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Could Central Banks do More during the Crisis?

September 7, 2018 3 comments

I rarely disagree with Martin Sandbu’s Free Lunch. But today’s piece on central banks is one of these cases.

In short, Martin argues that while the main culprit for the slow recovery is fiscal policy, almost everywhere too timid if not outright procyclical (we are all on board on that!), the mistakes of fiscal authorities do not exempt central banks from bearing part of the responsibility. In particular, he dismisses the claim that it was technically impossible to lower long-term interest rates further, and/or bring policy rates even more into negative territory.

I agree with this point. Interest rates could have been lowered further. Nevertheless, I think that this would have made very little difference, because after 2008 central banks were essentially pushing on a string.  This point of disagreement between us can be traced to a different view about what is the liquidity trap.

I recently published a book, La Scienza inutile (a general public account of a century of debates in macroeconomics. For the moment it is in Italian and in French, English translation in progress), in which I discuss the different notions of liquidity trap. Here is the quote (sorry, a bit too long):

 The first source of trouble that Keynes considers is the most extreme, the so-called liquidity trap: `There is the possibility, […] that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest’ (Keynes 1936, p.207). In slightly more technical terms, the interest elasticity of money demand is near-infinite: no matter how much liquidity the central bank injects into the economy, it is entirely hoarded by agents and hence it leaks out of the system in its entirety. Monetary expansion is not effective in lowering interest rates.

There may be different reasons why the economy enters a liquidity trap. Keynes argued, by looking at the great depression, that this usually happens at very low (but not necessarily nil) levels of the interest rate, because in this case agents would expect interest rates to rise in the future and thus would be willing to hold any extra amount of money and postpone the purchase of bonds to the moment when interest rates will be up again. More recently the liquidity trap has been defined as a situation in which the interest rate that equates savings and investment is negative, and therefore cannot be attained by the central bank (the so-called Zero Lower Bound, or ZLB; see e.g. Krugman 2000). This latter definition leaves some room for monetary policy effectiveness: if the central bank manages to trigger the expectation of positive inflation, the real interest rate (the nominal interest rate minus the inflation rate) will become negative and lead to the full employment equilibrium.

So, if we think in terms of ZLB, it exists a real interest rate at which the output gap would be closed. If that interest rate is negative, then it is harder to reach, as central banks need to raise inflation expectations and try to push short term rates as much as possible in negative territory, which requires boldness and creativity (we have seen this). But, once again I agree with Martin on that, this can be done. If instead private expenditure becomes irresponsive to interest rates, the ‘Keynes definition’, then there is little central banks could do. I had noticed, back in 2016, that while it succeeded in easing credit conditions, EMU Quantitative Easing seemed to have done little to boost confidence and expected demand (the ultimate driver of firm’s credit needs). The EMU most recent Bank Lending Survey seems to confirm the prediction of the time. Both chart 4 (enterprises) and chart 12 (households) depict a flat demand for loans, that picks up only when the EMU economic outlook brightens.

This is by no means hard evidence (I am not aware of any papers thoroughly investigating the impact of QE on credit demand). But stylized facts seem to acquit central bankers.

 

 

ps

The two works cited in the quote:

Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. London: McMillan.

Krugman, P. (2000). Thinking About the Liquidity Trap. Journal of the Japanese and International Economies 14(4), 221–237.

The Euro Debate: Back to Square One

November 20, 2017 2 comments

I was glad to write a preface for the Italian translation (La moneta rinnegata) of Martin Sandbu’s latest effort (Europe’s Orphan). A somewhat shorter version can be found on the website of LuissOpen.

In a few sentences, I believe that the interest of the book lies in two points:

  • First, its rebuttal of the “flawed euro” narrative. This narrative is shared by euro skeptics and federalists (including myself more often than not), and it fatally hurts the capacity of the latter to win the argument. If the euro is flawed, and if a political union is not in the cards, then it is hard to argue against XX-exiters with arguments other than fear. And fear (Brexit docet) does not work.
  • Second, Sandbu shows masterfully something I have also been saying, much less effectively: institutions (and money is one) do not make policies. People do. None of the policy mistakes that disseminate the euro crisis Via Crucis  was inevitable. In the piece for LuissOpen I notice that institutions may still bias the choice in certain directions (think of the Stability Pact), but in spite of that I join Sandbu in believing that the Euro is the scapegoat for policies that could and should have been different. La moneta rinnegata, indeed.

