Austerity. The Past That Doesn’t Pass

[As usual lately, this is a slightly edited AI translation of a piece written for the Italian Daily Domani]

The European Commission recently revised downwards its forecasts for both growth and inflation, which continues to fall faster than expected. In contrast to the United States, there is no “soft landing” here. As argued by many, monetary tightening has not played a major role in bringing inflation under control (even as of today, price dynamics are mainly determined by energy and transportation costs). Instead, according to what the literature tells us on the subject, it is starting, 18 months after the beginning of the rate hike cycle, to bite on the cost of credit, therefore on consumption, investment and growth.

This slowdown in the economy is taking place in a different context from that of the pandemic. Back then, central bankers and finance ministers all agreed that business should be supported by any means, a fiscal “whatever it takes”. Today, the climate is very different, and public discourse is dominated by an obsession with reducing public debt, as evidenced by the recent positions taken by German Finance Minister Lindner and the disappointing reform of the Stability Pact. The risk for Europe of repeating the mistakes of the past, in particular the calamitous austerity season of 2010-2014, is therefore particularly high.

In this context, we can only look with concern at what is happening in France, where the government also announced a downward revision of the growth forecast for 2024, from 1.4% to 1%. At the same time, the Finance Minister Bruno Le Maire announced a cut in public spending of ten billion euros (about 0.4% of GDP), to maintain the previously announced deficit and debt targets. This choice is wicked for at least two reasons. The first is that it the government plans making the correction exclusively by cutting public expenditure, focusing in particular on “spending for the future”. €2 billion will be taken from the budget for the ecological transition, €1.1 billion for work and employment, €900 million for research and higher education, and so on. In short, it has been chosen, once again, not to increase taxes on the wealthier classes but to cut investment in future capital (tangible or intangible).

But regardless of the composition, the choice to pursue public finance objectives by reducing spending at a time when the economy slows, down goes against what economic theory teaches us; even more problematic, for a political class at the helm of a large economy, it goes against recent lessons from European history.

The ratio of public debt to GDP is usually taken an indicator (actually, a very imperfect one, but we can overlook this here) of the sustainability of public finances. When the denominator of the ration, GDP, falls or grows less than expected, it would seem at first glance logical to bring the ratio back to the desired value by reducing the debt that is in the numerator, i.e. by raising taxes or reducing government spending. But things are not so simple, because in fact the two variables, GDP and debt, are linked to each other. The reduction of government expenditure or the increase of taxes, and the ensuing reduction of the disposable income for households and businesses, will negatively affect aggregate demand for goods and services and therefore growth. Let’s leave aside here a rather outlandish theory, which nevertheless periodically re-emerges, according to which austerity could be “expansionary” if the reduction in public spending triggers the expectation of future reductions in the tax burden, thus pushing up private consumption and investment. The data do not support this fairy tale: guess what? Austerity turns out to be contractionary!

In short, a decline in the nominator, the debt, brings with it a decline in the denominator, GDP. Whether the ratio between the two decreases or increases, therefore, ends up depending on how much the former influences the latter, what economists call the multiplier. If austerity has a limited impact on growth, then debt reduction will be greater than GDP reduction and the ratio will shrink: albeit at the price of an economic slowdown, austerity can bring public finances back under control. The recovery plans imposed by the troika on the Eurozone countries in the early 2010s were based on this assumption and all international institutions projected a limited impact of austerity on growth. History has shown that this assumption was wrong and that the multiplier is very high, especially during a recession. A  public mea culpa from  the International Monetary Fund caused a sensation at the time (economists are not known for admitting mistakes!), explaining how a correct calculation gave multipliers up to four times higher than previously believed. In the name of discipline, fiscal policy in those years was pro-cyclical, holding back the economy when it should have pushed it forward. The many assistance packages conditioning the troika support to fiscal consolidation did not secure public finances; on the contrary, by plunging those countries into recession, they made them more fragile. Not only was austerity not expansive, but it was self-defeating. It is no coincidence that, in those years, speculative attacks against countries that adopted austerity multiplied and that, had it not been for the intervention of the ECB, with Draghi’s whatever it takes in 2012, Italy and Spain would have had to default and the euro would probably not have survived.

