Posts Tagged ‘austerity’

The Sin of Central Bankers

April 19, 2016 Leave a comment

I read, a bit late, a very interesting piece by Simon Wren-Lewis, who blames central bankers for three major mistakes: (1) They did not see the crisis coming, while they were the only one in the position to see the build-up of leverage; (2) They did not warn governments that at the Zero Lower Bound central banks would lose traction and could not protect the economy from the disasters of austerity. (3) They may be rushing in declaring that we are back to normal, thus attributing all the current slack to a deterioration of the supply side of the economy.

What surprises me is (2), for which I quote Wren-Lewis in full:

Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.

The way Wren-Lewis writes it, central banks were not involved in the push towards fiscal consolidation, and their “only” sin was of not being vocal enough. I think he is too nice. At least in the Eurozone, the ECB was a key actor in pushing austerity. It was directly involved in the Trojka designing the rescue packages that sunk Greece (and the EMU with it). But more importantly, the ECB contributed to design and impose the Berlin View narrative that fiscal profligacy was at the roots of the crisis, so that rebalancing would have to be on the shoulders of fiscal sinners alone. We should not forget that “impeccable disaster” Jean-Claude Trichet was  one of the main supporters of the confidence fairy: credible austerity would magically lift expectations, pushing private expenditure and triggering the recovery. He was the President of the ECB when central banks made the second mistake. And I really have a hard time picturing him warning against the risks of austerity at the zero lower bound.

And things are not drastically different now. True, Mario Draghi often calls for fiscal support to the ECB quantitative easing program. But as I argued at length, calling for fiscal policy within the existing rules’ framework has no real impact.

So I disagree with Wren-Lewis on this one. Central banks, or at least the ECB, did not simply fail to contrast the problem of wrongheaded austerity. They were, and may  still be, part of the problem.

The problem is one of economic doctrine. And as long as this does not change, I am unsure that removing central bank independence would have made a difference. Would a Bank of England controlled by Chancellor  Osborne have been more vocal against austerity? Would an ECB controlled by the Ecofin? Nothing is less sure…


Resilience? Not Yet

April 11, 2016 1 comment

Last week the ECB published its Annual Report, that not surprisingly tells us that everything is fine. Quantitative easing is working just fine (this is why on March 10 the ECB took out the atomic bomb), confidence is resuming, and the recovery is under way. In other words, apparently, an official self congratulatory EU document with little interest but for the data it collects.

Except, that in the foreword, president Mario Draghi used a sentence that has been noticed by commentators, obscuring, in the media and in social networks, the rest of the report. I quote the entire paragraph, but the important part is highlighted

2016 will be a no less challenging year for the ECB. We face uncertainty about the outlook for the global economy. We face continued disinflationary forces. And we face questions about the direction of Europe and its resilience to new shocks. In that environment, our commitment to our mandate will continue to be an anchor of confidence for the people of Europe.

Why is that important? Because until now, a really optimistic and somewhat naive observer could have believed that, even amid terrible sufferings and widespread problems, Europe was walking the right path. True, we have had a double-dip recession, while the rest of the world was recovering. True, the Eurozone is barely at its pre-crisis GDP level, and some members are well below it. True, the crisis has disrupted trust among EU countries and governments, and transformed “solidarity” into a bad word in the mouth of a handful of extremists. But, one could have believed, all of this was a necessary painful transition to a wonderful world of healed economies and shared prosperity: No gain without pain. And the naive observer was told, for 7 years, that pain was almost over, while growth was about to resume, “next year”. Reforms were being implemented (too slowly, ça va sans dire) , and would soon bear fruits. Austerity’s recessionary impact  had maybe been underestimated, but it remained a necessary temporary adjustment. The result, the naive observer would believe,  would eventually be that the Eurozone would grow out of the crisis stronger, more homogeneous, and more competitive.

I had noticed a long time ago that the short term pain was evolving in more pain, and more importantly, that the EMU was becoming more heterogeneous precisely along the dimension, competitiveness, that reforms were supposed to improve. I also had noticed that as a result the Eurozone would eventually emerge from the crisis weaker, not stronger. More rigorous analysis ( e.g. here, and here) has recently shown that the current policies followed in Europe are hampering the long term potential of the economy.