I would add something, that came to my mind after I had sent out the piece. Sandbu puts at the center of his narrative the issue of debt restructuring. It is the refusal of EU creditors to consider forgiveness for a debt that was anyway never to be repaid, that led to self-defeating austerity. Sharing the burden (debt relief) would have entailed lower costs and eventually, would have increased resilience and more sustainable public finances. The IMF recognized this fundamental contradiction, but the other creditors (must notably Germany) did not.

And they still don’t. I believe that the whole debate about risk sharing versus risk reduction, that shapes the discussion on EMU reforms, replicates the fault lines we saw at work for debt crisis management. On one side those who believe that market mechanisms or policy constraints, alone, cannot dampen the centrifugal forces that are inevitably built in any monetary union. On the other, those who believe that the collective convergence will happen once each member behaves, so that enhanced rules and firewalls are all that is needed for the euro to thrive.

Thus Sandbu’s book helps making sense of what happened, but also to assess the proposals for the future. Refusal to share costs linked to the debt crisis turned out to be a huge mistake. We should avoid making another one by refusing to fight divergence through risk sharing.

Can France Survive Without Europe?

May 6, 2017 2 comments

I should begin by saying that it is sad to see that my last post dates from February 20. Lots of things going on right now, in particular the wrapping up a book on the history of macro, that is draining all my energies. But I need to try harder to keep the blog going…

At any rate, tomorrow France votes. And I wrote a piece for Social Europe, in which I try to put the outcome of the election in the European context. If you do not want to read all of it, here are the bullet points:

  1. France is considered the sick man of Europe for the standard reasons (rigidity lack of reform etc)
  2. 2) But in fact “hard” data are not that bad, rather the contrary (productivity investment FDI, etc). Just look at Thomas Piketty’s blog post from a few months ago.
  3. lost competitiveness is price competitiveness, that is not France’s fault, but Germany’s (wage deflation).
  4. In fact the sick man of Europe is Europe itself, because it forces countries into a dilemma:
    • They can engage in fiscal competition and internal devaluation. But let’s not fool ourselves, there is no way that this can be done without killing the European social model. Only the downsizing of the welfare state can allow reducing taxes and labour costs and keeping public finances sustainable;
    • Or, they (try to) protect their social model, but pay the price of low competitiveness and slow growth.
  5. France oscillated between Scylla and Charybdis, leaning more towards the second path.  And it suffers, because most other countries did take the internal devaluation  path, willingly or not . Everything in the way the EMU is constructed, pushes countries to engage in deflationary policies.
  6. Exiting (from the Euro, from the ECU, from the EU) would in no way subtract countries to the dilemma. A small open economy would have an even harder time carrying on autonomous economic policies (more in general, what I think of XXexit is well summarized here. To be fair to my colleagues, I contributed very little to that piece, but was happy to sign it).
  7. Thus, the survival of the French model is in Europe, or it is nowhere. The next President’s fate will have to be decided there
  8. If France wants to save its social model, it needs to trigger change in the EU. It will save its model. Otherwise it is doomed; it will not survive, socially and electorally, to five more years of muddling through.
  9. And viceversa, if there is a chance for Europe to change, that chance is represented by a coalition against deflationary policies that only France would have the strength to form and lead. There is one way, and only one way, to escape Scylla and Charybdis.

I did not write that in the Social Europe piece, but I want to add that the path is very narrow. Macron has the virtue of putting Europe at the center of his project, but his reform proposals are for the moment very vague. And more importantly, his tax reduction plan resembles a bit too much to the good ol’  supply side measures that sank Jean-Baptiste Hollande.  But then, what do we know? First, policies are shaped by events; and second Le Pen would of course mean the end of the Euro right now. So, we can just hope that (and fight for) France and Europe will walk that narrow path.

Killing Them Softly?

December 15, 2016 1 comment

Just a very quick and unstructured note on Greece. There is lots of confusion under the sky, and it seems to me that creditors are today advancing in sparse order.

Yesterday something rather upsetting happened, as the Eurogroup suspended bailout payments because Greece engaged in some extra expenditures. These are mostly targeted to pensioneers and to the Greek islands that had to endure unexpected costs linked to the refugee crisis. Unexpectedly, the Commission is siding with Greece, with Pierre Moscovici arguing that the country is on target, and that its effort has been remarkable so far. In fact, I have understood, Greece is doing so well that it overshot the target of structural surplus for 2016, and it it these extra resources that it is engaging in order to soft the impact of austerity.

