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.
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?
I was puzzled by Daniel Gros’ recent Project Syndicate piece, in which he claims that Germany’s dominance of the EMU may be coming to an end. Gros’ argument is based on two facts. The first is the slowing growth rate of Germany, that seems to be heading towards the pre-crisis “normal” of slow growth (Germany grew less than EMU average for most of the period 1999-2007). The second, more geo-political, is the lack of willingness (or of capacity) to manage, the crises that face the EU (in particular the refugees crisis).
Gros concludes that this loss of influence is dangerous, because Germany will not be able to resist the changes in policies that are pushed by peripheral countries and by the ECB. Of course, implicit in this statement, is Gros’ belief that these policies were necessary and useful.
I welcome the recognition that Germany has steered the EMU since the beginning of the crisis. Those of us talking about the Germanification of Europe have been decried until very recently. Yet, I do not share, not at all, Gros view.
True, Germany’s growth is slowing down. These are the risks of an export-led growth model: countries are not masters of their own fate. Germany stayed clear from the peripheral countries’ crisis (that it contributed to create) by turning to the US and to emerging economies as markets for its exports. But now that these countries are also having problems, the limits of jumping on other countries’ shoulders to grow, become evident. I am surprised by Gros’ surprise, as this was evident from the very beginning.
But here I do not want to reiterate my criticisms of the export-led model, starting from the fallacy of composition. Instead, I would like to challenge Gros’ argument that Germany influence is waning. I would say on the contrary that the Germanification of the eurozone is almost complete.
I took a few macroeconomic variables, and contrasted Germany with the remaining 11 EMU members. Let’s start with (missing) domestic demand, a defining characteristic of the export-led growth model:
Since 2007, the yellow line (EMU11) and the red line (Germany) converged, mostly because domestic demand in the rest of the EMU was reduced. This led of course to an increased reliance of the EMU as a whole on exports. The EMU as a whole had an overall balanced external position in 2007, while it has a substantial current account surplus today (the EMU12 went from 0.5% to 3.4 projected for 2016. Germany went from 7% to 7.7%). In other words, the EMU11 joined Germany on the shoulders of the rest of the world.
Austerity has of course much to be blamed for this compression of domestic demand: Just look at government balances (net of interest payments):
True, the difference between Germany and the rest of EMU is today larger than in 2007. But since Germany and the Troika took the driving seat in 2010, government balances of the EMU11 have been steadily converging to surplus, and they are not going to stop in the foreseeable horizon (the Commission forecasts go until 2016).
Finally, if we look at one of the main drivers of growth, investment, the picture is the same.
Be it private or public, the EMU11 Gross Fixed Capital Formation has been converging towards the (excessively low) German level (I did not draw the differences, not to clutter the figure).
And of course, there are labour costs, for which convergence to Germany was brutal, even if the latter, rather than EMU peripheral countries, were the outlier. To summarize, during the crisis the difference between Germany and the rest of the EMU was substantially reduced, and will continue to be in the next years:
The difference was reduced for all variables, except for government deficit. Self-defeating austerity slowed down the convergence. But private expenditure, in particular investment, more than compensated.
So, if I were Gros, I would not worry too much. The Germanification of Europe is well on its way. If Germany does not go to the EMU11 (it definitely does not!), the EMU11 keeps going to Germany.
But as I am not Gros, I worry a lot.
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):
- 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.
- 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.
So, Mario Draghi is disappointed by eurozone growth, and is ready to step up the ECB quantitative easing program. The monetary expansion apparently is not working out as planned.
Big surprise. I am afraid some people do not have access to Wikipedia. If they had, they would read, under “liquidity trap“, the following:
A liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war.
In a liquidity trap the propensity to hoard of the private sector becomes virtually unlimited, so that monetary policy (be it conventional or unconventional) loses traction. It is true that the age of great moderation, and three decades of almighty central bankers had made the concept fade into oblivion. But, since 2008 we were forced to reconsider the effectiveness of monetary policy at the so-called zero lower bound.
