It’s Politics, Stupid

I quickly want to come back to the issue of fiscal rules and of the Commission’s proposal for reforming the Stability and Growth Pact. In my previous post I discussed how the proposal does not do enough for public investment. Yet, this is not what most commentators have been focusing on.

The proposal foresees an important role for the Commission. First, it goes without saying, it is central in the sanctioning process, the Excessive Deficit Procedure, that is mostly the same as in today’s framework. But on two crucial aspects of the reformed Pact, if it had to see the light, the Commission acquires new competencies (and the power that goes with them).

The first is in setting the stage for the countries’ debt reduction plans. The Commission is in fact supposed to define the scenarios with which debt sustainability risks are determined, using a tool developed in recent years by the World Bank and IMF, the Dynamic Debt Analysis, or DSA). The tool is well tested but, as it is obvious, the different scenarios heavily depend on the parameters (growth, interest rates, etc) that are fed to it. The second expanded role that the Commission has is in negotiating with the governments the country-specific debt reduction paths and expenditure targets.

This centrality of the Commission, however, has been almost unanimously criticised. Opponents of austerity fear that discretion will allow draconian  policies to be imposed, thus reviving the austerity catastrophic experiment of the 2010s. At the other side of the spectrum, the fiscal hawks of the so-called “frugal” countries do not trust the Commission in its role of watchdog of public finances, and have criticized it several times for being too permissive with the “Club-Med” countries. They are therefore afraid that too timid debt-reduction paths will be agreed with profligate governments of the South.

Here is an unpopular opinion: both teams are right, and it is very good this way. As far as I am concerned, I always believed that the fiscal policy of deeply integrated countries should never be a technocratic endeavor but, on the contrary, be the result of a political process of coordination, in which more or less hawkish outcomes stem from bargaining between different positions, economic and political contingencies and, last but not least, compromises between the needs of individual countries and the attainment of common goals. No rule can deliver this. In 2002, the then President of the Commission Romano Prodi was violently attacked when he defined the Stability Pact “stupid, like all decisions which are rigid.” But in fact he was perfectly right, and as we finally manage to abandon the flawed view that all countries should implement the same policies (one-size-fits-all), then no rule can be put in place unless it leaves space (a lot of it!) to discretion, negotiation, case-by-case assessments.

In short, how much and how to use fiscal policy must emerge from the capacity of governments and policy makers to persuade their partners of the pertinence of their policy stance. Those opposing excessive fiscal discipline should reach their goals by winning the hearts and minds of those favoring it (and vice-versa), not by pushing  for mechanical (“stupid”) rules that embed their views. As a side note, we already have, in the European framework, a seat for discretionary assessments and choices. The European Semester was created for coordinating and monitoring fiscal policies, to then quickly become, in the austerity frenzy of the time, just a tool for the latter. It would be time to go back to the letter of the Law and finally make the European Semester the place for dialogue and coordination among member states and the Commission.

There should not be a discussion on whether fiscal policy in European countries should be determined leaving space to discretion. The discussion should be about who should have the discretionary power. Some argue for example that an almighty Commission might create an imbalance in the delicate tripartite decision structure of the EU, and that it would be better to give a role (for example in debt sustainability assessments) to a reformed European Fiscal Board. There are pros and cons of such a strategy, but that is the discussion that we must have.

Whatever your views on the desirability and on the extent of fiscal policy in managing the European economies, blaming the Commission proposal because it leaves too much space to discretion does not make any sense. Fiscal policy is politics, stupid.

Advertisement

A Plea for a European Public Investment Agency

The European Commission has introduced a legislative proposal for the reform of European fiscal rules with the aim to have the new rules approved by member states and the European Parliament by the end of the year, and to be in force by 2024. If this timeline is not met, the old Stability and (lack of) Growth Pact (SGP), adopted in 1997 and discredited during the sovereign debt crisis, will be reintroduced.

The Stability Pact, together with the  Fiscal Compact hastily adopted in 2012 in the belief (oh, how erroneous! ) that it was necessary to impose austerity in order to get out of the sovereign debt crisis, impose annual targets in terms of structural (i.e. cyclically-adjusted) deficit to ensure that public debt falls steadily towards the level of 60% set by the Maastricht Treaty (a level that is totally arbitrary, incidentally).  From the outset, many of us criticised the Stability Pact, because the emphasis on annual targets pushes countries to adopt pro-cyclical policies: in the event of a crisis  and a fall in GDP, to stay on the path of debt reduction, fiscal restraint is needed; this has nevertheless a negative impact on growth, triggering a vicious circle. Moreover, the Pact imposes the same objectives on everyone (one size fits all is used). Last but not least, the current rule does not distinguish between current expenditure and investment spending, ending up penalizing the latter which, politically, is less problematic to cut.