And then there is the IMF, accused by Greece of pushing for more austerity, is also under attack from EU institutions (Eurogroup and Commission) for its refusal to join the bailout package. The Fund has hit back, in a somewhat irritual blog post signed by Maurice Obstfeld and Poul Thomsen (not just any two staffers) and seems not to be available to play the scapegoat for a program that in their opinion was born flawed. In fact, I think that more than to Greece, Obstfeld and Thomsen have written with the other creditors in mind.

I have two considerations, one on the economics of all this, one on the politics.

  • I think I will side with the IMF on this. At least with the recent IMF. Since the very beginning The IMF has dubbed as irrealistic the bailout package agreed after the referendum of 2015 . The effort demanded to Greece (the infamous 3.5% structural surplus to be reached by 2018) was recognized to be self-defeating, and the IMF asked for more emphasis on reform, with in exchange a more lenient and realistic approach to fiscal policy: debt relief and much lower required suprluses (1.5% of GDP). In other words, the IMF seems to have learnt from the self-defeating austerity disaster of 2010-2014, and to have finally an eye to the macroeconomic consistency of the reform package. I still believe that the bailout should have been unconditional, and require reforms once the economy had recovered (sequencing, sequencing, and sequencing again). But still, at least the IMF now has a coherent position. Moscovici’s FT piece linked above also seems to go in the same direction, arguing that nothing more can be asked to Greece. It falls short of acknowledging that the package is unrealistic, but at least it avoids blaming the country. And then there is the Eurogroup, actually, Mr Dijsselbloem and Schauble (let’s name names), that did not move an inch since 2010, and fail to see that their demands are slowly (?) choking the Greek economy, stifling any effort to soften the hardship of the adjustment.
  • The political consideration is that the hawks still give the cards, as they dominate the eurogroup. But they are more isolated now. Evidence is piling that the eurozone crisis has been mismanaged to an extent that is impossible to hide, and that the austerity-reforms package that the Berlin View has imposed to the whole eurozone is a big part of the explanation for the political disgregation that we see across the continent. The more nuanced position of the Commission, the IMF challenge to the policies dictated by the hawks, therefore represent an opportunity. There is a clear political space for an alternative to the Berlin View and to the disastrous policies followed so far. The question is which government will be willing (and able) to rise to the occasion. I am afraid I know the anwser.

What Went Wrong with Jean-Baptiste

December 2, 2016 2 comments

The news of the day is that François Hollande will not seek reelection in May 2017. This is rather big news, even it if was all too logical given his approval ratings. But what went wrong with Hollande’s (almost) five years as a President?

Well, I believe that the answer is in a post I wrote back in 2014, Jean-Baptiste Hollande. There I wrote that the sharp turn towards supply side measures (coupled with austerity) to boost growth was doomed to failure, and that firms themselves showed, survey after survey, that the obstacles they faced  came from insufficient demand and not from the renown French “rigidities” or from the tax burden. I was not alone, of course in calling this a huge mistake. Many others made the same point. Boosting supply during an aggregate demand crisis is useless, it is as simple as that. Allow me to quote the end of my post:

Does this mean that all is well in France? Of course not. The burden on French firms, and in particular the tax wedge, is a problem for their competitiveness. Finding ways to reduce it, in principle is a good thing. The problem is the sequencing and the priorities. French firms seem to agree with me that the top priority today is to restart demand, and that doing this “will create its own supply”. Otherwise, more competitive French firms in a context of stagnating aggregate demand will only be able to export. An adoption of the German model ten years late. I already said a few times that sequencing in reforms is almost as important as the type of reforms implemented.

I am sure Hollande could do better than this…

It turns out that we were right. A Policy Brief (in French) published by OFCE last September puts all the numbers together (look at table 1): Hollande did implement what he promised, and gave French firms around €20bn (around 1% of French GDP) in tax breaks. These were compensated, more than compensated actually, by the increase of the tax  burden on households (€35bn). And as this tax increase assorted of reshuffling was not accompanied by government expenditure, it logically led to a decrease of the deficit (still too slow according to the Commission; ça va sans dire!). But, my colleagues show, this also led to a shortfall of demand and of growth. A rather important one. They estimate the negative impact of public finances on growth to be almost a point of GDP per year since 2012.

Is this really surprising? Supply side measures accompanied by demand compression, in a context of already insufficient demand, led to sluggish growth and stagnating employment (it is the short side of the market baby!). And to a 4% approval rate for Jean-Baptiste Hollande.

