Update (1/7/2016): The whole paper is now available on Repec.
I have recently written a text on EMU governance and the implementation of a Golden Rule of public finances. I will provide the link as soon as it comes out. The last section of that paper can be read stand alone (with some editing). A bit long, I warn you, but here it is:
Because of its depth, and of its length, the crisis has triggered an interesting discussion among economists about whether the advanced economies will eventually return to the growth rates they experienced in the second half of the twentieth century.
One view, put forward by Robert Gordon focuses on supply-side factors. Gordon argues that each successive technological revolution has lower potential impact, and that in this particular moment, “Slower growth in potential output from the supply side, emanating not just from slow productivity growth but from slower population growth and declining labor-force participation, reduces the need for capital formation, and this in turn subtracts from aggregate demand and reinforces the decline in productivity growth.”
In a famous speech at the IMF in 2013, later developed in a number of other contributions, Larry Summers revived a term from the 1930s, “secular stagnation”, to describe a dilemma facing advanced economies. Summers develops some of Gordon’s arguments to argue that lower technical progress, slower population growth, the drifting of firms away from debt-financed investment, all contributed to shifting the investment schedule to the left. At the same time, the debt hangover, accumulation of reserves (public and private) induced by financial instability, increasing income inequality (on that, I came first!), tend to push the savings schedule to the right. The resulting natural interest rate is close to zero if not outright negative, thus leading to a structural excess of savings over investment.
Summers argues that most of the factors exerting a downward pressure on the natural interest rate are not cyclical but structural, so that the current situation of excess savings is bound to persist in the medium-to-long run, and the natural interest rate may remain negative even after the current cyclical downturn. The conclusion is not particularly reassuring, as policy makers in the next several years will have to navigate between the Scylla of accepting permanent excess savings and low growth (insufficient to dent unemployment), and the and Charybdis of trying to fight secular stagnation by fuelling bubbles that eliminate excess savings, at the price of increased instability and risks of violent financial crises like the one we recently experienced.
The former IMF chief economist Olivier Blanchard has elaborated on the meaning of Summers’ conjecture for macroeconomic policy. If interest rates will remain at (or close to) zero even once the crisis will be over, monetary policy will continuously face the Scylla and Charybdis. The recent crisis is a good case study of this dilemma, with the two major central banks of the world under fire from some quarters, for opposiite reasons: the Fed for having kept interest rates too low, contributing to the housing bubble and the ECB for having done too little and too late during the Eurozone crisis.
Drifting away from the Consensus that he contributed to consolidate, Blanchard concludes that exclusive reliance on monetary policy for macroeconomic stabilization should be reassessed. With low interest rates that make debt sustainability a non-issue; with financial markets deregulation that risks yielding more variance in GDP and economic activity; and with monetary policy (almost) constantly at the Zero Lower Bound, fiscal policy should regain a prominent role among the instruments for macroeconomic regulation, beyond the cycle. This is a very important methodological advance.
Nevertheless, in his plea for fiscal policy, Blanchard falls short of a conclusion that naturally stems from his own reading of secular stagnation: If the economy is bound to remain stuck in a semi-permanent situation of excessive savings, and if monetary policy is incapable of reabsorbing the imbalance, then a new role for fiscal policy may appear, that goes beyond the short-term stabilization that Blanchard (and Summers) envision. In fact, there are two ways to avoid that the ex ante excess savings results in a depressed economy: either one runs semi-permanent negative external savings (i.e. a current account surplus), or one runs semi-permanent government negative savings. The first option, the export-led growth model that Germany is succeeding to generalize at the EMU level, is not viable, except for an individual country implementing non cooperative strategies, because aggregate current account balances need to be zero. The second option, a semi-permanent government deficit, needs to be further investigated, especially in its implication for EMU macroeconomic governance
There are a number of ways, not necessarily politically feasible, to allow EMU countries to run semi-permanent government deficits. A first one could be to restore complete national budget sovereignty, (scrapping the Stability Pact). This would mean relying on market discipline alone for maintaining fiscal responsibility. As an alternative, at the opposite side of the spectrum, countries could create a federal expenditure capacity (which would imply the creation of an EMU finance minister with capacity to spend, the issuance of Eurobonds, etc.). Such an option is as unrealistic as the previous one. In an ideal world, the crisis and deflation would be dealt with by means of a vast European investment program, financed by the European budget and through Eurobonds. Infrastructures, green growth, the digital economy, are just some of the areas for which the optimal scale of investment is European, and for which a long-term coordinated plan would necessary. The increasing mistrust among European countries exhausted by the crisis, and the fierce opposition of Germany and other northern countries to any hypothesis of debt mutualisation, make this strategy virtually impossible. The solution must therefore be found at national level, without giving up European-wide coordination, which would guarantee effective and fiscally sustainable investment programs.
