Austerity. The Past That Doesn’t Pass

[As usual lately, this is a slightly edited AI translation of a piece written for the Italian Daily Domani]

The European Commission recently revised downwards its forecasts for both growth and inflation, which continues to fall faster than expected. In contrast to the United States, there is no “soft landing” here. As argued by many, monetary tightening has not played a major role in bringing inflation under control (even as of today, price dynamics are mainly determined by energy and transportation costs). Instead, according to what the literature tells us on the subject, it is starting, 18 months after the beginning of the rate hike cycle, to bite on the cost of credit, therefore on consumption, investment and growth.

This slowdown in the economy is taking place in a different context from that of the pandemic. Back then, central bankers and finance ministers all agreed that business should be supported by any means, a fiscal “whatever it takes”. Today, the climate is very different, and public discourse is dominated by an obsession with reducing public debt, as evidenced by the recent positions taken by German Finance Minister Lindner and the disappointing reform of the Stability Pact. The risk for Europe of repeating the mistakes of the past, in particular the calamitous austerity season of 2010-2014, is therefore particularly high.

In this context, we can only look with concern at what is happening in France, where the government also announced a downward revision of the growth forecast for 2024, from 1.4% to 1%. At the same time, the Finance Minister Bruno Le Maire announced a cut in public spending of ten billion euros (about 0.4% of GDP), to maintain the previously announced deficit and debt targets. This choice is wicked for at least two reasons. The first is that it the government plans making the correction exclusively by cutting public expenditure, focusing in particular on “spending for the future”. €2 billion will be taken from the budget for the ecological transition, €1.1 billion for work and employment, €900 million for research and higher education, and so on. In short, it has been chosen, once again, not to increase taxes on the wealthier classes but to cut investment in future capital (tangible or intangible).

But regardless of the composition, the choice to pursue public finance objectives by reducing spending at a time when the economy slows, down goes against what economic theory teaches us; even more problematic, for a political class at the helm of a large economy, it goes against recent lessons from European history.

The ratio of public debt to GDP is usually taken an indicator (actually, a very imperfect one, but we can overlook this here) of the sustainability of public finances. When the denominator of the ration, GDP, falls or grows less than expected, it would seem at first glance logical to bring the ratio back to the desired value by reducing the debt that is in the numerator, i.e. by raising taxes or reducing government spending. But things are not so simple, because in fact the two variables, GDP and debt, are linked to each other. The reduction of government expenditure or the increase of taxes, and the ensuing reduction of the disposable income for households and businesses, will negatively affect aggregate demand for goods and services and therefore growth. Let’s leave aside here a rather outlandish theory, which nevertheless periodically re-emerges, according to which austerity could be “expansionary” if the reduction in public spending triggers the expectation of future reductions in the tax burden, thus pushing up private consumption and investment. The data do not support this fairy tale: guess what? Austerity turns out to be contractionary!

In short, a decline in the nominator, the debt, brings with it a decline in the denominator, GDP. Whether the ratio between the two decreases or increases, therefore, ends up depending on how much the former influences the latter, what economists call the multiplier. If austerity has a limited impact on growth, then debt reduction will be greater than GDP reduction and the ratio will shrink: albeit at the price of an economic slowdown, austerity can bring public finances back under control. The recovery plans imposed by the troika on the Eurozone countries in the early 2010s were based on this assumption and all international institutions projected a limited impact of austerity on growth. History has shown that this assumption was wrong and that the multiplier is very high, especially during a recession. A  public mea culpa from  the International Monetary Fund caused a sensation at the time (economists are not known for admitting mistakes!), explaining how a correct calculation gave multipliers up to four times higher than previously believed. In the name of discipline, fiscal policy in those years was pro-cyclical, holding back the economy when it should have pushed it forward. The many assistance packages conditioning the troika support to fiscal consolidation did not secure public finances; on the contrary, by plunging those countries into recession, they made them more fragile. Not only was austerity not expansive, but it was self-defeating. It is no coincidence that, in those years, speculative attacks against countries that adopted austerity multiplied and that, had it not been for the intervention of the ECB, with Draghi’s whatever it takes in 2012, Italy and Spain would have had to default and the euro would probably not have survived.

