Yesterday the Council decided that Spain and Portugal’s recent efforts to reduce deficit were not enough. This may lead to the two countries being fined, the first time this would happen since the inception of the euro.
It is likely that the fine will be symbolic, or none at all; given the current macroeconomic situation, imposing a further burden on the public finances of
these two any country would be crazy.
Yet, the decision is in my opinion enraging. First, for political reasons: Our
world is crumbling. The level of confidence in political elites is at record low levels, and as the Brexit case shows, this fuels disintegration forces. It is hard not to see a link between these processes and, in Europe, the dismal political and economic performances we managed to put together in the last decade (you are free pick your example, I will pick the refugee crisis (mis) management, and the austerity-induced double-dip recession).
But hey, one might say. We are not here to save the world, we are here to apply the rules. Rules that require fiscal discipline. And of course, both Portugal and Spain have been fiscal sinners since the crisis began (and of course before):
Once we neglect interest payments, on which there is little a government can do besides hoping that they ECB will keep helping, both countries spectacularly reduced their deficit since 2010. And this is true whether we take the headline figures (total deficit, the dashed line), or the structural figures that the Commission cherishes, i.e. deficit net of cyclical components (the solid lines). Looking at this figure one may wonder what they serve to drink during Council (and Commission) meetings, for them to argue that the fiscal effort was insufficient…
What is even more enraging, is that not only this effort was not recognized as remarkable by EU authorities. But what is more, it was harmful for these economies (and for the Eurozone at large).
In the following table I have put side by side the output gaps and fiscal impulse, the best measure of discretionary policy changes1. I have highlighted in green all the years in which the fiscal stance was countercyclical, meaning that a negative (positive) output gap triggered a more expansionary (contractionary) fiscal stance. And in red cases in which the fiscal stance was procyclical, i.e. in which it made matters worse.
|Output Gap and Discretionary Fiscal Policy Stance|
|Output Gap||Fiscal Impulse||Output Gap||Fiscal Impulse||Output Gap||Fiscal Impulse|
|Source: Datastream – AMECO Database|
|Note: Fiscal Impulse computed as change of cyclically adjusted deficit net of interest|
The reader will judge by himself. Just two remarks. linked to the fines put in place. First, the Portuguese fiscal contraction of 2015-2016 is procyclical, as the output gap was and still is negative. On the other hand, Spain has increased its structural deficit, but it had excellent reasons to do so.
One may argue that the table causes problems, because the calculation of the output gap is arbitrary and political in nature. Granted, I could not agree more. So I took headline figures, and compared the “gross” fiscal impulse with the “growth gap”, meaning the difference between the actual growth rate and the 3% level that was assumed to be normal when the Maastricht Treaty was signed (If you are curious about EMU numerology, just look here). This is of course a harsher criterion, as 3% as nowadays become more a mirage than a realistic objective. But hey, if we want to use the rules, we should take them together with their underlying hypotheses. Here is the table:
|Growth Gap and Overall Fiscal Policy Stance|
|Growth Gap to 3%||Fiscal Impulse||Growth Gap to 3%||Fiscal Impulse||Growth Gap to 3%||Fiscal Impulse|
|Source: Datastream – AMECO Database|
|Note: Fiscal Impulse computed as change of government deficit net of interest|
Lot’s of red, isn’t it? Faced with a structural growth deficit, the EMU at large, as well as Spain and Portugal, has had an excessively restrictive fiscal stance. I know, no real big news here.
To summarize, the decision to fine Portugal and Spain is politically ill-timed and clumsy. And it is economically unwarranted. And yet, here we are, discussing it. My generation grew up thinking that When The World Is Running Down, You Make The Best of What’s Still Around. In Brussels, no matter how bad things get, it is business as usual.
1. The fiscal impulse is computed as the negative of the change in deficit. As such it captures the change in the fiscal stance. Just to make an example, going from a deficit of 1% to a deficit of 5% is more expansionary than going form a deficit of 10% to a deficit of 11%↩.
