We are becoming accustomed to European policy makers’ schizophrenia, so when yesterday during his press conference Mario Draghi mentioned the consolidating recovery while announcing further easing in December, nobody winced. Draghi’s call for expansionary fiscal policies was instead noticed, and appreciated. I suggest some caution. Let’s look at Draghi’s words:
Fiscal policies should support the economic recovery, while remaining in compliance with the EU’s fiscal rules. Full and consistent implementation of the Stability and Growth Pact is crucial for confidence in our fiscal framework. At the same time, all countries should strive for a growth-friendly composition of fiscal policies.
During the Q&A, the first question was on precisely this point:
Question: If I could ask you to develop the last point that you made. Governor Nowotny last week said that monetary policy may be coming up to its limits and perhaps it was up to fiscal policy to loosen a little bit to provide a bit of accommodation. Could you share your thoughts on this and perhaps even touch on the Italian budget?
(Here is the link to Austrian Central Bank Governor Nowotny making a strong statement in favour of expansionary fiscal policy). Draghi simply did not answer on fiscal policy (nor on the Italian budget, by the way). The quote is long but worth reading
Draghi: On the first issue, I’m really commenting only on monetary policy, and as we said in the last part of the introductory statement, monetary policy shouldn’t be the only game in town, but this can be viewed in a variety of ways, one of which is the way in which our colleague actually explored in examining the situation, but there are other ways. Like, for example, as we’ve said several times, the structural reforms are essential. Monetary policy is focused on maintaining price stability over the medium term, and its accommodative monetary stance supports economic activity. However, in order to reap the full benefits of our monetary policy measures, other policy areas must contribute decisively. So here we stress the high structural unemployment and the low potential output growth in the euro area as the main situations which we have to address. The ongoing cyclical recovery should be supported by effective structural policies. But there may be other points of view on this. The point is that monetary policy can support and is actually supporting a cyclical economic recovery. We have to address also the structural components of this recovery, so that we can actually move from a cyclical recovery to a structural recovery. Let’s not forget that even before the financial crisis, unemployment has been traditionally very high in the euro area and many of the structural weaknesses have been there before.
Carefully avoiding to mention fiscal policy, when answering a question on fiscal policy, speaks for itself. In fact, saying that “Fiscal policies should support the economic recovery, while remaining in compliance with the EU’s fiscal rules” and putting forward for the n-th time the confidence fairy, amounts to a substantial approval of the policies followed by EMU countries so far. We should stop fooling ourselves: Within the existing rules there is no margin for a meaningful fiscal expansion of the kind invoked by Governor Nowotny. If we look at headline deficit, forecast to be at 2% in 2015, the Maastricht limits leave room for a global fiscal expansion of 1% of GDP, decent but not a game changer (without mentioning the fiscal space of individual countries, very unevenly distributed). And if we look at the main indicator of fiscal effort put forward by the fiscal compact, the cyclical adjusted deficit, the eurozone as a whole should keep its fiscal consolidation effort going, to bring the deficit down from its current level of 0.9% of GDP to the target of 0.5%.
It is no surprise then that the new Italian budget (on which Mario Draghi carefully avoided to comment) is hailed (or decried) as expansionary simply because it slows a little (and just a little) the pace of fiscal consolidation. Within the rules forcefully defended by Draghi, this is the best countries can do. As a side note, I blame the Italian (and the French) government for deciding to play within the existing framework. Bargaining a decimal of deficit here and there will not lift our economies out of their disappointing growth; and more importantly, on a longer term perspective, it will not help advance the debate on the appropriate governance of the eurozone.
In spite of widespread recognition that aggregate demand is too low, Mario Draghi did not move an inch from his previous beliefs: the key for growth is structural reforms, and structural reforms alone. He keeps embracing the Berlin View. The only substantial difference between Draghi and ECB hawks is his belief that, in the current cyclical position, structural reforms should be eased by accommodating monetary policy. This is the only rationale for QE. Is this enough to define him a dove?
A new Occasional Paper details the new methodology adopted by the Bank of Italy for calculating an index of price competitiveness, and applies it to the four largest eurozone economies.
