This post is nothing new. It is just a reminder for non European readers (or for distracted European readers), about the way things work in the EMU. The German Bundesbank President Weidmann violently attacked the European Commission for failing to enforce fiscal discipline within the Stability Pact.
What is wrong with this? Is this not just another confirmation of the old cliché that Germans are obsessed with respecting the rules?
Well, think again. Everybody knows that EU countries need to curb their public deficit to be below 3% of GDP, and need to aim to structural balance. But it is less known, especially outside Europe, that since 2011, as a part of the so-called “six-pack”, the EU introduced the Macroeconomic Imbalances Procedure (MIP), “which aims to identify, prevent and address the emergence of potentially harmful macroeconomic imbalances that could adversely affect economic stability in a particular Member State, the euro area, or the EU as a whole”.
This procedure builds on a scoreboard of 14 indicators, among which we can read the following:
- 3-year backward moving average of the current account balance as percent of GDP, with thresholds of +6% and -4%;
Yeah, that is right, at the very first place. And guess what, Germany’s current account surplus, since the MIP came into force has been above 6% every single year. (it is expected to be 9% in 2016).
And yet, no corrective action has been imposed, and of course no sanctions. I understand that Germany has no problems with not being sanctioned. But maybe it would be wise to keep a low profile regarding others’ violations..
So, for once, I agree with Jens Weidmann: the Commission should be harsher on those who do not respect the rules. And of course, it will, but just with some. Among the many problems European governance has, this is not the least: all animals are equal, but some animals are more equal than others.
A sentence from Donald Trump’s victory speech retained a good deal of attention:
We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.
This was widely quoted in the social media, together with the following from an FT article about the Fed:
In particular, some members of his economic advisory team are convinced that central banks such as the US Federal Reserve have exhausted their use of super-loose monetary policy. Instead, in the coming months they hope to announce a wave of measures such as infrastructure spending, tax reform and deregulation to boost growth — and combat years of economic stagnation.
In spite of its vagueness, the idea of an infrastructure push has sent markets
to beyond the roof. In short, a simple (and rather generic) speech on election night has dispelled all the anxiety about the long phase of uncertainty that we face. So long for efficient markets…
But this is not what I care about here. The point I want to make is that Trump’s announcement has triggered a strange reaction. Something going like: “See? Trump managed to break the establishment’s hostility to Keynes and to finally implement the stimulus policies we need. Forget the sexism and the p-word, the attacks on minorities, the incompetence. Enter Trump, exit neo-liberalism”. I see this especially (but not only) among Italian internauts, who tend to project the European situation in other contexts.
Well, I have some reservations on this claim. Where to start? Maybe with the “Contract with the American Voter“, that together with the (generic, once more) promise of new investment, promised a massive withdrawal of the State from the economy? Or from the fact that “Establishment Obama” made Congress vote, a month into his presidency, a “Recovery Act (ARRA)” worth 7% of GDP, that successfully stopped the free-fall and helped restore growth? Or from the fact that the “anti-establishment” Tea Party forced austerity since 2011, climaxing in the sequester saga of 2013?
Critics of current austerity policies in Europe should not be delusional. Trump is not the John Maynard Keynes of 2016. His agenda is, broadly speaking, an agenda of deregulation, tax cuts for the rich, and retreat of the State from the economy. Not to mention the strong chance of a more hawkish Fed in the future. To sum up, Trump is, in the best case scenario a new Reagan, substituting military Keynesianism with bridges’ Keynesianism. And we all (should) know that Reaganomics does shine much less than usually claimed.
Those progressives looking for a Trump Keynesian agenda should probably have looked more carefully at the plan proposed by “establishment-Clinton”: A significant infrastructure push (in fact, the emphasis on infrastructures was the only point in common between the two candidates), with the ambition to crowd-in private investment. And what is more important, such an expansionary fiscal policy was framed within a more active role of the government in key sectors like education, health care, and with increased progressivity of the tax system.
Would we have had Hilary Rodham Keynes? Unfortunately we’ll never know…
Life and work keep having the nasty habit of intruding into this blog, but it feels nice to resume writing, even if just with a short comment.