In general, the multiplier associated with public investment is larger than the overall expenditure multiplier. This is particularly true in times of crisis, when the economy is, like today, at the zero lower bound. With Kemal Dervis I proposed that the EMU adopts a fiscal rule similar to the one implemented in the UK by Chancellor of the Exchequer Gordon Brown in the 1990s, and applied until 2009. The new rule would require countries to balance their current budget, while financing public capital accumulation with debt. Investment expenditure, in other words, would be excluded from deficit calculation, a principle that timidly emerges also in the Juncker plan. Such a rule would stabilize the ratio of debt to GDP, it would focus efforts of public consolidation on less productive items of public spending, and would ensure intergenerational equity (future generations would be called to partially finance the stock of public capital bequeathed to them). Last, but not least, especially in the current situation, putting in place such a rule would not require treaty changes, and it is already discussed, albeit timidly, in EU policy circles.
To avoid the bias towards capital expenditure that the golden rule could trigger, we proposed that at regular intervals, for example in connection with the European budget negotiation, the Commission, the Council and the Parliament could find an agreement on the future priorities of the Union, and make a list of areas or expenditure items exempted from deficit calculation for the subsequent years.
Some comments, and endless twitter discussions on my Blanchard Touch post call for a couple of clarifications.
The first has to do to the most common reaction, that has been: “the IMF may well have made advances in its analysis, but the policy prescriptions are remarkably unchanged. So what good is it?” After all, isn’t the IMF considered an hardliner in the current
Troika Institutions‘ negotiation with Greece? No Blanchard touch, there.
These objections are of course justified, but in my opinion they miss an important point: Blanchard is not the IMF executive director. Nor the representative of a major country. He is “only” the head of the research department, and as such his job is to provide analyses, not to decide the use of these analyses made by a process that (luckily) is political in nature. Does this mean that what Blanchard and his staff do is irrelevant? Of course not. I do think that making the debate evolve is a fundamental task for public figures like Blanchard. One of the strength of the Washington Consensus has been the narrative that accompanied it, the market efficiency hypothesis that laid the theoretical foundations of supply side policies. This is why I believe that the fact that the narrative is crumbling, among other things thanks to the IMF own research, is of paramount importance. The change in narrative is a precondition for a policy change. The hiatus between the Fund’s actions and words will be increasingly visible, and eventually, I hope, it will lead to a change of policies. I cannot believe that the narrative is irrelevant; otherwise I would have chosen a different job.
The second clarification concerns the end of my post:
If I write a paper saying that austerity will not be costly because multipliers are 0.5, and 2 years later retract my previous statement and argue that austerity is in fact self defeating, the impact on the world is zero. If the IMF does the same, during the two years huge suffering will be needlessly inflicted to masses of people. This poses a problem, as research by definition may be falsified. In the past an institution like the IMF would never have admitted a mistake. And we certainly do not want to go back there. Today they do admit the mistakes, but the suffering remains. The only way out to this problem is that the “new” IMF should learn to be cautious in its policy prescriptions, and always remember that any policy recommendation is bound to be sooner or later proven inappropriate by new data and research. We don’t live in a black and white world. Adopting a more prudent stance in dictating policies would be wise (in Brussels as well, it goes without saying)
By this I surely did not mean that the IMF should refrain from giving policy advice. Nor that governments should follow their guts instead of informed analysis, as one reader very clearly put it. I meant that the first and most important achievement for a policy adviser is to abandon dogmatism, and acknowledge that however robust we believe our knowledge to be, there always is a chance that it will be proved wrong. With such an attitude, policy advice would become “cautious” in the sense of being aware of possible unintended consequences of policies; policies that should therefore be implemented with in mind alternative scenarios. Just to make an example, the IMF could have suggested, as it did, to implement austerity based on the belief that the multiplier was low. But it should have asked governments to do it gradually, in order to be ready to reverse course in case the estimated multipliers would prove (as it did) to be larger. In a sentence, being cautious means avoiding advising for extreme behaviors that could prove to be extremely costly and hard to unwind. Especially in crisis situations, policy makers should look east and cross the river by feeling the stones.
I would also like to add that in the case of the Washington Consensus, we had already, in the past decade, a number of episodes when its prescriptions turned out to be catastrophic. Thus, caution would have been even wiser. But hey, dogmatism is by definition unwise…
Yesterday I commented on the intriguing box in which the IMF staff challenges one of the tenets of the Washington consensus, the link between labour market reform and economic performance.
