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Posts Tagged ‘Fiscal Policy’

The Blanchard Touch

April 15, 2015 9 comments

Yesterday I commented on the intriguing box in which the IMF staff challenges one of the tenets of the Washington consensus, the link between labour market reform and economic performance.
But the IMF is not new to these reassessments. In fact over the past three years research coming from the fund has increasingly challenged the orthodoxy that still shapes European policy making:

  1. First, there was the widely discussed mea culpa in the October 2012 World Economic Outlook, when the IMF staff basically disavowed their own previous estimates of the size of multipliers, and in doing so they certified that austerity could not, and would not work (of course this led EU leaders to immediately rush to do more of the same).
  2. Then, the Fund tackled the issue of income inequality, and broke another taboo, i.e. the dichotomy  between  fairness and efficiency. Turns out that unequal societies tend to perform less well, and IMF staff research reached the same conclusion. And once the gates opened, it did not stop. The paper by Berg and Ostry was widely read. Then we had Ball et al on the distributional effects of fiscal consolidation (surprise, it increases inequality). Another paper investigated the channels for this link, highlighting how consolidation leads to increased inequality mostly via unemployment. And just last week I assisted to a presentation by IMF economists showing how austerity and inequality are positively related with political instability.
  3. On labour markets, before yesterday’s box 3.5, the Fund had disseminated research linking increased inequality with the decline in unionization.
  4. Then, of course, the “public Investment is a free lunch” chapter three of the World Economic Outlook, in the fall 2014.
  5. In between, they demolished another building block of the Washington Consensus: free capital movements may sometimes be destabilizing…

These results are not surprising per se. All of these issues are highly controversial, so it is obvious that research does not find unequivocal support for a particular view. All the more so if that view, like the Washington Consensus, is pretty much an ideological construction. Yet, the fact that research coming from the center of the empire acknowledges that the world is complex, and interactions among agents goes well beyond the working of efficient markets, is in my opinion quite something.

What does this mass (yes, now it can be called a mass) of work tells us? Three things, I would say. First, fiscal policy is back. it really is. The Washington Consensus does not exist anymore, at least in Washington. Be it because the multipliers are large, or because it has an impact on income distribution (and on economic efficiency); or again because public investment boosts growth, fiscal policy has a role to play both in dampening business cycle fluctuations and in facilitating stable and balanced long term growth. The fact that a large institution like the IMF has lent its support to this revival of consideration for fiscal policy, makes me hope that discussions about macroeconomic policy will be less ideological, even once the crisis will have passed.

The second thing I learn is that the IMF research department proves to be populated of true researchers, who continuously challenge and test their own views, and are not afraid of u-turns if their own research dictates them. I am sure it has always been the case. What is different from the past is that now they have a chief economist who seems more interested in understanding where the world goes than in preaching a doctrine.

The third remark is more problematic. If I write a paper saying that austerity will not be costly because multipliers are 0.5, and 2 years later retract my previous statement and argue that austerity is in fact self defeating, the impact on the world is zero. If the IMF does the same, during the two years huge suffering will be needlessly inflicted to masses of people. This poses a problem, as research by definition may be falsified. In the past an institution like the IMF would never have admitted a mistake. And we certainly do not want to go back there. Today they do admit the mistakes, but the suffering remains. The only way out to this problem is that the “new” IMF should learn to be cautious in its policy prescriptions, and always remember that any policy recommendation is bound to be sooner or later proven inappropriate by new data and research. We don’t live in a black and white world. Adopting a more prudent stance in dictating policies  would be wise (in Brussels as well, it goes without saying). And of course, the disconnect between the army and the general is also a problem.

Sand Fiscal Foundations

April 11, 2015 6 comments

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.

Raise Fed Rates Now?

March 23, 2015 4 comments

A quick note on the US and the Fed. Pressure for rate rises never really stopped, but lately it has intensified. Today I read on the FT that James Bullard, Saint Louis Fed head, urges Janet Yellen to raise rates as soon as possible, to avoid “devastating asset bubbles”. Just a few months ago we learned that QE was dangerous because, once again through asset price inflation, it led to increasing inequality. Not to mention the inflationistas (thanks PK for the great name!) who since 2009 have been predicting Weimar-type inflation because of irresponsible Fed behaviour (a very similar pattern can be found in the EMU). Let’s play the game, for the sake of argument. After all, asset price inflation, and distortions in general are not unlikely in the current environment. So let’s assume that the Fed suddenly were convinced by its critics, and turned its policy stance to restrictive (hopefully this is just a thought experiment). I have two related questions to rate-raisers (the same two questions apply to QE opponents in the EMU):

  1. Do they think that private expenditure is healthy enough to grow and to sustain economic activity without the oxygen tent of monetary policy?
  2. If not, would they be willing to accept that monetary restriction is accompanied by a fiscal expansion?