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.
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.
I already noticed how the post-Jackson Hole Consensus is inconsistent with the continuing emphasis of European policy makers on supply side measures. In these difficult times, the lack of a coherent framework seems to have become the new norm of European policy making. The credit for spotting another serious inconsistency this time goes to the Italian government. In the draft budgetary plan submitted to the European Commission (that might be rejected, by the way), buried at page 12, one can find an interesting box on potential growth and structural deficit. It really should be read, because it is in my opinion disruptive. To summarize it, here is what it says:
- A recession triggers a reduction of the potential growth rate (the maximum rate at which the economy can grow without overheating) because of hysteresis: unemployed workers lose skills and/or exit the labour market, and firms scrap productive processes and postpone investment. I would add to this that hysteresis is non linear: the effect, for example on labour market participation, of a slowdown, is much larger if it happens at the fifth year of the crisis than at the first one.
- According to the Commission’s own estimates Italy’s potential growth rate dropped from 1.4% on average in the 15 years prior to the crisis (very low for even European standards), to an average of -0.2% between 2008 and 2013. A very large drop indeed.
- (Here it becomes interesting). The box in the Italian plan argues that we have two possible cases:
- Either the extent of the drop is over-estimated, most probably as the result of the statistical techniques the Commission uses to estimate the potential. But, if potential growth is larger than estimated, then the output gap, the difference between actual and potential growth is also larger.
- As an alternative, the estimated drop is correct, but this means that Italy there is a huge hysteresis effect. A recession is not only, as we can see every day, costly in the short run; but, even more worryingly, it quickly disrupts the economic structure of the country, thus hampering its capacity to grow in the medium and long run.
The box does not say it explicitly (it remains an official government document after all), but the conclusion is obvious: either way the Commission had it wrong. If case A is true, then the stagnation we observed in the past few years was not structural but cyclical. This means that the Italian deficit was mainly cyclical (due to the large output gap), and as such did (and does) not need to be curbed. The best way to reabsorb cyclical deficit is to restart growth, through temporary support to aggregate demand. If case B is true, then insisting on fiscal consolidation since 2011 was borderline criminal. When a crisis risks quickly disrupting the long run potential of the economy, then it is a duty of the government to do whatever it takes to fight, in order to avoid that it becomes structural.
In a sentence: with strong hysteresis effects, Keynesian countercyclical policies are crucial to sustain the economy both in the short and in the long run. With weaker, albeit still strong hysteresis effects, a deviation from potential growth is cyclical, and as such it requires Keynesian countercyclical policies. Either way, fiscal consolidation was the wrong strategy.
I am not a fan of the policies currently implemented by the Italian government. To be fair, I am not a fan of the policies implemented by any government in Europe. Too much emphasis on supply side measures, and excessive fear of markets (yes, I dare say so today, when the spreads take off again). But I think the Italian draft budget puts the finger where it hurts.
The guys in Via XX Settembre dit a pretty awesome job…
Update, March 20th: Speaking of ideological biases concerning inflation, Paul Krugman nails it, as usual.
On today’s Financial Times, Phillip Hildebrand gives yet another proof of unwarranted inflation terror. His argument is not new: In spite of the consensus on a weak recovery, the US economy may be close to its potential , so that further monetary stimulus would eventually be inflationary.
He then deflects (?) the objection that decreasing unemployment reflects decreasing labour force participation rather than new employment, by suggesting that it is hard to know how many of the 13 millions jobs missing are structural, i.e.not linked to the crisis. I think it is worth quoting him, because otherwise it would be hard to believe:
However, an increasingly vocal group of observers, including within the Fed, posits that more of the fall in the participation rate appears to have been structural than cyclical, and it was even predictable – the result of factors such as an ageing workforce and the effect of technology on jobs.
(the emphasis is mine). Now look at this figure, quickly produced from FRED data: Read more