We learned a few weeks ago that the Bank of Japan has walked one extra step in its attempt to escape lowflation, and that it has committed to overshoot its 2% inflation target. A “credible promise to be irresponsible”, as the FT says quoting Paul Krugman.
This may be a long overdue first step towards a revision of the inflation target, as invoked long ago by Olivier Blanchard, and more recently by Larry Ball. This is all too reasonable: if the equilibrium interest rates are negative, if monetary policy is bound by the zero-or-only-slightly-negative-lower-bound, higher inflation targets would make sense, and 4% is an arbitrary target as legitimate as the current also arbitrary 2% level. Things may be moving, as the subject was evoked, if not discussed, at the recent Central Bankers gathering in Jackson Hole. We’ll see if anything comes out of this.
But the FT also adds an interesting comment to the BoJ move, namely that the more serious risk is a blow to credibility. If it failed to lift the inflation to the 2% target, how can it be credibly believed to overshoot it?
This is a different sort of credibility issue, much more reasonable indeed, than the one we have been used to in the past three decades, linked to the concept of dynamic inconsistency. In plain English the idea that an actor has no incentive to keep prior commitments that go against its own interest, and hence deviates from the initial plan. Credibility was therefore associated to changing incentives over time (typically for policy makers), and invoked to recommend rules over discretion.
Today, eight years into the zero lower bound, we go back to a more intuitive definition of credibility: announcing an objective and not being able to attain it.
The difference between the two definitions of credibility is not anodyne. In the first case, the unwillingness of central banks to behave appropriately can be corrected through the adoption of constraining rules. In the latter, the central bank cannot attain the objective regardless of incentives and constraints, and other strategies need to be put in place.
The other strategy, the reader will not be surprised to learn, is fiscal policy. Monetary dominance is in fact a second tenet of the Consensus from the 1990s that the crisis has wiped out. We used to live in a world in which structural reforms would take care of increasing potential growth, monetary policy would be used to take care of (minor) demand-driven fluctuations, and fiscal policy was in a closet.
This is gone (luckily). Even the large policy making institutions now call for a comprehensive and multi-instrument policy making. The policy mix, a central element of macroeconomics in the pre-rational expectations era, is now back. Even the granitic dichotomy between short (demand driven) and long (supply driven) term, is somewhat rediscussed.
The excessively simplified consensus that dominated macroeconomics for the past thirty years seems to be seriously in trouble; complexity, tradeoffs, coordination, are now the issues discussed in academia and in policy circles. This is good news.
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):
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|
|Output Gap||Fiscal Impulse||Output Gap||Fiscal Impulse||Output Gap||Fiscal Impulse|
|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|
|Growth Gap to 3%||Fiscal Impulse||Growth Gap to 3%||Fiscal Impulse||Growth Gap to 3%||Fiscal Impulse|
|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%↩.
Last week’s data on EMU growth have triggered quite a bit of comments. I was intrigued by Paul Krugman‘s piece arguing (a) that in per capita terms the EMU performance is not as bad (he uses working age population, I used total population); and (b) that the path of the EMU was similar to that of the US in the first phase of the crisis; and (c) that divergence started only in 2011, due to differences in monetary policy (an impeccable disaster here, much more reactive in the US). Fiscal policy, Krugman argues, was equally contractionary across the ocean.
I pretty much agree that the early policy response to the crisis was similar, and that divergence started only when the global crisis went European, after the Greek elections of October 2009. But I am puzzled (and it does not happen very often) by Krugman’s dismissal of austerity as a factor explaining different performances. True, at first sight, fiscal consolidation kicked in at the same moment in the US and in Europe. I computed the fiscal impulse, using changes in the cyclically adjusted primary deficit. In other words, by taking away the cyclical component, and interest payment, we can obtain the closest possible measure to the discretionary fiscal stance of a government. And here is what it gives:
Krugman is certainly right that austerity was widespread in 2011 and in 2012 (actually more in the US). So what is the problem?
The problem is that fiscal consolidation needs not to be assessed in isolation, but in relation to the environment in which it takes place. First, it started one year earlier in the EMU (look at the bars for 2010). Second, expansion had been more robust in the US in 2008 and in 2009, thus avoiding that the economy slid too much: having been bolder and more effective in 2008-2010, continued fiscal expansion was less necessary in 2011-12.