But the IMF is not new to these reassessments. In fact over the past three years research coming from the fund has increasingly challenged the orthodoxy that still shapes European policy making:
- First, there was the widely discussed mea culpa in the October 2012 World Economic Outlook, when the IMF staff basically disavowed their own previous estimates of the size of multipliers, and in doing so they certified that austerity could not, and would not work (of course this led EU leaders to immediately rush to do more of the same).
- Then, the Fund tackled the issue of income inequality, and broke another taboo, i.e. the dichotomy between fairness and efficiency. Turns out that unequal societies tend to perform less well, and IMF staff research reached the same conclusion. And once the gates opened, it did not stop. The paper by Berg and Ostry was widely read. Then we had Ball et al on the distributional effects of fiscal consolidation (surprise, it increases inequality). Another paper investigated the channels for this link, highlighting how consolidation leads to increased inequality mostly via unemployment. And just last week I assisted to a presentation by IMF economists showing how austerity and inequality are positively related with political instability.
- On labour markets, before yesterday’s box 3.5, the Fund had disseminated research linking increased inequality with the decline in unionization.
- Then, of course, the “public Investment is a free lunch” chapter three of the World Economic Outlook, in the fall 2014.
- In between, they demolished another building block of the Washington Consensus: free capital movements may sometimes be destabilizing…
These results are not surprising per se. All of these issues are highly controversial, so it is obvious that research does not find unequivocal support for a particular view. All the more so if that view, like the Washington Consensus, is pretty much an ideological construction. Yet, the fact that research coming from the center of the empire acknowledges that the world is complex, and interactions among agents goes well beyond the working of efficient markets, is in my opinion quite something.
What does this mass (yes, now it can be called a mass) of work tells us? Three things, I would say. First, fiscal policy is back. it really is. The Washington Consensus does not exist anymore, at least in Washington. Be it because the multipliers are large, or because it has an impact on income distribution (and on economic efficiency); or again because public investment boosts growth, fiscal policy has a role to play both in dampening business cycle fluctuations and in facilitating stable and balanced long term growth. The fact that a large institution like the IMF has lent its support to this revival of consideration for fiscal policy, makes me hope that discussions about macroeconomic policy will be less ideological, even once the crisis will have passed.
The second thing I learn is that the IMF research department proves to be populated of true researchers, who continuously challenge and test their own views, and are not afraid of u-turns if their own research dictates them. I am sure it has always been the case. What is different from the past is that now they have a chief economist who seems more interested in understanding where the world goes than in preaching a doctrine.
The third remark is more problematic. If I write a paper saying that austerity will not be costly because multipliers are 0.5, and 2 years later retract my previous statement and argue that austerity is in fact self defeating, the impact on the world is zero. If the IMF does the same, during the two years huge suffering will be needlessly inflicted to masses of people. This poses a problem, as research by definition may be falsified. In the past an institution like the IMF would never have admitted a mistake. And we certainly do not want to go back there. Today they do admit the mistakes, but the suffering remains. The only way out to this problem is that the “new” IMF should learn to be cautious in its policy prescriptions, and always remember that any policy recommendation is bound to be sooner or later proven inappropriate by new data and research. We don’t live in a black and white world. Adopting a more prudent stance in dictating policies would be wise (in Brussels as well, it goes without saying). And of course, the disconnect between the army and the general is also a problem.
I am ready to bet that the latest IMF World Economic Outlook, that was presented today in Washington, will make a certain buzz for a box. It is box 3.5, at page 36 of chapter 3, which has been available on the website for a few days now. In that box, the IMF staff presents
lack of evidence on the relationship between structural reforms and total factor productivity, the proxy for long term growth and competitiveness. (Interestingly enough people at the IMF tend to put their most controversial findings in boxes, as if they wanted to bind them).
What is certainly going to stir controversy is the finding that while long term growth is negatively affected by product market regulation, excessive labour market regulation does not hamper long term performance.
It is not the first time that the IMF surprises us with interesting analysis that goes against its own previous conventional wisdom. I will write more about this shortly. Here I just want to remark how these findings are relevant for our old continent.
imposed to embraced by eurozone crisis countries has taken the shape of expenditure cuts and labour market deregulation, whose magic effects on growth and competitiveness have been sold to reluctant and exhausted populations as the path to a bright future. I already noted, two years ago, that the short-run pain was slowly evolving into long-run pain as well, and that the gain of structural reforms was nowhere to be seen. The IMF tells us, today, that this was to be expected.
