Winner of the New Statesman SPERI Prize in Political Economy 2016

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. 


  1. Did you catch the George Osborne interveiw with Evan Davies on Newsnight last night? Evan had a fair go at him, but G.O simply repeated the "stuck to our economic plan" reply for almost every question! Amazing stuff. He also put the Eurozone's woes down to not following the same "credible fiscal policy" (a direct quote) that he implemented in the UK which has led to the UK recovery/growth being better than almost any other major...blah blah...

    1. I was sent it. Evan also asked him the 'isn't this all about a smaller state' question, to which his reply was that its not ideological to want lower taxes! One day someone will ask him if the reason the UK is doing better than the Eurozone is because you stopped austerity in 2012, while the Eurozone continued with it.

    2. I don't think that workers in the public services, or those in receipt of social security, would recognise that austerity stopped in 2012 ...

    3. Like his speeches, almost everything he said during the interview was either a falsehood completely contradicted by the evidence, or more simply seemingly plausible statements designed to mislead.
      Eg. As you mention, in calling for a smaller state of "35% of GDP" from the present 42% (approx.), he made the fallacious argument that other parties, in not wanting it to be as small (as 35%), would require an 'increase in borrowing and therefore taxes'. Sounds plausible on the surface, until you realise that by not wanting to be quite so small (eg. a reduction to say 38%) would actually mean LESS borrowing than present of course, not more as he claimed. He erroneously used 35% as the reference point, instead of the present 42%, then argued that anyone who wanted it to be not as low as 35% was calling for higher borrowing and taxes. If Labout today announced a target of 30%, by the same token they could accuse G.O of wanting higher borrowing and taxes! A completely incoherent argument.
      Of course referring to 'higher borrowing and taxes when discussing the size of the state as a % of GDP is also highly misleading, since any change to the size of GDP will obviously change the result even when public expenditure (or TME) stays constant or rose more slowly than the growth rate of GDP!

      SWL: "stopped austerity in 2012, while the Eurozone continued with it".
      This is formerly noted and recognised in the 2014 Treasury Committee Budget report (p.9/10), best summed up by Michael Saunders, Head of West European Economics at Citi who said that “the shift from very heavy fiscal restraint to almost no fiscal restraint in 2012, 2013 and 2014” had “lifted a headwind”. The Rt Hon George Osborne was named, present and contributed in these meetings, and made no noted objection to the above analysis also agreed by others present. Yet publicly, he still refers to sticking with the "credible" long term economic plan...which he himself recognises (as per the report above) was not stuck to at all. More's the pity that Evan Davis didn't have this official report ready to quote from directly and put him on the spot. More to the point, why doesn't Labour, the media or anyone else do so??

    4. Forgot the link:

      (Click on PDF link under picture.)

  2. What Labour haven't grasped yet is that it has nothing to do with economic realities, it is all about presentation and to whom you are presenting. Not spin, but misleading or allowing the non-expert listener to go down the wrong path based on an assumption that was reasonable but totally wrong. Osborne, and Cameron too, are simply repeating terminological inexactitudes. Sorry, Ed, but you neither get it, nor have the "oomph" to carry it off if you do. And that's a tragedy... because Labour are playing along in Cameron's game. Nobody in the opposition or media is leading the conversation, they're just responding. Except for Farage of course, and he's worse than Cameron!

  3. An interesting blog.

    Does saying 2011 ECB monetary policy was "perverse" mean you now agree with MM (and PK and other Keynesians at the time) that the ECB helped cause the EZ crisis? It looked pro-cyclical at the time.

    1. I never disagreed, and never said I disagreed.

    2. "Mainly Macro14 January 2015 at 06:23
      james - yes, I'd forgotten that in MM lore, the current Eurozone recession is entirely down to that interest rate increase, and has nothing to do with fiscal austerity."

      It's not just MM, as I said. This chap get's referred to quite a lot:
      Hetzel, Robert, 2014, “Contractionary Monetary Policy Caused the Great Recession in the Eurozone: A New-Keynsian Perspective,” Federal Reserve Bank of Richmond, Working Paper WP 13-07R.

    3. This is very helpful, too. Perhaps I'll shut up.

  4. Footnote: MM was "called" quasi-monetarism at the time.

  5. To listen to Schäuble on a CNBC panel at Davos attacking Soros, who was arguing for fiscal stimulus in Europe, is all you need to understand that they see austerity as a purgative for their perceived structural economic maladies. At least blood letting in early modern times was done from ignorance...


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