Since then, empirical work has multiplied, with very interesting results. For example, multipliers are higher for public investment (especially for green investment) and social expenditure has an important impact on long-term growth. And these are precisely the items of expenditure most cut by the French government in reaction to deteriorating economic conditions.

While President Roosevelt in 1937 prematurely sought to reduce the government deficit by plunging the American economy into recession, John Maynard Keynes famously stated that “the boom, not the recession, is the right time for austerity.” The eurozone crisis was a colossal and very painful (Greece has not yet recovered to 2008 GDP levels), a natural experiment that proved Keynes right.

Bruno Le Maire and the many standard-bearers of fiscal discipline can perhaps be forgiven for their ignorance of the academic literature on multipliers in good and bad times. Perhaps they can also be forgiven for their lack of knowledge of economic history and of the debates that inflamed the twentieth century. But the compulsion to repeat mistakes that only ten years ago triggered a financial crisis, and threatened to derail the single currency, is unforgivable even for a political class without culture and without memory.

My Two Cents on the “Yellow Vests” Movement

In a widely commented televised address President Macron  has made a last-minute attempt to stop the “yellow vests” wave, that is investing France and his presidency. After a dramatic (a bit too much to seem sincere, if you ask me) mea culpa on past arrogance, and a promise to “listen to the suffering of the people”, Macron announced a few changes to the French budget law, to sustain the purchasing power of the lower part of the income distribution. The most important and immediate changes are: an increase of minimum wage (more precisely of the “employment subsidy” that is given to most people working at or around minimum wage): the exemption from taxes and social contribution of extra hours (a very popular measure that had been introduced by Nicolas Sarkozy and later abolished by François Hollande); and last but not least, the repeal of the increase of social contributions for retirees, and the confirmation of the freezing (for at least the year 2019) of the “ecological tax” on fuel. Macron also signaled the intention to backtrack on his vertical leadership style (the président jupitérien); he pleaded for renewed role for intermediate bodies (most notably the mayors and local politicians) in putting in place a concerted effort (a “social compact”) to boost growth and social cohesion.

Will Macron’s announcement appease the uprising that inflames France? Most probably not, because they suffer from an original sin, a contradiction that the President is unwilling (or incapable) of seeing. The yellow vest protest originates from the gas price increase, that affected rural households and farmers in particular? But the malaise has much deeper roots, that are widespread. The French economy feels, after ten years, the full weight of a crisis that has hit very hard the middle and lower classes: Unemployment that fell too slowly  (costing re-election to François Hollande ; austerity that, although less marked than in the peripheral eurozone countries, has reduced the perimeter and coverage of public services and of the welfare system, while increasing the tax burden; and, finally, the reduction of family allocations and welfare in general, which particularly affected the most disadvantaged categories. All of this led to what Julia Cagé, on French daily Le Monde, called “the purchasing power crisis”, that simmered for a long time, before exploding in the past weeks.

Emmanuel Macron has an enormous responsibility for the bursting of the crisis. True, the increase in the tax burden for the middle class is mainly due to François Hollande (under the impulse of an ambitious undersecretary, and then minister of the economy, named … Emmanuel Macron). One might even argue that the budget law for 2019 reverses the trend as that the reduction of some taxes (in particular the elimination of the housing tax for the majority of households, and the flat tax on capital income) has more than offset the reduction in social benefits.

