As I write the Greek people are voting. I was puzzled in the past weeks by the fear (more in the media than in markets, actually) of a “radical” left win. Puzzled, because the radical and ideological policy makers do not seem to live in Greece, today. On January 20 I wrote a piece for the Greek website Macropolis, where I claimed that we should not expect an Armageddon if Syriza wins, but rather some welcome fresh air. I reproduce the piece here:
It is most likely that from the elections of January 25 will emerge a Syriza-led government, the main uncertainty being how large a coalition Alexis Tsipras will have to gather to obtain a comfortable parliamentary majority. This is seen with a fair deal of preoccupation in Europe. A preoccupation that does not seem warranted. Syriza is no longer the radical party of the beginning, which called for the exit from the euro and for a default on Greek public debt. Today it is party whose program can hardly be defined revolutionary, and whose label of “radical” left is justified mostly by the drifting of other social democratic party in Europe (for example in Italy and in France) towards the center of the political spectrum, and towards a de facto acceptance of the European macroeconomic orthodoxy. Syriza’s leader, Tsipras, as the prospects of victory become more concrete, has further softened his tones and is already actively negotiating with the Commission and with the major countries, in view of a compromise on the key points of his program. However, some of the media and some political leaders around Europe continue to present the Greek elections as an incoming Armageddon, and the possibility of a Syriza victory as the beginning of the end for the monetary union.
Let’s see what are the reasons for concern. Regarding Europe, Syriza’s agenda has two key elements. First, in case of victory Tsipras would ask to renegotiate a substantial chunk of Greece’s unbearable public debt, that today is mostly (for around 80%) in the hands of official creditors. Of course, this would mean a loss for creditors to absorb. But, as the Financial Times noted as well, it is difficult to imagine a durable exit from the crisis that has choked Europe since 2008, if at least a part of the debt burden that is stifling the recovery is not removed. The French finance minister has agreed yesterday that some compromise on Greek debt will be have to be found, even if some northern countries are at least as of now inflexible. What seems increasingly evident, in fact is that with the European economy back into deflation the costs, for creditor countries as well as for debtors, of a long stagnation, seem far more important than the loss associated with the debt restructuring. The second key point of Syriza’s electoral agenda is the abandonment of austerity that, albeit less stringent than in previous years, continues to characterize European economic policy In other words, Syriza asks to address the problem of unsustainable debt, so far hidden under the rug, and to finally acknowledge the need for a comprehensive plan to restart the European economy, that goes well beyond the accounting tricks of the Juncker plan. Syriza may seem radical to some German economist. But it is in good company of other well-known extremists such as Paul De Grauwe, the IMF, the US government, and much of the Anglo-Saxon press. The European economy is unbalanced and stuck in a deflationary liquidity trap, Mario Draghi’s faces fierce political opposition, and his arrows are increasingly ineffective; it is therefore increasingly clear that only fiscal policy will be able to get us out of trouble.
On closer inspection, it seems far more radical the position of those who, despite having grossly underestimated the negative effects of austerity, ask for more of the same; of those who insist on advocating supply-side reforms to cope with a chronic lack of demand; and of those who boast having achieved a balanced budget one year ahead of forecasts, when Europe would benefit from a recovery of domestic demand in Germany.
What will happen then, if “radical” Syriza will win the election? Actually not much. Tsipras, comforted by opinion polls among his fellow citizens, does not consider the Grexit option. He will sit at the negotiating table to try to obtain for his country a substantial restructuring of debt, and for Europe change towards a more Keynesian policy. If on the latter objective it is hard to imagine that substantial progress will be made, debt restructuring in some form will probably happen. First, because as we said above, it seems to be an unavoidable event, just waiting for the political conditions to be reunited. And second, because Greece will negotiate from a position of strength. Its primary budget surplus (a proof, if needed, that contrary to widespread beliefs Greece actually did its homework; and painfully so), and the low share of debt held by private investors, around 15%, would allow it not to be subject to market pressures in case of exit and default.
And contrary to some declarations that resemble to pre-electoral tactics (the Greek election game is played in the European arena as well), Greece’s exit from the euro would not arrange its European partners either. First, because it would be accompanied by default, and losses for creditors would be significantly larger than in the case of restructuring. Then, probably more important, because Grexit would have unpredictable contagion effects on other peripheral economies, which not hazardously today look with concern to the increasingly harsh tones used in particular by the German Government. In case of a Syriza victory Angela Merkel will most probably soften the tone and agree to negotiate. It is hard to imagine that orthodoxy will go as far as to push Greece out of the euro.
