Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 3 September 2015

Spain, and how the Eurozone has to get real about countercyclical policy

Matthew Klein has a good account of how Spain’s macroeconomic fortunes are improving, but only from a very bad place. I’m not that knowledgeable about the Spanish economy, so I cannot add any detail. However I do want to pick up on one point, which he and others (including Martin Wolf - see below) have made, which I think is wrong and misleading.

Before I do that, I just want to make a general point about the current recovery. At its heart it is export led, which is exactly what you would expect. Just as this post which compares Greece to Ireland shows, the Eurozone does have a natural correction mechanism when a country becomes hopelessly uncompetitive as a result of a temporary domestic boom (whatever its cause). The mechanism is a recession and what economists call ‘internal devaluation’: falling wages and prices. The problem with this correction mechanism is that, on its own, it is slow and painful, particularly when Eurozone inflation is so low.

So the key question is what could Spain have done to avoid having such a painful period of correction. The cause of the problem was the excess private sector borrowing of the pre-crisis period, and the associated capital inflows. This was part of an unsustainable property boom that led to a large current account deficit and rising inflation. (I liked the point that Matthew Klein made about how export orientated firms have recently increased their borrowing. Extra borrowing is not bad if the investment is sound.) What could Spain have done to cool things down? As Matthew Klein points out, Spain already had some sensible macroprudential monetary policies, and it seems likely that more of the same would not have been enough.

Which brings us of course to fiscal policy, and it is here that so many commentators go wrong. They say, correctly, that Spain’s problem was never a profligate government. They say, correctly, that the actual budget was in surplus from 2005-2007. Of course the relevant number is the underlying (cyclical adjusted) balance, and the IMF now thinks that shows a persistent although small deficit. But as Martin Wolf points out, again correctly, the IMF in 2008 thought very differently. As I have said many times in the case of the UK, ex post numbers for pre-crisis cyclically adjusted deficits can be very dodgy because of the depth and persistence of this recession.

The mistake everyone here makes is to judge the appropriate fiscal policy by the size of the deficit. That is like saying that a bigger fiscal stimulus in the US in 2009 was impossible because the deficit was already very large. For an individual country in a currency union the deficit is not the appropriate metric to judge short term fiscal policy. Unless there are very good reasons for believing the economy is too competitive, the appropriate metric is national inflation relative to the Eurozone average. From 2001 to 2007 the GDP deflator (the price of domestically produced goods) for the Eurozone as a whole increased at an average rate of just over 2%. In Spain it increased at an average rate of nearly 4%. 2% excess inflation over 7 years implies a 15% loss in competitiveness. So forget the actual budget deficit or any cyclically corrected version, fiscal policy was just not tight enough.

I have been told so many times that for Spain to have a tighter fiscal policy before the crisis was ‘politically impossible’. If that really is true, then Spain has little to complain about when it comes to the subsequent recession. If you cannot do any better, you have to leave the natural correction mechanism to do its slow and painful work. But I suspect what is ‘politically impossible’ is in part a reflection of the Eurozone’s flawed Stability and Growth pact itself, which focused entirely on deficits.

It seems more than likely that the existing monetary but not fiscal/political union is here to stay for some time. Many in Europe’s political elite plan to move quickly to greater union (see Andrew Watt here), but there are serious obstacles in their path. The current system can be made to work better, and strong countercyclical fiscal policy is an obvious part of that. Combining this with medium term deficit reduction is technically trivial. Just how many years and recessions does it take before what is obvious textbook macroeconomics can become politically acceptable?




28 comments:

  1. So you think there should be a Euro rule that national fiscal policy should target national inflation relative to the Eurozone average. And this would be a sufficient excuse to go beyond the fixed deficit limit. On the other hand, a country with higher inflation would need to reduce its deficit further. Is this like a transfer union with guard rails?

