The news of the day is that François Hollande will not seek reelection in May 2017. This is rather big news, even it if was all too logical given his approval ratings. But what went wrong with Hollande’s (almost) five years as a President?
Well, I believe that the answer is in a post I wrote back in 2014, Jean-Baptiste Hollande. There I wrote that the sharp turn towards supply side measures (coupled with austerity) to boost growth was doomed to failure, and that firms themselves showed, survey after survey, that the obstacles they faced came from insufficient demand and not from the renown French “rigidities” or from the tax burden. I was not alone, of course in calling this a huge mistake. Many others made the same point. Boosting supply during an aggregate demand crisis is useless, it is as simple as that. Allow me to quote the end of my post:
Does this mean that all is well in France? Of course not. The burden on French firms, and in particular the tax wedge, is a problem for their competitiveness. Finding ways to reduce it, in principle is a good thing. The problem is the sequencing and the priorities. French firms seem to agree with me that the top priority today is to restart demand, and that doing this “will create its own supply”. Otherwise, more competitive French firms in a context of stagnating aggregate demand will only be able to export. An adoption of the German model ten years late. I already said a few times that sequencing in reforms is almost as important as the type of reforms implemented.
I am sure Hollande could do better than this…
It turns out that we were right. A Policy Brief (in French) published by OFCE last September puts all the numbers together (look at table 1): Hollande did implement what he promised, and gave French firms around €20bn (around 1% of French GDP) in tax breaks. These were compensated, more than compensated actually, by the increase of the tax burden on households (€35bn). And as this tax increase assorted of reshuffling was not accompanied by government expenditure, it logically led to a decrease of the deficit (still too slow according to the Commission; ça va sans dire!). But, my colleagues show, this also led to a shortfall of demand and of growth. A rather important one. They estimate the negative impact of public finances on growth to be almost a point of GDP per year since 2012.
Is this really surprising? Supply side measures accompanied by demand compression, in a context of already insufficient demand, led to sluggish growth and stagnating employment (it is the short side of the market baby!). And to a 4% approval rate for Jean-Baptiste Hollande.
OFCE happens to have published, just yesterday, a report on public investment in which we of join the herd of those pleading for increased public investment in Europe, and in particular in France. Among other things, we estimate that a public investment push of 1% of GDP, would have a positive impact on French growth and would create around 200,000 jobs (it is long and it is in French, so let me help you: go look at page 72). Had it been done in 2014 (or earlier) instead of putting the scarce resources available in tax reductions, things would be very different today, and probably M. Hollande yesterday would have announced his bid for a second mandate.
In a sentence we don’t need to look too far, to understand what went wrong.
Two more remarks: first, we have now mounting evidence of what we could already expect in 2009 based on common sense. Potential growth is not independent of current economic conditions. Past and current failure to aggressively tackle the shortage of demand that has been plaguing the French – and European – economy, hampers its capacity to grow in the long run. The mismanagement of the crisis is condemning us to a state of semi-permanent sluggish growth, that will keep breeding demagogues of all sorts. The European elites do not seem to have fully grasped the danger.
Second, France is not the only large eurozone country that has taken the path of supply side measures to pull the economy out of a demand-driven slump. The failure of the Italian Jobs Act in restarting employment growth and investment can be traced to the very same bad diagnosis that led to Hollande’s failure. Hollande will be gone. Are those who stay, and those who will follow, going to change course?
Readers of this blog know that I have been skeptical on the ECB quantitative easing program.
I said many times that the eurozone economy is in a liquidity trap, and that making credit cheaper and more abundant would not be a game changer. Better than nothing, (especially for its impact on the exchange rate, the untold objective of the ECB), but certainly not a game changer.
The reason, is quite obvious. No matter how cheap credit is, if there is no demand for it from consumers and firms, the huge liquidity injections of the ECB will end up inflating some asset bubble. Trying to boost economic activity (and inflation) with QE is tantamount to pushing on a string.
I also said many times that without robust expansionary fiscal policy, recovery will at best be modest.
