Draghi the Fiscal Hawk

We are becoming accustomed to European policy makers’ schizophrenia, so when yesterday during his press conference Mario Draghi mentioned the consolidating recovery while announcing further easing in December, nobody winced. Draghi’s call for expansionary fiscal policies was instead noticed, and appreciated. I suggest some caution. Let’s look at Draghi’s words:

Fiscal policies should support the economic recovery, while remaining in compliance with the EU’s fiscal rules. Full and consistent implementation of the Stability and Growth Pact is crucial for confidence in our fiscal framework. At the same time, all countries should strive for a growth-friendly composition of fiscal policies.

During the Q&A, the first question was on precisely this point:

Question: If I could ask you to develop the last point that you made. Governor Nowotny last week said that monetary policy may be coming up to its limits and perhaps it was up to fiscal policy to loosen a little bit to provide a bit of accommodation. Could you share your thoughts on this and perhaps even touch on the Italian budget?

(Here is the link to  Austrian Central Bank Governor Nowotny making a strong statement in favour of expansionary fiscal policy). Draghi simply did not answer on fiscal policy (nor on the Italian budget, by the way). The quote is long but worth reading

Draghi: On the first issue, I’m really commenting only on monetary policy, and as we said in the last part of the introductory statement, monetary policy shouldn’t be the only game in town, but this can be viewed in a variety of ways, one of which is the way in which our colleague actually explored in examining the situation, but there are other ways. Like, for example, as we’ve said several times, the structural reforms are essential. Monetary policy is focused on maintaining price stability over the medium term, and its accommodative monetary stance supports economic activity. However, in order to reap the full benefits of our monetary policy measures, other policy areas must contribute decisively. So here we stress the high structural unemployment and the low potential output growth in the euro area as the main situations which we have to address. The ongoing cyclical recovery should be supported by effective structural policies. But there may be other points of view on this. The point is that monetary policy can support and is actually supporting a cyclical economic recovery. We have to address also the structural components of this recovery, so that we can actually move from a cyclical recovery to a structural recovery. Let’s not forget that even before the financial crisis, unemployment has been traditionally very high in the euro area and many of the structural weaknesses have been there before.

Carefully avoiding to mention fiscal policy, when answering a question on fiscal policy, speaks for itself. In fact, saying that “Fiscal policies should support the economic recovery, while remaining in compliance with the EU’s fiscal rules” and putting forward for the n-th time the confidence fairy, amounts to a substantial approval of the policies followed by EMU countries so far. We should stop fooling ourselves: Within the existing rules there is no margin for a meaningful fiscal expansion of the kind invoked by Governor Nowotny. If we look at headline deficit, forecast to be at 2% in 2015, the Maastricht limits leave room for a global fiscal expansion of 1% of GDP, decent but not a game changer (without mentioning the fiscal space of individual countries, very unevenly distributed). And if we look at the main indicator of fiscal effort put forward by the fiscal compact, the cyclical adjusted deficit, the eurozone as a whole should keep its fiscal consolidation effort going, to bring the deficit down from its current level of 0.9% of GDP to the target of 0.5%.

It is no surprise then that the new Italian budget (on which Mario Draghi carefully avoided to comment) is hailed (or decried) as expansionary simply because it slows a little (and just a little) the pace of fiscal consolidation. Within the rules forcefully defended by Draghi, this is the best countries can do. As a side note, I blame the Italian (and the French) government for deciding to play within the existing framework. Bargaining a decimal of deficit here and there will not lift our economies out of their disappointing growth; and more importantly, on a longer term perspective, it will not help advance the debate on the appropriate governance of the eurozone.

In spite of widespread recognition that aggregate demand is too low, Mario Draghi did not move an inch from his previous beliefs: the key for growth is structural reforms, and structural reforms alone. He keeps embracing the Berlin View. The only substantial difference between Draghi and ECB hawks is his belief that, in the current cyclical position, structural reforms should be eased by accommodating monetary policy. This is the only rationale for QE. Is this enough to define him a dove?

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The End of German Hegemony. Really?

I was puzzled by Daniel Gros’ recent Project Syndicate piece, in which he claims that Germany’s dominance of the EMU may be coming to an end. Gros’ argument is based on two facts. The first is the slowing growth rate of Germany, that seems to be heading towards the pre-crisis “normal” of slow growth (Germany grew less than EMU average for most of the period 1999-2007). The second, more geo-political, is the lack of willingness (or of capacity) to manage, the crises that face the EU (in particular the refugees crisis).

Gros concludes that this loss of influence is dangerous, because Germany will not be able to resist the changes in policies that are pushed by peripheral countries and by the ECB. Of course, implicit in this statement, is Gros’ belief that these policies were necessary and useful.

I welcome the recognition that Germany has steered the EMU since the beginning of the crisis. Those of us talking about the Germanification of Europe have been decried until very recently. Yet, I do not share, not at all, Gros view.

True, Germany’s growth is slowing down. These are the risks of an export-led growth model: countries are not masters of their own fate. Germany stayed clear from the peripheral countries’ crisis (that it contributed to create) by turning to the US and to emerging economies as markets for its exports. But now that these countries are also having problems, the limits of jumping on other countries’ shoulders to grow, become evident. I am surprised by Gros’ surprise, as this was evident from the very beginning.

But here I do not want to reiterate my criticisms of the export-led model, starting from the fallacy of composition. Instead, I would like to challenge Gros’ argument that Germany influence is waning. I would say on the contrary that the Germanification of the eurozone is almost complete.