To address these issues, the European Commission reform proposal replaces annual targets with multi-year debt reduction programs agreed upon by member countries and the Commission. Although very imperfect, the proposal represents a very clear improvement on the existing rule, on two grounds..

1. The annual numerical targets are replaced by multi-annual (4-year) debt reduction programs. The adoption of a medium-term perspective, is the only reasonable one when it comes to the sustainability of public finances. It is good that we have finally realised the absurdity of annual targets
2. Debt-reduction plans are formulated (in terms of expenditure targets) by member countries in agreement with the Commission, on the basis of scenarios for the evolution of public finances. High-debt countries obviously need to make greater efforts, especially if the most likely scenarios are high interest rates and low growth, and therefore more risks to future sustainability. Abandoning the one-size-fits-all and top-down approach is important for democratic legitimacy and credibility of implementation.

Against these very significant improvements, the amended rule would remain seriously problematic for two reasons. The first is that overall the focus is still on debt reduction. Too much Stability and not enough growth, like with the old SGP, at the risk of obtaining neither (ever heard of self-defeating austerity?) This is even trues since, to accommodate strong German pressures the Commission has introduced safeguards to ensure that debt remains strongly anchored to a downward path. This excessive weight on debt reduction might be tempered by the increased politicization of the process, a feature of the Commission proposal that has been criticized but that on the contrary I find quite appealing. I will come back to that in a future post.

The second reason why the Commission proposal (a significant improvement, let me state it again) falls short of my expectations is the lack of specific provisions for protecting public investment. The only concession that is made is that “Member States will benefit from a more gradual fiscal adjustment path if they commit in their plans to a set of reforms and investment that comply with specific and transparent criteria”. This is what I would like to address in this post.

With my colleagues Floriana Cerniglia (Catholic University Milano) and Andy Watt (IMK Berlin), we have been editors for some years of a series of yearly European Public Investment Outlook involving dozens of European researchers. Volume after volume, the message that comes out of this series is that in OECD countries public investment has been sacrificed on the altar of fiscal discipline since the 1980s. In Europe the downward trend is particularly marked and  has further accelerated with the austerity programs of the 2010s. The result is a chronic shortage of public capital, both tangible and intangible (social capital) which today seriously limits the growth potantial of all European countries, even those that are apparently healthier. As an example, the German colleagues who worked on the chapters on Germany estimated the  amount needed over the next decade to fill the German infrastructure gap at around 45 billion per year, not to mention the additional investment needs made necessary by an aging population and by the ecological and digital transition. Italy is no exception: Cerniglia and her co-authors report  an estimate by which between 2008 and 2018 about 200 billion were lost along the way compared to the scenario in which public investment had continued at the (not excellent) previous rates. This figure is sobering: the entire allocation of the Italian NRRP (191 billion), which should project us into the ecological and digital transition, will not even be able to bridge the gap that has opened up in the last ten years.

Looking ahead, the numbers get even more impressive. The Commission has estimated that the  European Union would need €520 billion in additional investment each year to meet the Green Deal’s 55% emissions cut target before the end of the decade.  Although the Commission believes that a significant part of this investment should come from the private sector, the figure gives a measure of the colossal effort that lies before us.

A team from the New Economics Foundation (NEF), took the figure given by the Commission as a basis for simulations in which it also considered the needs related to social investment (education, health, etc.) and the digital transition. These simulations lead, in a report also published last week, to conclude that only nine European countries would have the fiscal space to implement such large investment programs, were they to respect the existing rule or even the one amended by the Commission proposal. Italy is obviously not one of them, but neither are France nor Germany. The assumption of the NEF report may be questioned, of course, but the overall picture they draw is quite clear, and highlights a  fundamental incompatibility between the huge investment needs of the coming years and a system of European rules that, even in the reformed version, remain too oriented towards debt reduction as a self standing objective. The intransigent position of the German government has even prompted a usually cautious and moderate economist like Olivier Blanchard, former chief economist of the IMF, to ask rhetorically  whether it is preferable to preserve the earth with a slightly higher debt or to go towards climate catastrophe with  sound public finances

Many, including myself have for years called for a reform of European rules that would allow governments to invest outside the constraints of the budget. Such a “golden rule” would make it possible to finance the ecological transition while preserving the stability of public finances. In the past year it has at times seemed that such a proposal might have a chance of being discussed. Today the mood has changed. We should consider ourselves lucky if the Commission’s proposal is not twisted in an even more restrictive way by the negotiations with the Member States. In the coming years, therefore, it will be necessary to accept a continued state of chronically insufficient national public investment.

