Sunday, 1 February 2015

Saying the obvious

Give any student who has just done a year of economics some national accounts data for the US, UK and Eurozone, and ask them why the recovery from the Great Recession has been so slow, and they will almost certainly tell you it is because of fiscal austerity. And they would be right, as I set out in this recent VoxEU piece. There I present some back of the envelope calculations, but they are confirmed by model simulations: not just those I quoted in the text, but also others that I did not have space to mention.

When writing that piece, I kept having doubts. Not about the analysis, but just that this was all so obvious. It uses basic models (DSGE or more eclectic) that we teach undergraduates and postgraduates. It is supported by the clear majority of empirical evidence. I felt like I was telling people the macroeconomic equivalent of a rise in the demand for apples will mean an increase in their price.

The reason I put those doubts aside are also familiar. The fact that at least half the world’s politicians and mediamacro continue to ignore the obvious. The fact that too many economists continue to look for other reasons to explain this malaise (or pretend there is no malaise), because somehow they think acknowledging that fiscal policy can influence demand is old fashioned, or left wing, or something. These facts and that I was in good company.

While there are too many academic economists who want to deny that fiscal policy is largely responsible for the weak recovery from the Great Recession, I also suspect there is a majority that know it is true. This is why I wrote a post about the lessons to draw for the future. Although we teach students all about time inconsistency and say at the same time what advantages independent central banks can have, I suspect we also know that the case for independent central banks is broader than issues to do with commitment.

Economics is always in danger of being corrupted by politics and ideology, and macroeconomics seems particularly vulnerable in this respect. (I have still not entirely convinced myself if and why macroeconomics is special in this respect. Sometimes things that are actually micro, like financial regulation or labour supply responses to tax changes, seem just to get labelled macro when they become controversial or have macro consequences!) Some say that this corruption is inevitable and that we should embrace it, rather than attempt to avoid it through delegation to institutions like independent central banks. I disagree: demand management is basically a technical issue with political implications. If we did not have independent central banks today, I suspect we would be seeing the US congress voting to raise interest rates. And of course there would be a few economists with their models saying it was a good idea, even though the vast majority thought otherwise.

The reaction to my earlier post, both from comments and elsewhere, was that this weak recovery caused by fiscal austerity was not just bad luck caused by a misreading of the Eurozone crisis, but the result of a more fundamental political economy problem. We therefore need to rethink how stabilisation policy is done at the Zero Lower Bound (ZLB). Of course we also need to think about whether we should try and minimise these ZLB episodes, by either raising the inflation target, or by reformulating how monetary policy is done, or some other means. However the risk of large negative demand shocks will remain, so it would be prudent to complete the delegation of macroeconomic stabilisation policy that was begun by making the operation of interest rate policy independent of political control. Doing that would also be a good opportunity to revisit the arrangements that can ensure independence is compatible with accountability and some degree of democratic oversight.   

Saturday, 31 January 2015

Delusions on the UK left

Syriza has won the Greek election, which is the result I hoped for. For some this heralds the death of neoliberalism. To celebrate, George Monbiot - whose journalism consistently tells me more than most other journalists - says that here in the UK we should no longer vote tactically, but instead vote for what we want. What dangerous nonsense!

At least he is honest in what such an approach implies. Anyone who votes Green in any seat where Labour has a chance to win, aside from maybe a few seats where the Greens have a chance (more realistically one or two), is voting for a Conservative government. They will be in small part responsible for what happens under that government. (Not voting in a seat Labour has a chance to win is almost as bad.) This is going to be a tight election, so it matters. [1]

Monbiot says “If Labour wins in May, it is likely to destroy itself faster and more surely than if it loses, through the continued implementation of austerity.” His normal high standards of journalism based on solid research go out of the window. I have, along with the IFS and Resolution Foundation and many others, repeatedly pointed out that there is a huge difference between Labour and Conservative fiscal plans beyond 2015. It is quite possible that we will see very little additional fiscal tightening under Labour, and a lot more public investment.

But with Monbiot in this mood, all this means nothing. The additional hardship that those that depend on the state will undoubtedly suffer if Labour do not win: collateral damage for the eventual triumph of the left. The disintegration of the NHS starved of funds: it will happen anyway  - but the last Labour government raised taxes to increase NHS spending! This is not a strategy based on any kind of analysis, but wishful thinking because he finds it distasteful to vote tactically. (The British people had a chance to change their electoral system, and they chose not to.)