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    1. Or target national unemployment rates relative to the Eurozone average. According to the Economist:

      Europe's "unemployment falling from 11.1% in June to 10.9% in July, some way off its high of 12.1% in early 2013. However, the range in unemployment, from 4.7% in Germany to 22.2% in Spain and 25% in Greece, remains disconcertingly large. "

      Fiscal policy should be allowed some room to bring about full employment quickly and only then worry about government deficits and debt.

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  2. Simon. Yes, but ...

    The but" concerns the role of "others" in restoring balance (neither rising nor falling Spanish relative goods prices). There is nothing inherent in a shared currency which determines who is responsible for correcting an imbalance which appears in one member. So pre-2009, should Spanish fiscal have been tighter, or should the "others" fiscal have been looser ? This indeterminacy, rather than the misspecification of the relevant metric for determine the appropriate fiscal stance, seems to me to be the fundamental failure.

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    1. This seems to me to be the crucial point. The Spanish real estate asset bubble was the flip side of, among other things, years of excess German savings generated by the Hartz reforms, that put a gap between productivity and wage increases, and so starved the domestic market of demand in Germany. It was surplus recycling as ponzi scheme. There are better ways, including increased domestic public investment.

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    2. I may be being stupid, but I do not see this overdeterminacy as a problem. The rule will be symmetric, so because German inflation was below average over this period they should have had a looser fiscal policy. It relies on the ECB to get the average inflation rate right, of course.

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  3. Some remarks about the Spanish boom:

    An intersting question is why, considering the size of the boom in Spain, GDP inflation and wage increases weren't even higher. The answer is (at least to an extent) the dynamic natur of the (supply side) of the Spanish labour market. A combination of a rapid increase of the female participation rate, a decline in the (before 1995: very high) rate of unemployment and massive in-migration mitigated wage increases and led to a (again: considering the magnitude of the boom) relatively low increase of wages and the GDP price level (which is still quite a bit lower than in for instance Germany!). Don't underestimate the size of this effect. In an absolute sense, job creation in Spain was (looking at western economies and 'western offshoots') second only to the USA (while Spanish population is about 40 million and USA population is above 300 million). As the inflow of workers was to quite some extent caused by a pull factor from the outsized construction sector this inflow and its mitigating effect on (construction) wages enabled the boom to continue. Tellingly, the investment price level did not really increase faster than the GDP price level, before 2008, despite the boom! Countercyclical policies should have consisted of either wage(cost) increasing measures, macro prudential measures restructing construction or measures aimed at mitigating the inflow of foreign construction workers or the shift of unemployed from unemployment to the 'broad' construction sector. Macro prudential measures aimed at the inflow of 'foreign' capital (i.e. a strickter licencing of construction projects) instead of fiscal countercyclical measures should have been the policy of choice. From the macro-economic point of view: the extremely rapid deterioration of the current account should have been taken much more serious after 2004. Less restrictive macro policies in Germany should of course also have been part of the Euro-deal.

    Merijn Knibbe

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  4. Merijn Knibbe
    You are just making my point that "housing" booms are really "land price" booms and it the debt that is the issue. It is very hard to calculate the inherent value of a piece of land as collateral for a loan and so it is very hard to calculate the solvency of a borrower. One thing that should be thought about is that lending prudential controls should move in the opposite direction to land prices (perhaps by using backward looking moving average valuation).

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    1. One relatively simple way to implement something like this would be to calculate mortgage ratio maxima against such a backward looking average, e.g. if property valuations were 50% above the average over the last 5 years, then a 90% ratio would automatically become a 60% ratio against current values, which would help to slow lending and price rises.

      It also suggests a larger role for property/land taxes as a counter-cyclical instrument.

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  5. Lets see, after joining euro, Spain advanced its wages toward more equality to northern members all thanks to fiscal spending even tough with low deficit.

    Tighter fiscal policy, whic is what you are suggesting would prevent that equalization for the purpose of not feeling drastic fall in wages now. The diference would have not been so huge as is now.

