Posts Tagged ‘EMU’

On the Political Nature of Monetary Policy

February 20, 2017 Leave a comment

I was intrigued by Munchau’s editorial on central bank independence, that appeared on today’s FT. Munchau argues that central banks’ choices are increasingly political in nature, especially if their mandate is broad, as is the case for example of the Fed. His argument is that a broad mandate implies tradeoffs, and as such it does not go well with central bank independence.

I must say I am unconvinced to say the least, on at least two levels.

First, I do not see how a strict mandate would make central bank choices less political in nature. It makes them more opaque, but by no means less political. I wrote about this in a paper on ECB action during the crisis, and more succinctly in an op-ed for Social Europe co-written with Yan Islam back in 2015.  Let me quote a few excerpts from that piece:

A dual mandate requiring the central bank to pursue two, sometimes conflicting, objectives forces the institution to make inherently political choices. Far from being a shortcoming, this allows for a more flexible and unbiased monetary policy. A central bank following a dual mandate will always be able to take an aggressive stance on inflation, if it deems this necessary. Appropriate choice of the weights given to employment and inflation would allow incorporation of any combination of the two objectives. […]

Inflation-targeting central banks, such as the ECB, de facto also target growth but timidly and without explicitly saying so. This leads to low reactivity and opaque communication, hampering in turn the capacity of central banks to manage expectations and effectively steer the economy. A good case in point is the ECB that – compared to the Fed – did “too little and too late” from 2009, amid a constant debate on whether the inflation-targeting mandate was being violated. […]

ECB opacity is intrinsically linked to the confusion between its mandate and its activities in the real world, and as such it cannot lead to any meaningful discussion but only to legalistic disputes on the definition of price stability, of how medium is the medium term and the like.

The main merit of a dual mandate is in fact that it lets the political nature of monetary policy emerge without ambiguities. It is indeed true that monetary policy with a dual mandate requires hard choices, just like those debated these days, and hence is political by its very nature. The point is, so is monetary policy with a simple inflation-targeting objective. The level of inflation targeted, and the choice of the instruments to attain it, is anything but neutral in terms of its consequences on the economy. Thus, an inflation-targeting central bank is as political in its actions as a bank following a dual mandate, the only difference being that In the former case the political nature of monetary policy is concealed behind a technocratic curtain.

In a sentence, we argued that monetary policy choices are always political, and as such they should be incorporated in the policy mix, without hiding behind what Yan and I called a technocratic illusion.

Munchau’s link between the broadness of the mandate and its political nature, is simplistic and in my opinion strongly misleading. In fact, we concluded back in 2015 that it is linked to a specific intellectual framework

The profound justification of an exclusive focus on price stability can only lie in the acceptance of a neoclassical view in which virtually powerless governments need to make little or no choices. Once we dismiss that platonic view, monetary policy acquires a political role, regardless of the mandate it is given.

The second reason why Munchau’s argument is unconvincing is the conclusion, somewhat implicit in his piece, that a central bank making political choices needs to be a “government agency”. Why is it so, exactly? I fail to see it. What matters is not that the central bank is controlled by the finance ministry, but that it is accountable, like any other actor doing policy, in a system of well functioning checks and balances.

Once we recognize that a central bank has a political role, we need to make sure first, that its mandate is not falsely perceived as technocratic; and second, that its actions are properly embedded in a balanced policy mix, in which there is coordination with, not subordination to, the other branches of government. It seems to me that the US institutional system comes pretty close to this. The same cannot be said for the eurozone.

A Plea for Semi-Permanent Government Deficits

December 9, 2016 3 comments

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.

Perseverare Diabolicum

July 13, 2016 1 comment

Yesterday the Council decided that Spain and Portugal’s recent efforts to reduce deficit were not enough. This may lead to the two countries being fined, the first time this would happen since the inception of the euro.

It is likely that the fine will be symbolic, or none at all; given the current macroeconomic situation, imposing a further burden on the public finances of these two any country would be crazy.

Yet, the decision is in my opinion enraging. First, for political reasons:  Our world is crumbling. The level of confidence in political elites is at record low levels, and as the Brexit case shows, this fuels disintegration forces. It is hard not to see a link between these processes and, in Europe, the dismal political and economic performances we managed to put together in the last decade (you are free pick your example, I will pick the refugee crisis (mis) management, and the austerity-induced double-dip recession).