The guy who should be happy is Alexis Tsipras; he has been resisting since January pressure from his peers (and the Troika, that includes IMF staff!) to further curb labour market regulations, and recently presented a list of reforms that mostly pledges to reduce crony capitalism, tax evasion and product market rigidities. Exactly what the IMF shows to be effective in boosting growth. Of course, at the opposite, those who spent their political capital to implement labour market reforms are most probably not rejoicing at the IMF findings.
This happens in Washington. Problem is, Greece, and Europe at large, seem to be light years away from the IMF research department. We already saw, for example with the mea culpa on multipliers, that IMF staff in program countries does not necessarily read what is written at home. Let’s see whether the discussion on Greece’s reforms will mark a realignment between the Fund’s research work and the prescriptions they implement/suggest/impose on the ground.
Remember the old times? Here is a quote from ECB President Jean-Claude Trichet, September 2nd, 2010:
[Fiscal Consolidation] is a prerequisite for maintaining confidence in the credibility of governments’ fiscal targets. Positive effects on confidence can compensate for the reduction in demand stemming from fiscal consolidation, when fiscal adjustment strategies are perceived as credible, ambitious and focused on the expenditure side. The conditions for such positive effects are particularly favourable in the current environment of macroeconomic uncertainty.
And just in case it was not clear, on September 3rd, 2010:
We encourage all countries to be absolutely determined to go back to a sustainable mode for their fiscal policies,” Trichet said, speaking after the ECB rate decision on Thursday. “Our message is the same for all, and we trust that it is absolutely decisive not only for each country individually, but for prosperity of all.”
“Not because it is an elementary recommendation to care for your sons and daughter and not overburden them, but because it is good for confidence, consumption and investment today”.
Well, think again. Here is the abstract of ECB Working Paper no 1770, March 2015:
We explore how fiscal consolidations affect private sector confidence, a possible channel for the fiscal transmission that has received particular attention recently as a result of governments embarking on austerity trajectories in the aftermath of the crisis. Panel regressions based on the action-based datasets of De Vries et al. (2011) and Alesina et al. (2014) show that consolidations, and in particular their unanticipated components affect confidence negatively. The effects are stronger for revenue-based measures and when institutional arrangements, such as fiscal rules, are weak. To obtain a more accurate picture of how consolidations affect confidence, we co nstruct a monthly dataset of consolidation announcements based on the aforementioned datasets, so that we can study the confidence effects in real time using an event study. Consumer confidence falls around announcements of consolidation measures, an effect driven by revenue-based measures. Moreover, the effects are most relevant for European countries with weak institutional arrangements, as measured by the tightness of fiscal rules or budgetary transparency. The effects on producer confidence are generally similar, but weaker than for consumer confidence.
The confidence fairy seems to have turned into a confidence witch. One more victim of the crisis. But this one will not be missed.
It is not shameful to change opinion. Rather the contrary, it is a sign of intellectual courage. Two years ago, the IMF famously surprised commentators worldwide with a rather substantial U-turn on the impact of austerity. Revised calculations on the size of multipliers led them to acknowledge that they had underestimated the impact of austerity on economic activity.
Even at that time it started with a technical paper. But significantly, that paper was coauthored by Olivier Blanchard, IMF Chief Economist. It then served as the basis for a progress report on Greece, in June 2013, that de facto disavowed the first bailout program arguing that austerity had proven to be self-defeating.
Let us just hope that in the ECB new building communication between the research department and the top guys is more effective than in the old one…
I am glad to give credit for the title to Merijn Knibbe, from Real-World Economics Review Blog, who used the term in a comment to my last post.
The run up to the Italian elections in February is a welcome occasion to come back to the issue of austerity. The debate in Italy was fired by the widely discussed Wolfgang Munchau editorial, blaming Mario Monti for not opposing austerity. In the heat of electoral competition, this unsurprisingly stirred harsh discussions on whether Italy has room for reversing the austerity that ravaged the country. Some commentators got slightly carried away, accusing those opposing austerity of “silliness and falsehood”. I wonder whether they include the IMF chief economist in the bunch… Whatever, this is a minor issue; the way I see it, these discussions totally miss the point.
With Greece desperately trying to obtain more time to carry on its fiscal consolidation plan, it is interesting to read a recent IMF working paper on “Successful Austerity in the United States, Europe and Japan”. The study tries to assess how fiscal consolidation and the growth rate affect each other, in expansions and in contractions. I copied and pasted (from their page 7; I just suppressed a couple of technical points) the main results of the paper: