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Confusion in Brussels

October 17, 2014 Leave a comment Go to comments

already noticed how the post-Jackson Hole Consensus is inconsistent with the continuing emphasis of European policy makers on supply side measures. In these difficult times, the lack of a coherent framework seems to have become the new norm of European policy making. The credit for spotting another serious inconsistency this time goes to the Italian government. In the draft budgetary plan submitted  to the European Commission (that might be rejected, by the way), buried at page 12, one can find an interesting box on potential growth and structural deficit. It really should be read, because it is in my opinion disruptive. To summarize it, here is what it says:

  1. A recession triggers a reduction of the potential growth rate  (the maximum rate at which the economy can grow without overheating) because of hysteresis: unemployed workers lose skills and/or exit the labour market, and firms scrap productive processes and postpone investment. I would add to this that hysteresis is non linear: the effect, for example on labour market participation, of a slowdown, is much larger if it happens at the fifth year of the crisis than at the first one.
  2. According to the Commission’s own estimates Italy’s potential growth rate dropped from 1.4% on average in the 15 years prior to the crisis (very low for even European standards), to an average of -0.2% between 2008 and 2013. A very large drop indeed.
  3. (Here it becomes interesting). The box in the Italian plan argues that we have two possible cases:
    1. Either the extent of the drop is over-estimated, most probably as the result of the statistical techniques the Commission uses to estimate the potential. But, if potential growth is larger than estimated, then the output gap, the difference between actual and potential growth is also larger.
    2. As an alternative, the estimated drop is correct, but this means that Italy there is a huge hysteresis effect. A recession is not only, as we can see every day, costly in the short run; but, even more worryingly, it quickly disrupts the economic structure of the country, thus hampering its capacity to grow in the medium and long run.

The box does not say it explicitly (it remains an official government document after all), but the conclusion is obvious: either way the Commission had it wrong. If case A is true, then the stagnation we observed in the past few years was not structural but cyclical. This means that the Italian deficit was mainly cyclical (due to the large output gap), and as such did (and does) not need to be curbed. The best way to reabsorb cyclical deficit is to restart growth, through temporary support to aggregate demand. If case B is true, then insisting on fiscal consolidation since 2011 was borderline criminal. When a crisis risks quickly disrupting the long run potential of the economy, then it is a duty of the government to do whatever it takes to fight, in order to avoid that it becomes structural.

In a sentence: with strong hysteresis effects, Keynesian countercyclical policies are crucial to sustain the economy both in the short and in the long run. With weaker, albeit still strong hysteresis effects,  a deviation from potential growth is cyclical, and as such it requires Keynesian countercyclical policies. Either way, fiscal consolidation was the wrong strategy.

I am not a fan of the policies currently implemented by the Italian government. To be fair, I am not a fan of the policies implemented by any government in Europe. Too much emphasis on supply side measures, and excessive fear of markets (yes, I dare say so today, when the spreads take off again). But I think the Italian draft budget puts the finger where it hurts.

The guys in Via XX Settembre dit a pretty awesome job…

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  1. October 17, 2014 at 10:15 am

    I suspect the Commission will retort that the drop in the potential growth rate in Italy is rather due to lack of reform amid the negative impact of globalization on Italian competitiveness. In other words, they could argue that the drop in the potential growth rate is consequence of:either i) recession; ii) or lack of structural reform (whatever that means); iii) or a combination of i) and ii). How to discriminate empirically? Hard to say!

    In my opinion, the reason the Italian treasury introduced that exhibit is that they want to challenge the Commission’s estimate of Italian potential output and claim that the Italian structural deficit meets the requirements of the Fiscal Compact.

    • José Araújo
      October 17, 2014 at 11:40 am

      Why doesn’t the italian tresury argue that Interests paid to ECB shouldn’t be accounted on the deficit.

      Also sovereign Italian debt held by the ECB, should’t be accounted has debt on italian books, but has near capital…. afterall ECB is the Italian Central Bank, isn’t it?

  2. José Araújo
    October 17, 2014 at 11:33 am

    I think we are facing some kind of cult or religious order, if not they for sure use the same tactics. They tell the lie so many times that eventually it becomes truth. And no matter what they observe, no matter what reality is, they keep on pushing the same lies.

    How can Italy, Portugal, Spain or Greece or Ireland, be facing structural unemployment when youth and graduate unemployment is in such high values, it’s absolutely non-sense.

    In what way have this countries problems with labor flexibility when you more than double unemployment rates in such a short period of time.

    But what’s more, how the hell can you argue for budget consolidation and increase the competitive conditions of the economy. Don’t you realize that all the slack there was on our economies has been absorbed by tax increases?

    If governments were not raising taxes for sure there would be an opportunity for corporations to adjust wages, but with the constant raises in taxes workers can’t afford to have both.

    We are now worried with deflation and stagnation, but guess what CPI index accounts for taxes, so with the VAT taxes increases we have been experiencing, Deflation has set on the periphery countries some years ago….

  3. cig
    October 17, 2014 at 1:04 pm

    Don’t you also get a parallel kind of hysterisis effect with poor public allocations (directly in the public sector or via mandates)? If people get paid way too well for low intensity or obsolete sinecures, they may lose (some of) their potential to switch to more productive occupations the longer they stay put, while also having an ever greater incentive to work at maintaining the patronage and legacy privilege systems that allocate and preserve the sinecures.

    • José Araújo
      October 17, 2014 at 4:20 pm

      If you are in full employment I see your point, but when you are so far from potential output firing someone only adds to the loss of productivity, total productivity not marginal productivity.

      Also the first determinants of productivity are scale and technology (one shifts the cost curve the other allows you to mone in the cost curve). The situation we are living in its clearly a scale problem due to lack of demand, and nothing is solved looking into production determinants.

      We have to shift the demand so we can move in the cost curve and increase productivity. We are so far from potential output and full employment that the demand shift will not crowd out supply.

      • cig
        October 31, 2014 at 10:56 am

        Imagine Air France goes through an overnight bankruptcy, during which they fire all the pilots. The next day, New Air France re-employs the very exact same number of pilots at market conditions (much lower than the previous legally protected sinécure conditions). Net employment is unchanged. Has total productivity been lost, even before considering marginal effects (where the more clever pilots change carreer to something more productive, and now better paid, than being a glorified bus driver, and are replaced at New AF by formerly unemployed pilots who’re not good at anything else)?

      • José Araújo
        November 3, 2014 at 2:52 pm

        The first answer is that productivity would be lower, you get less money hence you work less, but I think looking at productivity under a monetary view its the wrong way to do it, productivity, IMHO, should be viewed looking into the output produced by an unit of input.

        The second answer is that rehiring the pilots at a lower wage would decrease demand in the economy and hence lower the output of the economy, eventually it would hit new air-france that would have to fire againg its pilots and rehire them has the new new air-france.

        We are facing a demand shortage, so looking at the problems with supply goggles isn’t, IMHO, the answer.

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