OFCE happens to have published, just yesterday, a report on public investment in which we of join the herd of those pleading for increased public investment in Europe, and in particular in France. Among other things, we estimate that a public investment push of 1% of GDP, would have a positive impact on French growth and would create around 200,000 jobs (it is long and it is in French, so let me help you: go look at page 72).  Had it been done in 2014 (or earlier) instead of putting the scarce resources available in tax reductions, things would be very different today, and probably M. Hollande yesterday would have announced his bid for a second mandate.

In a sentence we don’t need to look too far, to understand what went wrong.

Two more remarks: first, we have now mounting evidence of what we could already expect in 2009 based on common sense. Potential growth is not independent of current economic conditions. Past and current failure to aggressively tackle the shortage of demand that has been plaguing the French – and European – economy, hampers its capacity to grow in the long run. The mismanagement of the crisis is condemning us to a state of semi-permanent sluggish growth, that will keep breeding demagogues of all sorts. The European elites do not seem to have fully grasped the danger.

Second, France is not the only large eurozone country that has taken the path of supply side measures to pull the economy out of a demand-driven slump. The failure of the Italian Jobs Act in restarting employment growth and investment can be traced to the very same bad diagnosis that led to Hollande’s failure. Hollande will be gone. Are those who stay, and those who will follow, going to change course?

Perseverare Diabolicum

July 13, 2016 1 comment

Yesterday the Council decided that Spain and Portugal’s recent efforts to reduce deficit were not enough. This may lead to the two countries being fined, the first time this would happen since the inception of the euro.

It is likely that the fine will be symbolic, or none at all; given the current macroeconomic situation, imposing a further burden on the public finances of these two any country would be crazy.

Yet, the decision is in my opinion enraging. First, for political reasons:  Our world is crumbling. The level of confidence in political elites is at record low levels, and as the Brexit case shows, this fuels disintegration forces. It is hard not to see a link between these processes and, in Europe, the dismal political and economic performances we managed to put together in the last decade (you are free pick your example, I will pick the refugee crisis (mis) management, and the austerity-induced double-dip recession).

But hey, one might say. We are not here to save the world, we are here to apply the rules. Rules that require fiscal discipline. And of course, both Portugal and Spain have been fiscal sinners since the crisis began (and of course before):

2016_07_13_SpainPortugal

Once we neglect interest payments, on which there is little a government can do besides hoping that they ECB will keep helping, both countries spectacularly reduced their deficit since 2010. And this is true whether we take the headline figures (total deficit, the dashed line), or the structural figures that the Commission cherishes, i.e. deficit net of cyclical components (the solid lines). Looking at this figure one may wonder what they serve to drink during Council (and Commission) meetings, for them to argue that the fiscal effort was insufficient…

What is even more enraging, is that not only this effort was not recognized as remarkable by EU authorities. But what is more, it was harmful for these economies (and for the Eurozone at large).

In the following table I have put side by side the output gaps and fiscal impulse, the best measure of discretionary policy changes1. I have highlighted in green all the years in which the fiscal stance was countercyclical, meaning that a negative (positive) output gap triggered a more expansionary (contractionary) fiscal stance. And in red cases in which the fiscal stance was procyclical, i.e. in which it made matters worse.

Output Gap and Discretionary Fiscal Policy Stance
Portugal Spain EMU 12
Output Gap Fiscal Impulse Output Gap Fiscal Impulse Output Gap Fiscal Impulse
2009 -0.1 4.6 1.5 3.9 -1.9 1.4
2010 2.1 2.3 1.1 -2.3 -0.5 0.7
2011 0.6 -5.9 -0.3 -1.1 0.4 -1.6
2012 -3.2 -3.7 -3.3 -0.7 -1.1 -1.1
2013 -4.1 -0.9 -5.4 -4.4 -2.1 -0.9
2014 -3.2 2.9 -4.8 -0.2 -2.0 -0.1
2015 -2.0 -1.7 -2.8 1.2 -1.3 0.2
2016 -0.9 -1.0 -1.7 0.2 -0.8 0.3
2017 0.3 0.4 -0.9 0.3 -0.2 0.2
Source: Datastream – AMECO Database
Note: Fiscal Impulse computed as change of cyclically adjusted deficit net of interest

The reader will judge by himself. Just two remarks. linked to the fines put in place. First, the Portuguese fiscal contraction of 2015-2016 is procyclical, as the output gap was and still is negative. On the other hand, Spain has increased its structural deficit, but it had excellent reasons to do so.