Since then, empirical work has multiplied, with very interesting results. For example, multipliers are higher for public investment (especially for green investment) and social expenditure has an important impact on long-term growth. And these are precisely the items of expenditure most cut by the French government in reaction to deteriorating economic conditions.

While President Roosevelt in 1937 prematurely sought to reduce the government deficit by plunging the American economy into recession, John Maynard Keynes famously stated that “the boom, not the recession, is the right time for austerity.” The eurozone crisis was a colossal and very painful (Greece has not yet recovered to 2008 GDP levels), a natural experiment that proved Keynes right.

Bruno Le Maire and the many standard-bearers of fiscal discipline can perhaps be forgiven for their ignorance of the academic literature on multipliers in good and bad times. Perhaps they can also be forgiven for their lack of knowledge of economic history and of the debates that inflamed the twentieth century. But the compulsion to repeat mistakes that only ten years ago triggered a financial crisis, and threatened to derail the single currency, is unforgivable even for a political class without culture and without memory.

Wolfgang Schäuble’s Ideas are Alive and Kicking

[As usual lately, this is an English AI translation of a piece written for the Italian Daily Domani]

Wolfgang Schäuble was a central figure in the German political landscape. A member of parliament for the centre-right Christian Democrats party from 1972 until his death on Tuesday evening at the age of 81, he was very close to Chancellor Helmut Kohl and, as a lawyer, one of the negotiators of the treaty that brought about the reunification with East Germany. But it was with Angela Merkel as Chancellor that Schäuble became known beyond national borders. For a few years Minister of the Interior, he was appointed Minister of Finance in 2009, a few weeks before the revelations about the state of Greek public finances that triggered the sovereign debt crisis. Since then, he has been one of the central figures in the calamitous management of the crisis. A staunch pro-European, he has nevertheless always been convinced, in homage to the ordoliberal doctrine, that integration could only be achieved by harnessing the European economy in a dense network of rules that would guarantee the public and private thrift necessary to make the EU competitive on world markets. Schäuble was the main standard-bearer of the “Berlin View” (or Brussels or Frankfurt, being adopted by the heads of the European Commission and the ECB of the time) which attributed the debt crisis to the fiscal profligacy and lack of reforms of the so-called “peripheral” EMU countries. A narrative about the crisis that forced “homework” (austerity and structural reforms) on the countries in crisis: we owe to Schäuble’s intransigence, backed by Angela Merkel, the Commission and the ECB (and sometimes against the IMF, which often had a more pragmatic approach), the draconian conditions imposed on Greek governments in exchange for financial assistance from the so-called Troika. In those years, he and the then president of the ECB, Jean-Claude Trichet, argued, against all empirical evidence, for expansionary austerity, the idea that fiscal restriction would supposedly free markets’ animal spirits and thus revive growth. An austerity that Schäuble imposed on countries in crisis but also followed at home. On the occasion of his departure from the Ministry of Finance in 2017, the photo of the employees forming a large zero in the courtyard in homage to the achievement of a balanced budget objective went around the world.

History has taken it upon itself to show the ineffectiveness and cost of that strategy. Not surprisingly, austerity is almost never expansionary and certainly has not been so in the eurozone. The fiscal adjustment imposed on the EMU peripheral countries triggered a crisis which for some of them had not yet been absorbed by the end of the decade.  A crisis that, moreover, could have been less painful if the countries in better shape had supported the eurozone growth with expansionary policies, instead of adopting a restrictive stance themselves. The EMU is the only large advanced economy that suffered a second recession in 2012-13, after the Global Financial crisis of 2008. Not only that: since then, domestic demand has remained anaemic, and the European economy has become “Germanized”, managing to grow only thanks to exports; this contributes to the growing trade tensions, and Germany stands accused by international bodies and by the United States of exerting deflationary pressure on the world economy.

