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|
|Output Gap||Fiscal Impulse||Output Gap||Fiscal Impulse||Output Gap||Fiscal Impulse|
|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|
|Growth Gap to 3%||Fiscal Impulse||Growth Gap to 3%||Fiscal Impulse||Growth Gap to 3%||Fiscal Impulse|
|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%↩.
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?
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|
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.
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.
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.
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.