I took the time to copy the numbers of table 3 in an excel file (let’s hope for the best), and to look at what happened since 2009. Here is the evolution of price competitiveness (a decrease means improved competitiveness):
I find this intriguing. We have been sold the story of Spain as the success story for EMU austerity as, contrary to other countries, it restored its external balance through internal devaluation. Well, apparently not. Since 2008 its price competitiveness improved, but less so than in the three other major EMU countries.
The reason must be that the rebalancing was internal to the eurozone, so that the figure does not in fact go against austerity nor internal devaluation. For sure, within eurozone price competitiveness improved for Spain. Well, think again…
This is indeed puzzling, and goes against anedoctical evidence. We’ll have to wait for the new methodology to be scrutinized by other researchers before making too much of this. But as it stands, it tells a different story from what we read all over the places. Spain’s current account improvement can hardly be related to an improvement in its price competitiveness. Likewise, by looking at France’s evolution, it is hard to argue that its current account problems are determined by price dynamics.
Without wanting to draw too much from a couple of time series, I would say that reforms in crisis countries should focus on boosting non-price competitiveness, rather than on reducing costs (in particular labour costs). And the thing is, some of these reforms may actually need increased public spending, for example in infrastructures, or in enhancing public administration’s efficiency. To accompany these reforms there is more to macroeconomic policy than just reducing taxes and at the same time cutting expenditure.
Since 2010 it ha been taken for granted that reforms and austerity should go hand in hand. This is one of the reasons for the policy disaster we lived. We really need to better understand the relationship between supply side policies and macroeconomic management. I see little or no debate on this, and I find it worrisome.
I am ready to bet that the latest IMF World Economic Outlook, that was presented today in Washington, will make a certain buzz for a box. It is box 3.5, at page 36 of chapter 3, which has been available on the website for a few days now. In that box, the IMF staff presents
lack of evidence on the relationship between structural reforms and total factor productivity, the proxy for long term growth and competitiveness. (Interestingly enough people at the IMF tend to put their most controversial findings in boxes, as if they wanted to bind them).
What is certainly going to stir controversy is the finding that while long term growth is negatively affected by product market regulation, excessive labour market regulation does not hamper long term performance.
It is not the first time that the IMF surprises us with interesting analysis that goes against its own previous conventional wisdom. I will write more about this shortly. Here I just want to remark how these findings are relevant for our old continent.
imposed to embraced by eurozone crisis countries has taken the shape of expenditure cuts and labour market deregulation, whose magic effects on growth and competitiveness have been sold to reluctant and exhausted populations as the path to a bright future. I already noted, two years ago, that the short-run pain was slowly evolving into long-run pain as well, and that the gain of structural reforms was nowhere to be seen. The IMF tells us, today, that this was to be expected.
The guy who should be happy is Alexis Tsipras; he has been resisting since January pressure from his peers (and the Troika, that includes IMF staff!) to further curb labour market regulations, and recently presented a list of reforms that mostly pledges to reduce crony capitalism, tax evasion and product market rigidities. Exactly what the IMF shows to be effective in boosting growth. Of course, at the opposite, those who spent their political capital to implement labour market reforms are most probably not rejoicing at the IMF findings.
This happens in Washington. Problem is, Greece, and Europe at large, seem to be light years away from the IMF research department. We already saw, for example with the mea culpa on multipliers, that IMF staff in program countries does not necessarily read what is written at home. Let’s see whether the discussion on Greece’s reforms will mark a realignment between the Fund’s research work and the prescriptions they implement/suggest/impose on the ground.
It seems that we finally have our Bazooka. Quantitative Easing will be put in place; its size is slightly larger than expected (€60bn a month), and Mario Draghi, once again, seems to have gotten what he wanted in his confrontation with hawks within and outside the ECB (I won’t comment on risk sharing. I am far from clear about the consequences of that).
And yet, something is just not right. I am afraid that QE will end up like LTRO and all the other liquidity injections the ECB performed in the past. What bothers me is not the shape of the program (given the political constraints, one could hardly imagine something more radical), but Draghi’s press conference. Here is a quote from the introductory statement:
Monetary policy is focused on maintaining price stability over the medium term and its accommodative stance contributes to supporting economic activity. However, in order to increase investment activity, boost job creation and raise productivity growth, other policy areas need to contribute decisively. In particular, the determined implementation of product and labour market reforms as well as actions to improve the business environment for firms needs to gain momentum in several countries. It is crucial that structural reforms be implemented swiftly, credibly and effectively as this will not only increase the future sustainable growth of the euro area, but will also raise expectations of higher incomes and encourage firms to increase investment today and bring forward the economic recovery. Fiscal policies should support the economic recovery, while ensuring debt sustainability in compliance with the Stability and Growth Pact, which remains the anchor for confidence. All countries should use the available scope for a more growth-friendly composition of fiscal policies.