What to do then?  If we do not want to fail in the objective of ecological transition, there  is only  one way: to work on the quick creation of a European Investment Agency able not only to finance national governments’ investment (as in the proposal for a Sovereign Fund for Industrial Policy, buried in the Brussels’ mist); but also to design and implement genuinely European investment projects. The governance of such an Agency should be designed very carefully: fiscal policy has an inherently political dimension that requires accountability in front of voters.  In our non federal system this accountability lies with national governments, which should therefore be involved in European public investment choices. Some form of control by the Parliament and the Council in determining (or at least validating) investment projects would certainly make the work of the European Investment Agency more cumbersome. But this seems inevitable to ensure the democratic legitimacy of spending programmes (and their financing) at the European level.

Draghi the Fiscal Hawk

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?

Sand Fiscal Foundations

Simon Wren-Lewis has an interesting piece on structural deficits. He has issues with Pisani-Ferry’s plea for more stable  structural deficit targets for EU countries. While Pisani-Ferry has a point in invoking more certainty for EU government action, Wren-Lewis argues, rightly so, that stable targets risk creating straitjackets for countries, and that the problem is mostly in the excessively short time horizon of structural deficit targets.

The fact that both Pisani and Wren-Lewis have a point highlights what is in my opinion a structural flaw of EU fiscal governance, namely its reliance on the slippery concept of structural government deficit.

To explain this simply, the idea underlying structural deficit targets is that  not all deficit were created equal. if the government runs a deficit because of adverse cyclical conditions (low growth yields lower tax revenues and larger welfare payements), this deficit is “healthy” because it supports economic activity, and bound to disappear when the economy recovers. As such, governments should not be required to target cyclical deficit, but only  the structural (or cyclically adjusted) deficit, which is precisely the deficit “cleaned” of its cyclical component.

The EU fiscal rule, the Stability Pact and its hardened Fiscal Compact extension, recognizes this distinction, and imposes that governments balance their budget over the cycle, which is yet another definition of structural deficit. This may seem a sensible approach, recognizing, as I just said, that not all deficits were created equal. But in fact sensible it is not.

The problem lies precisely in the word “cleaned” I used above . How do we clean headline deficit from its cyclical component, to compute the structural deficit that should be targeted by governments? This is how we should do it: We compute “potential output”, i.e. the capacity of production of the economy. From that we can obtain the output gap, i.e. the distance of actual output from its potential level; finally, by applying an estimate of how the deficit responds to the output gap, we can clean headline deficit from its cyclical component. Simple, right? Yes, in theory. In practice, we have no way to do it in a sufficiently precise way.

Just consider what the Commission itself states in the page dedicated to its own methodology for measuring potential output. (Their most recent methodological paper can be found here).

Any meaningful analysis of cyclical developments, of medium term growth prospects or of the stance of fiscal and monetary policies are all predicated on either an implicit or explicit assumption concerning the rate of potential output growth. Given the importance of the concept, the measurement of potential output is the subject of contentious and sustained research interest.

All the available methods have “pros” and “cons” and none can unequivocally be declared better than the alternatives in all cases. Thus, what matters is to have a method adapted to the problem under analysis, with well defined limits and, in international comparisons, one that deals identically with all countries. (emphasis is mine)

There is nothing wrong with recognizing that potential output estimates are “contentious”. Contrary to what some Talebans persist to argue, economics is a social science, subject to all the uncertainties, mismeasurements, and ambiguities that are inherently linked to human and social interactions.

Where we have a problem is in using a contentious concept as the foundation for rules in which a zeropointsomething deviation from the target may lead to sanctions and public disapproval by the EU community, with all the potential financial market disruptions associated with it.

This makes the rule non credible, because the contentious estimate may be questioned. More importantly, it leads to what Wren-Lewis fears: countries imposing harsh sacrifices to their people that may turn out to be unwarranted when the estimate is revised.

I am not clear about what fiscal rule we should have in the EU. I actually am not even convinced that we really would need one. What is certain is that two necessary conditions for any rule to be effective, credible, and reasonable are that it is not short -termist (I rejoin Wren-Lewis), and that it is based on indicators that are quantitatively as precise as possible.

The current rule fails on both ground (and don’t get me started on how crazily complicated and arbitrary it grew over time). EU fiscal governance remains founded on sand. And of course, a serious debate on its reform is nowhere to be seen in European policy circles.