The narrative of a crisis caused by the fiscal irresponsibility of spendthrift governments quickly lost its luster and already in 2014 many of its initial supporters (e.g. Mario Draghi, who in the meantime became president of the ECB) opted for a more “symmetrical” explanation, according to which the trigger of the crisis were balance of payments imbalances of which the over-spendthrift and the over-austere countries were equally guilty. But Schäuble never backed from his belief that the only necessary medicine was the downsizing of public spending; Germany also imposed this view to its partner when reforming the European institutions (from the ESM to the fiscal compact).

With the Covid crisis and Germany’s staunch support for Next Generation EU, it seemed that the ordoliberal doctrine finally went into retirement, along with Schäuble, its proudest partisan. But recent events show us that this was wishful thinking. Schäuble would probably have approved the (non-)reform of the Stability Pact imposed by his successor Lindner, whose only guiding light is the reduction of public debt. Schäuble has left us, but the fetish of public and private thrift as a healing virtue is alive and well.

Markets are also rooting for a European Central Fiscal Capacity

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

An interesting article published a few days ago in  the Financial Times highlights one of the many paradoxes that the European Union is facing. The article is apparently technical and aimed at insiders, but in reality, it highlights a political problem for Europe, a global player that stubbornly does not equip itself with the tools to fully play its role. The authors note that for the first time in its history, mainly because of the Next Generation EU  programme, the European Union is now issuing a debt of significant size, which will reach €900 billion in 2026 (in 2020 it was just €50 billion). This is happening for the first time, as we said, because one of the pillars of the European Union budget is the principle of equilibrium: unlike the Member States, under normal conditions the EU must have a balanced budget. The issuance of debt by the Union, therefore, must always pass “off-balance-sheet”, through financial vehicles set up for specific and exceptional purposes. Until the pandemic, and the creation of Next Generation EU, this had been done for negligible amounts, and there was little debt properly European circulating on the markets.

The debt linked to Next Generation EU  was initially plebiscited by markets, which fought over the first issuances at zero or negative rates; but, notes  the Financial Times, European debt is today less desirable than that of some member countries: the ten-year interest rates of the EU, a debtor with the highest rating (AAA) are higher than those of Germany,  but also to those of France, which has a lower rating (AA). Why are markets more inclined to buy bonds from a relatively riskier debtor like France than those issued by the European Union? The explanation lies in the oft-forgotten fact that liquidity, i.e., the ease with which a security can be traded, also contributes along with risk to determining the attractiveness of financial investment. And a security is liquid, easily exchangeable, if at any given moment there are buyers for those who want to sell, and sellers for those who want to buy. This is precisely the problem with European debt today: of course, today the amount of bonds issued is significant, especially when compared to a few years ago. But what guarantees the markets that debt issuance will continue even after 2026, when the last Next Generation EU bonds will be put on the market? In other words, once this phase is over, will there continue to be a market for European stocks?

In short, investors are skeptical (unfortunately rightly so) and are unable to understand  whether the Next Generation EU  program is an isolated measure, the result of the Covid emergency, or whether it can become a sort of model to finance the colossal investment programs necessary for the ecological and digital transitions in the future. In short, the markets are trying to figure out whether in the more or less near future a European fiscal capacity could materialize: an agency that, acting as a sort of EU finance minister, would be capable of finding resources to finance EU expenditure, including by issuing European debt.

The discussion on reforming the EU fiscal rule is peaking. Just a few days ago, the Eurozone finance ministers reaffirmed their intention to quickly approve a rule that would replace the outdated and no longer credible Stability Pact. As argued here, in order to be approved quickly, the reform will probably, and unfortunately, be a minimalist compromise. It is likely that the new Stability Pact will not be too different from the old one and that it will not allow governments to adequately finance public goods, industrial policies, and public investment.