In looking at Labour, he sees only their departures from his own vision, and ignores their virtues and the realities of gaining power in today’s environment. He thinks Labour is currently silent on the evils of austerity because they believe in its virtues, whereas in reality they have been forced into this position by mediamacro’s obsession with the deficit. That is why they do not publicise their very different fiscal plans, but good journalism should see through that. Wouldn’t it be nice to have a prime minister who was prepared to stand up to the Murdoch press - oh wait. Wouldn’t it be nice to have a prime minister who said: “This country is too unequal. And we need to change it." - oh wait again (see postscript).

To say that Monbiot’s analysis represents a profound misreading of history seems trivially obvious, but not for left utopianism. Monbiot says “Fearful voting shifts the whole polity to the right.” Where is the evidence for that? Neoliberalism did not triumph because the left decided to compromise. Yes Greece voted for Syriza, but only when half of its young people were stuck in unemployment. Is that the future that he hopes for by abandoning tactical voting?

Parts of the radical left has always suffered from this misty eyed idealism, where through blurred vision everyone else looks the same. I remember being told by otherwise very intelligent people on the left that there was no real difference between George Bush and Al Gore. Monbiot described voting No in the Scottish referendum as “an astonishing act of self-harm”: no matter that the SNP tried to deceive the electorate that they would at all times be better off independent; a sorry claim given what has subsequently happened to the oil price. No doubt some said in 2010 that a future Labour government would be much the same as a Conservative government. Please, just look at the evidence.  

So, to repeat, anyone voting Green (or failing to vote) in a seat that Labour can win but the Greens cannot will in part be responsible for the consequences of a future Conservative government.

[1] An interesting question, from an academic point of view, is whether this argument is symmetrical, applying to UKIP and the Conservatives. Perhaps not in one sense. If Labour loses because of votes lost to the Greens, the reaction within the party will simply be to look for a more telegenic leader. If the Conservatives lose because of votes lost to UKIP, perhaps there is a chance that the Conservative Party will merge with UKIP, and adopt leaving the EU as policy.

Thursday, 29 January 2015

To all UK journalists

who plan to talk about the economy over the next 100 days. Here is a very simple fact. [3] GDP per head (a much better guide to average prosperity than GDP itself) grew at an average rate of less than 1% in the four years from 2010 to 2014. [1] In the previous 13 years (1997 to 2010), growth averaged over 1.5%. So growth in GDP per head was more than 50% higher under Labour than under the Conservatives, even though the biggest recession since the 1930s is included in the Labour period!

You have all read, and perhaps written, that the Conservatives will focus on the economy, because they think that is their strong point. Compared to their performance on other issues, maybe it is their strong point. But relative to the previous administration, this simple fact suggests otherwise.

George Osborne says: “Britain has had the fastest growing major economy in the world in 2014.” However GDP per head in the UK in 2014 remains below 2007 levels, but it had exceeded those levels in the US and Japan by 2013. The UK is not bottom of the league in these terms only because the Eurozone’s performance has been so poor. That GDP per head growth under 1.9% in 2014 can be trumpeted as a great success when it is no more than average growth between 1971 and 2010, and when we should be recovering from a huge recession, and when there are signs that this growth may not be sustainable, shows how diminished our expectations have become.  

In terms of a historical comparison between the record of this government and the previous administration Labour has no case to answer, because its performance is miles better. I am sure a supporter of the current government would say at this point that they had to clear up the mess that Labour created. But just think what such an excuse implies:

(1)  The Great Recession was in 2009, so it is included in the Labour government’s growth average, not that of the current government. You can see the impact of the recession on the average (the red line) in the chart below. [2] Are they really saying that the mess Labour left was worse than the impact of the global financial crisis!?

(2)  This excuse implies that bringing the government deficit down rapidly (austerity) meant that GDP growth is bound to be lower. This is something that the government’s critics have long argued, and which the OBR agrees with [4], but the government has always denied. Are they now admitting that austerity was (really) bad for growth?

(3)  If a government was elected just after a major recession, you would normally expect the exact opposite from these figures to be true. The new government would benefit from the recovery from the recession, while their predecessors average would be weighed down by the recession itself. So in any normal world, you would expect GDP per head to have grown much more rapidly over the last four years than any long run average. The fact that it has grown by considerably less means that the government should have a lot of explaining to do.