I remember Krugman arguing at the time that the recovery would have been stronger and faster if the fiscal stance in the US had remained expansionary. I agreed then and I agree now: government support to the economy was withdrawn when the private sector was only partially in condition to take the witness. But to me it is just a question of degree and of timing in reversing a fiscal policy stance that overall had been effective.
I had made the same point back in 2013. Here is, updated from that post, the correlation between public and private expenditure:
|Correlation Between Public and Private Expenditure|
Remember, a positive correlation means that fiscal policy moves together with private expenditure, and fails to act countercyclically. The table tells us that public expenditure in the US was withdrawn only when private expenditure could take the witness, and never was procylclical (it turned neutral in the past 2 years). Europe is a whole different story. Fiscal contraction began when the private sector was not ready to take the witness; the withdrawal of public demand therefore led to a plunge in economic activity and to the double dip recession that the US did not experience. Here is the figure from the same post, also updated:
To sum up: the fiscal stance in the US was appropriate, even if it changed a bit too hastily in 2011. In Europe, it was harmful since 2010.
And monetary policy in all this? It did not help in Europe. I join Krugman in believing that once the economy was comfortably installed in the liquidity trap Mario Draghi’s activism while necessary was (and is) far from sufficient. Being more timely, the Fed played an important role with its aggressive monetary policy, that started precisely in 2012. It supported the expansion of private demand, and minimized the risk of a reversal when the withdrawal of fiscal policy begun. But in both cases I am unsure that monetary policy could have made a difference without fiscal policy. Let’s not forget that a first round of aggressive monetary easing in 2007-2008 had been successful in keeping the financial sector afloat, but not in avoiding the recession. This is why in 2009 most economies launched robust fiscal stimulus plans. I see no reason to believe that, in 2010-2012, more appropriate and timely ECB action would have made a big difference. The problem is fiscal, fiscal, fiscal.
FT Alphaville‘s Matthew Klein goes back to the issue of financial stability and monetary policy. A recent speech of Bank of Canada’s Timothy Lane is the occasion for Klein to reassess monetary policy before the crisis, when policy makers (in particular he refers to Ben Bernanke, but the Fed chair was in good company) dismissed fears of asset price bubbles, thus failing recognize, and to counter, the buildup of the crisis.
What I find interesting in Lane’s speech is the acknowledgement that monetary policy alone is vastly insufficient to attain the many interrelated objectives of today’s policy makers. This in turn calls for reassessing the drift of academic economists (in the 1990s and 2000s) towards a vision of the world in which all policy objectives could be attained by “Maestros“, almighty technocrats skillfully using monetary levers to reach multiple objectives at once.
With a few colleagues we recently challenged the “conventional wisdom” that inflation targeting central banks can effectively attain financial stability as well, simply by “leaning against the wind”. We highlighted that this violation of Timbergen’s principle (“one instrument per policy objective”) is allowed by an analytical trick, a “divine coincidence”, buried within the hypotheses of the standard model. Asessing policy analysis in a framework in which low and stable inflation goes hand in hand with low unemployment and stable asset prices, will lead to conclude that (what a surprise!!) targeting inflation helps attaining all these objectives at once. Our work (among others) shows that price and financial stability exhibit no stable correlation; similarly, the debate on the “return of the Phillips Curve” (if ever it left) shows that a tradeoff usually exists between inflation and unemployment objectives. Thus, in the end, inflation targeting is mostly effective in, well… targeting inflation. There is no magics here. The Consensus buried Timbergen way too soon.
The debate on the effective use of instruments to attain sometimes conflicting objectives is particularly interesting in general and, I argue, relevant for the EMU. As the readers of this blog know, I have been obsessed by the excessive focus of (mainly) European economists and policy makers on monetary policy. Especially in the current situation of liquidity trap, the stubborn refusal to fully deploy fiscal policy can only be explained by ideological anti-Keynesianism.
But as Timothy Lane’s speech suggests, the problem extends beyond the current exceptional circumstances. As normal times will (eventually) resume, we should go back to Timbergen and acknowledge that monetary policy alone cannot cure all ills. Fiscal policy and effective regulation need to be used as aggressively as interest rates and monetary instruments to manage business cycle fluctuation. A trivial and yet often forgotten lesson from the old times.