But hey, one might say. We are not here to save the world, we are here to apply the rules. Rules that require fiscal discipline. And of course, both Portugal and Spain have been fiscal sinners since the crisis began (and of course before):


Once we neglect interest payments, on which there is little a government can do besides hoping that they ECB will keep helping, both countries spectacularly reduced their deficit since 2010. And this is true whether we take the headline figures (total deficit, the dashed line), or the structural figures that the Commission cherishes, i.e. deficit net of cyclical components (the solid lines). Looking at this figure one may wonder what they serve to drink during Council (and Commission) meetings, for them to argue that the fiscal effort was insufficient…

What is even more enraging, is that not only this effort was not recognized as remarkable by EU authorities. But what is more, it was harmful for these economies (and for the Eurozone at large).

In the following table I have put side by side the output gaps and fiscal impulse, the best measure of discretionary policy changes1. I have highlighted in green all the years in which the fiscal stance was countercyclical, meaning that a negative (positive) output gap triggered a more expansionary (contractionary) fiscal stance. And in red cases in which the fiscal stance was procyclical, i.e. in which it made matters worse.

Output Gap and Discretionary Fiscal Policy Stance
Portugal Spain EMU 12
Output Gap Fiscal Impulse Output Gap Fiscal Impulse Output Gap Fiscal Impulse
2009 -0.1 4.6 1.5 3.9 -1.9 1.4
2010 2.1 2.3 1.1 -2.3 -0.5 0.7
2011 0.6 -5.9 -0.3 -1.1 0.4 -1.6
2012 -3.2 -3.7 -3.3 -0.7 -1.1 -1.1
2013 -4.1 -0.9 -5.4 -4.4 -2.1 -0.9
2014 -3.2 2.9 -4.8 -0.2 -2.0 -0.1
2015 -2.0 -1.7 -2.8 1.2 -1.3 0.2
2016 -0.9 -1.0 -1.7 0.2 -0.8 0.3
2017 0.3 0.4 -0.9 0.3 -0.2 0.2
Source: Datastream – AMECO Database
Note: Fiscal Impulse computed as change of cyclically adjusted deficit net of interest

The reader will judge by himself. Just two remarks. linked to the fines put in place. First, the Portuguese fiscal contraction of 2015-2016 is procyclical, as the output gap was and still is negative. On the other hand, Spain has increased its structural deficit, but it had excellent reasons to do so.

One may argue that the table causes problems, because the calculation of the output gap is arbitrary and political in nature. Granted, I could not agree more. So I took headline figures, and compared the “gross” fiscal impulse with the “growth gap”, meaning the difference between the actual growth rate and the 3% level that was assumed to be normal when the Maastricht Treaty was signed (If you are curious about EMU numerology, just look here). This is of course a harsher criterion, as 3% as nowadays become more a mirage than a realistic objective. But hey, if we want to use the rules, we should take them together with their underlying hypotheses. Here is the table:

Growth Gap and Overall Fiscal Policy Stance
Portugal Spain EMU 12
Growth Gap to 3% Fiscal Impulse Growth Gap to 3% Fiscal Impulse Growth Gap to 3% Fiscal Impulse
2009 -6.0 6.2 -6.6 6.4 -7.4 4.2
2010 -1.1 1.4 -3.0 -1.7 -0.9 0.0
2011 -4.8 -5.2 -4.0 -0.4 -1.4 -2.2
2012 -7.0 -2.3 -5.6 0.3 -3.9 -0.5
2013 -4.1 -0.8 -4.7 -3.9 -3.3 -0.5
2014 -2.1 2.3 -1.6 -1.0 -2.1 -0.2
2015 -1.5 -2.4 0.2 -0.5 -1.4 -0.3
2016 -1.5 -1.6 -0.4 -1.0 -1.4 0.0
2017 -1.3 -0.2 -0.5 -0.7 -1.3 -0.2
Source: Datastream – AMECO Database
Note: Fiscal Impulse computed as change of government deficit net of interest

Lot’s of red, isn’t it? Faced with a structural growth deficit, the EMU at large, as well as Spain and Portugal, has had an excessively restrictive fiscal stance. I know, no real big news here.