What explains then the fact that the discontent emerges, so violently, just now? The explanation is simple: it is to be found in the approach that the French President pursued since he beginning of his mandate. Like Donald Trump, with whom he disagrees on almost everything, Emmanuel Macron believes in the so-called “trickle down” theory: shifting the tax burden away from the rich is the best strategy to revive growth, because these people are more productive than the average, and invest the extra income in innovative activities. The fruits of higher growth would then percolate to everyone, even those who were initially penalized by the tax reform. From the beginning of his mandate, Macron’s choice to give France a pro-business image was clear, leading to a drastic reduction of taxes on the richest, and making the taxation, for the upper part of the distribution, fundamentally regressive.

The last budget law represents the clearest proof of this approach. The “Institute for Public Policies” has shown (see the figure, taken from a Le Monde article appeared last October) that while the overall disposable income slightly increases, the bottom 20% and the upper-middle class see a substantial worsening of their situation, while the very rich (the top 1%) see their purchasing power increase of 6%.

The problem is, as an increasing body of evidence shows, that trickle down does not work. Favoring the richest does not increase productive investment (it rather tends to boost non-produced asset prices and unproductive consumption), and the impact on growth is both negligible and not shared; these days’ demonstrations stand to prove it. History cannot be rewritten, but the attempt to twist the tax system in favor of the ecological transition would probably have been met with much more enthusiasm, in a country like France where environmental awareness is high, where it not accompanied by the sentiment of increasing social injustice that Macron’s economic policies have deepened.

It is interesting to notice, in this regard, that traditional media have given a somewhat distorted image of the protest movement (which is very hard to clearly decrypt). A group of researchers from Toulouse University uses lexicographic analysis to show that the narrative of traditional media was centered on revolt against taxes (ras-le-bol fiscal), and therefore in contradiction with the request of better public services;  this does not correspond to the message coming from social networks that organized “from the bottom” the movement, in which instead the predominant mood was revolt against social injustice and against the elites that grow richer and richer, while leaving the check for the others to pay. To sum up, a plea for a more equal and cohesive society.

How will this end? It is hard to say. The yellow vests have obtained a partial win, with the freezing of the gas increase, and with the measures announced by Macron on Monday. But it is unlikely that we will see a substantive change of economic policy, precisely because of the President’s views outlined above. He rushed to rule out any reinstatement of the wealth tax, because “in the past unemployment increased even when the wealth tax existed” (a rather unconvincing argument, to say the truth).

If higher incomes are not called to contribute to the effort (towards ecological transition, but more generally towards the financing of the French social model), even the measures just announced will have a very limited impact. The State will somehow have to take back with one hand (for example by reducing public services, that benefit lower income most, or increasing other taxes) what it just handed out with the other hand. The demand for social justice that confusedly emerges from the yellow vests movement will once more go unanswered, leaving untouched the tension that is ripping the French (and not just the French) society.

To meet these needs, a new political proposal would have to put the complex theme of the redistribution of resources in a globalized world at the center of its project. It would be necessary to rediscover the “Regulatory State” which, in the golden years of social democracy (and of the social right), guaranteed social and macroeconomic stability, and thus laid the foundations for investment, innovation, and growth. That role is more difficult to define in a globalized world in which individual States have limited room for maneuver, and in which therefore international cooperation, however difficult, is now the only way forward. But this challenge can not be avoided if we do not want movements such as those of yellow vests to fall prey to nativist autocratic populism.

 

(This is the translation of a piece I published in Italian on the Luiss Open website)

A German Model?

Tomorrow Germany votes, and there is little suspense, besides the highly symbolic question of whether the far right will make it into the Bundestag.

Angela Merkel will be Chancellor for the fourth time, marking a long period of political and policy stability. In the past fifteen years Germany emerged as the model to follow for the other large economies. For since its economy has performed better, in terms of growth and unemployment, than France or Italy.

I have at discussed at length, here and elsewhere, the costs of the German success in terms of global imbalances and uncooperative behaviours. Last week I wrote a piece for the newly born magazine LuissOpen (Ad: Follow it on twitter! There is plenty of interesting content well beyond economics! End of Ad).