    What you are suggesting is that Spain should have prevented lowering of unemployment from 15% as befor entering EZ just so that drop to 20% unemployment from 10 as in boom times would be not so painfull.
    Interesting.

    What euro users have is an automatic mechanism to cement wage and purchasing power at the time of joining a single currency. Members of EZ are not allowed to equalize wages no matter what a disparity is

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    1. There is nothing to stop wages equalising if productivity also equalises. Rising wages in line with rising productivity would have no impact on inflation.

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  6. The argument that Spain could not have done much to "cool things down" is flawed. In May 2006 the Bank of Spain alerted Finance Minister Pedro Solbes about the dangers of the excessive price increases of residential real estate and need to rein in bank lending to property developers. The report was binned; back in 2006 it would have been very easy to introduce capital requirements or outright caps on bank lending to developers. Not in Spain, where finance minister Solbes thought that house prices would never go down and where Prime Minister Zapatero declared the Spanish banking system as the most solid in the world. Add to this a considerable dose of corruption at the local level (that decides on planning laws) and appalling corporate governance at Spanish savings banks (controlled by politicians from the main parties).
    Spain's bubble was entirely home-made.

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    1. Not entirely home made. Net foreign lending to Spain rose to over 90% GDP by 2009 from around 35% at the start of the decade. Most of this increase was lent to Spanish banks by other European banks, who must also take responsibility.

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  7. How should fiscal policy within the EMU have been conducted if the SGP wasn't present? (Recall that the SGP really was not a very strict policy - a country was allowed to run a 3% of GDP deficit for a continued number of years, which is an incredibly loose fiscal policy).

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    1. «a 3% of GDP deficit for a continued number of years,»

      That's the new normal, for what I call the 2-5 economies: 2% real growth, 2% inflation, 5% unemployment, 5% trade deficit, and 2-5% government deficits, "forever".

      «which is an incredibly loose fiscal policy)»

      Not necessarily. But also: try to imagine an eurozone member running a 10-15% government deficit (and a similar or higher trade deficit) for several years, *at the top of the cycle*, pro-cyclically.

      Then they call "austerity" the end of that :-).

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  8. Great post Simon - are you implicitly saying that fiscal policy in EZ should be used to keep CPI close to overall EZ level - i.e. target competitivness?

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    1. There is an issue of whether it is better to respond to inflation disparities or price level disparities (competitiveness). Because there is a natural mechanism working from the second, it is not clear which is better for fiscal policy. Our work in the JMCB suggested it didn't make much difference, but this needs more research, but that will only happen if the EZ acknowledges the need for countercyclical policy.

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  9. Interesting article and comments. Maybe Eurozone should have a 2-step fiscal policy rule/guidelines: look at the collective deficit of the entire Eurozone with finance ministers deciding on what is the optimal/desired level on an annual/biennual basis. From this, national fiscal stance is then determined relative to the Eurozone average/target (for inflation and/or unemployment). In this situation, national debt within the Eurozone is effectively underwritten by the collective, which is effectively what has happened.

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    1. I do not think this is necessary. Leave each country to decide how quickly it wants to reduce debt over time. What you do need is some union wide mechanism to handle matters when things go seriously wrong, but that is a different matter.

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  10. Here is a graph from my blog showing how much Spain, and others deviated from the 2% inflation target over time:

    https://eurogate101.files.wordpress.com/2011/12/2prozentabweichung_alle.jpg

    The deviation from the target is not that much, the problem is also Germany which undershoots the target by a fair way.

    That is the average rates (mean) from 2002 to 2008:


    Griechenland: 3,5%
    Spanien: 3,4%
    Irland: 3,1%
    Portugal: 2,8%
    Italien: 2,5%
    Deutschland, zum Vergleich: 1,85%.

    None of these rates include, of course, asset price inflation. If asset prices were included and targeted by the central banks (property in particular) we would have a much healthier economy. And problems would become more noticablwe much earlier.

