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%↩.
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.
The newly born Italian magazine Pagina99 published a piece I wrote on rebalancing in Europe after the German elections. Here is an English version.
The preliminary estimates for 2013 released by the German Federal Statistical Office, depict a mixed picture. Timid signs of revival in domestic demand do not seem able to compensate for the slowdown in exports to other countries in the euro zone, still mired in weak or negative growth rates. The German economy does not seem able to ignore the economic health of its European partners. In spite of fierce resistance of Germany policymakers, there is increasing consensus that the key to a durable exit from the Eurozone crisis can only be found in restoring symmetry in the adjustment following the crisis. The reduction of expenditure and deficits in the Eurozone periphery, that is currently happening, needs to be matched by an increase of expenditure and imports by the core, in particular by the Netherlands and Germany (Finland and Austria have actually drastically reduced their trade surpluses). In light of the coalition agreement signed by the CDU and the SPD, it seems unlikely that major institutional innovation will happen in the Eurozone, or that private demand in Germany will increase sufficiently fast to have an impact on imbalances at the aggregate level. This leaves little alternative to an old-fashioned fiscal expansion in Germany.
The Eurozone reaction to the sovereign debt crisis, so far, has focused on enhancing discipline and fiscal restraint. Germany, the largest economy of the zone, and its largest creditor, was pivotal in shaping this approach to the crisis. The SPD, substantially shared the CDU-Liberal coalition view that the crisis was caused by fiscal profligacy of peripheral member countries, and that little if any risk sharing should be put in place (be it a properly functioning banking union, or some form of debt mutualisation). The SPD also seems to support Mrs Merkel’s strategy of discretely looking elsewhere when the ECB is forced to stretch its mandate to respond to exceptional challenges, while refusing all discussion on introducing the reform of the bank statute in a wider debate on Eurozone governance. This consensus explains why European matters take relatively little space in the 185 pages coalition agreement.
This does not mean that the CDU-SPD government will have no impact on Eurozone rebalancing. The most notable element of the coalition agreement is the introduction of a minimum wage that should at least partially attenuate the increasing dualism of the German labour market. This should in turn lead, together with the reduction of retirement age to 63 years, to an increase of consumption. The problem is that these measures will be phased-in slowly enough for their macroeconomic impact to be diluted and delayed.
Together with European governance, the other missing character in the coalition agreement is investment; this is surprising because the negative impact of the currently sluggish investment rates on the future growth potential of the German economy is acknowledged by both parties; yet, the negotiations did not include direct incentives to investment spending. The introduction of the minimum wage, on the other hand, is likely to have conflicting effects. On the one hand, by reducing margins, it will have a negative impact on investment spending. But on the other, making labour more expensive, it could induce a substitution of capital for labour, thus boosting investment. Which of these two effects will prevail is today hard to predict. But it is safe to say that changes in investment are not likely to be massive.
To summarize, the coalition agreement will have a small and delayed impact on private expenditure in Germany. Similarly, the substantial consensus on current European policies, leaves virtually no margin for the implementation of rebalancing mechanisms within the Eurozone governance structure.
Thus, there seems to be little hope that symmetry in Eurozone rebalancing is restored, unless the only remaining tool available for domestic demand expansion, fiscal policy, is used. The German government should embark on a vast fiscal expansion program, focusing on investment in physical and intangible capital alike. There is room for action. Public investment has been the prime victim of the recent fiscal restraint, and Germany has embarked in a huge energetic transition program that could be accelerated with beneficial effects on aggregate demand in the short run, and on potential GDP in the long run. Finally, Germany’s public finances are in excellent health, and yields are at an all-times low, making any public investment program short of pure waste profitable. Besides stubbornness and ideology, what retains Mrs Merkel?
Well, not him, actually (I wish I could); I need to content myself with his latest post on austerity. Krugman argues that austerity is happening (it is trivial, but he needs repeating over and over again), showing that in the US expenditure as a share of potential GDP is back to its pre-crisis level (while unemployment remains too high, and growth stagnates).
I replicated his figure including some European countries, and with slightly different data. I took OECD series on cyclically adjusted public expenditure, net of interest payment. This is commonly taken as a rough measure of discretionary government expenditure. I also re-based it to 2008, as most stimulus plans were voted and implemented in 2009. Here is what it gives: Read more