It goes without saying that the negotiation will be harsh, and that tensions will emerge. But today the ECB is more active in assisting countries in difficulty, and its program OMT, which recently received preliminary clearance by the European Court of Justice, is a good protection against speculative attacks.
To conclude, Europeans should stop worrying and let democracy play its role. A Syriza-led government (possibly forming an alliance with George Papandreou’s To Kinima) would not cause an earthquake. Rather the contrary, it could help stirring things up, and bring within the European debate discussion about measures the need for which is now obvious to all except to those who will not see.
I already noticed how the post-Jackson Hole Consensus is inconsistent with the continuing emphasis of European policy makers on supply side measures. In these difficult times, the lack of a coherent framework seems to have become the new norm of European policy making. The credit for spotting another serious inconsistency this time goes to the Italian government. In the draft budgetary plan submitted to the European Commission (that might be rejected, by the way), buried at page 12, one can find an interesting box on potential growth and structural deficit. It really should be read, because it is in my opinion disruptive. To summarize it, here is what it says:
- A recession triggers a reduction of the potential growth rate (the maximum rate at which the economy can grow without overheating) because of hysteresis: unemployed workers lose skills and/or exit the labour market, and firms scrap productive processes and postpone investment. I would add to this that hysteresis is non linear: the effect, for example on labour market participation, of a slowdown, is much larger if it happens at the fifth year of the crisis than at the first one.
- According to the Commission’s own estimates Italy’s potential growth rate dropped from 1.4% on average in the 15 years prior to the crisis (very low for even European standards), to an average of -0.2% between 2008 and 2013. A very large drop indeed.
- (Here it becomes interesting). The box in the Italian plan argues that we have two possible cases:
- Either the extent of the drop is over-estimated, most probably as the result of the statistical techniques the Commission uses to estimate the potential. But, if potential growth is larger than estimated, then the output gap, the difference between actual and potential growth is also larger.
- As an alternative, the estimated drop is correct, but this means that Italy there is a huge hysteresis effect. A recession is not only, as we can see every day, costly in the short run; but, even more worryingly, it quickly disrupts the economic structure of the country, thus hampering its capacity to grow in the medium and long run.
The box does not say it explicitly (it remains an official government document after all), but the conclusion is obvious: either way the Commission had it wrong. If case A is true, then the stagnation we observed in the past few years was not structural but cyclical. This means that the Italian deficit was mainly cyclical (due to the large output gap), and as such did (and does) not need to be curbed. The best way to reabsorb cyclical deficit is to restart growth, through temporary support to aggregate demand. If case B is true, then insisting on fiscal consolidation since 2011 was borderline criminal. When a crisis risks quickly disrupting the long run potential of the economy, then it is a duty of the government to do whatever it takes to fight, in order to avoid that it becomes structural.
In a sentence: with strong hysteresis effects, Keynesian countercyclical policies are crucial to sustain the economy both in the short and in the long run. With weaker, albeit still strong hysteresis effects, a deviation from potential growth is cyclical, and as such it requires Keynesian countercyclical policies. Either way, fiscal consolidation was the wrong strategy.
I am not a fan of the policies currently implemented by the Italian government. To be fair, I am not a fan of the policies implemented by any government in Europe. Too much emphasis on supply side measures, and excessive fear of markets (yes, I dare say so today, when the spreads take off again). But I think the Italian draft budget puts the finger where it hurts.
The guys in Via XX Settembre dit a pretty awesome job…
I have just read Mario Draghi’s opening remarks at the Brookings Institution. Nothing very new with respect to Jackson Hole and his audition at the European Parliament. But one sentence deserves commenting; when discussing how to use fiscal policy, Draghi says that:
Especially for those [countries] without fiscal space, fiscal policy can still support demand by altering the composition of the budget – in particular by simultaneously cutting distortionary taxes and unproductive expenditure.
So, “restoring fiscal policy” should happen, at least in countries in trouble, through a simultaneous reduction of taxes and expenditure. Well, that sounds reasonable. So reasonable that it is exactly the strategy chosen by the French government since the famous Jean-Baptiste Hollande press conference, last January.