The piece lists, in a non exhaustive way, a number of weaknesses that can be spotted behind the shining macroeconomic results, and also argues that there is much more than labour market liberalization behind a successful economic model (including in Germany).

The original piece can be found here (and here in Italian). I copy and paste it below

Three months after his commencement, Emmanuel Macron delivered last week one of the most important, and controversial, promises of his agenda. The loi travail that will become operational in the next few weeks mostly deals employment protection, which is weakened especially for small and medium enterprises. The aim is to lift constraints for firms hiring, and thus increase employment. This first set of norms should be followed in the next weeks or months by norms aimed at improving training and employability of unemployed workers. Once completed, the package would be the French version of the flexicurity that Scandinavian countries put in place in the past, with different degrees of success.

Without entering into the details of the law, the set of norms approved by the French government, just as the Italian Jobs Act voted in 2014, is a bold step towards the flexibilization of  labour market relations that Germany has in place since the early years 2000, with the so-called “Hartz Reforms”. The German experience, and to a minor extent the first few years of application of the Job Act, can help understand how the French labour market could evolve in the next few years.

Germany in fact sets itself as an example. The argument goes that the reforms it implemented in 2003-2005, did liberalize labour markets, and since then, with the exception of the first years of the crisis, unemployment has been steadily decreasing. But in fact, this is a misleading example, because the Hartz reforms were embedded in a complex institutional setting, which goes well beyond labour market flexibility.

First, an important segment of the German labour market, the one linked to manufacturing and business services, has always been ruled by long-term agreements between employers, workers, and local work councils. For these insider workers a system of work relations was in place, in which highly paid workers acquired skills through vocational training (within or outside the firm), and were protected by an all-encompassing welfare system. Vocational training created robust bonds between the firms, that had often invested substantial resources in the training, and the workers, whose specific skills could not easily be transferred to other sectors or even to other firms.

At the turn of the century, globalized markets coupled with the aftermath of the reunification, exerted a serious pressure for a restructuring  of labour relations.  This restructuring happened through a consensus process that did not involve the government, and kept untouched the bond between the firm and the worker created by vocational training.

The mutual interest in preserving the long-term relationship between workers and firms in the insider markets, led to agreements aimed at reducing costs or to increase productivity without increasing turnover or reducing average job tenure. These agreements could involve on the workers’ side labour sharing, flexibility in hours and in labour mobility, wage concessions, reductions in absenteeism. In exchange for this, firms would guarantee continued investments in innovation and in the (vocational) training of workers, and job security.

It is crucial to understand that the Hartz reform did not touch the insiders market (manufacturing, finance, insurance and business, etc), that as we just said had already begun restructuring without government intervention. The reform made the welfare system less generous, while  allowing access to benefits even for workers with low earnings, thus de facto introducing incentives to low-paid jobs. Furthermore, it liberalized temporary work contracts, and made more flexible a few sectors subject to competition from posted workers (i.e. construction).

The combined result of reforms and endogenous restructuring yielded a spike in part time jobs, and an increase of employment. But it also widened the gap in earnings and in protection between workers in the export-oriented sectors and the others.

The second feature of the German system that made it resilient during the crisis is the existence of a dense network  of local public savings banks (the Sparkassen). Savings bank were a defining feature of the banking sectors of a number of European countries (e.g. Spain, Italy), but have progressively become marginal. Germany is therefore an exception in that its local savings banks are still a pillar of its economy.

Local savings banks have specific public interest missions, as they are involved in the development of local communities, and in financing households and firms (in particular SMEs). The law only allows operation within the region of competence, which shields them from competition while keeping them close to their stakeholders. Similarly, the ambit of their operations is limited (for example, they face limits in their capacity to engage in securities trading or in excessively risky financing).

