A Euro Tragedy

“Italy, I believe, is the eurozone’s fault line.” Not from an article on the recent crisis, but from a book by Ashoka Mody, called “Euro Tragedy: A Drama in Nine Acts”, just published in the US and due out in the UK in July.

As the title indicates, this is not a pros versus cons assessment. Instead the author treats the Euro as a clear mistake, a triumph of a political ideal of European unity over basic economics. The author provides a clear (and accessible for non-economists) account of how the idea of the Euro began to dominate the political discourse of particularly the French elite and how Germany leaders agreed on the condition that they determined the design, how warning signs during the pre-crisis period were ignored, how the risks from a Greek default were overblown so the wrong policies were adopted in 2009 and 2010, and how subsequent actions exposed the democratic deficit implicit in that German design, encouraging populist movements across Europe. (For UK readers I have to emphasise that this is about the Eurozone and not the EU.)

Many of these points will be familiar to regular readers of my blog, but here the story is told with the knowledge and authority of someone who, as deputy director of the IMF’s European department, was close to the action. The sections on the Greek crisis especially should be read by all those who stick to the ‘official’ line that Greece turned a crisis (excessive deficits) into a disaster because it refused to take the medicine it needed. The reality, as the author describes, is that Syriza’s call for debt relief should have been granted. He writes

“This demand had overwhelming support in both the scholarly economics literature and the practice of economic policy. Scholars for decades had emphasised that excessive debt - ‘debt overhang’ - reduces the ability and incentive to invest, slows economic growth, causes low inflation or even deflation to set in, and makes debts harder to pay.”

And as he notes earlier, these debts should have led to default in 2009/10 rather than being mainly transferred into obligations of the Greek government to other Eurozone governments. Varoufakis may have been unconventional, but many of his proposals, including linking repayments to GDP growth, were “economically sound”.

Indeed he goes further than I have done. He writes about the final days of the standoff between the Syriza government and the Eurogroup after the referendum. The IMF made increasingly strident public noises about the urgency of debt relief, but the Germans - fearing political comeback from their taxpayers - refused to budge. He writes

“The IMF could have forgiven the debt owed to it by the Greeks. This drastic gesture would have created international pressure on the Germans and other European creditors to do the right thing. The IMF had a moral obligation to take such a drastic step, if for no other reason than to make amends for its complicity in the tragedy. At the time of the original bailout in May 2010, IMF management had prevented the Greek government from defaulting on its private creditors, an action that several members of the IMF’s Executive Board and the vast majority of external analysis then and later believed was essential to reduce Greece’s debt burden”

This book is a comprehensive and impressive history of the creation and subsequent performance of the Eurozone, and one of the few books on the subject where I find myself nodding in agreement most of the time.  (Martin Sandbu’s Europe’s Orphan is another.) There is much more interesting detail and analysis that I cannot do justice to in one blog post. I can think of two areas where I might have told a slightly different story. The author in parts writes as if it was commonly understood by economists that the Euro would not work. I think there were, in Europe at least, two other significant groups among academic economists. The first thought that perhaps the Euro could work, but only if it allowed fiscal policy to replace monetary policy as the national stabilisation mechanism. I still remember how astonished I was reading the Stability and Growth pact when it was announced, which effectively ignored this critical role for fiscal policy. Another group gave more unconditional support to the Euro, although whether they did so because they really believed in its merits or because they saw it as politically inevitable is difficult to tell.

The second story which I do not think is given enough emphasis is the role of German wage undercutting in the early 2000s. As Peter Bofinger has argued, this was a deliberate attempt to devalue the German real exchange rate within the Eurozone. It was significant for two reasons. First, it helped Germany to emerge from the financial crisis in an economically stronger position than France and others, which in turn had a strong economic and political influence on subsequent events. Second, it indicated an unwillingness on the part of the strongest country in the union to play by the rules of the game.

But these are just differences in emphasis. I would absolutely agree with the author that to avoid a continuing tragedy the direction of travel has to change. He writes

“The evidence in this book points insistently to specific measures to improve the functioning of the eurozone. These include scrapping the fiscal rules, creating mechanisms for predictable and orderly default on public debt to instill greater discipline in debtor governments and their creditors, and changing the ECB’s mandate to require that reducing unemployment be an objective of monetary policy on a par with maintaining price stability.”

Unfortunately that is not the path the eurozone is currently on. It retains a belief in ‘falling forward’ from each crisis to further integration. If the governing elite is the head and the people are the legs, the great danger is that the legs will not move and the eurozone will fall flat on its face.