If this is the case, there is an urgent need to put the creation of a central fiscal capacity back at the centre of the debate on the European institutional set-up. The issue has always been present under the radar but is struggling to impose itself on the agenda of European reforms. It can be argued convincingly (as the former head of Commissioner Gentiloni’s cabinet, Marco Buti, does in an article written with Marcello Messori) that the creation of a central fiscal capacity would make it possible to provide for economic stabilisation and to finance European public goods more effectively and at lower cost than through national policies. It would also make it easier and more stable to finance transnational investment projects, again with an efficiency gain compared to the Next Generation model, which seeks to achieve coherence between national plans (the NRRPs) through conditions on the destination of funds.

 The (modest) difficulties in placing European debt issues add an additional reason for the creation of a central fiscal capacity. Not only would it have obvious macroeconomic and structural benefits, but it would also help stabilise financial markets. Firstly, because, as mentioned above, it would help to provide markets with a stable supply of a safe, liquid and attractive asset, reducing financing costs for the EU. Secondly, because the European financing of part of public policies would make it possible to lighten the burden on the shoulders of member countries, which could more easily keep their debt under control. The segmentation of European financial markets would thus be reduced, and the cost of debt would fall for everyone. Thirdly, the existence of European debt would allow the ECB to sell and buy securities to regulate the liquidity of the system without having to scramble to hold the bonds of different countries in proportion to their economic weight. Finally, because the existence of a European debt would make it possible to consolidate the role of the euro as one of the international reserve currencies, once again ensuring stability and sustainability.

Unfortunately, as we said, the creation of a centralised fiscal capacity is not a priority in today’s EU political agenda. First of all, because it would be necessary to change the Treaties in order to get rid of the principle of equilibrium which, as we said, is now embedded in the European budget. Moreover, the creation of the capacity to spend, tax and borrow centrally, while electoral accountability to the electorate remains at the level of national governments, would require a complex system of checks and balances aimed at ensuring that no further European democratic deficit emerges (which would open up prairies for sovereigntists and Eurosceptics of various backgrounds). It will therefore be difficult to build consensus on such a complex and innovative proposal, among European countries weakened by multiple crises and increasingly looking inwards. In short, it is a complex construction site. But it still needs to be opened as soon as possible.

On the Stability Pact, no hurry. For once, let’s try to be forward looking.

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

This Fall the right-wing Italian government will face a difficult balancing act, with a resource-less budget law and slowing growth. It is then not a surprise that in recent weeks members of the cabinet finally woke up, rediscovering the debate about the reform of European rules. Ministers Giorgetti (Treasury) and Fitto (European Affairs) sounded the alarm about the possible return of the Stability Pact, suspended since 2020.

It is useful to summarize the situation, for those who did not follow the discussion in the past months. With the pandemic, in March 2020, the European Commission immediately activated the Stability and Growth Pact suspension clause to allow European countries to respond to the health and economic crisis with budget policies. The Pact was actually already under heavy criticism, so much so that the Commission had already launched a consultation process on its revision. Some, including myself, had criticized the Pact even during the “great” (and illusory) convergence in the early 2000s. But the flaws became evident with the sovereign debt crisis when the European rules, instead of securing the economy and public finances, had the opposite effect: austerity sunk the economies of so-called peripheral countries (primarily Greece, but also Italy, Portugal, and to a lesser extent Spain) without making their public finances more sustainable. Many economists (including those from the Commission) now agree that in addition to forcing countries to implement pro-cyclical policies (budget restriction in an economic crisis), the existing rules hinder public investment, industrial policies, and inequality reduction. Above all, they turn budget laws into exercises in trimming decimal percentage points of deficits, rather than moments for planning public policies to address the major challenges we face.