Europe Needs a Real Industrial Policy

The Juncker Commission is now up and running, and it is beginning to give an idea of where it wants to go. Unfortunately not far enough. The two defining moments of the first few months are the Juncker plan, and the new guidelines on flexibility in applying the Stability and Growth Pact. Both focus on public investment.

Public investment deficiency is now chronic across the OECD, and particularly in the EU. Less visible and politically sensible than current expenditure, for twenty years it has been the adjustment variable for European governments seeking to meet the Maastricht criteria, and to control their deficit. Since the crisis hit, private investment also collapsed, and it is still kept well below its long term trend by depressed demand and negative expectations.

Let’s start from the most recent Commission measure. The guidelines issued last weeks, that some countries trumpeted as a great victory against austerity, are in fact just a marginal change. The Commission only conceded that the structural effort towards the 60% debt-to-GDP ratio be relaxed for countries growing below potential, while reaffirming that in no circumstance, the 3% deficit limit should be breached, and that any extra investment needs to be compensated by expenditure reduction in the medium term¹.

The Juncker plan foresees the creation of an Investment Fund endowed with €21bn from the European budget and from the European Investment Bank. This is meant to lever conspicuous private funds (in a ratio of 15 to 1) to attain €315bn, mobilized in three years. EU countries may chip into the Fund, but this is not compulsory, and the incentives to contribute are unclear: while the contribution to the fund would not be accounted as deficit (the guidelines confirm it), the allocation of investment will not be proportional to countries’ contributions.

Two aspects of the plan raise issues. First, it is hard to see how it will be possible for the newly established fund to raise the announced amount. The expected leverage ratio is very ambitious (some have described the plan as a huge subprime scheme). Second, even assuming that the plan could create a positive dynamics and mobilize private resources to the announced 315 billions, this amounts to just over 2% of GDP for the next three years (approximately 0.7% annually). In comparison, Barack Obama’s American Recovery and Reinvestment Act of 2009 amounted to more than 800 US$ billions. The US mobilized more than twice as much as the Juncker plan, in fresh money, and right at the beginning of the crisis.

To sum up, the plan and the guidelines are welcome in that they put investment back to the centre of the stage. But, as is the norm with Europe, they are too little, far too little, to put the continent back on track, and to reverse the investment trend of the last three decades.

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 is necessary. That will not happen, however, for the fierce opposition of Germany and other northern countries to any hypothesis of debt mutualisation.

The solution must therefore be found at national level, without losing the need for European-wide coordination, that would guarantee effective and fiscally sustainable investment programs. With Kemal Dervis I recently proposed that the EU adopt a golden rule, similar in spirit to the one implemented in the United Kingdom between 1998 and 2009. The rule requires government current expenditure to be financed from current revenues, while public debt may be used to finance capital accumulation. Investment expenditure, in other words, could be excluded from deficit calculation, without any limit. Such a rule would stabilize the ratio of debt to GDP, and would ensure intergenerational equity (future generations would be called to partially finance the stock of public capital bequeathed to them). Last, but especially in the current situation not least, putting in place such a rule would not require treaty changes, but just an unanimous Council deliberation.

But there’s more in our proposal. The golden rule is not a new idea, and in the past it has been criticized on the ground that it introduces a bias in favor of physical capital; expenditure that – while classified as current – is crucial for future growth (in many countries spending for education would be more growth enhancing than building new highways) would be penalized by the golden rule. This criticism, however, can be turned around and transformed into a strength. At regular intervals, for example every seven years, 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. Joint programs between neighboring countries could be encouraged by providing European Investment Bank co-financing. What Dervis and I propose is in fact returning to industrial policy, through a political and democratic determination of the EU long-term objectives. The entrepreneurial State, through public investment, would once again become the centerpiece of a large-scale European industrial policy, capable of implementing physical as well as intangible investment in selected strategic areas. Waiting for a real federal budget, the bulk of investment would remain responsibility of national governments, in deference to the principle of subsidiarity. But the modified golden rule would coordinate and guide it towards the development and the well-being of the Union as a whole.

Ps an earlier and shorter version of this piece was published in Italian on December 31st in the daily Il Sole 24 Ore.

^1. Specifically, the provisions are the following:

Member States in the preventive arm of the Pact can deviate temporarily from their medium-term budget objective or from the agreed fiscal adjustment path towards it, in order to accommodate investment, under the following conditions:

1. Their GDP growth is negative or GDP remains well below its potential (resulting in an output gap greater than minus 1.5% of GDP);
2. The deviation does not lead to non-respect of the 3% deficit reference value and an appropriate safety margin is preserved;
3. Investment levels are effectively increased as a result;
4. Eligible investments are national expenditures on projects co-funded by the EU under the Structural and Cohesion policy (including projects co-funded under the Youth Employment Initiative), Trans-European Networks and the Connecting Europe Facility, as well as co-financing of projects also co-financed by the EFSI.
5. The deviation is compensated within the timeframe of the Member State’s Stability or Convergence Programme (Member States’ medium-term fiscal plans).