I took a few macroeconomic variables, and contrasted Germany with the remaining 11 EMU members. Let’s start with (missing) domestic demand, a defining characteristic of the export-led growth model:

Since 2007, the yellow line (EMU11) and the red line (Germany) converged, mostly because domestic demand in the rest of the EMU was reduced. This led of course to an increased reliance of the EMU as a whole on exports. The EMU as a whole had an overall balanced external position in 2007, while it has a substantial current account surplus today (the EMU12 went from 0.5% to 3.4 projected for 2016. Germany went from 7% to 7.7%). In other words, the EMU11 joined Germany on the shoulders of the rest of the world.

Austerity has of course much to be blamed for this compression of domestic demand: Just look at government balances (net of interest payments):

True, the difference between Germany and the rest of EMU is today larger than in 2007. But since Germany and the Troika took the driving seat in 2010, government balances of the EMU11 have been steadily converging to surplus, and they are not going to stop in the foreseeable horizon (the Commission forecasts go until 2016).

Finally, if we look at one of the main drivers of growth, investment, the picture is the same.

Be it private or public, the EMU11 Gross Fixed Capital Formation has been converging towards the (excessively low) German level (I did not draw the differences, not to clutter the figure).

And of course, there are labour costs, for which convergence to Germany was brutal, even if the latter, rather than EMU peripheral countries, were the outlier. To summarize, during the crisis the difference between Germany and the rest of the EMU was substantially reduced, and will continue to be in the next years:

The difference was reduced for all variables, except for government deficit. Self-defeating austerity slowed down the convergence. But private expenditure, in particular investment, more than compensated.

So, if I were Gros, I would not worry too much. The Germanification of Europe is well on its way. If Germany does not go to the EMU11 (it definitely does not!), the EMU11 keeps going to Germany.

But as I am not Gros, I worry a lot.

Fed Debates and the EMU Technocratic Illusion

Thanks to the invaluable Economist’s View, I have read with lots of interest the speech that newly appointed Federal Reserve Board Member Lael Brainard gave last Monday. The speech is a plea for holding on rate rises, and uses a number of convincing arguments. Much has been said on the issue (give a look at comments by Tim Duy and Paul Krugman). I have little to add, were it not for the point I made a number of times, that the extraordinarily difficult task of central bankers would be made substantially easier if fiscal policy were used more actively.

What I’d like to express here is my jealousy for the discussions (and the confrontation) that we observe in the US. These discussions are a sideproduct, a very positive one if you ask me, of the institutional design of the Fed. I just returned from a series of engaging policy meetings on central bank policy in Costa Rica, facilitated by the local ILO office, where I pleaded for the introduction of a dual mandate.

I wrote a background paper (that can be seen here) in which my main argument is that a central bank following a dual mandate will always be able to take an aggressive stance on inflation, if it deems it necessary to do so. Appropriate choice of the weights given to employment and inflation would allow incorporation of any combination of the two objectives. A good case in point are the United States, where the Federal Reserve under Chairman Volcker embarked on a bold disinflation program in the early 1980s when the country had just adopted the dual mandate. No choice of weights, on the other hand, would allow a central bank following an inflation targeting mandate to explicitly target employment as well. Thus, the dual mandate can embed inflation targeting strategies, while the converse is not true. In terms of policy effectiveness, therefore, the dual mandate is a superior institutional arrangement.

I also cited evidence showing, and here we come at my jealousy for the Fed, that inflation targeting central banks, like the ECB, de facto target the output gap, but timidly and without explicitly saying so. This leads to low reactivity and opaque communication, that hamper the capacity of central banks to manage expectations and effectively steer the economy. I am sure that those who followed the EMU policy debate in the past few years will know what I am talking about.

One may argue that the cacophony currently characterizing the Federal Reserve Board is hardly positive for the economy, and that in terms of managing expectations, lately, the Fed did not excel. This is undeniable, and is the result of the Fed groping its way out of unprecedented policy measures. The difference with the ECB is that for the Fed the opacity results from an ongoing debate on how to best attain an objective that is clear and shared. We are not there yet, but the debate will eventually lead to an unambiguous (and hopefully appropriate) policy choice. The ECB opacity, is intrinsically linked to the confusion between its mandate and its actual action, and as such it cannot lead to any meaningful discussion, but just to legalistic disputes on the definition of price stability, of how medium is the medium term and the like.

And I can now come to my final point: a dual mandate has the merit to let the political nature of monetary policy emerge without ambiguities. It is indeed true that monetary policy with a dual mandate requires hard choices, as the ones that are debater these days, and hence is political in nature. The point is, that so is monetary policy with a simple inflation targeting objective. The level of inflation targeted, and the choice of the instruments to attain it, are all but neutral in terms of their consequences on the economy, most notably on the distribution of resources among market participants. Thus, an inflation targeting central bank is as political in its actions as a bank following a dual mandate, the only difference being that In the former case the political nature of monetary policy is concealed behind a technocratic curtain.
The deep justification of exclusive focus on price stability can only lie in the acceptance of a neoclassical platonic world in which powerless governments need to make no choice. Once we dismiss that platonic view, monetary policy acquires a political role, regardless of the mandate it is given. A dual mandate has the merit of making this choice explicit, and hence to dispel the technocratic illusion.

I am not saying there would be no issues with the adoption of a dual mandate. The institutional design should be carefully crafted, in order to ensure that independence is maintained, and accountability (currently very low indeed) is enhanced. What I am saying is that after seven years (and counting) of dismal economic performance, and faced with strong arguments in favour of a broader central bank mandate, EMU policy makers should be engaged in discussions at least as lively as the ones of their counterparts in Washington. And yet, all is quiet on this side of the ocean… Circulez y a rien à voir