Oh, wait. What was that story of balanced budgets and multipliers? I am sure Mario Draghi remembers it from Economics 101. Every euro of expenditure cuts, put in the pockets of consumers and firms, will not be entirely spent, but partially saved. This means that the short term impact on aggregate demand of a balanced budget expenditure reduction is negative. Just to put it differently, we are told that the risk of deflation is real, that fiscal policy should be used, but that this would have to happen in a contractionary way. Am I the only one to see a problem here?
But Mario Draghi is a fine economist, many will say; and his careful use of adjectives makes the balanced budget multiplier irrelevant. He talks about distortionary taxes. Who would be so foolish as not to want to remove distortions? And he talks about unproductive expenditure. Again, who is the criminal mind who does not want to cut useless expenditure? Well, the problem is that, no matter how smart the expenditure reduction is, it will remain a reduction. Similarly, even the smartest tax reduction will most likely not be entirely spent; especially at a time when firms’ and households’ uncertainty about the future is at an all-times high. So, carefully choosing the adjectives may hide, but not eliminate, the substance of the matter: A tax cut financed with a reduction in public spending is recessionary, at least in the short run.
To be fair there may be a case in which a balanced budget contraction may turn out to be expansionary. Suppose that when the government makes one step backwards, this triggers a sudden burst of optimism so that private spending rushes to fill the gap. It is the confidence fairy in all of its splendor. But then, Mario Draghi (and many others, unfortunately) should explain why it should work now, after having been invoked in vain for seven years.
Truth is that behind the smoke screen of Draghinomics and of its supposed comprehensive approach we are left with the same old supply side reforms that did not lift the eurozone out of its dire situation. It’ s the narrative, stupid!
Just a quick note on something that went surprisingly unnoticed so far. After Draghi’s speech in Jackson Hole, a new consensus seems to have developed among European policy makers, based on three propositions:
- Europe suffers from deficient aggregate demand
- Monetary policy has lost traction
- Investment is key, both as a countercyclical support for growth, and to sustain potential growth in the medium run
My first reaction is, well, welcome to the club! Some of us have been saying this for a while (here is the link to a chat, in French, I had with Le Monde readers in June 2009). But hey, better late than never! It is nice that we all share the diagnosis on the Eurocrisis. I don’t feel lonely anymore.
What is interesting, nevertheless, is that while the diagnosis has changed, the policy prescriptions have not (this is why I failed to share the widespread excitement that followed Jackson Hole). Think about it. Once upon a time we had the Berlin View, arguing that the crisis was due to fiscal profligacy and insufficient flexibility of the economy. From the diagnosis followed the medicine: austerity and structural reforms, to restore confidence, competitiveness, and private spending.
Today we have a different diagnosis: the economy is in a liquidity trap, and spending stagnates because of insufficient expected demand. And the recipe is… austerity and structural reforms, to restore confidence, competitiveness, and private spending (in case you wonder, yes, I have copied-pasted from above).
Just as an example among many, here is a short passage from Mario Draghi’s latest audition at the European Parliament, a couple of weeks back:
Let me add however that the success of our measures critically depends on a number of factors outside of the realm of monetary policy. Courageous structural reforms and improvements in the competitiveness of the corporate sector are key to improving business environment. This would foster the urgently needed investment and create greater demand for credit. Structural reforms thus crucially complement the ECB’s accommodative monetary policy stance and further empower the effective transmission of monetary policy. As I have indicated now at several occasions, no monetary – and also no fiscal – stimulus can ever have a meaningful effect without such structural reforms. The crisis will only be over when full confidence returns in the real economy and in particular in the capacity and willingness of firms to take risks, to invest, and to create jobs. This depends on a variety of factors, including our monetary policy but also, and even most importantly, the implementation of structural reforms, upholding the credibility of the fiscal framework, and the strengthening of euro area governance.
This is terrible for European policy makers. They completely lost control over their discourse, whose inconsistency is constantly exposed whenever they speak publicly. I just had a first hand example yesterday, listening at the speech of French Finance Minister Michel Sapin at the Columbia Center for Global Governance conference on the role of the State (more on that in the near future): he was able to argue, in the time span of 4-5 minutes, that (a) the problem is aggregate demand, and that (b) France is doing the right thing as witnessed by the halving of structural deficits since 2012. How (a) can go with (b), was left for the startled audience to figure out.
Terrible for European policy makers, I said. But maybe not for the European economy. Who knows, this blatant contradiction may sometimes lead to adapting the discourse, and to advocate solutions to the deflationary threat that are consistent with the post Jackson Hole consensus. Maybe. Or maybe not.