The Commission, which had strongly supported austerity policies in the 2010s, deserves praise for the change in perspective that emerged from a working proposal put forward at the end of 2022. Without going into details, that proposal, despite its flaws, abandoned the idea that the sole guiding principle of public policies should be debt reduction and envisioned a rule that would allow each country ample leeway to autonomously design its budget policies over multi-year horizons, as long as the sustainability of public finances was guaranteed.

Unfortunately, despite being silent for a while following the disasters of the 2010s and being forced by the pandemic to accept a more active role for budget policies, the hawks of public finances, the so-called “frugals,” have reemerged at the earliest opportunity. Thus, the German Finance Ministry published a short text last spring that called the Commission to order just a few weeks before it presented a formal legislative proposal. In fact, that proposal, compared to the November 2022 document, marked a return to the guiding principle of debt reduction and annual deficit targets. All this happened in the substantial silence of the Italian, French, and Spanish governments. I cannot recall a single intervention by the leaders of these countries in support of the Commission under attack from frugal countries.

Today something is changing. The idea of a “golden rule” is back, allowing certain investments (ecological transition, digitalization, and defense, to obtain approval from Eastern countries) to be excluded from the deficit calculation. Italy, France, and Spain are struggling to coordinate on this rule in anticipation of the finance ministers’ meeting in the coming weeks. Even the German government, given the growth crisis and the industrial and infrastructural obsolescence plaguing the country, might compromise, especially if it obtained a relaxation of the state aid regulations in return.

Perhaps the hawks have not yet won, and there is room for an improvement of the current fiscal framework. Now the main risk is that, fearing that the old Pact will come back into force on January 1, 2024, we settle for a compromise that lowers the bar. The world is changing quickly, and the risk of Europe becoming economically and geopolitically irrelevant has never been higher. Industrial policies and public investment will be the main leverage to ensure growth and positioning in future sectors. The Chinese and American governments understood this years ago, while we continue to formulate ambitious programs that we do not adequately finance, pulling in all directions a blanket that remains inexorably short.

We cannot be satisfied with some cosmetic adjustments to a framework that remains oriented towards reducing spending and public debt. Given the stakes, the January 1 deadline should be the least of our problems. The new rule will remain in effect for years, and it is better to adopt a good rule late than a bad one on time. It’s so obvious that it seems absurd to have to emphasize it. If a serious and in-depth negotiation could be initiated that goes beyond the fall, the Commission could extend the suspension clause or adopt all the flexibility necessary to prevent the old Pact from biting.

Of course, we have had three years, and it is depressing that on this topic, much more important than many others, we have waited until the last moment to act. The only visible participants in the European debate have been the Commission, which has done its job, and the frugals, led by Germany, who have occupied the field. The Italian and French governments were MIA, and today we are paying the price for this absence. Shortsightedness continues to be the common thread that ties the leadership of European countries.

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.

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.

Germany’s longing for the Ancien Régime is a Threat for Europe

Note: this is a rough translation of a piece published on the Italian neswpaper Domani, with a few edits and additions.

While the campaign for the election captures all the attention of the Italian establishment, we should not stop looking beyond our borders. In particular, the lack of interest in what is happening in Germany is striking and worrisome. The difficulties Europe’s largest economy is experiencing will in fact have far more significant consequences for many European countries than their domestic political struggles.

Last week, the ministry of economy and ecological transition (headed by the vice-chancellor and number two of the Green party, Robert Habeck) published a report on the reform of the stability pact, which, although we tend to forget it, will be THE topic of the coming months. The guiding principles for reform that the report outlines are basically a re-proposal of the existing rule, as if the disasters of the sovereign debt crisis and the Covid tsunami were a parenthesis to be closed as soon as possible by returning to the old world.