    It is about time property is included in official inflation rates, Axel Weber (ex Bundesbank chief) wrote about it on Project Syndicate a couple of months ago.

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    1. I gave the numbers for output prices for Spain and the average, and the differences were not 'small', because they accumulate. Output prices are more relevant than consumer prices.

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  11. I think an inflation rate tax for banks in countries which are deviating from the norm could be good way of reducing credit growth, and the inevitable boom and bust which resulted in that.

    That tax could be just levied on lending to the financial and real estate sectors only, it would be up to the local central bank to fine-tune the ECB rate to reach a rate closer to the 2%.

    So deviations from the 2% target rate, which brought about the Eurocrisis could have been avoided.

    https://eurogate101.files.wordpress.com/2011/12/2prozentabweichung_giips1.jpg

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  12. I'm generally all for counter-cyclical fiscal policy, so I can't say I'm opposed.
    Yet there aren't many examples of it really insulating economies from "hot money" flows.
    At some level, as Lyn Eynon suggests, this crisis in Spain was created by the arrival of pan-European lending and the fact that national governments were in a complex regulatory relationship with non-home Eurozone lenders.

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    1. «I'm generally all for counter-cyclical fiscal policy, so I can't say I'm opposed.»

      Same here, but cases like Greece, Spain, ... were of *pro-cyclical* fiscal or credit policy, of mad and bad public or private balance sheet expansion (I have started to like this euphemism) funded by "hot money" inflows, of actual GDP going way above potential, and then falling back to potential (and sometimes even below, but not in the case of Greece). Counter cyclical policy is supposed to happen when actual is below potential, as fiscal austerity then makes things worse. It is not counter-cyclical policy to aim to restore the situation where actual GDP is way above potential GDP, by having mandatory donations of 20% of GDP direct from the taxpayers of other countries to replace the "lending" from the taxpayer-backed banks of the same countries.

      «Yet there aren't many examples of it really insulating economies from "hot money" flows»

      Many countries have had electors and politicians that *beg* for "hot money" flows, because while the "hot money" inflows and the balance sheet expands pro-cyclically and actual GDP is higher than potential GDP a lot of those people make a lot of money (which they move abroad as fast as they can), and these people are usually those who are influential insiders.

      «At some level, as Lyn Eynon suggests, this crisis in Spain was created by the arrival of pan-European lending and the fact that national governments were in a complex regulatory relationship with non-home Eurozone lenders»

      First we must note that all these things happened to all EU (not just eurozone) countries, and none others, and yet several EU countries did not have colossal balance sheet expenasions, and yet several non-EU countries had giant balance sheet expensions, most obviously the anglo-american culture ones, whose conservative parties share sponsors and political consultants.

      What the politicians and voters of EU and anglo-american countries did when (as M Lewis wrote) they were «left alone in a dark room with a pile of money» thanks to "hot money" inflows differed significantly from country to country, even if many went for a giant leverage fueled residential and commercial property bubble (or two or three bubbles).

      As to specifically the EU and the «complex regulatory relationship» the people at the BIS have provided an interesting insight (already mentioned) in their house journal, and the tone is very funny:

      http://www.bis.org/publ/qtrpdf/r_qt1312v.htm
      «In the European Union (EU), authorities have allowed supervisors to permit banks that follow the IRB approach to stay permanently on the Standardised Approach for their sovereign exposures.
      In applying the Standardised Approach, in turn, EU authorities have set a zero risk weight not just to sovereign exposures denominated and funded in the currency of the corresponding Member State, but also to such exposures denominated and funded in the currencies of any other Member State.»

