Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 23 August 2014

Draghi at Jackson Hole

To understand the significance of yesterday's speech (useful extract from FT Alphaville here), it is crucial to know the background. The ECB has appeared to be in the past a centre of what Paul De Grauwe calls balanced-budget fundamentalism. I defined this as a belief that we needed fiscal consolidation (austerity) even when we were in a liquidity trap (i.e. interest rates were at or very close to their zero lower bound). Traditionally ECB briefings would not be complete without a ritual call for governments to undertake structural reforms and to continue with fiscal consolidation.

An important point about these calls from the central bank for fiscal consolidation is that they predate the 2010 Eurozone crisis. As I noted in an earlier post, the ECB’s own research found that “the ECB communicates intensively on fiscal policies in both positive as well as normative terms. Other central banks more typically refer to fiscal policy when describing foreign developments relevant to domestic macroeconomic developments, when using fiscal policy as input to forecasts, or when referring to the use of government debt instruments in monetary policy operations.” The other point to note, of course, is that the ECB had in the past always called for fiscal consolidation, whatever the macroeconomic situation.

How can we explain both this obsession with fiscal consolidation, and the ECB’s lack of inhibition in its public statements? I suspect some might argue that the ECB feels especially vulnerable to fiscal dominance - the idea that fiscal profligacy will force the monetary authority to print money to cover deficits. In my earlier post I suggested this was not plausible, because in reality the ECB was less vulnerable in this respect than other central banks. Unfortunately I think the true explanation is rather simpler, and we get an indication from the Draghi speech. There he says:

“Thus, it would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy, and I believe there is scope for this, while taking into account our specific initial conditions and legal constraints. These initial conditions include levels of government expenditure and taxation in the euro area that are, in relation to GDP, already among the highest in the world. And we are operating within a set of fiscal rules – the Stability and Growth Pact – which acts as an anchor for confidence and that would be self-defeating to break.”

The big news is the first sentence, which suggests that Draghi does not (at least now) believe in balanced-budget fundamentalism. Instead this speech follows the line taken by Ben Bernanke, who made public his view that fiscal consolidation in the US was not helping the Fed do its job (and who was quite unjustifiably criticised in some quarters for doing so). However note also the second sentence, which clearly implies that the size of the state in Euro area countries is too large. Whether you believe this to be true or not, it is an overtly political statement. I think part of the problem is that Draghi and the ECB as a whole do not see it as such - instead they believe that large states simply generate economic inefficiencies, so calling for less government spending and taxation is similar to calling for other ‘structural reforms’ designed to improve efficiency and growth.

The simple explanation for the ECB’s obsession, until now, with fiscal consolidation is that its members take the neoliberal position as self evident, and that their lack of accountability to the democratic process allows them to believe this is not political.

As a result, it might be possible to argue that the ECB never believed in balanced-budget fundamentalism, but instead kept on calling for fiscal consolidation after the Great Recession through a combination of zero lower bound denial, panic after the debt funding crisis, and a belief that achieving a smaller state remained an important priority. It is hard to believe that members of the ECB, unlike other central banks, were unaware of the substantial literature confirming that fiscal policy is contractionary: there does not seem to be any difference in educational or professional backgrounds between members of the ECB and Fed, for example. 

Should we celebrate the fact that Draghi is now changing the ECB’s tune, and calling for fiscal expansion? The answer is of course yes, because it may begin to break the hold of balanced-budget fundamentalism on the rest of the policy making elite in the Eurozone. However we also need to recognise its limitations and dangers. As the third sentence of the quote above indicates, Draghi is only talking about flexibility within the Stability and Growth Pact rules, and these rules are the big problem.

The danger comes from the belief that the size of the state should be reduced. Whether this is right or not, it leads Draghi later on in his speech to advocate balanced budget cuts in taxes. He says: “This strategy could have positive effects even in the short-term if taxes are lowered in those areas where the short-term fiscal multiplier is higher, and expenditures cut in unproductive areas where the multiplier is lower.” My worry is that in reality such combinations are hard to find, and that what we might get instead is the more conventional balanced budget multiplier, which will make things worse rather than better.  


  1. The two partners in the UK's Coalition government now look symmetric: the Tories were neoliberal anyway, but the Orange Book Liberals were helped along by what must to them have been a pretty appealing path by the ECB and the Eurozone VSPs.

    This explains why Clegg in 2010 accepted a right-wing think-tank's view that taking spending back to 2004 levels in the UK was not a big deal, a view heartily supported by Stephanie Flanders in her BBC blog. I complained to the BBC that Flanders knew that you take the trend line out from the peak of 2008 GDP not the trough post-crisis, but the BBC gave its usual noises of patrician ignorance.

    Recall the treatment Krugman got from Brussels (Krugman blog March 7, 2013 'Bushifying the Berlaymont')?

    They are all Jeremy Warners now.

  2. Why is it that whenever ratios are described as being too high that it is always said that it is the numerator that should be reduced and not the denominator that should be increased? Both would have the same effect after all... or am I missing something?

    1. Seems like there's a connection between Europe's economy faltering, Draghi's statement and France specifically. Hollande says they won't hit their deficit targets seeing as how growth has slowed.