Under a gleaming hood, the German engine has been in crisis for years

There will be time to return to the inadequacy of this proposal (Carlo Clericetti does it well in the Italian magazine Micromega) and to the issue of European governance. What I would like to emphasise here is that the German elites, with this frenzy to return to the past, do not seem to fully grasp at least two things: First, the fact that after the experience of the last ten years it is not possible to return to an idea of economic policy for which the only beacon is fiscal discipline, neglecting public investment, industrial policy, social protection and so on. Second, and this is more surprising, they do not grasp the fact that the German growth model seems to have hit its boundaries. As a reminder, we are talking about a model aiming at export-led growth, that was based on the one hand on the compression of domestic demand (with wages that for decades grew much less than productivity); on the other hand it was based on an export sector that took advantage of both the dualism of the labour market and of value chains rooted in the countries of the former Soviet bloc. Germany could therefore import intermediate goods and low-cost components and re-export finished products, often with a high technological content, to non-European markets. This is the main reason why it remained a manufacturing power while most advanced countries had to cope with de-industrialisation and relocation.
Many, including myself have criticised this model, which during the sovereign debt crisis Germany successfully managed to generalise to the rest of the eurozone. In 2020, in concluding an essay on Europe, I pointed out how that model has come to an end. The public and private investment deficit, the result of decades of self-imposed frugality, has progressively depleted the capital stock and reduced the competitiveness of German industry. Meanwhile, while the growth of emerging countries has helped to provide outlets for German goods, it has also seen these countries develop high value-added production that competes with German exporting firms. But there is more: I also noted that the progressive distortion of the ordoliberal model, the increase in inequality and precariousness (which contributes to demographic stagnation and to the ageing of population), and the growing dependence on foreign demand, more problematic than ever in an increasingly uncertain geopolitical context, have all contributed to making Germany a giant with feet of clay.

A Giant with Feet of Clay

Feet of clay that today are cracking. The bottlenecks that appeared during and after the pandemic, due to lockdowns and to the recomposition of global supply and demand, have (not surprisingly) proved to be more persistent than many expected. Furthermore, the acceleration of investment in the ecological transition, obviously welcome and all too late, creates shortages particularly in sectors that are key for the German economy, such as the automotive. Finally, geopolitical tensions, the slowdown in emerging economies, and of course the war in Ukraine greatly reduce the outlets for the German export sector and have laid bare the short-sightedness of the past German leadership’s choice to rely on Russian oil and gas, admittedly reducing costs, but creating a dependency for which the country is now paying the price. It is important, however, to emphasise again that the events of the last two years have only come to add to the structural problems of a model of growth and organisation of production that was beginning to show its limits even before the pandemic.

The German elites at a crossroads

In 2020, I concluded my essay by stating that the crisis of the German model could have been an opportunity for Europe, as it would have forced Germany to worry about the imbalances within the eurozone, to promote public and private investment, to rethink industrial policy, to support (German and European) domestic demand; not out of altruism, but to create a stable European market in an international context that had become structurally uncertain and turbulent. The heartfelt support for Next Generation EU seemed to confirm the feeling that something had changed in Germany. The recent turn of the German debate is therefore worrisome and should be looked at closely. Habeck’s paper and the recent stances of the Minister of Finances, the liberal Lindner, point to a kind of “ostrich syndrome” of the German elites, who seem to long for a return to the past in order not to have to deal with the structural problems of Germany and of European integration. If this tendency prevails, not only the German citizens but the whole of Europe, which will slip into irrelevance, will pay the price in the coming years. On the contrary, representatives of the German government at European tables need to be called upon to contribute to the rethinking of industrial and energy policy and public investment policies, to the development of a European welfare state, to the definition of budget rules that allow for active and sustainable policies, to the development of the internal market, to the completion of the banking union, and the list could go on. In short, an ambitious and wide-ranging European discussion is needed to make the German elites look away from their navels and try to restore Europe’s centrality at a time of great geopolitical turbulence (which will certainly extend well beyond the war in Ukraine). France and Italy, because of their size and the influence they have had in Europe in the recent past, would obviously play a key role in countering the return to the past of the German elites. This is why the absence of European issues from the (pre-electoral) Italian and (post-electoral) French debate cannot but cause concern.