To avoid that these limitations hamper their effectiveness and their solidity, the banks work as a network  among them. The network exhibits economies of scale and of scope, while remaining close, in its individual components, to local communities. Furthermore, the existence of solidarity mechanisms (rescue funds) ensures that temporary difficulties of a bank are tackled without spreading contagion.

The major private commercial banks, very active in international markets, did suffer like in most other countries, were a drain on public finances, and drastically contracted their lending to the real sector. The Sparkassen on the other hand kept their financing steady (especially to SMEs) and required virtually no state aid. As a consequence, the local savings banks cushioned the impact of the financial crisis on the German economy, and their continued financing of firms is certainly a major factor in explaining the quick rebound of the German economy after 2010.

If taken together, the banking sector and the labour market institutions design a remarkably efficient system, geared towards the establishment of long run relationships in which the interests and the objectives (between entrepreneurs and workers, between banks and firms) were aligned.

But this effectiveness did not come without costs. From a macroeconomic point of view, profitability and competitiveness increased, but also precautionary savings, induced by a less generous welfare state, and by the increased uncertainty faced by workers. The “success” of the German export-led economy, that had a 9% current account surplus in 2016, is based on the compression of domestic demand, and on a labour market that is increasingly split in two, and in which inequality increased dramatically.  The low unemployment that should make other countries envious hides a massive increase of the so-called working poor. (See figure 2 here)

I would push this even further: the Hartz Reform had a strong impact on labour market dualism and precariousness, but only a minor one in explaining the resilience of the economy. A recent CER policy brief makes a somewhat similar point.

Following the Jobs Act, the Italian labour market seems to be headed in a similar direction as the German one. The recent data released by ISTAT on labour market development certified the return of employed people to the pre-crisis peak (2008), thus marking, symbolically the end of the crisis. Yet, GDP is still 7% below its 2008 level, meaning that the increase of employment happened in low value added sectors (such as for example tourism and catering), and often with part-time contracts. These are typically sectors with low and very low wages, and stagnant productivity dynamics. At the same time, wages (but not employment) increase in manufacturing-export oriented sectors. The Italian labour market, in a sentence, is heading towards the same dualistic structure that characterizes the German one. This explains why, like in Germany, Italian domestic demand stagnates; why the increase in employment is obtained at the price of increased precariousness and of the working poor; why, finally, while the numbers say that the crisis is beyond us, the actual experience of households is often different. Italy, and to a minor extent Germany, are the best proof that employment and growth do not necessarily go hand in hand with increased well-being.

Focusing exclusively on labour market flexibility, Italy and in France only imported one element of the German “model”; and probably the one that is by far the least important.  The German capacity to put in place long term relationships, the real key to economic resilience success, is lost in our countries.

Can France Survive Without Europe?

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.

What Went Wrong with Jean-Baptiste

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?

Jean-Baptiste Hollande

 le temps est venu de régler le principal problème de la France : sa production.
Oui, je dis bien sa production. Il nous faut produire plus, il nous faut produire mieux.
C’est donc sur l’offre qu’il faut agir. Sur l’offre !
Ce n’est pas contradictoire avec la demande. L’offre crée même la demande.
François Hollande – January 14, 2014

France is often pointed to as the “sick man of Europe”. Low growth, public finances in distress, increasing problems of competitiveness, a structural inability to reform its over-regulated economy.  Reforms that, it goes without saying, would open the way to a new era of growth, productivity and affluence.

François Hollande has tackled the second half of his mandate subscribing to this view. In the third press conference since he became President, he outlined the main lines of intervention to revive the French economy,  most notably a sharp reduction of social contributions for French firms (around € 30bn before 2017), financed by yet unspecified reductions in public spending.  During the press conference, he justified this decision on the ground that growth will resume once firms start producing more. Thus, he tells us, “It is upon supply that we need to act. On supply! This is not contradictory with demand. Supply actually creates demand“. Hmmm, let me think.  Supply creates demand. Where did I read this?