Growth under Labour, including the Great Recession, was 50% better than under the Coalition. So please, if you want to make your reporting on the economy over the next 100 days objective, use this fact. If the Conservatives win this election because enough people believe that they are more competent than the previous government at handling the economy, it will be a devastating verdict - on the UK media and its journalists.  

Quarter on previous year's quarter growth in UK GDP per head, 1997Q2 to 2014Q3

[1] The ONS data can easily be found here. The fourth quarter data is not out yet, so I have taken the ONS data updated on 21st January, and assumed growth of 0.5% in the final quarter, which is the first estimate of GDP growth in that quarter. That is obviously an overestimate, as it assumes no population growth in that quarter.

[2] The chart uses quarter on previous year’s quarter growth rates for the actual data (no estimates), and the average shown there is simply the average of these growth rates.

[3] A tweet from Ann Pettifor inspired this post, but of course responsibility for it is entirely mine.

[4] The OBR estimate, somewhat conservatively, that austerity reduced GDP growth by 1% in both FY 2010-11 and 2011-12. That alone would raise the average growth in GDP per head over the four years from 0.9% to 1.4%. Research by Jorda and Taylor suggests austerity had larger and more prolonged effects. 

Wednesday, 28 January 2015

Debt restructuring: a proposed principle

With Greece under Syriza about to enter negotiations with the Troika, there has been much discussion of what might happen, and what should happen. This post is in the ‘should’ category. In the past I have argued that the Troika should welcome the opportunity to put right earlier mistakes. There should be a large amount of guilt, or at least regret, on their side. I will say why in a minute, but just to show that I’m not living in a dreamland, read this FT piece by Reza Moghadam, the former head of the European Division of the IMF.

In reality debt restructuring is a bargaining game, but I want to suggest a general principle that any agreement should hold to. That principle is that there should be no significant increase in unemployment above its natural rate (let’s call this excess unemployment) as a direct result of having to pay interest on any government debt. Unemployment above the natural rate when there is no excess core inflation is a waste of resources as well as being damaging to most of those unemployed, so any deal that creates such unemployment, or allows it to persist, should be regarded as the result of creditors acting against the social good. Indeed you could easily argue that it involves creditors acting against their own self-interest, because the more of an economy’s resources you waste, the less is available to pay its debts.

This is why the Troika should feel guilty, because by not allowing Greece to default on all its debt back in 2010 it helped create a situation where over half young people in Greece are unemployed. Some excess unemployment was inevitable in Greece after 2010 because the country had become very uncompetitive, and the impact of this on demand had been offset by large primary budget deficits. (This problem was made worse by pre-recession cost-cutting in Germany.) However, as I have argued in the past in the context of Latvia, the efficient way to restore competitiveness is to have small but persistent excess unemployment: a ‘short sharp shock’ is much more costly. The Troika imposed much too much austerity on Greece in a futile effort to avoid full and early default.

The process transferred the ownership of the remaining Greek government debt from the private sector to the public sector - other Eurozone governments and the IMF. The transfer to other European governments was wrong in two respects. First, it was another example of governments bailing out their own banks and other financial institutions with no costs to those institutions. Second, it made any subsequent restructuring of Greek debt much more difficult politically. If there had been full and immediate default there would have still been need for additional lending to Greece to give them time to adjust their public finances and avoid a large increase in unemployment, but that is what the IMF is for. If the Troika had not been involved, the IMF may well have gone for early and complete default.

So much for the past and guilt. What about what should happen now. The priority is for Greece to reduce unemployment as quickly as possible. That would be consistent with my principle, and so should be a priority for both sides. It could be achieved, for example, by suspending all interest payments on all Greek debt immediately, with those payments resuming on any debt not written off once excess unemployment had been eliminated. Paul Krugman shows what a positive effect no longer having to run a primary surplus to pay interest could have on the Greek economy. (As Paul Krugman observes in a separate post, and OECD data confirm, the competitive position of Greece is now back to the level it was when the Euro was created.)

What about all the ‘structural reform’ that the Troika has imposed. The new Greek government is likely to introduce plenty of structural reform of its own, so encouragement from outside is hardly necessary. If it is not the structural reform that the Troika prefers, then I’m afraid that is the price you pay for having a democratic Europe. We know that some within the Eurozone bureaucracy have little respect for national sovereignty, and it is time these people were put in their place.  