Two very recent ECB surveys provide strong evidence in favour of the liquidity trap narrative. The first is the latest (April 2016) Eurozone Bank Lending Survey. Here is a quote from the press release:
The net easing of banks’ overall terms and conditions on new loans continued for loans to enterprises and intensified for housing loans and consumer credit, mainly driven by a further narrowing of loan margins.
So, nothing surprising here. QE and negative rates are making so expensive for financial institutions to hold liquidity, that credit conditions keep easing.
So why do we not see economic activity and inflation pick up? The answer is on the other side of the market, credit demand. And the Survey on the Access to Finance of Enterprises in the euro area, published this week also by the ECB, provides a clear and loud answer (from p. 10):
“Finding customers” was the dominant concern for euro area SMEs in this survey period, with 27% of euro area SMEs mentioning this as their main problem, up from 25% in the previous survey round. “Access to finance” was considered the least important concern (10%, down from 11%), after “Regulation”, “Competition” and “Cost of production” (all 14%) and “Availability of skilled labour” (17%). Among SMEs, access to finance was a more important problem for micro enterprises (12%). For large enterprises, “Finding customers” (28%) was reported as the dominant concern, followed by “Availability of skilled labour” (18%) and “Competition” (17%). “Access to finance” was mentioned less frequently as an important problem for large firms (7%, unchanged from the previous round)
No need to comment, right?
Just a final and quick remark, that in my opinion deserves to be developed further: finding skilled labour seems to become harder in European countries. What if these were the first signs of a deterioration of our stock of “human capital” (horrible expression), after eight years of crisis that have reduced training, skill building, etc.?
When sooner or later the crisis will really be over, it will be worth keeping an eye on “Availability of skilled labour” for quite some time.
Tell me again that story about structural reforms enhancing potential growth?
As a complement to the latest post, here is a quite eloquent figure
I computed real GDP of the periphery (Spain-Ireland-Portugal-Greece) and of the core (Germany-Netherlands-Austria-Finland), and then I took the difference of yearly growth rates in three subperiods that correspond to the run-up to the single currency, to the euro “normal times”, and to the crisis.
Let’s focus on the red bar: until 2008 the periphery on average grew more than 1% faster than the core, a difference that was even larger during the debt (private and public) frenzy of the years 2000. Was that a problem? No. Convergence, or catch-up, is a standard feature of growth. Usually (but remember, exceptions are the rule in economics), poorer economies tend to grow faster because there are more opportunities for high productivity growth. So it is not inconceivable that growth in the periphery was consistently higher than in the core especially in a phase of increasing trade and financial integration;
We all know (now; and some knew even then) that this was unhealthy because imbalances were building up, which eventually led to the crisis. But it is important to realize that the problem were the imbalances, not necessarily faster growth. In fact, if we look at the yellow bar depicting the difference in potential growth, it shows the same pattern (I know, the concept of potential growth is unreliable. But hey, if it underlies fiscal rules, I have the right to graph it, right?).
During the crisis the periphery suffered more than the core, and its potential output grew less
fell more. This is magnified by the mechanic effect of current growth that “pulls” potential output. But it is undeniable that the productive capacity of the periphery (capital, skills) has been dented by the crisis, much more so than in the core. Thus, not only we are collectively more fragile, as I noted last Monday;on top of that, the next shock will hurt the periphery more than the core, further deepening the divide.
The EMU in its current design lacks mechanisms capable of neutralizing pressure towards divergence. It was believed when the Maastricht Treaty was signed that markets alone would ensure convergence. It turns out (unsurprisingly, if you ask me) that markets not only did not ensure convergence. But they were actually a powerful force of divergence, first contributing to the buildup of imbalances, then by fleeing the periphery when trouble started.
Markets do not act as shock absorbers. It is as simple as that, really.
Last week the ECB published its Annual Report, that not surprisingly tells us that everything is fine. Quantitative easing is working just fine (this is why on March 10 the ECB took out the atomic bomb), confidence is resuming, and the recovery is under way. In other words, apparently, an official self congratulatory EU document with little interest but for the data it collects.
