Update (1/7/2016): The whole paper is now available on Repec.
I have recently written a text on EMU governance and the implementation of a Golden Rule of public finances. I will provide the link as soon as it comes out. The last section of that paper can be read stand alone (with some editing). A bit long, I warn you, but here it is:
Because of its depth, and of its length, the crisis has triggered an interesting discussion among economists about whether the advanced economies will eventually return to the growth rates they experienced in the second half of the twentieth century.
One view, put forward by Robert Gordon focuses on supply-side factors. Gordon argues that each successive technological revolution has lower potential impact, and that in this particular moment, “Slower growth in potential output from the supply side, emanating not just from slow productivity growth but from slower population growth and declining labor-force participation, reduces the need for capital formation, and this in turn subtracts from aggregate demand and reinforces the decline in productivity growth.”
In a famous speech at the IMF in 2013, later developed in a number of other contributions, Larry Summers revived a term from the 1930s, “secular stagnation”, to describe a dilemma facing advanced economies. Summers develops some of Gordon’s arguments to argue that lower technical progress, slower population growth, the drifting of firms away from debt-financed investment, all contributed to shifting the investment schedule to the left. At the same time, the debt hangover, accumulation of reserves (public and private) induced by financial instability, increasing income inequality (on that, I came first!), tend to push the savings schedule to the right. The resulting natural interest rate is close to zero if not outright negative, thus leading to a structural excess of savings over investment.
Summers argues that most of the factors exerting a downward pressure on the natural interest rate are not cyclical but structural, so that the current situation of excess savings is bound to persist in the medium-to-long run, and the natural interest rate may remain negative even after the current cyclical downturn. The conclusion is not particularly reassuring, as policy makers in the next several years will have to navigate between the Scylla of accepting permanent excess savings and low growth (insufficient to dent unemployment), and the and Charybdis of trying to fight secular stagnation by fuelling bubbles that eliminate excess savings, at the price of increased instability and risks of violent financial crises like the one we recently experienced.
The former IMF chief economist Olivier Blanchard has elaborated on the meaning of Summers’ conjecture for macroeconomic policy. If interest rates will remain at (or close to) zero even once the crisis will be over, monetary policy will continuously face the Scylla and Charybdis. The recent crisis is a good case study of this dilemma, with the two major central banks of the world under fire from some quarters, for opposiite reasons: the Fed for having kept interest rates too low, contributing to the housing bubble and the ECB for having done too little and too late during the Eurozone crisis.
Drifting away from the Consensus that he contributed to consolidate, Blanchard concludes that exclusive reliance on monetary policy for macroeconomic stabilization should be reassessed. With low interest rates that make debt sustainability a non-issue; with financial markets deregulation that risks yielding more variance in GDP and economic activity; and with monetary policy (almost) constantly at the Zero Lower Bound, fiscal policy should regain a prominent role among the instruments for macroeconomic regulation, beyond the cycle. This is a very important methodological advance.
Nevertheless, in his plea for fiscal policy, Blanchard falls short of a conclusion that naturally stems from his own reading of secular stagnation: If the economy is bound to remain stuck in a semi-permanent situation of excessive savings, and if monetary policy is incapable of reabsorbing the imbalance, then a new role for fiscal policy may appear, that goes beyond the short-term stabilization that Blanchard (and Summers) envision. In fact, there are two ways to avoid that the ex ante excess savings results in a depressed economy: either one runs semi-permanent negative external savings (i.e. a current account surplus), or one runs semi-permanent government negative savings. The first option, the export-led growth model that Germany is succeeding to generalize at the EMU level, is not viable, except for an individual country implementing non cooperative strategies, because aggregate current account balances need to be zero. The second option, a semi-permanent government deficit, needs to be further investigated, especially in its implication for EMU macroeconomic governance
There are a number of ways, not necessarily politically feasible, to allow EMU countries to run semi-permanent government deficits. A first one could be to restore complete national budget sovereignty, (scrapping the Stability Pact). This would mean relying on market discipline alone for maintaining fiscal responsibility. As an alternative, at the opposite side of the spectrum, countries could create a federal expenditure capacity (which would imply the creation of an EMU finance minister with capacity to spend, the issuance of Eurobonds, etc.). Such an option is as unrealistic as the previous one. 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 would necessary. The increasing mistrust among European countries exhausted by the crisis, and the fierce opposition of Germany and other northern countries to any hypothesis of debt mutualisation, make this strategy virtually impossible. The solution must therefore be found at national level, without giving up European-wide coordination, which would guarantee effective and fiscally sustainable investment programs.