What about the backlash from voters in Northern Europe? I find arguments that say this should be (we are talking about what should happen here) a barrier to debt restructuring hard to take seriously. Northern Europe’s politicians foolishly socialised the Greek debt held by their own country’s financial institutions. To say Greece has to pay the price of this mistake seems perverse. What about other periphery countries wanting to revise the terms they were required to accept for Troika help? Well maybe they are right to do so. And finally what about the argument that this would ‘frighten the markets’ (always a good tell by the side that uses it that their argument is weak)? The markets will be unsettled far more if negotiations break down because creditors refuse to give enough.

Germany is now the third most popular country of origin for pageviews of my blog, which is something I’m very happy about. I’m sure at least some of those readers will be worrying that any renegotiation violates ‘the law’, or at least contracts that have been previously agreed. I have very little sympathy with that argument. The British government was also protecting the rule of law when it provided armed guards to ensure that shipments of grain left Ireland during the famine of the 1840s.

Even if you do not accept my argument about the role that creditors played in inflicting great harm on the Greek economy and people in the past, these creditors have a clear choice for the future. Current levels of unemployment in Greece represent a criminal waste of resources and source of unhappiness, and it should be brought to an end as soon as possible. Creditors can make this happen with a small economic cost to themselves by at least suspending all interest payments until the Greek economy has recovered. It is a cost that creditors are almost certainly going to have to pay at some point anyway. As Martin Wolf says in an excellent column, “What cannot be paid will not be paid.” It would be much better for the Greek people and Europe as a whole for the Troika to admit this now rather than later.    

Tuesday, 27 January 2015

Post Recession Lessons

If you are familiar with this blog, you will know that I regard 2010 as a fateful year for the advanced economies in their recovery from recession. That was the year that the US, UK and Eurozone switched from fiscal stimulus to fiscal contraction. Because we were at the Zero Lower Bound (ZLB), this policy switch is directly responsible for the weak recovery in all three countries/zones. A huge amount of resources have been needlessly wasted as a result, and much misery prolonged.

This post is not about justifying that statement, but taking at as given and asking what should we conclude as a result. [1] To answer that question, what happened in Greece (in 2010, not two days ago) may be critical. To see why, let me paint a relatively optimistic picture of the recent past. 

Greece had to default because previous governments had been profligate and had hidden that fact from everyone, including the Greek people. Recessions rather than booms tend to be when things like that get exposed. If Greece had been a country with its own exchange rate, then it would have been a footnote in global macroeconomic history: fiscal stimulus that had begun in all three countries/zones in 2009 would have continued (or at least not been reversed), and the recovery would have been robust.

Instead Greece was part of the Eurozone, a monetary union that had been implemented in such a way that it was particularly vulnerable to the threat of default by one of its members. Policy makers in other union countries prevaricated, partly to protect their own banks, partly because they worried about contagion. The ECB refused to act as a lender of last resort - we only got OMT in 2012. So the Greek crisis became a Eurozone periphery crisis. (For more detail, based on an IMF evaluation of their role in this affair, see this post.) This led to panic not just in the Eurozone but in all the advanced economies. Stimulus turned to austerity. By the time some in organisations like the IMF began to realise that this shift to austerity had been a mistake, it was too late. The recovery had been anemic.

Why is that an optimistic account? Because it is basically a story of bad luck, which we have no reason to believe will be repeated again. When the next crisis comes along, the Eurozone will have OMT in place, and hopefully there will be some rational system for deciding when a Eurozone country that gets into difficulties should get ECB help or should be allowed to default. If this was just bad luck, we do not need to rethink how macro policy is made.

Now for the pessimistic version. The political right in all three countries/zones was always set against fiscal stimulus. It is true that during 2009, when no one was sure how bad things might get, Germany enacted a modest (if fairly ineffective [2]) stimulus, but in the US and UK the political right opposed it. Without Greece, we still would have had a Conservative led government taking power in the UK in 2010, and we still would have had Republicans blocking stimulus moves and then forcing fiscal austerity. The right’s strength in the media, together with the ‘commonsense’ idea that governments like individuals need to tighten their belts in bad times, would mean that opposition to austerity within the political elite would be lukewarm, and so austerity was bound to prevail. While we might hope that this right wing opportunism does not happen again during a future crisis, there is no clear reason to believe it will not. Greece may have just voted against austerity, but there is every chance that in the UK the Conservatives will retain power this year on an austerity platform and the Republicans are just the presidency away from complete control in the US.