One may argue that the table causes problems, because the calculation of the output gap is arbitrary and political in nature. Granted, I could not agree more. So I took headline figures, and compared the “gross” fiscal impulse with the “growth gap”, meaning the difference between the actual growth rate and the 3% level that was assumed to be normal when the Maastricht Treaty was signed (If you are curious about EMU numerology, just look here). This is of course a harsher criterion, as 3% as nowadays become more a mirage than a realistic objective. But hey, if we want to use the rules, we should take them together with their underlying hypotheses. Here is the table:

Growth Gap and Overall Fiscal Policy Stance
Portugal Spain EMU 12
Growth Gap to 3% Fiscal Impulse Growth Gap to 3% Fiscal Impulse Growth Gap to 3% Fiscal Impulse
2009 -6.0 6.2 -6.6 6.4 -7.4 4.2
2010 -1.1 1.4 -3.0 -1.7 -0.9 0.0
2011 -4.8 -5.2 -4.0 -0.4 -1.4 -2.2
2012 -7.0 -2.3 -5.6 0.3 -3.9 -0.5
2013 -4.1 -0.8 -4.7 -3.9 -3.3 -0.5
2014 -2.1 2.3 -1.6 -1.0 -2.1 -0.2
2015 -1.5 -2.4 0.2 -0.5 -1.4 -0.3
2016 -1.5 -1.6 -0.4 -1.0 -1.4 0.0
2017 -1.3 -0.2 -0.5 -0.7 -1.3 -0.2
Source: Datastream – AMECO Database
Note: Fiscal Impulse computed as change of government deficit net of interest

Lot’s of red, isn’t it? Faced with a structural growth deficit, the EMU at large, as well as Spain and Portugal, has had an excessively restrictive fiscal stance. I know, no real big news here.

To summarize, the decision to fine Portugal and Spain is politically ill-timed and clumsy. And it is economically unwarranted. And yet, here we are, discussing it. My generation grew up thinking that When The World Is Running Down, You Make The Best of What’s Still Around. In Brussels, no matter how bad things get, it is business as usual.


1. The fiscal impulse is computed as the negative of the change in deficit. As such it captures the change in the fiscal stance. Just to make an example, going from a deficit of 1% to a deficit of 5% is more expansionary than going form a deficit of 10% to a deficit of 11%.

Pushing on a String

June 3, 2016 1 comment

Readers of this blog know that I have been skeptical on the ECB quantitative easing program.
I said many times that the eurozone economy is in a liquidity trap, and that making credit cheaper and more abundant would not be a game changer. Better than nothing, (especially for its impact on the exchange rate, the untold objective of the ECB), but certainly not a game changer.
The reason, is quite obvious. No matter how cheap credit is, if there is no demand for it from consumers and firms, the huge liquidity injections of the ECB will end up inflating some asset bubble. Trying to boost economic activity (and inflation) with QE is tantamount to pushing  on a string.

I also said many times that without robust expansionary fiscal policy, recovery will at best be modest.

Two very recent ECB surveys provide strong evidence in favour of the liquidity trap narrative. The first is the latest (April 2016) Eurozone Bank Lending Survey. Here is a quote from the press release:

The net easing of banks’ overall terms and conditions on new loans continued for loans to enterprises and intensified for housing loans and consumer credit, mainly driven by a further narrowing of loan margins.

So, nothing surprising here. QE and negative rates are making so expensive for financial institutions to hold liquidity, that credit conditions keep easing.
So why do we not see economic activity and inflation pick up? The answer is on the other side of the market, credit demand. And the Survey on the Access to Finance of Enterprises in the euro area, published this week  also by the ECB, provides a clear and loud answer (from p. 10):

“Finding customers” was the dominant concern for euro area SMEs in this survey period, with 27% of euro area SMEs mentioning this as their main problem, up from 25% in the previous survey round. “Access to finance” was considered the least important concern (10%, down from 11%), after “Regulation”, “Competition” and “Cost of production” (all 14%) and “Availability of skilled labour” (17%). Among SMEs, access to finance was a more important problem for micro enterprises (12%). For large enterprises, “Finding customers” (28%) was reported as the dominant concern, followed by “Availability of skilled labour” (18%) and “Competition” (17%). “Access to finance” was mentioned less frequently as an important problem for large firms (7%, unchanged from the previous round)

No need to comment, right?

Just a final and quick remark, that in my opinion deserves to be developed further: finding skilled labour seems to become harder in European countries. What if these were the first signs of a deterioration of our stock of “human capital” (horrible expression), after eight years of crisis that have reduced training, skill building, etc.?
When sooner or later the crisis will really be over, it will be worth keeping an eye on  “Availability of skilled labour” for quite some time.

Tell me again that story about structural reforms enhancing potential growth?