Today, the ECB recognizes that “we face questions about the resilience [of Europe] to new shocks”. Even if the subsequent pages call for more of the same, that simple sentence is an implicit and yet powerful recognition that more of the same is what is killing us. Seven years of treatment made us less resilient. Because, I would like to point out, we are less homogeneous than we were  in 2007. A hard blow for the naive observer.

Draghi Wants the Cake, and Eat It

February 16, 2016 6 comments

Yesterday Mario Draghi has called once more for other policies to support the ECB titanic (and so far vain) effort to lift the eurozone economy out of its state of semi-permanent stagnation. Here is the exact quote from his introductory remarks at the European Parliament hearing:

In parallel, other policies should help to put the euro area economy on firmer grounds. It is becoming clearer and clearer that fiscal policies should support the economic recovery through public investment and lower taxation. In addition, the ongoing cyclical recovery should be supported by effective structural policies. In particular, actions to improve the business environment, including the provision of an adequate public infrastructure, are vital to increase productive investment, boost job creations and raise productivity. Compliance with the rules of the Stability and Growth Pact remains essential to maintain confidence in the fiscal framework.

In a sentence, less taxes, more public investment (in infrastructures), and respect of the 3% limit. I just have two very quick (related) comments:

  1. Boosting growth remaining within the limits of the stability pact simply cannot happen. I just downloaded from the Commission database the deficit figures and the growth rate for 2015. And I computed the margin (difference between deficit and the 3% SGP limit). Here is what it gives:
    Not only the margin for a fiscal expansion is ridiculously low for the EMU as a whole (at 0.8% of GDP, assuming a multiplier of 1.5 this would give globally 1.2% of extra growth). But it is also unevenly distributed. The (mild) positive slope of the yellow trend line, tells us that the countries that have a wider margin are those which need it the less as, overall, they grew faster in 2015. Said otherwise, we should ask the same guys who are unable to show a modicum of decency and solidarity in managing a humanitarian emergency like the refugee crisis, to coordinate in a fiscal expansion for the common good of the eurozone. Good luck with that…
    Mr Draghi is too smart not to know that the needed fiscal expansion would require breaching the limits of the pact. Unless we had a real golden rule, excluding public investment from deficit computation.
  2. So, how can we have lower taxes, more investment, and low deficit? The answer seems one, and only one. Cutting current expenditure. And I think it is worth being frank here: Besides cutting some waste at the margin, the only way to reduce current public expenditure is to seriously downsize our welfare state. We may debate whether our social model is incompatible with the modern globalized economy (I don’t think it is). But pretending that we can have the investment boost that even Mr Draghi today think is necessary, leaving our welfare state untouched, is simply nonsense. You can’t have the cake and eat it.

Therefore, what we should be talking about is our social contract. Do we want to keep it or not? Are we ready to pay the price for it? Are we aware of what the alternative of low social protection would imply? Are our institutions ready for a world in which automatic stabilization would play a significantly lesser role? If after considering these (and other) questions, the EU citizen decided, democratically, to abandon the current EU social model, I would not object to it. I would disagree, but I would not object. The problem is that this change is being implemented, bit by bit, without a real debate. I am no fan of conspiracy theories. But when reading Draghi yesterday, I could not avoid thinking of an old piece by Jean-Paul Fitoussi, arguing that European policy makers were pursuing an hidden agenda  (I have discussed it already). The crisis weakened resistance and is making it easier to gradually dismantle the EU social model. The result is growing disaffection, that really surprises nobody but those who do not want to see it. An Italian politician from an other era famously said that to think the worst of someone is a sin, but usually you are spot on…

The Quest for Discretionary Fiscal Policy

January 15, 2016 2 comments

It is nice to resume blogging after a quite hectic Fall semester. Things do not seem to have gotten better in the meantime…

The EMU policy debate in the past few months kept revolving around monetary policy. Just this morning I read a Financial Times report on the never ending struggle between hawks and doves within the ECB. I am all for continued monetary stimulus. It cannot hurt. But there is only so much monetary policy can do in a liquidity trap. I said it many times in the past (I am in very good company, by the way), and nothing so far proved me wrong.