↩

 

Of the EU Budget and Fiscal Rules

Last Friday the negotiations on the 2014-2020 EU budget were put on hold because of  fundamental disagreements among Member States. Surprise, Surprise… I do not think it is a big deal anyway. There is not doubt that at the next meeting a last-minute- low-key compromise will materialize. A compromise that will most likely save the most controversial items of the EU budget, like agricultural policy, and  cut the very few investment programs that had made it into the budget in the past. But who cares, after all; our leaders will be able to show the usual self complacency, and the rest of us will be left with the all-too familiar sentiment of yet another missed opportunity.

Most commentators blamed David Cameron, but his position was not new, and hardly surprising. The UK has always tried to extract as much as it could from the European process, while giving as little as possible; others did it, are doing it, and will do it. But rarely with the consistency and the single-mindedness of the UK. This was true with EFTA in the 1960s, then again with the infamous UK rebate negotiated by Margaret Thatcher in 1984. If England never played for the common good in the past, how could we expect it to do so at a times of crisis?

No, the real surprise of the failed budget negotiation was not England, but Germany, and the coalition of the fiscal hawks.

The Fiscal Compact puts Europe on the Wrong Track

Today the Irish  people will vote on the Treaty “on the Stability, Coordination and Governance in the EMU”, also known as the “fiscal compact”. This referendum is of paramount importance for the whole European Union.  I recently wrote an editorial on the French daily Le Monde, together with Imola Streho, explaining why we believe it to be poorly designed and economically ill conceived. Here is an English version.

Wait and See

In a moment of chaos, in which it is very difficult to even simply make sense of actual events, it becomes almost impossible to formulate forecasts. I would not be able to bet on grexit (or porxit, spaxit, itaxit, for that matter), in one sense or in another. I just wait and see.

A few things seem to be changing the broad picture, with a mix of encouraging elements, and added uncertainty.

Fact number one: The new French president is acting as a catalyst for those who are unhappy about German-imposed austerity. Yesterday’s informal council meeting, disappointing as usual, shows that Hollande has the strength to at least impose the discussion of his themes to reluctant Germans (for example the eurobonds). But it remains to be seen whether him and his newly found supporters will be able to force implementation of the measures they advocate for.

European Suicide

Not that he needs it, but I feel I must advertise this New York Times editorial by Paul Krugman, on the looming European catastrophe. As usual, it is masterly written. I just want to add one remark: The economic suicide of Europe happens because of ideological blindness. We are trapped in a doctrinal approach to economics and economic policy. There is nothing you can do against fundamentalism.

Should the title of this blog change from Gloomy to Desperate?

Rebalancing and Small Europe

Martin Wolf has a very interesting piece on China’s attempt to rebalance its growth model from exports to domestic demand. Wolf remarkably shows how this attempt has been going on for at least a decade, with unequal pace, and several stop-and-go. I’d add that the crisis itself played a contradictory role. China on one side was one of the first countries in 2009 to implement a robust stimulus plan amounting to more than 10% of GDP; on the other, it did not resist  (as most countries) more or less hidden protectionist measures and currency manipulation. Wolf concludes that, while successful, the rebalancing from external to domestic demand led to excessive (and not necessarily productive) investment. The new rebalancing challenge of China lies in increasing income and consumption of its population.

What I take from this is that China fully grasps its new role in the world economy. Its leadership understood long ago that  the transition from  developing/emerging economy to fully developed economy needed to pass among other things through less dependence on exports. A large dynamic economy  cannot rely on growth in the rest of the world for its prosperity. Even the debate on reforming the welfare state and on health care had as one of his reasons the necessity to reduce precautionary savings. The rebalancing act is long and unsteady, but definitively under way.

It is also worth noticing that a better balance between domestic and external demand in the large economies is crucial element in reducing the macroeconomic fragility of the world economy through decreasing trade imbalances.

It is striking, in contrast, how Europe remains trapped in a sort of small country syndrome. The “Berlin View” permeating the Fiscal Compact  advocates fiscal discipline and domestic demand  compression, in order to improve competitiveness and to foster export-led growth. Besides the fact that it is not working, this is equivalent to tying Europe’s fate to the performance of the rest of the world, giving up the ambition of being a major player in the world economic arena. What a difference with the ambition and the forward looking attitude of China…