Or at least we should have…
So, had policy makers taken the time to look at the history of the great depression, or at least to open the Wikipedia entry, they should have learnt that when monetary policy loses traction, the witness in lifting the economy out of the recession, needs to be taken by fiscal policy. In a liquidity trap the winner is fiscal policy. Or at least it should be. Here is a measure of the fiscal stance, computed as the change in government balance once we exclude cyclical components and interest payments.
The vast majority of E
MU countries undertook a strong fiscal tightening, regardless of the actual health of their public finances. This generalized austerity, an offspring of the Berlin View, led to our double dip recession, and to further divergence in the eurozone, that would have needed coordinated, not synchronized fiscal policies. Well done guys…
And yet, Mario Draghi is surprised by the impact of QE.
A new Occasional Paper details the new methodology adopted by the Bank of Italy for calculating an index of price competitiveness, and applies it to the four largest eurozone economies.
I took the time to copy the numbers of table 3 in an excel file (let’s hope for the best), and to look at what happened since 2009. Here is the evolution of price competitiveness (a decrease means improved competitiveness):
I find this intriguing. We have been sold the story of Spain as the success story for EMU austerity as, contrary to other countries, it restored its external balance through internal devaluation. Well, apparently not. Since 2008 its price competitiveness improved, but less so than in the three other major EMU countries.
The reason must be that the rebalancing was internal to the eurozone, so that the figure does not in fact go against austerity nor internal devaluation. For sure, within eurozone price competitiveness improved for Spain. Well, think again…
This is indeed puzzling, and goes against anedoctical evidence. We’ll have to wait for the new methodology to be scrutinized by other researchers before making too much of this. But as it stands, it tells a different story from what we read all over the places. Spain’s current account improvement can hardly be related to an improvement in its price competitiveness. Likewise, by looking at France’s evolution, it is hard to argue that its current account problems are determined by price dynamics.
Without wanting to draw too much from a couple of time series, I would say that reforms in crisis countries should focus on boosting non-price competitiveness, rather than on reducing costs (in particular labour costs). And the thing is, some of these reforms may actually need increased public spending, for example in infrastructures, or in enhancing public administration’s efficiency. To accompany these reforms there is more to macroeconomic policy than just reducing taxes and at the same time cutting expenditure.
Since 2010 it ha been taken for granted that reforms and austerity should go hand in hand. This is one of the reasons for the policy disaster we lived. We really need to better understand the relationship between supply side policies and macroeconomic management. I see little or no debate on this, and I find it worrisome.
Germany did not speak yet, and until then nothing is certain. But it looks like the new Tsipras proposal may turn into an agreement between Greece and its creditors.
We’ll see what happens in the next days, but I want to make a few remarks
At first sight, this does not look good for Tsipras. On all the points that remained contentious when negotiations were interrupted, the new proposal substantially accepts the creditors requests (labour law being an important exception): On VAT, privatizations, retirement age, we are now very close to the original creditors’ requests, and very far from the Greek ones.
And in fact the new package is even more “austerian” than the Juncker plan, as it contains deficit reduction for 12 billions instead of 8.
This said, if Tsipras manages to link the package to the obtention of a new loan (plus unblocking of structural funds) for a duration of three years, he will have obtained what he has been asking so far in vain, and what had been refused to Papandreou in 2011: Time and money.
While accusing him of doing nothing to change his country, creditors forced Tsipras to spend the past five months flying back and forth from Athens to Brussels, each time asking for a fistful of euros. If he manages to obtain a new loan over the next three years, this will finally stop. He will have the time to implement his recipe for Greece, and it will be finally possible to judge his government on acts rather than promises.
In this light the referendum was very important. By asking the Greek people the mandate to negotiate while remaining in the euro, he succeeded in throwing the ball in the creditors camp. Those speaking of betrayal of the people’s will probably did not pay attention to the Greek debate in the week of July 5th. This is why Syriza keeps climbing in the polls, by the way.
Tsipras had to pay the price of a stricter austerity than he would have wished for. But he gains breathing space, which is orders of magnitude more valuable. No surprise that Germany is hesitant. If a deal is not reached, as of now, it will be clear to all who will have kicked Greece out.
Not a bad day for Tsipras after all