To summarize, the decision to fine Portugal and Spain is politically ill-timed and clumsy. And it is economically unwarranted. And yet, here we are, discussing it. My generation grew up thinking that When The World Is Running Down, You Make The Best of What’s Still Around. In Brussels, no matter how bad things get, it is business as usual.

1. The fiscal impulse is computed as the negative of the change in deficit. As such it captures the change in the fiscal stance. Just to make an example, going from a deficit of 1% to a deficit of 5% is more expansionary than going form a deficit of 10% to a deficit of 11%.

Pushing on a String

June 3, 2016 Leave a comment

Readers of this blog know that I have been skeptical on the ECB quantitative easing program.
I said many times that the eurozone economy is in a liquidity trap, and that making credit cheaper and more abundant would not be a game changer. Better than nothing, (especially for its impact on the exchange rate, the untold objective of the ECB), but certainly not a game changer.
The reason, is quite obvious. No matter how cheap credit is, if there is no demand for it from consumers and firms, the huge liquidity injections of the ECB will end up inflating some asset bubble. Trying to boost economic activity (and inflation) with QE is tantamount to pushing  on a string.

I also said many times that without robust expansionary fiscal policy, recovery will at best be modest.

Two very recent ECB surveys provide strong evidence in favour of the liquidity trap narrative. The first is the latest (April 2016) Eurozone Bank Lending Survey. Here is a quote from the press release:

The net easing of banks’ overall terms and conditions on new loans continued for loans to enterprises and intensified for housing loans and consumer credit, mainly driven by a further narrowing of loan margins.

So, nothing surprising here. QE and negative rates are making so expensive for financial institutions to hold liquidity, that credit conditions keep easing.
So why do we not see economic activity and inflation pick up? The answer is on the other side of the market, credit demand. And the Survey on the Access to Finance of Enterprises in the euro area, published this week  also by the ECB, provides a clear and loud answer (from p. 10):

“Finding customers” was the dominant concern for euro area SMEs in this survey period, with 27% of euro area SMEs mentioning this as their main problem, up from 25% in the previous survey round. “Access to finance” was considered the least important concern (10%, down from 11%), after “Regulation”, “Competition” and “Cost of production” (all 14%) and “Availability of skilled labour” (17%). Among SMEs, access to finance was a more important problem for micro enterprises (12%). For large enterprises, “Finding customers” (28%) was reported as the dominant concern, followed by “Availability of skilled labour” (18%) and “Competition” (17%). “Access to finance” was mentioned less frequently as an important problem for large firms (7%, unchanged from the previous round)

No need to comment, right?

Just a final and quick remark, that in my opinion deserves to be developed further: finding skilled labour seems to become harder in European countries. What if these were the first signs of a deterioration of our stock of “human capital” (horrible expression), after eight years of crisis that have reduced training, skill building, etc.?
When sooner or later the crisis will really be over, it will be worth keeping an eye on  “Availability of skilled labour” for quite some time.

Tell me again that story about structural reforms enhancing potential growth?

On the Importance of Fiscal Policy

May 2, 2016 3 comments

Last week’s data on EMU growth have triggered quite a bit of comments. I was intrigued by Paul Krugman‘s piece arguing (a) that in per capita terms the EMU performance is not as bad (he uses working age population, I used total population); and (b) that the path of the EMU was similar to that of the US in the first phase of the crisis; and (c) that divergence started only in 2011, due to differences in monetary policy (an impeccable disaster here, much more reactive in the US). Fiscal policy, Krugman argues, was equally contractionary across the ocean.
I pretty much agree that the early policy response to the crisis was similar, and that divergence started only when the global crisis went European, after the Greek elections of October 2009. But I am puzzled (and it does not happen very often) by Krugman’s dismissal of austerity as a factor explaining different performances. True, at first sight, fiscal consolidation kicked in at the same moment in the US and in Europe. I computed the fiscal impulse, using changes in the cyclically adjusted primary deficit. In other words, by taking away the cyclical component, and interest payment, we can obtain the closest possible measure to the discretionary fiscal stance of a government. And here is what it gives:
Krugman is certainly right that austerity was widespread in 2011 and in 2012 (actually more in the US). So what is the problem?
The problem is that fiscal consolidation needs not to be assessed in isolation, but in relation to the environment in which it takes place. First, it started one year earlier in the EMU (look at the bars for 2010). Second, expansion had been more robust in the US in 2008 and in 2009, thus avoiding that the economy slid too much: having been bolder and more effective in 2008-2010, continued fiscal expansion was less necessary in 2011-12.
I remember Krugman arguing at the time that the recovery would have been stronger and faster if the fiscal stance in the US had remained expansionary. I agreed then and I agree now: government support to the economy was withdrawn when the private sector was only partially in condition to take the witness. But to me it is just a question of degree and of timing in reversing a fiscal policy stance that overall had been effective.
I had made the same point back in 2013. Here is, updated from that post, the correlation between public and private expenditure:

