It’s the Institutions, Stupid!

Tomorrow’s ECB decision on Quantitative Easing is awaited like a messiah (it would be interesting to see what happens if the ECB does not announce QE). We’ll see the shape this takes, but I already argued some time ago that excessive expectations on ECB action stem from the suicidal neglect of fiscal policy, the instrument of choice at times of liquidity traps. Mario Draghi and the ECB Governing Council are given an excessive burden by the inertia of governments trapped in ideology and/or in a crazy fiscal rule.

There will be time to assess the shape and the impact of tomorrow’s decisions. Here I want to focus on one aspect of all this that is not sufficiently emphasized. Even the bolder and more effective Quantitative Easing program would come unacceptably late. The ECB should have stepped in to sustain economic activity much earlier, at least in 2012, when its counterparts launched their own programs; or possibly earlier, given the Eurozone specific sovereign debt crisis. But it did not, mostly because it was politically impossible to take such a decision without the threat of deflation looming on the eurozone.

And I get to my point. I just saw a paper by Philippe Martin and  Thomas Philippon (here a VoxEU column presenting its main results) that tries to disentangle the impact of different shocks on the crisis, and runs a number of counterfactual experiments. Its conclusion are interesting and commonsensical. The first is that except for Greece, more prudent fiscal policies in the early 2000s would not have been effective in preventing or softening the private deleveraging shock that happened from 2008. Only if more prudent fiscal policies had been coupled with macroprudential policies (i.e., curbing private leverage in the first place), there would have been an impact on the crisis. The counterfactual I found more interesting is the one on the “Whatever it Takes” OMTs program. The authors ask whether  the OMT, if implemented in 2008 and not in late 2012, would have made a difference, and the answer is a clear yes. If through ECB insurance spreads had been kept low, peripheral countries would have had the fiscal space to counter the crisis, and unemployment would have been reabsorbed. Interestingly, the authors neglect the impact of the 3% limit on public deficits. Of course, had they introduced a fiscal rule limiting fiscal space, the impact of OMT would have been less glorious.

The way I see it (I am not sure the authors would have the same interpretation), Martin and Philippon show that the roots of EMU problems are institutional. If we had a normal central bank, capable of acting as a Lender of Last Resort, and of insuring the euro denominated debt; if we had normal governments, capable of using fiscal policy as a countercyclical tool, then… well, then we would be the US! The crisis would have hit hard because excessive leverage did not depend on macroeconomic governance, but policy could have been reactive and coordinated, thus leading to a recovery like the one we saw in the US (while I hear those who complain about policy and about the state of the economy in the US, it is undeniable that their economic performance is orders of magnitude better than our own!). Of course, the US also have a system of fiscal transfers that we can only dream of…

So our problem is that we don’t have normal institutions for macroeconomic governance. Macroeconomic policy in the EMU is the result of political skirmishes, and rests more on the diplomatic capacities of Mario Draghi Angela Merkerl, or Alexis Tsipras, than on a clear assessment of problems and solutions. Furthermore, this (mal)functioning yields last-minute decisions, only if under threat  (OMT because of speculation on periphery’s debt; QE because of deflation).

We are in the eight year of the crisis, and the trending topics among European elites are QE, and the Juncker plan. The former will likely be a byzantine compromise between Mario Draghi and the German government (as a side note: what about central bank independence, Mrs Merkel? Wasn’t that one of the things that you kept in such high consideration that you did not want it endangered by debt monetization?); the Juncker plan is simply an empty box. And they both come into the picture way too late, as the need for expansionary fiscal and monetary policies was clear at least since 2010.

The new European motto should be too little too late.