In general, the multiplier associated with public investment is larger than the overall expenditure multiplier. This is particularly true in times of crisis, when the economy is, like today, at the zero lower bound. With Kemal Dervis I proposed that the EMU adopts a fiscal rule similar to the one implemented in the UK by Chancellor of the Exchequer Gordon Brown in the 1990s, and applied until 2009. The new rule would require countries to balance their current budget, while financing public capital accumulation with debt. Investment expenditure, in other words, would be excluded from deficit calculation, a principle that timidly emerges also in the Juncker plan. Such a rule would stabilize the ratio of debt to GDP, it would focus efforts of public consolidation on less productive items of public spending, and would ensure intergenerational equity (future generations would be called to partially finance the stock of public capital bequeathed to them). Last, but not least, especially in the current situation, putting in place such a rule would not require treaty changes, and it is already discussed, albeit timidly, in EU policy circles.
To avoid the bias towards capital expenditure that the golden rule could trigger, we proposed that at regular intervals, for example 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.
Life and work keep having the nasty habit of intruding into this blog, but it feels nice to resume writing, even if just with a short comment.
We learned a few weeks ago that the Bank of Japan has walked one extra step in its attempt to escape lowflation, and that it has committed to overshoot its 2% inflation target. A “credible promise to be irresponsible”, as the FT says quoting Paul Krugman.
This may be a long overdue first step towards a revision of the inflation target, as invoked long ago by Olivier Blanchard, and more recently by Larry Ball. This is all too reasonable: if the equilibrium interest rates are negative, if monetary policy is bound by the zero-or-only-slightly-negative-lower-bound, higher inflation targets would make sense, and 4% is an arbitrary target as legitimate as the current also arbitrary 2% level. Things may be moving, as the subject was evoked, if not discussed, at the recent Central Bankers gathering in Jackson Hole. We’ll see if anything comes out of this.
But the FT also adds an interesting comment to the BoJ move, namely that the more serious risk is a blow to credibility. If it failed to lift the inflation to the 2% target, how can it be credibly believed to overshoot it?
This is a different sort of credibility issue, much more reasonable indeed, than the one we have been used to in the past three decades, linked to the concept of dynamic inconsistency. In plain English the idea that an actor has no incentive to keep prior commitments that go against its own interest, and hence deviates from the initial plan. Credibility was therefore associated to changing incentives over time (typically for policy makers), and invoked to recommend rules over discretion.
Today, eight years into the zero lower bound, we go back to a more intuitive definition of credibility: announcing an objective and not being able to attain it.
The difference between the two definitions of credibility is not anodyne. In the first case, the unwillingness of central banks to behave appropriately can be corrected through the adoption of constraining rules. In the latter, the central bank cannot attain the objective regardless of incentives and constraints, and other strategies need to be put in place.
The other strategy, the reader will not be surprised to learn, is fiscal policy. Monetary dominance is in fact a second tenet of the Consensus from the 1990s that the crisis has wiped out. We used to live in a world in which structural reforms would take care of increasing potential growth, monetary policy would be used to take care of (minor) demand-driven fluctuations, and fiscal policy was in a closet.
This is gone (luckily). Even the large policy making institutions now call for a comprehensive and multi-instrument policy making. The policy mix, a central element of macroeconomics in the pre-rational expectations era, is now back. Even the granitic dichotomy between short (demand driven) and long (supply driven) term, is somewhat rediscussed.
The excessively simplified consensus that dominated macroeconomics for the past thirty years seems to be seriously in trouble; complexity, tradeoffs, coordination, are now the issues discussed in academia and in policy circles. This is good news.