A useful reminder of how important fiscal policy is, and therefore of how criminal it is to willingly decide to give it up, comes from a recent piece from Blinder and Zandi, who tried to assess what the US GDP trajectory would have been, had the discretionary policy measures implemented since 2008 not been in place. I made a figure of their counterfactual:


It is worth just using their own words:

Without the policy responses of late 2008 and early 2009, we estimate that:

  • The peak-to-trough decline in real gross domestic product (GDP), which was barely over 4%, would have been close to a stunning 14%;
  • The economy would have contracted for more than three years, more than twice as long as it did;
  • More than 17 million jobs would have been lost, about twice the actual number.
  • Unemployment would have peaked at just under 16%, rather than the actual 10%;
  • The budget deficit would have grown to more than 20 percent of GDP, about double its actual peak of 10 percent, topping off at $2.8 trillion in fiscal 2011.
  • Today’s economy might be far weaker than it is — with real GDP in the second quarter of 2015 about $800 billion lower than its actual level, 3.6 million fewer jobs, and unemployment at a still-dizzying 7.6%.

We estimate that, due to the fiscal and financial responses of policymakers (the latter of which includes the Federal Reserve), real GDP was 16.3% higher in 2011 than it would have been. Unemployment was almost seven percentage points lower that year than it would have been, with about 10 million more jobs.

The conclusion I draw is unequivocal: Blinder and Zandi give yet another proof that what made the current recession different from the tragedy of the 1930s it the swift and bold policy reaction.

This of course nothing new. But unfortunately, it sounds completely heretic in European policy circles. In my latest post (internet ages ago) I noticed that how little Mario Draghi’s position on fiscal matters differed from Angela Merkel’s, and in general from the European pre-crisis consensus.

The reader will have noticed that in the figure above I also drew EMU12 real GDP. It did not fall as much as the US no-policy counterfactual (among other things because exports kept us afloat thanks to…the US recovery). But we are today stuck in a semi-permanent state of stagnant growth. EMU12 GDP is today at the same level as the level the US would have had, had their policies been completely inertial. Once again, a visual aid:


I already showed this figure in the past. On the x-axis you have the output gap, i.e. a measure of how deep in a recession the economy is. On the y-axis you have he fiscal impulse, i.e. a measure of discretionary fiscal policy (net of interest payment and of cyclical adjustment of government deficit). A well functioning fiscal policy would result in a negative correlation: If the economy goes down (negative output gap), fiscal policy is expansionary (positive fiscal impulse). This is what actually happened in 2008-2009 (red series). But then as we know European policy makers succumbed to the fairy tale of expansionary fiscal consolidations, and fiscal policy turned pro-cyclical (yellow series). A persisting output gap was met with fiscal consolidation (improvement in structural fiscal balance).

Overall, policy was neutral. This is consistent with the Berlin View, that  fears discretionary policies as if they were the plague. And explains much of our dismal performance. The fact that we are close to Blinder and Zandi’s “no-policy” scenario is no coincidence at all. Our policy makers should look at their blue line for the US, and realize that we could be around there too, if only they were less stubbornly ideological.


Draghi the Fiscal Hawk

October 23, 2015 8 comments

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

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

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

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

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

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

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

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

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

EMU Troubles: The Narrow Way Out

September 18, 2015 4 comments

I was asked to write a piece on whether we should continue to study the EMU (my answer is yes. In case you wonder, this is called vested interest). One section of it can be a stand-alone blog post: Here it is, with just a few edits:

While in the late 1980s the consensus among economists and policy makers was that the EMU was not an optimal currency area (De Grauwe, 2006), the choice was made to proceed with the single currency for two essentially opposed reasons: The first, stemming from the Berlin-Brussels Consensus, saw monetary integration, together with the establishment of institutions limiting fiscal and monetary policy activism, as an incentive for pursuing structural reforms and converging towards market efficiency: as the role of macroeconomic management was believed to be limited, giving up monetary policy would impose negligible costs to countries while forcing them, through competition, to remove growth-stifling  obstacles to markets.