If the pessimistic account is right, then it has important implications for macroeconomics. Although it may be true that fiscal stimulus is capable of assisting monetary policy when interest rates are at the ZLB, the political economy of the situation will mean it may well not happen, and that instead we get the fiscal instrument moving in the wrong direction. That means that macroeconomists have to start thinking about how to fundamentally change the way policy is done at the ZLB.

When some economists over the last few years began to push the idea of helicopter money, I was initially rather sceptical. The scepticism could be summed up by saying that helicopter money when you have inflation targets is identical to tax cuts plus Quantitative Easing (QE), so why not just argue for an expansionary fiscal policy? (There was also the point that tax cuts might be a rather poor form of stimulus compared to, for example, bringing forward public investment.)

However, if the pessimistic account is correct, then arguing with politicians for better fiscal policy is quite likely to be a waste of time, a lost cause. A more robust response is to argue for institutional changes so that politicians find it much more difficult to embark on austerity at the ZLB, or to allow others to effectively offset this austerity if it happens. Central banks have QE, but helicopter money would be a much more effective instrument. To put it another way, central bank independence was all about taking macroeconomic stabilisation away from politicians, because politicians were not very good at it. The last five years have demonstrated how bad at it they can be. However that move to independence was always incomplete because of the ZLB problem. We now need to make it complete.

This of course raises all kinds of questions. Do we want to give additional powers to the central bank, or should another independent institution be involved? If we do give central banks more power, could this be limited to enforcing a dialogue between central banks and government (along the lines suggested here), or should we go for something like helicopter money? If the latter, what are the knock on consequences to ensure the central bank can always tighten policy as necessary? Going down that road must in my view include thinking about how to make central banks a lot more accountable, so that they do not behave like the ECB. Arguably macroeconomics has been naive in suggesting that the more independent a central bank is the better.

However, we only need to go there if the pessimistic interpretation of the last five years is correct. Should we put the last five years down to bad luck, or to political economy forces that will not go away. I currently think the pessimistic interpretation is more persuasive, but I will be very happy to change my mind.

[1] Many argue that the recovery was weak because the recession was caused by a financial crisis, and it was always going to take a long time before banks would start to want to lend again. Even if you put a lot of weight on this argument, it implies a multiplier of one, not zero. It does not justify reducing public spending and employment i.e. making people unemployed when there was little chance they would find work in the private sector.

[2] The stimulus focused on tax cuts, which are less effective than increased government spending because some of the tax cuts will be saved. See Carare, A, Mody, A and F Ohnsorge (2009) “The German fiscal stimulus package in perspective” VoxEU  23/01/09. 

Sunday, 25 January 2015

Keeping quiet about hidden motives?

This is about UK politics, but it involves a wider point that applies in all countries where austerity policies are being justified by the need for immediate deficit reduction  

John Rentoul, chief political commentator for The Independent on Sunday, liked my Prospect debate with Oliver Kamm. To quote:

“I found it usefully clarifying. I started off on Kamm’s side, because I worry about running a huge deficit in case interest rates return to normal. But Wren-Lewis makes a convincing case for worrying about that later, although he threw away some of his advantage at the end by suggesting George Osborne has an ulterior motive for cutting public spending, namely the ideology of a smaller state. Who wants the state to be larger than it need be?”

There is an awful lot I could talk about in that paragraph, but let me focus on the ulterior motive point. [1] First the bit of my argument that Rentoul is referring to.

“Why is this government proposing to repeat past mistakes, and embark on a policy that makes so little sense in terms of the macroeconomics taught to students around the world? As an academic I have tried and failed to find a macroeconomic logic to what the government is proposing. Could it be that in reality the deficit is a smokescreen to hide the underlying goal, which is a smaller state? The British people do not want a smaller state, so the only way it can be achieved is by maintaining the myth that reducing the deficit is our top priority. The government can only get away with this myth as long as enough of the media, with the help of City economists, support it.”

Let me be honest here. I did think twice before writing this, because I knew it might evoke a negative reaction among some who read it. Why not, as Rentoul suggests, just stick to the ‘no macroeconomic rationale’ point?