      Krugman feels Draghi knows what's going, he has known him over the years, but Germany doesn't want to do what needs to be done.

  3. An important part of the the problem with the Euro is that each of the countries have their old 'sticky' thoughts and policies to deal with their economies. And some of the most sticky policy thoughts are still hanging around. Not appropriate for the new monetary regime under the Euro. All these countries are slowly adapting, but nobody is able or even wants to totally do what the others want them to do. And in the mean time the ECB has to keep the Euro together, and slowly evolve the interpretation of rules following some kind of consensus of all the member central banks and their countries.

    It looks like Draghi takes the stability and growth pact as a given, from politics, and is willing to help stimulate and find ways to fund investment and stimulus without breaking those rules.

    Would it make sense to know a bit more about the various central bank presidents meeting in Frankfurt to better understand the motivations of the ECB's public spokesman, Draghi?

    Is there some chance in this 'waiting for QE' moment? Can they come up with ways around the rules of the Euro to still create credit for investments and stimulus in the Euro countries, in such a way that it is not directly on the balance sheet of either the EU or any of the Euro governments? Example: if the ECB buys a 'balanced basket' of Euro sovereign debt, this basket would effectively be something very near to a Euro Bond. The ECB and the member countries only dare to move in small steps. Hoping to slowly move towards a state that is will be stable, balanced, robust. If they don't fail.

  4. A good sign coming out of Jackson hole is that Wall Street bankers have not been invited as a "complement to the focus on labor markets".

  5. I think the EU desperately needs fiscal integration -- they seem to be heading for Japan-style lost decade(s), but Japan has been better able to muddle through than the EU because fiscal transfers can flow from Tokyo to Osaka. Essentially the EU is "on track" in terms of inflation and output. It is just a stagnating track:

  6. Good article, S W-L.

    While the ECB is bound by the treaties and is not allowed to finance member states directly, it could take the "ensuring proper transmission of monetary policy, buying in the secondary markets"-route. It has done this with SMP. It can go off-balance-sheet, Enron-style, and buy bonds issued by the European Stability Mechanism or the European Investment Bank, which could funnel money to governments or alternatively finance infrastructure projects directly and bypass the governments. I doubt much good would follow from another mammoth EU-project. The track record of Brussels is appalling.

    But as Draghi hinted, much like Bernanke has previously, if fiscal policy is tight, structures are inelastic and a common budget to alleviate asymmetrical shocks is missing, monetary policy becomes a blunt weapon – though still effective, it requires more force, which could have unwanted consequences.

    Could even more dovish and unconventional monetary policy be supported with macro-prudential policies? Experiences with shadow banks, self-regulation and too-big-to-fails suggest that it would probably not work

    I am siding with the NGDP-targeting crowd and market monetarists here. The easiest thing to do would be to stop the 2%-target. It is not listed in the treaties, it is only a result of a consensus of the executive board. If they voted and agreed to a target of 4% with caveats, it would become reality.

    1. Easiest, maybe. Could it happen? I would eat my hat if it did - this is the most conservative central bank. The politically realistic option is to discretely ignore or bypass the SGP - something of course the market monetarists do not want to talk about.

    2. I believe your scenario is more probable, and that is something that is in fact already happened, in France, Spain and numerous other countries. Brussels just looks the other way as deficits mount up. But they cannot play that for long - the deadlines to fix things under the SGP are closing in. The voices from France and Italy were again demanding more fiscal easing during the weekend. As someone who is always thinking of redundancy and synergy, I think both should be done. 4% target and scrapping SGP would work like a charm. Europe's problem is that instead of running to the wall, only half-measures are used, and that only allows the orthodox crowd to sneer and say "See, I told you it would not work". I'm finishing a write-up on Draghi and will quote this discussion.

    3. Juhani Huopainen25 August 2014 at 08:43

      For what's it worth, here I went:

  7. From an apolitical stance, why would increases in specialisation, compartmentalisation, information asymmetry, wealth asymmetry, and technological asymmetry not call for more, not less, regulation and for greater, not smaller, government? The more complex the system, the more lines of control code. Libertarianism and its close cousin, small government conservatism, is for 19th century hicksville - at the latest.

    1. My dear Alphonse, this is where you put your finger on the point where the nice Mr Wren-Lewis' analysis is wrong because plainly the skilled and rational response in complex, dynamic and interconnected systems to continual states of inequality and damage is more information and more control points not fewer.

      You make an accurate point but he thinks the entrails he is reading point to a small-government mindset of the people in charge when in reality these signals only indicate a stratospheric level of incompetence coupled with ferocious greed to maintain their privileges at the feeding-trough. Self-serving venality and technocratic ineptitude are better explanations for the state we find ourselves in, I'm afraid, but nice people consistently fail to diagnose these all-too-common failings and prefer convoluted intellectual narratives.

  8. Why not giving every citizen of the EU 1000 Euro to their bank account ? This will lead to more consumption to stimulate economy, therefore more inflation and it would lower the worth of the Euro on the international markets.

    Im sure this way there would be a much higher acceptance from the average people cause they also would directly profit from it.


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.