taxes, namely the income taxes, what you will get is a little hike on savings but also a big increase on the consumption of this goods, now what the government has to do is avoid that the money goes into buying the new IPhone but instead is used in fine Italian goods, or a good dinner in a good Italian restaurant.

    • Patrick VB
      October 14, 2014 at 2:48 pm

      José, VAT is an “ad valorem” tax on consumption, and applies to both domestically produced and imported final goods and services. If the rate is applied very broadly, it is not so much distortionary as it is socially regressive: it affects the poor relatively more than the rich, who save a greater share of their income.

      • José Araújo
        October 16, 2014 at 7:13 pm

        Its distortionary because its politicaly transparent the way its implemented, and it actually penalizes the value created in a country, which is mostly labor, management and creativity incorporation.

        We are used to think,or being told VAT is a consumer tax, but we have to think it has a corporate tax that taxes the value created by a company. Consumers will demand y quantity at a given price X, VAT or no VAT, the value perceived of the good or service is independent of VAT.

        But for a company VAT is a tax on gross margin, and we end up with many companies paying VAT when they are in a loss.

        Also in the EU it taxes the same way the value a country creates vs the imported value, unless you get creative with VAT and start implementing different tax rates.

        Lower VAT for services and agricultural products in a country is a must, allowing for VAT deduction on labor cost is another.

      • José Araújo
        October 16, 2014 at 7:36 pm

        Regarding the social impact of VAT, not only a worker is going to have to pay more for the goods he consumes but it also sees its wages decreased by the VAT because companies have to account for VAT on the incorporated work of the goods and services they sell.

        VAT taxes have to be differenciated, both to account for redistribution on consumers, but also to account for corporate profits. Same tax on a industry that has 5% margins to another with 50% margins is highly distortive.

  6. José Araújo
    October 14, 2014 at 1:22 pm

    Sorry, I meant that we in Portugal are well past the laffer point on income taxes and behind on wealth taxation

    • Alt
      October 15, 2014 at 8:33 pm

      How do you measure the “laffer point” in Portual? By feeling? Faith? Ideology?

      • José Araújo
        October 16, 2014 at 7:16 pm

        By the elasticity of the budget to tax increases, that the definition. Portugal increased taxes and the tax revenues went down, which is a sign we are way past the laffer point.

        Actually I think we crossed the laffer point, way way back when we increased VAT from 17% to 19%

  1. November 5, 2014 at 8:25 am

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