Before directly addressing this, let me draw an analogy. Here is a piece by Jeffrey Sachs in the FT about climate change which on this occasion I’m happy to agree with. He does not waste time with a point by point refutation of everything that climate change sceptics put forward. Here is his conclusion:

“At the end of the day, we have a classic story of political economy. There is a very concentrated but very weighty interest group with an interest in finding and pumping oil, and then there is the rest of humanity, with an interest in a rapid transition to a low-carbon future. The interest group owns Congress and much of the airwaves; it moves election results in Australia and Canada, two other carbon economies; it drives politics in the Middle East and Russia. Politics is often a close call. This one – for the survival of the planet – is going down to the wire, with a crucial rendezvous in Paris at the end of the year.”

Now you might equally say on this occasion why taint a perfectly good scientific case about climate change with conspiracy theories about oil interests? There are two excellent reasons. First, the trouble with debating the 'scientific' arguments of this interest group at face value is that it gives the impression that there is genuine debate going on, and that the key facts about climate change are controversial in scientific terms. That is nonsense, but it is also exactly the impression that this interest group wants to create. Most people will not go through the science and realise that the sceptics case is virtually non-existent. Instead they will think the science is controversial, and so go with their instinct, or with whatever those who support their politics advocate. This is why the US has an unusually low number of people who think climate change is a major threat. Second, I think social scientists have a duty to explain the world as they see it, and not hide these truths away because it might be too much for some.

Of course climate change and austerity debates are not completely comparable for many reasons. However when it comes to the macroeconomics of Osborne’s policy, I think we have now reached a similar point. Back in 2010, there was an arguable case for rapid deficit reduction, particularly as the source of the Eurozone crisis was unclear. In 2014 we know a lot more. Let me justify that with three arguments.

First, the paragraph I wrote is quite truthful in describing my own thought process. I have searched hard to find a macroeconomic rationale for Osborne’s policy stance. A belief that QE is as effective as conventional monetary policy (there is no liquidity trap) comes close, but as I explained here it does not really fit with what Osborne has said (or not said). Osborne is certainly no market monetarist, as he has shown no interest in nominal GDP targeting. So there does not appear to be a coherent case for Osborne’s fiscal proposals that a macroeconomist could take seriously.

Second, the idea that the real motive is a small state is not the preserve of some small group of left wing conspiracy theorists. Here I quote Jeremy Warner, economics editor of the Telegraph (for non-UK readers, a newspaper firmly to the right): “In the end, you are either a big-state person, or a small-state person, and what big-state people hate about austerity is that its primary purpose is to shrink the size of government spending.” He also wrote: “The bottom line is that you can only really make serious inroads into the size of the state during an economic crisis. This may be pro-cyclical, but there is never any appetite for it in the good times; it can only be done in the bad.” I also think many of my non-UK readers will wonder why I am having to justify what is obvious in their countries.

Third, it must have become clear to many people now that reducing the deficit cannot be the overriding priority when there have been so many tax giveaways (50p rate, Help to Buy which creates large contingent liabilities, Cameron’s conference commitments, stamp duty changes that are far from fiscally neutral, pensioner bonds). Putting these down to ‘politics’, but counting spending cuts as ‘economics’, will not wash. (See Brad DeLong for the equivalent in the US). You cannot pretend that deficit reduction is driving government policy, when that driver only operates on the spending side of the accounts.

Economists in the media are beginning to realise this. It is really important that political commentators do so as well, so that those without an economics background get a clearer idea of the nature of the choices they will have to make in 100 days time.

[1] Who wants the state to be larger than it need be? I couldn’t agree more, but then each state activity should be examined on a case by case basis. Osborne’s cuts are not based on analysis of that kind, because it presupposes the result (there have to be cuts of a certain size). 

Friday, 23 January 2015

Alternative Eurozone histories

I missed this paper by Philippe Martin and Thomas Philippon when it came out last October, but thanks to Francesco Saraceno I have now read it. There is also a VoxEU post by the authors. It is particularly interesting for me because it undertakes analysis (using a model which is itself interesting but which would make this post too long to discuss) of a couple of alternative histories for the Eurozone which are related to two claims that I have made in the past:

1)    It is now widely accepted among macroeconomists (but not politicians or the media) that fiscal profligacy was only the major cause of subsequent problems in Greece, while elsewhere private excess was the main problem. I have argued that aggressive countercyclical fiscal policy before 2008 would have reduced subsequent problems.

