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.