Zombie Arguments Against Fiscal Stimulus

Busy days. I just want to drop a quick note on a piece just published on the Financial Times that is puzzling on many levels. Ruchir Sharma pleads against Joe Biden’s stimulus on the ground that it risks “exacerbating inequality and low productivity growth”. The bulk of the argument is in this paragraph:

Mr Biden captured this elite view perfectly when he said, in announcing his spending plan: “With interest rates at historic lows, we cannot afford inaction.”

This view overlooks the corrosive effects that ever higher deficits and debt have already had on the global economy. These effects, unlike roaring inflation or the dollar’s demise, are not speculative warnings of a future crisis. There is increasing evidence, from the Bank for International Settlements, the OECD and Wall Street that four straight decades of growing government intervention in the economy have led to slowing productivity growth — shrinking the overall pie — and rising wealth inequality.

If one reads the two papers cited by Sharma, they say, in a nutshell, (a) that expansionary monetary policies have deepened income inequality via an increase in asset prices (while for low interest rates and bond prices there is no clear link); (b) that the increasing share of zombie firms drags down the performance of more productive firms thus slowing down overall productivity growth.

So far so good. So where is the problem? Linking these results to excessive debt and deficit, to the “constant stimulus”, is stretched (and I am being kind). A clear case of Zombie Economics.

Let’s start with monetary policy and its impact on inequality (side note: the effect is not so clear-cut). One may see expansionary monetary policies as the consequence of fiscal dominance, excessive deficit and debt that force central banks to finance the government. But, they can also be seen as the consequence of stagnant aggregate demand that is not properly addressed by excessively restrictive fiscal policies, forcing central banks to step in. Many have argued in the past decade that especially in the Eurozone one of the causes of central bank activism was the inertia of fiscal policies. Don’t take my word. Read former ECB President Mario Draghi’s Farewell speech, in October 2019:

Today, we are in a situation where low interest rates are not delivering the same degree of stimulus as in the past, because the rate of return on investment in the economy has fallen. Monetary policy can still achieve its objective, but it can do so faster and with fewer side effects if fiscal policies are aligned with it. This is why, since 2014, the ECB has gradually placed more emphasis on the macroeconomic policy mix in the euro area.

A more active fiscal policy in the euro area would make it possible to adjust our policies more quickly and lead to higher interest rates.

This is as straightforward as a central banker can be: in order to go back to standard monetary policy making, fiscal policy needs to step up its game. Notice that Draghi also hints to another source of problems: the causality does not go from expansionary policies to low interest rates, but the other way round. We have been living in a a long period of secular stagnation, excess savings, low interest rates and chronic demand deficiency which monetary policy expansion can accommodate by keeping its rates close to “the natural” rate, but not address. Once again, fiscal policy should do the job.

Regarding zombie firms, it is unclear, barring the current and very special situation created by the pandemics, why this would prove that stimulus is unwarranted. The paper describes a secular trend whose roots are in insufficient business investment and a drop in potential growth rate (that in turn the authors link to a drop in multi-factor productivity). The debate on the role of fiscal policy in these matters is as old as macroeconomics. In the past ten years, nevertheless, the cursor has moved against the Sharma’s priors and an increasing body of literature points to crowding-in effects: especially when the stock of public capital is too low (as is the case in most advanced countries), an increase of public investment — “constant stimulus”– has a positive impact on private investment and potential growth (see for reference the most recent IMF fiscal monitor and the chapter by EIB economists of the European Public Investment Outlook). Lack of public investment is also widely believed to be one of the factors keeping our economies stuck in secular stagnation.

Fifteen years ago one could have read Sharma’s case against fiscal policy on many (more or less prestigious) outlets. Even then, it would have been easy to argue that it was flawed and fundamentally built on an ideological prior. Today, it seems simply written by somebody living in another galaxy.

Some Animals are More Equal than Others

This post is nothing new. It is just a reminder for non European readers (or for distracted European readers), about the way things work in the EMU. The German Bundesbank President Weidmann violently attacked the European Commission for failing to enforce fiscal discipline within the Stability Pact.