Another group of academics and policy makers, while not necessarily subscribing to the Consensus, highlighted the political economy of the single currency: Adopting the euro in a non-optimal currency area would have created the incentives for completing it with a political union: a federation, endowed with a common fiscal policy and capable of implementing the fiscal transfers that are required to avoid divergence. In other words a non-optimal euro was seen as just an intermediate step towards a real United States of Europe. A key argument of the proponents of a federal Europe was, and still is, that fiscal transfers seem unavoidable to ensure economic convergence. A seminal paper by Sala-i-Martin and Sachs (1991) shows that even in the United States, where market flexibility is substantially larger than in the EMU, transfers from booming states to states in crisis account for almost 50% of the reaction to asymmetric shocks.

It is interesting to notice how the hopes of both views were dashed by subsequent events. As the theory of optimal currency areas correctly predicted, the inception of the euro without sufficiently strong correction mechanisms, triggered a divergence between a core, characterized by excess savings and export-led growth, and a periphery that sustained the Eurozone growth through debt-driven (public and private) consumption and investment.

Even before the crisis the federal project failed to make it into the political agenda. The euro came to be seen by the political elites not, as the federalists hoped, as an intermediate step towards closer integration, but rather as the endpoint of the process initiated by Jean Monnet and Robert Schuman in 1950. The crisis further deepened economic divergence and recrimination, highlighting national self-interest as the driving force of policy makers, and making solidarity an empty word. As we write, the Greek crisis management, the refugee emergency, the centrifugal forces shaking Europe, are seen as a potential threat to the Union, rather than a push for further integration as it happened in the past (Rachman, 2015).

The Consensus partisans won the policy debate. The EMU institutions, banning discretionary policy, reflect their intellectual framework; and the policies followed (more or less willingly) by EMU countries, especially since the crisis, are the logical consequences of the consensus: austerity and structural reforms aimed at increasing competitiveness and reducing the weight of the State in the economy. But while they can rejoice of their victory, Consensus proponents have to deal with the failure of their policies: five years of Berlin View therapy has nearly killed the patient. Peripheral countries’ debt is still unsustainable, growth is nowhere to be seen (including in successful Germany), and social hardship is reaching unbearable levels (Kentikelenis et al., 2014). Coupling austerity with reforms proved to be self-defeating, as the short term recessionary impact on the economy was much larger than expected (Blanchard and Leigh, 2013), and as a consequence the long run benefits failed to materialize (Eggertsson et al., 2014). It is then no surprise that in spite of austerity and reforms, divergence between the core and the periphery of the Eurozone is even larger today than it was in 2007.

The dire state of the Eurozone economy is in some sense the revenge of optimal currency areas theory, with a twist. It appears evident today, but it was clear two decades ago, that market flexibility alone would never suffice to ensure convergence (rather the opposite), so that the Consensus faces a potentially fatal challenge. On the other hand, the federalist project, that was already faltering, seems to have received a fatal blow from the crisis.

The conclusion I draw from these somewhat trivial considerations is that the EMU is walking a fine line. If the federalist project is dead, and if Consensus policies are killing the EMU, what have we left, besides a dissolution of the euro?

I conclude the paper by arguing that two pillars of a new EMU governance/policy are necessary (neither of them in isolation would suffice):

  1. Putting in place any possible surrogate of fiscal transfers, like for example a EU wide unemployment benefit, making sure that it is designed to be politically feasible (i.e. no country is net contributor on average), eurobonds, etc.
  2. Scrapping  the Consensus together with its foundation, the efficient market hypothesis, and head towards real, flexible coordination of (imperfect) macroeconomic policies in order to deal with (imperfect) markets. Government by the rules only works in the ideal neoclassical world.

I know, more easily said than done. But I see no other possibility.