Correlation Between Public and Private Expenditure
2008-2009 2010-2012 2013-2015
EMU -0.96 0.73 0.99
USA -0.82 -0.96 -0.04

Remember, a positive correlation means that fiscal policy moves together with private expenditure, and fails to act countercyclically. The table tells us that public expenditure in the US was withdrawn only when private expenditure could take the witness, and never was procylclical (it turned neutral in the past 2 years). Europe is a whole different story. Fiscal contraction began when the private sector was not ready to take the witness; the withdrawal of public demand therefore led to a plunge in economic activity and to the double dip recession that the US did not experience. Here is the figure from the same post, also updated:
To sum up: the fiscal stance in the US was appropriate, even if it changed a bit too hastily in 2011. In Europe, it was harmful since 2010.

And monetary policy in all this? It did not help in Europe. I join Krugman in believing that once the economy was comfortably installed in the liquidity trap Mario Draghi’s activism while necessary was (and is)  far from sufficient. Being more timely, the Fed played an important role with its aggressive monetary policy, that started precisely in 2012. It supported the expansion of private demand, and minimized the risk of a reversal when the withdrawal of fiscal policy begun. But in both cases I am unsure that monetary policy could have made a difference without fiscal policy. Let’s not forget that a first round of aggressive monetary easing in 2007-2008 had been successful in keeping the financial sector afloat, but not in avoiding the recession. This is why in 2009 most economies launched robust fiscal stimulus plans. I see no reason to believe that, in 2010-2012, more appropriate and timely ECB action would have made a big difference. The problem is fiscal, fiscal, fiscal.

Convergence no More

April 14, 2016 Leave a comment

As a complement to the latest post, here is a quite eloquent figure


I computed real GDP of the periphery (Spain-Ireland-Portugal-Greece) and of the core (Germany-Netherlands-Austria-Finland), and then I took the difference of yearly growth rates in three subperiods  that correspond to the run-up to the single currency, to the euro “normal times”, and to the crisis.

Let’s focus on the red bar: until 2008 the periphery on average grew more than 1% faster than the core, a difference that was even larger during the debt (private and public) frenzy of the years 2000. Was that a problem? No. Convergence, or catch-up, is a standard feature of growth. Usually (but remember, exceptions are the rule in economics), poorer economies tend to grow faster because there are more opportunities for high productivity growth. So it is not inconceivable that growth in the periphery was consistently higher than in the core especially in a phase of increasing trade and financial integration;

We all know (now; and some knew even then) that this was unhealthy because imbalances were building up, which eventually led to the crisis. But it is important to realize that the problem were the imbalances, not necessarily faster growth. In fact, if we look at the yellow bar depicting the difference in potential growth, it shows the same pattern (I know, the concept of potential growth is unreliable. But hey, if it underlies fiscal rules, I have the right to graph it, right?).

During the crisis the periphery suffered more than the core, and its potential output grew less fell more. This is magnified by the mechanic effect of current growth that “pulls” potential output. But it is undeniable that the productive capacity of the periphery (capital, skills) has been dented by the crisis, much more so than in the core. Thus, not only we are collectively more fragile, as I noted last Monday;on top of that, the next shock will hurt the periphery more than the core, further deepening the divide.

The EMU in its current design lacks mechanisms capable of neutralizing pressure towards divergence. It was believed when the Maastricht Treaty was signed that markets alone would ensure convergence. It turns out (unsurprisingly, if you ask me) that markets not only did not ensure convergence. But they were actually a powerful force of divergence, first contributing to the buildup of imbalances, then by fleeing the periphery when trouble started.

Markets do not act as shock absorbers. It is as simple as that, really.