And here the answer to a question, even more explicit:
What monetary policy can do is to create the basis for growth, but for growth to pick up, you need investment. For investment you need confidence, and for confidence you need structural reforms. The ECB has taken a further, very expansionary measure today, but it’s now up to the governments to implement these structural reforms, and the more they do, the more effective will be our monetary policy. That’s absolutely essential, as well as the fiscal consolidation side. So structural reforms is one thing, budget and fiscal consolidation is a different issue. It’s very important to have in place a so-called growth-friendly fiscal consolidation for confidence strengthening. This combined with a monetary policy which is very expansionary, which has been and is even more so after our decisions today, is actually the optimal combination. But for this now, we need the actions by the governments, and we need the action also by the Commission, both in its overseeing role of fiscal policies and in its implementing the investment plan, which was launched by the President of the Commission, which was certainly welcome at the time, now has to be implemented with speed. Speed is of the essence.
The message could not be any clearer: Draghi expects the QE program to impact economic activity through private spending. What we have here is the nt-th comeback of the confidence fairy: accommodative monetary policy, structural reforms and fiscal consolidation, will cause a private expenditure surge (“[..] but will also raise expectations of higher incomes and encourage firms to increase investment today and bring forward the economic recovery“). We have been told this many times since 2010.
Unfortunately, it did not work like this, and I am afraid it will not this time either. The private sector signals in all surveys available that it is not ready to resume spending. If governments are not given the possibility to spend more, most of the liquidity injected into the system will remain idle, exactly as it was the case for the (T)LTRO.
The concept of countercyclical policies is so trivial as to become commonsensical: Governments should step in when markets step out, and withdraw when markets step in again. Filling the gap will actually sustain economic activity, and crowd-in private expenditure; more so, much more so, than filling the pockets of agents with money they are not willing to spend. This is the essence of Keynes. Since 2010 in Europe governments rushed to the exit together with markets; joint deleveraging meant depressed economy. How could one be surprised that confidence does not return?
I would like to add that invoking more active fiscal policy within the limits of the Treaties has the flavour of a bad joke. Just so as we understand what we are talking about, the EMU 18 in 2014 had a deficit-to-GDP ratio of 2.6% (preliminary estimates by the Commission, Ameco database); this means that to remain within the Treaty a fiscal stimulus would have to be limited to 0.4% of GDP. How large would the multiplier have to be, for this to lift the eurozone economy out of deflation? Even the most ardent Keynesian would have a hard time claiming that!! And also, so as we don’t forget, at less than 95% of GDP EMU, Gross public debt can hardly be seen as an obstacle to a serious fiscal stimulus. Even in the short run.
The point I want to make is that QE is all very good, but European governments need to be put in condition to spend the money. It is tiring to repeat the same thing again and again: in a liquidity trap monetary policy can only be a companion to the main tool that could be used by policy makers: fiscal policy.
But in Europe, bad economic policy is today considered a virtue.
I have just read Mario Draghi’s opening remarks at the Brookings Institution. Nothing very new with respect to Jackson Hole and his audition at the European Parliament. But one sentence deserves commenting; when discussing how to use fiscal policy, Draghi says that:
Especially for those [countries] without fiscal space, fiscal policy can still support demand by altering the composition of the budget – in particular by simultaneously cutting distortionary taxes and unproductive expenditure.
So, “restoring fiscal policy” should happen, at least in countries in trouble, through a simultaneous reduction of taxes and expenditure. Well, that sounds reasonable. So reasonable that it is exactly the strategy chosen by the French government since the famous Jean-Baptiste Hollande press conference, last January.
Oh, wait. What was that story of balanced budgets and multipliers? I am sure Mario Draghi remembers it from Economics 101. Every euro of expenditure cuts, put in the pockets of consumers and firms, will not be entirely spent, but partially saved. This means that the short term impact on aggregate demand of a balanced budget expenditure reduction is negative. Just to put it differently, we are told that the risk of deflation is real, that fiscal policy should be used, but that this would have to happen in a contractionary way. Am I the only one to see a problem here?