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  13. So I have been more astonished to read:

    «The cause of the problem was the excess private sector borrowing of the pre-crisis period, and the associated capital inflows. This was part of an unsustainable property boom that led to a large current account deficit»

    What? What? Of course I agree with this, but the change in topic is amazing. The discussion starts with conventional wisdom, however inapplicable to the situation, about a loss of competitiveness, and then it switches suddenly to the consequences of balance sheet "indigestion", a totally different situation, and applicable to some recent circumstances.

    «and rising inflation.»

    Usually when there is a «large current account deficit» rising consumer-price inflation does not happen, as supply is not constrained. But probably "inflation" here means "wage-inflation" as usual, which was happening despite the large boost in labor supply noted by another commenter.

    «(I liked the point that Matthew Klein made about how export orientated firms have recently increased their borrowing. Extra borrowing is not bad if the investment is sound.)»

    Absolutely! Austerity is damaging. And there is apparently so much investable capital, and apparently so few sound investment opportunities, that preventing sound investment just because borrowing is bad is a huge waste.

    «What could Spain have done to cool things down? As Matthew Klein points out, Spain already had some sensible macroprudential monetary policies, and it seems likely that more of the same would not have been enough.»

    Balance sheet expansion, like "inflation", is always and everywhere a *political* phenomenon. The «sensible macroprudential monetary policies» did not count for anything given the political will to unleash a giant private sector balance sheet expansion, and suitably workarounds were easily found.

    «Which brings us of course to fiscal policy, and it is here that so many commentators go wrong. They say, correctly, that Spain’s problem was never a profligate government. They say, correctly, that the actual budget was in surplus from 2005-2007.»

    And there never was a real competitiveness issue either.

    The difference between Greece and Spain was that Greece did an old style "public keynesian" pro-cyclical public balance sheet expansion, and Spain did a new-style "private keynesian" (in the C Crouch sense) pro-cyclical private bank and household balance sheet expansion, and then nationalised it into a reatroactive "public keynesian" one.

    Nothing new to see here, move along :-).

    PS Neither balance sheet expansions were done to maintain spending levels despite a loss of competitiveness, as in the "classic" story, they were done in both case to boost spending levels even with no loss, but no gain either, in competitiveness. The tedious talk by "institution" and anti-"institution" Economists about competitiveness seems to me either the automatic application of conventional wisdom, or deliberate obfuscation.

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  14. I had posted a couple of comments with supporting graphs for the arguments made above. They linked to web pages, but the links got stuck in the system.

    shame

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    1. Matt: Because of spam, I now have to approve every comment to my posts if those comments come more than 24 hours after the post is published. (Spam seems to mostly go for 'old' posts). I try to sort through 'old' comments every day, but occasionally .... So sorry for the delay, but right now I cannot see a better way of handling this problem.

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    2. thanks for clearing that up - I could not quite make out the pattern when posting comments worked and when not.

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  15. "2% excess inflation over 7 years implies a 15% loss in competitiveness. So forget the actual budget deficit or any cyclically corrected version, fiscal policy was just not tight enough."

    But (hypothetically) if the Spanish economy was 15% more competitive to start with, the increase in inflation merely brings the country back to parity with the rest of the Eurozone. I'm not saying this was the case, merely that it illustrates a problem with your analysis, Simon. If Spain had constrained fiscal policy to maintain low wage inflation, how could it ever catch up with the rest of the EU?

    Therefore, I suggest that the proper metric to use is not inflation, but the amount of capital inflow that drove the false economic boom. If the ECB had the power to tax member governments based on their current account deficit it could force them to tighten fiscal policy appropriately, but to do so based on the metric that drives the potential problem (capital inflows), not the one that doesn't (local wage inflation).

    In effect the ECB would be doing to Spain what it is now doing to Greece, forcing it to run a primary surplus, but it would be doing it during the boom in order to prevent recession, rather than in a depression that instead prevents a recovery. As such it would be countercyclical not pro-cyclical.

    I originally outlined these thoughts over 5 years ago. See here
    http://cantab83.blogspot.co.uk/2010/06/how-to-prevent-euromess.html

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