I am afraid we all know the answer, at least to the second of these questions. Just yesterday, on Italian daily Il Corriere della Sera, Alberto Alesina and Francesco Giavazzi called for public expenditure cuts, invoking the confidence fairy and expansionary austerity (yes, you have read well. Check for yourself if you understand Italian. And check the date, it is 2015, not 2007) What Fed (and ECB) bashers tend to forget, in conclusion, is that central bankers are at the center of the stage, reluctantly, because they have to fill the void left, for different reasons, by fiscal policy.  Look at the fiscal stance for the US: 2015_03_Fiscal_Impulse_1 Fiscal impulse, the discretionary stance of the US government, was positive only in 2008-2009, and has been restrictive since then. In other words, while the US were experiencing the worse crisis since the 1930s, while recovery was sluggish and jobless, the US government was pushing the brake. We all know why: political blockage and systematic boycott, by one side of Congress, of each and every one of the measures proposed by the administration (that was a bit too timid, if I may say so). Whatever the reasons, the fact remains that fiscal policy was of very limited help during the crisis. What do Fed bashers have to say about this? What would have happened if, faced with procyclical fiscal policy, the Fed had not stepped in with QE? I am afraid their answer would once again turn around confidence fairies… The EMU is pretty much in the same situation. The following figure shows the cumulative fiscal impulse since 2008 for a number of countries: 2015_03_Fiscal_Impulse_2   The figure speaks for itself. With the exception of Japan (thanks Abenomics!) governments overall acted as brakes for the economy (Alesina and Giavazzi should look at the data for Italy, by the way). Central banks had to act in the thunderous silence of fiscal policy. So I repeat my question once again: who would be willing to exchange a normalization of monetary policy with a radical change in the fiscal stance? To conclude, yes, monetary policy has been very proactive (even Mario Draghi’s ECB); yes, this led us in unchartered lands, and we do not fully grasp what will be the long term effects of QEs and unconventional monetary policies; yes, some distortions are potentially dangerous.  But central bankers had no choice. We are in a liquidity trap, and the main tool to be used should be fiscal policy. Monetary policy could and should be normalized, if only fiscal policy would finally take the witness, and the burden to lift the economy out of its woes; if fiscal policy finally tackled the increasing inequality that is choking the economy. If fiscal policy did its job, in other words.

I don’t know why, but I have the feeling that Janet Yellen and Mario Draghi would not completely disagree.

Confidence and the Bazooka

January 23, 2015 19 comments

It seems that we finally have our Bazooka. Quantitative Easing will be put in place; its size is slightly larger than expected (€60bn a month), and Mario Draghi, once again, seems to have gotten what he wanted in his confrontation with hawks within and outside the ECB (I won’t comment on risk sharing. I am far from clear about the consequences of that).

And yet, something is just not right. I am afraid that QE will end up like LTRO and all the other liquidity injections the ECB performed in the past.  What bothers me is not  the shape of the program (given the political constraints, one could hardly imagine something more radical), but Draghi’s press conference. Here is a quote from the introductory statement:

Monetary policy is focused on maintaining price stability over the medium term and its accommodative stance contributes to supporting economic activity. However, in order to increase investment activity, boost job creation and raise productivity growth, other policy areas need to contribute decisively. In particular, the determined implementation of product and labour market reforms as well as actions to improve the business environment for firms needs to gain momentum in several countries. It is crucial that structural reforms be implemented swiftly, credibly and effectively as this will not only increase the future sustainable growth of the euro area, but will also raise expectations of higher incomes and encourage firms to increase investment today and bring forward the economic recovery. Fiscal policies should support the economic recovery, while ensuring debt sustainability in compliance with the Stability and Growth Pact, which remains the anchor for confidence. All countries should use the available scope for a more growth-friendly composition of fiscal policies.

And here the answer to a question, even more explicit:

What monetary policy can do is to create the basis for growth, but for growth to pick up, you need investment. For investment you need confidence, and for confidence you need structural reforms. The ECB has taken a further, very expansionary measure today, but it’s now up to the governments to implement these structural reforms, and the more they do, the more effective will be our monetary policy. That’s absolutely essential, as well as the fiscal consolidation side. So structural reforms is one thing, budget and fiscal consolidation is a different issue. It’s very important to have in place a so-called growth-friendly fiscal consolidation for confidence strengthening. This combined with a monetary policy which is very expansionary, which has been and is even more so after our decisions today, is actually the optimal combination. But for this now, we need the actions by the governments, and we need the action also by the Commission, both in its overseeing role of fiscal policies and in its implementing the investment plan, which was launched by the President of the Commission, which was certainly welcome at the time, now has to be implemented with speed. Speed is of the essence.

The message could not be any clearer: Draghi expects the QE program to impact economic activity through private spending. What we have here is the nt-th comeback of the confidence fairy: accommodative monetary policy, structural reforms and fiscal consolidation, will cause a private expenditure surge (“[..] but will also raise expectations of higher incomes and encourage firms to increase investment today and bring forward the economic recovery“). We have been told this many times since 2010.

Unfortunately, it did not work like this, and I am afraid it will not this time either. The private sector signals in all surveys available that it is not ready to resume spending. If governments are not given the possibility to spend more, most of the liquidity injected into the system will remain idle, exactly as it was the case for the (T)LTRO.