But Mario Draghi is a fine economist, many will say; and his careful use of adjectives makes the balanced budget multiplier irrelevant. He talks about distortionary taxes. Who would be so foolish as not to want to remove distortions? And he talks about unproductive expenditure. Again, who is the criminal mind who does not want to cut useless expenditure? Well, the problem is that, no matter how smart the expenditure reduction is, it will remain a reduction. Similarly, even the smartest tax reduction will most likely not be entirely spent; especially at a time when firms’ and households’ uncertainty about the future is at an all-times high. So, carefully choosing the adjectives may hide, but not eliminate, the substance of the matter: A tax cut financed with a reduction in public spending is recessionary, at least in the short run.
To be fair there may be a case in which a balanced budget contraction may turn out to be expansionary. Suppose that when the government makes one step backwards, this triggers a sudden burst of optimism so that private spending rushes to fill the gap. It is the confidence fairy in all of its splendor. But then, Mario Draghi (and many others, unfortunately) should explain why it should work now, after having been invoked in vain for seven years.
Truth is that behind the smoke screen of Draghinomics and of its supposed comprehensive approach we are left with the same old supply side reforms that did not lift the eurozone out of its dire situation. It’ s the narrative, stupid!
Just a quick note on something that went surprisingly unnoticed so far. After Draghi’s speech in Jackson Hole, a new consensus seems to have developed among European policy makers, based on three propositions:
- Europe suffers from deficient aggregate demand
- Monetary policy has lost traction
- Investment is key, both as a countercyclical support for growth, and to sustain potential growth in the medium run
My first reaction is, well, welcome to the club! Some of us have been saying this for a while (here is the link to a chat, in French, I had with Le Monde readers in June 2009). But hey, better late than never! It is nice that we all share the diagnosis on the Eurocrisis. I don’t feel lonely anymore.
What is interesting, nevertheless, is that while the diagnosis has changed, the policy prescriptions have not (this is why I failed to share the widespread excitement that followed Jackson Hole). Think about it. Once upon a time we had the Berlin View, arguing that the crisis was due to fiscal profligacy and insufficient flexibility of the economy. From the diagnosis followed the medicine: austerity and structural reforms, to restore confidence, competitiveness, and private spending.
Today we have a different diagnosis: the economy is in a liquidity trap, and spending stagnates because of insufficient expected demand. And the recipe is… austerity and structural reforms, to restore confidence, competitiveness, and private spending (in case you wonder, yes, I have copied-pasted from above).
Just as an example among many, here is a short passage from Mario Draghi’s latest audition at the European Parliament, a couple of weeks back:
Let me add however that the success of our measures critically depends on a number of factors outside of the realm of monetary policy. Courageous structural reforms and improvements in the competitiveness of the corporate sector are key to improving business environment. This would foster the urgently needed investment and create greater demand for credit. Structural reforms thus crucially complement the ECB’s accommodative monetary policy stance and further empower the effective transmission of monetary policy. As I have indicated now at several occasions, no monetary – and also no fiscal – stimulus can ever have a meaningful effect without such structural reforms. The crisis will only be over when full confidence returns in the real economy and in particular in the capacity and willingness of firms to take risks, to invest, and to create jobs. This depends on a variety of factors, including our monetary policy but also, and even most importantly, the implementation of structural reforms, upholding the credibility of the fiscal framework, and the strengthening of euro area governance.
This is terrible for European policy makers. They completely lost control over their discourse, whose inconsistency is constantly exposed whenever they speak publicly. I just had a first hand example yesterday, listening at the speech of French Finance Minister Michel Sapin at the Columbia Center for Global Governance conference on the role of the State (more on that in the near future): he was able to argue, in the time span of 4-5 minutes, that (a) the problem is aggregate demand, and that (b) France is doing the right thing as witnessed by the halving of structural deficits since 2012. How (a) can go with (b), was left for the startled audience to figure out.
Terrible for European policy makers, I said. But maybe not for the European economy. Who knows, this blatant contradiction may sometimes lead to adapting the discourse, and to advocate solutions to the deflationary threat that are consistent with the post Jackson Hole consensus. Maybe. Or maybe not.