Except, that in the foreword, president Mario Draghi used a sentence that has been noticed by commentators, obscuring, in the media and in social networks, the rest of the report. I quote the entire paragraph, but the important part is highlighted
2016 will be a no less challenging year for the ECB. We face uncertainty about the outlook for the global economy. We face continued disinflationary forces. And we face questions about the direction of Europe and its resilience to new shocks. In that environment, our commitment to our mandate will continue to be an anchor of confidence for the people of Europe.
Why is that important? Because until now, a really optimistic and somewhat naive observer could have believed that, even amid terrible sufferings and widespread problems, Europe was walking the right path. True, we have had a double-dip recession, while the rest of the world was recovering. True, the Eurozone is barely at its pre-crisis GDP level, and some members are well below it. True, the crisis has disrupted trust among EU countries and governments, and transformed “solidarity” into a bad word in the mouth of a handful of extremists. But, one could have believed, all of this was a necessary painful transition to a wonderful world of healed economies and shared prosperity: No gain without pain. And the naive observer was told, for 7 years, that pain was almost over, while growth was about to resume, “next year”. Reforms were being implemented (too slowly, ça va sans dire) , and would soon bear fruits. Austerity’s recessionary impact had maybe been underestimated, but it remained a necessary temporary adjustment. The result, the naive observer would believe, would eventually be that the Eurozone would grow out of the crisis stronger, more homogeneous, and more competitive.
I had noticed a long time ago that the short term pain was evolving in more pain, and more importantly, that the EMU was becoming more heterogeneous precisely along the dimension, competitiveness, that reforms were supposed to improve. I also had noticed that as a result the Eurozone would eventually emerge from the crisis weaker, not stronger. More rigorous analysis ( e.g. here, and here) has recently shown that the current policies followed in Europe are hampering the long term potential of the economy.
Today, the ECB recognizes that “we face questions about the resilience [of Europe] to new shocks”. Even if the subsequent pages call for more of the same, that simple sentence is an implicit and yet powerful recognition that more of the same is what is killing us. Seven years of treatment made us less resilient. Because, I would like to point out, we are less homogeneous than we were in 2007. A hard blow for the naive observer.
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…
Eurostat just released its flash estimate for inflation in the Eurozone: 0.5% headline, and 0.8% core. We now await comments from ECB officials, ahead of next Thursday’s meeting, saying that everything is under control.
Just this morning, Wolfgang Münchau in the Financial Times rightly said that EU central bankers should talk less and act more. Münchau also argues that quantitative easing is the only option. A bold one, I would add in light of todays’
deflation inflation data. Just a few months ago, in September 2013, Bruegel estimated the ECB interest rate to be broadly in line with Eurozone average macroeconomic conditions (though, interestingly, they also highlighted that it was unfit to most countries taken individually).
In just a few months, things changed drastically. While unemployment remained more or less constant since last July, inflation kept decelerating until today’s very worrisome levels. I very quickly extended the Bruegel exercise to encompass the latest data (they stopped at July 2013). I computed the target rate as they do as
(if you don’t like the choice of parameters, go ask the Bruegel guys. I have no problem with these). The computation gives the following:
Using headline inflation, as the ECB often claims to be doing, would of course give even lower target rates. As official data on unemployment stop at January 2014, the two last points are computed with alternative hypotheses of unemployment: either at its January rate (12.6%) or at the average 2013 rate (12%). But these are just details…
So, in addition to being unfit for individual countries, the ECB stance is now unfit to the Eurozone as a whole. And of course, a negative target rate can only mean, as Münchau forcefully argues, that the ECB needs to get its act together and put together a credible and significant quantitative easing program.
Two more remarks:
- A minor one (back of the envelope) remark is that given a core inflation level of 0.8%, the current ECB rate of 0.25%, is compatible with an unemployment gap of 1.95%. Meaning that the current ECB rate would be appropriate if natural/structural unemployment was 10.65% (for the calculation above I took the value of 9.1% from the OECD), or if current unemployment was 11.5%.
- The second, somewhat related but more important to my sense, is that it is hard to accept as “natural” an unemployment rate of 9-10%. If the target unemployment rate were at 6-7%, everything we read and discuss on the ECB excessively restrictive stance would be significantly more appropriate. And if the problem is too low potential growth, well then let’s find a way to increase it…
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