Paul Krugman has a short post on the Eurozone, today (I’d like him to write more about us; he has been too America-centered lately), pointing out that the myth of fiscal profligacy is, well, just a myth. in fact, he argues, the only fiscally irresponsible country, in the years 2000 was Greece. It is maybe worth reposting here a figure that from an old piece of this blog, that since then made it into all my classes on the Euro crisis:
The figure shows the situation of public finances in 2007, against the Maastricht benchmark (3% deficit and 60% debt) before the crisis hit. As Krugman says, only one country of the so-called PIIGS (the red dots) is clearly out of line, Greece. Portugal is virtually like France, and Spain and Ireland way better than most countries, including Germany. Italy has a stock of old debt, but its deficit in 2007 is under control.
So Krugman is right in reminding us that fiscal policy per se was not a problem before the crisis; And yet, what he calls fiscal myths, have shaped policies in the EMU, with a disproportionate emphasis on austerity. And even today, when economists overwhelmingly discuss unconventional measures available to the ECB to contrast deflation, fiscal policy is virtually absent from the debate and continued fiscal consolidation is taken for granted. I will write more on this in the next days, but it is striking how we aim at the wrong target.
Last week’s publication of a Lancet article1 on the effect of austerity on Greek public health made a lot of noise (for those who know Italian, I suggest reading the excellent Barbara Spinelli, in La Repubblica).
The Lancet article sets the tone since the abstract, talking of “mounting evidence of a Greek public health tragedy”. It is indeed a tragedy, that highlights how fast social advances may be reversed, even in an advanced economy.
Some time ago (March 2012) I had titled a post “Greek Tragedies“. Mostly for my students, I had collected data on Greek macroeconomic variables. I concluded that austerity was self-defeating, and that at the same time it was imposing extreme hardship on Greek citizens. Of course one needed not be a good economist to know what was going on. It was enough not to work at the Commission or in Germany… But the Lancet article also allows to substantiate another claim I made at the time, i.e. that austerity would also have enormous impact in the long run. It is weird to quote myself, but here is my conclusion at the time:
Even more important, investment (pink line) was cut in half since 2007. This means that Greece is not only going through depressed growth today. But it is doing it in such a way that growth will not resume for years, as its productive capacity is being seriously dented.
What makes it sad, besides scary, is that behind these curves there are people’s lives. And that all this needed not to happen.
I think it is time for an update of the figure on the Greek tragedy. And here it is:
I said in 2012 that investment cut in half spelled future tragedy. Two years later it is down 14 more points, to 36% of 2007 levels. I am unsure the meaning of this is clear to everybody in Brussels and Berlin: when sooner or later growth will resume, the Greek will look at their productive capacity, to discover it melted. They will be unable to produce, even at the modest pre-crisis levels,without running into supply constraints and bottlenecks. I am ready to bet that at that time some very prestigious economist from Brussels will call for structural reforms to “free the Greek economy”. By the way, seven years into the crisis, the OECD keeps forecasting negative growth together with unsustainable (and growing) debt.
I also added unemployment to my personal “Greek Tragedy Watch”: Terrifying absolute numbers (almost 30% unemployment overall, youth unemployment around 60%, more than that for women!). And absolutely no trend reversal in sight. A final consideration, related to the melting of the capital stock. How much of this enormously high unemployment, is evolving into structural? How many of the unemployed will the economy be able to reabsorb, once it starts growing again? Not many, I am afraid, as there is no capital left.
Not bad as an assessment of austerity… And yet, just this morning the German government complained for a very limited softening of austerity demands. Errare umanum est, perseverare autem diabolicum…
1. Kentikelenis, Alexander, Marina Karanikolos, Aaron Reeves, Martin McKee, and David Stuckler. 2014. “Greece’s Health Crisis: From Austerity to Denialism.” The Lancet 383 (9918) (February): 748–753. Back
Germany rejected the US Treasury’s criticism of the country’s export-focused economic policies as “incomprehensible”. Much has been said about that. Let me just add some pieces of evidence, just to gather them all in the same place.
Exhibit #1: Net Lending Evolution
Note#1 : I took net lending because because net income flows from residents to non residents (not captured by the current account) may be an important part of a country’s net position (most notably in Ireland). Note #2: I took away France and Italy from the two groups called “Core” and “Periphery”, because their net position was relatively small as percentage of GDP in 2008, and changed relatively little.