What is wrong with this? Is this not just another confirmation of the old cliché that Germans are obsessed with respecting the rules?

Well, think again. Everybody knows that EU countries need to curb their public deficit to be below 3% of GDP, and need to aim to structural balance. But it is less known, especially outside Europe, that since 2011, as a part of the so-called “six-pack”, the EU introduced the Macroeconomic Imbalances Procedure (MIP), “which aims to identify, prevent and address the emergence of potentially harmful macroeconomic imbalances that could adversely affect economic stability in a particular Member State, the euro area, or the EU as a whole”.

This procedure builds on a scoreboard of 14 indicators, among which we can read the following:

• 3-year backward moving average of the current account balance as percent of GDP, with  thresholds of +6% and -4%;

Yeah, that is right, at the very first place. And guess what, Germany’s current account surplus, since the MIP came into force has been above 6% every single year. (it is expected to be 9% in 2016).

And yet, no corrective action has been imposed, and of course no sanctions. I understand that Germany has no problems with not being sanctioned. But maybe it would be wise to keep a low profile regarding others’ violations..

So, for once, I agree with Jens Weidmann: the Commission should be harsher on those who do not respect the rules. And of course, it will, but just with some. Among the many problems European governance has, this is not the least: all animals are equal, but some animals are more equal than others.

John Maynard Trump?

A sentence from Donald Trump’s victory speech retained a good deal of attention:

We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We’re going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it.

This was widely quoted in the social media, together with the following from an FT article about the Fed:

In particular, some members of his economic advisory team are convinced that central banks such as the US Federal Reserve have exhausted their use of super-loose monetary policy. Instead, in the coming months they hope to announce a wave of measures such as infrastructure spending, tax reform and deregulation to boost growth — and combat years of economic stagnation.

In spite of its vagueness, the idea of an infrastructure push has sent markets to beyond the roof. In short, a simple (and rather generic) speech on election night has dispelled all the anxiety about the long phase of uncertainty that we face. So long for efficient markets…

But this is not what I care about here. The point I want to make is that Trump’s announcement has triggered a strange reaction. Something going like: “See? Trump managed to break the establishment’s hostility to Keynes and to finally implement the stimulus policies we need. Forget the sexism and the p-word, the attacks on minorities, the incompetence. Enter Trump, exit neo-liberalism”. I see this especially (but not only) among Italian internauts, who tend to project the European situation in other contexts.

Well, I have some reservations on this claim. Where to start? Maybe with the “Contract with the American Voter“, that together with the (generic, once more) promise of new investment, promised a massive withdrawal of the State from the economy? Or from the fact that “Establishment Obama” made Congress vote, a month into his presidency, a “Recovery Act (ARRA)” worth 7% of GDP, that successfully stopped the free-fall and helped restore growth? Or from the fact that the “anti-establishment” Tea Party forced austerity since 2011, climaxing in the sequester saga of 2013?

Critics of current austerity policies in Europe should not be delusional. Trump is not the John Maynard Keynes of 2016. His agenda is, broadly speaking, an agenda of deregulation, tax cuts for the rich, and retreat of the State from the economy. Not to mention the strong chance of a more hawkish Fed in the future. To sum up, Trump is, in the best case scenario a new Reagan, substituting military Keynesianism with bridges’ Keynesianism. And we all (should) know that Reaganomics does shine much less than usually claimed.

Those progressives looking for a Trump Keynesian agenda should probably have looked more carefully at the plan proposed by “establishment-Clinton”: A significant infrastructure push (in fact, the emphasis on infrastructures was the only point in common between the two candidates), with the ambition to crowd-in private investment. And what is more important, such an expansionary fiscal policy was framed within a more active role of the government in key sectors like education, health care, and with increased progressivity of the tax system.

Would we have had Hilary Rodham Keynes? Unfortunately we’ll never know…