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.
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:
- Their GDP growth is negative or GDP remains well below its potential (resulting in an output gap greater than minus 1.5% of GDP);
- The deviation does not lead to non-respect of the 3% deficit reference value and an appropriate safety margin is preserved;
- Investment levels are effectively increased as a result;
- 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.
- The deviation is compensated within the timeframe of the Member State’s Stability or Convergence Programme (Member States’ medium-term fiscal plans).
The European Council meeting, next Monday, should finally lift the veil of mystery that has surrounded the new “fiscal compact”, the set of rules supposed to govern fiscal policy in EU member countries. As of now, the only official document in our hands is the Statement approved by the Heads of State and Government at the December 9 meeting.
I have argued at length that I am not in the camp of those who believe fiscal profligacy is the source of EMU problems (recently, here and here). Rather the contrary, I always thought (see for example here and here) that even the current rules de facto prevented EMU countries from effectively using the standard tools of macroeconomic policy.