2)    If the ECB’s OMT programme had been implemented in 2010, rather than September 2012, this would have substantially reduced the degree of austerity required outside Greece. As a result, these countries would have had a better recovery from the Great Recession. [2]

Put the two claims together and I would argue that the 2010-12 Eurozone crisis (rather than just a Greek crisis) need not have happened. OMT would have limited fears of contagion, allowing a quicker and more complete Greek default. There would have been no funding crisis outside Greece, and no need for the core Eurozone economies to immediately embark on austerity.

How does the paper address these arguments? In terms of fiscal policy, it imagines reaction functions for government spending and transfers that contain a (common) countercyclical element, but also a (country specific) positive drift term, in Greece, Ireland, Portugal and Spain. One counterfactual eliminates the drift. This does not exactly fit the scenario I had in mind, because I see actual policy as not being countercyclical but (Greece apart) having less drift. However the end result is the same: a counterfactual with much more fiscal tightening before the recession. An interesting result is that tighter fiscal policy could have substantially reduced the rise in interest rates spreads in Ireland and Spain. The pre-2008 employment boom would not have happened in Greece, and would have been substantially reduced in Ireland, but the impact in Spain would have been smaller but non-negligible.

It conducts another counterfactual which imagines macroprudential policies that eliminated the household leverage boom in each country. This has a significant effect in reducing the boom in Ireland and Spain. (There was no actual employment boom in Portugal.) By inference a combination of countercyclical fiscal policy with no drift, plus macroprudential policies, would have been ideal.

So claim (1) seems to hold up fairly well. Of particular interest is what would have happened to employment from 2008 under a purely countercyclical fiscal policy. In Spain it would have fallen as a result of the recession, but subsequently stabilised rather than continuing to fall as it did in reality. In Ireland employment would have fallen in the recession, but would have risen again from 2010 rather than continuing to fall. This is partly because countercyclical fiscal policy would have helped, but also because lower levels of debt going into the recession would have reduced the increase in interest rate spreads, easing monetary policy.

With a pure countercyclical fiscal policy the debt to GDP ratio in Greece would have stayed flat (because there would have been no boom), suggesting that the Greek crisis was essentially a result of fiscal profligacy. In Spain the debt to GDP ratio would have fallen to nearly 20% of GDP, rather than staying above 40% of GDP in reality. In Ireland public debt would have been largely eliminated. This indicates the substantial amount of countercyclical policy that was required to tackle what were very large domestic booms. (Fiscal policy would presumably have been less contractionary if combined with macroprudential controls.) It also tells us how foolish it was to have a Stability and Growth Pact which essentially ignored the need for such countercyclical fiscal policy.

Claim (2) is examined in its own counterfactual, which essentially eliminates the increase in interest rate spreads that occurred from 2008. The beneficial effects on all four periphery countries are substantial. This counterfactual is unrealistic for Greece, because OMT should never have been implemented for Greece - immediate default was the better and more sustainable option. However I think it is highly credible that, despite Greece, if OMT had existed in 2010 spreads in other countries would have stayed low. [1]

Francesco Saraceno draws the lesson that the real problems with the Eurozone are institutional, and I agree. The Stability and Growth Pact was misconceived (as some of us argued before the Eurozone was created), because it ignored the need for countercyclical fiscal policy. The ECB delayed acting as a sovereign lender of last resort for two years, creating a Eurozone crisis out of what should have been just a Greek problem. The conclusion I draw, unlike many economists, is that the concept of a European Monetary Union was not inherently doomed to fail. It was the way it was implemented that caused the crisis.

It would be very nice if this was all about history. Unfortunately exactly the same mistakes are continuing, with equally damaging effects. Fiscal policy continues to be pro-cyclical, meaning that we had a second Eurozone recession and no real recovery from that. Monetary policy is either perverse (2011), or 6 years too late (!) and continues to openly encourage fiscal austerity. That most policy makers in the Eurozone have still not understood past errors remains scandalous.

[1] The paper attributes this to the reduced risk of union break up. I suspect it does so because it wants to make interesting comparisons between Eurozone countries and US states. My own analysis has instead focused on the danger of a self-fulfilling funding crisis when there is no lender of last resort. That danger presumably exists for US states.

[2] An interesting question which I have not examined is whether, even if OMT had existed in 2010, it would still have been better for both Ireland and Spain to have written off some of their debt.