The concept of countercyclical policies is so trivial as to become commonsensical: Governments should step in when markets step out, and withdraw when markets step in again. Filling the gap will actually sustain economic activity, and crowd-in private expenditure; more so, much more so, than filling the pockets of agents with money they are not willing to spend. This is the essence of Keynes. Since 2010 in Europe governments rushed to the exit together with markets; joint deleveraging meant depressed economy. How could one be surprised that confidence does not return?

I would like to add that invoking more active fiscal policy within the limits of the Treaties has the flavour of a bad joke.  Just so as we understand what we are talking about, the EMU 18 in 2014 had a deficit-to-GDP ratio of 2.6% (preliminary estimates by the Commission, Ameco database); this means that to remain within the Treaty a fiscal stimulus would have to be limited to 0.4% of GDP. How large would the multiplier have to be, for this to lift the eurozone economy out of deflation? Even the most ardent Keynesian would have a hard time claiming that!! And also, so as we don’t forget, at less than 95% of GDP EMU, Gross public debt can hardly be seen as an obstacle to a serious fiscal stimulus. Even in the short run.

The point I want to make is that QE is all very good, but European governments need to be put in condition to spend the money. It is tiring to repeat the same thing again and again: in a liquidity trap monetary policy can only be a companion to the main tool that could be used by policy makers: fiscal policy.

But in Europe, bad economic policy is today considered a virtue.

It’s the Institutions, Stupid!

January 21, 2015 6 comments

Tomorrow’s ECB decision on Quantitative Easing is awaited like a messiah (it would be interesting to see what happens if the ECB does not announce QE). We’ll see the shape this takes, but I already argued some time ago that excessive expectations on ECB action stem from the suicidal neglect of fiscal policy, the instrument of choice at times of liquidity traps. Mario Draghi and the ECB Governing Council are given an excessive burden by the inertia of governments trapped in ideology and/or in a crazy fiscal rule.

There will be time to assess the shape and the impact of tomorrow’s decisions. Here I want to focus on one aspect of all this that is not sufficiently emphasized. Even the bolder and more effective Quantitative Easing program would come unacceptably late. The ECB should have stepped in to sustain economic activity much earlier, at least in 2012, when its counterparts launched their own programs; or possibly earlier, given the Eurozone specific sovereign debt crisis. But it did not, mostly because it was politically impossible to take such a decision without the threat of deflation looming on the eurozone.

And I get to my point. I just saw a paper by Philippe Martin and  Thomas Philippon (here a VoxEU column presenting its main results) that tries to disentangle the impact of different shocks on the crisis, and runs a number of counterfactual experiments. Its conclusion are interesting and commonsensical. The first is that except for Greece, more prudent fiscal policies in the early 2000s would not have been effective in preventing or softening the private deleveraging shock that happened from 2008. Only if more prudent fiscal policies had been coupled with macroprudential policies (i.e., curbing private leverage in the first place), there would have been an impact on the crisis. The counterfactual I found more interesting is the one on the “Whatever it Takes” OMTs program. The authors ask whether  the OMT, if implemented in 2008 and not in late 2012, would have made a difference, and the answer is a clear yes. If through ECB insurance spreads had been kept low, peripheral countries would have had the fiscal space to counter the crisis, and unemployment would have been reabsorbed. Interestingly, the authors neglect the impact of the 3% limit on public deficits. Of course, had they introduced a fiscal rule limiting fiscal space, the impact of OMT would have been less glorious.

The way I see it (I am not sure the authors would have the same interpretation), Martin and Philippon show that the roots of EMU problems are institutional. If we had a normal central bank, capable of acting as a Lender of Last Resort, and of insuring the euro denominated debt; if we had normal governments, capable of using fiscal policy as a countercyclical tool, then… well, then we would be the US! The crisis would have hit hard because excessive leverage did not depend on macroeconomic governance, but policy could have been reactive and coordinated, thus leading to a recovery like the one we saw in the US (while I hear those who complain about policy and about the state of the economy in the US, it is undeniable that their economic performance is orders of magnitude better than our own!). Of course, the US also have a system of fiscal transfers that we can only dream of…

So our problem is that we don’t have normal institutions for macroeconomic governance. Macroeconomic policy in the EMU is the result of political skirmishes, and rests more on the diplomatic capacities of Mario Draghi Angela Merkerl, or Alexis Tsipras, than on a clear assessment of problems and solutions. Furthermore, this (mal)functioning yields last-minute decisions, only if under threat  (OMT because of speculation on periphery’s debt; QE because of deflation).

We are in the eight year of the crisis, and the trending topics among European elites are QE, and the Juncker plan. The former will likely be a byzantine compromise between Mario Draghi and the German government (as a side note: what about central bank independence, Mrs Merkel? Wasn’t that one of the things that you kept in such high consideration that you did not want it endangered by debt monetization?); the Juncker plan is simply an empty box. And they both come into the picture way too late, as the need for expansionary fiscal and monetary policies was clear at least since 2010.

The new European motto should be too little too late.

Europe Needs a Real Industrial Policy

January 19, 2015 7 comments

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).