Academic knowledge about economic policy is not just another opinion

Does the financial crisis reveal that economists are at the leeches and mercury stage of their subject, and as a result policy makers and the public have every right to ignore what they say? Does the fact that economists working in finance failed to recognise the prospect of a systemic crisis, and that macroeconomists both took finance for granted and as a result failed to investigate financial-real links, mean that we should ignore what economists say when it comes to Brexit?

Speaking for my own subject, I think the financial crisis does raise serious questions about the methodology macroeconomists rely on, as I have explained at length elsewhere. But does it mean that everything macroeconomists have learnt in the last 80 years is virtually worthless, or at least no better than the opinion of the average politician? Why don’t we look at what has happened since the financial crisis.

Macroeconomists, having learnt the lessons of the 1930s, immediately recommended that policy makers do three things after the crisis: cut interest rates sharply, embark on fiscal stimulus and bailout banks. Policy makers took that advice in 2009, and as a result we avoided another Great Depression. Many said that rising government debt was sure to send interest rates on that debt rising: academic economists using basic ideas from Keynes said they would not and they were proved right. Many others said that Quantitative Easing (central banks creating money to buy government debt) would cause hyperinflation, but again academic economists looking at more modern New Keynesian models said that was nonsense and again they were right.

You might claim that in all this economists were just advocating what was obvious. The acid test came in and after 2010, when fiscal stimulus turned to austerity. What evidence we have suggests this move was opposed by a majority of academic economists, a majority that grew over time. There was a minority that supported austerity, at least for a time, and they gained a lot of publicity because politicians latched on to what they had to say. But the majority followed both textbook and state of art economics, and this majority was right. The recovery would have been stronger and faster if politicians had gone with this majority.

If we look back before the financial crisis at UK macro policy, we can again look at the record of economics compared to politicians. The obvious place to start is with the 364 economists, who despite all attempts by politicians and think tanks to suggest otherwise were right: tight fiscal policy in the 1981 budget delayed a proper recovery by over a year. We can look at the following recession in the early 1990s. A key driver behind that was the UK joining the ERM at far too strong an exchange rate. Here it gets personal. With colleagues at the National Institute I undertook what was acknowledged at the time to be the most comprehensive analysis of the appropriate entry exchange rate, and we argued that our entering at the then current rate was folly. We were ignored, and as a result the UK was the first to be kicked out of the ERM in 1992.

The next time the UK had to decide to join in this case the ultimate fixed exchange rate regime, the Euro in 2003, it was the economics that persuaded the Labour government not to join. In this case macroeconomic analysis played a critical role in making the right decision.

All this suggests to me that macroeconomics, if we compare it with medicine, is well beyond the bloodletting stage. It would be very surprising if we were not, given 80+ years of study and the huge amounts of data now available. Of course that does not mean academic macroeconomics will not make mistakes, and of course unconditional forecasters of the kind you read about endlessly in the papers will always get things wrong: our own models tell us they will. But when it comes to macroeconomic policy, experience suggests you are much more likely to get economic policy right if you ask an academic macroeconomist than if you ask anybody else. [1]

The other key thing to say is that the discussion above has virtually nothing to do with the long term impact of Brexit, which depends on international trade. The key bit of analysis that means trade with the EU cannot be simply replaced with trade elsewhere are gravity equations. Gravity equations do not come from theory but from the data: countries are much more likely, even today, to trade with near neighbours than far away countries after allowing for other factors. So when Rees-Mogg suggests that the Treasury must have fiddled the numbers, when the government’s analysis confirms those of other studies that Brexit will be costly for all of us, we know he is slandering civil servants for his own political gain. That he is also the favorite to replace May as leader of the Conservative party tells you all you need to know about the current mess the UK is in and why it is in this mess.

Of course we do not condemn engineering science when a new bridge wobbles or an oil rig fails, and we do not say that all medical science is nonsense when medics get things wrong, as they frequently do. But with economics, there are too many people who either want to replace the mainstream with their own school, or who like Rees-Mogg want to discredit economics because they suggest his preferred policy is harmful. As a result, whenever economics does make mistakes, as it will, there will be plenty of people around who want to bury the whole discipline. But when you look at all the evidence and not just one observation, as economists are trained to do, you find that you are better off following the advice of academic economists when it comes to economic policy than anyone else.

[1] The argument that academic economists should be modest or humble when giving their views should be seen in this light. They should certainly be honest about their own views compared to their colleagues, and they should also if they are given the opportunity express the uncertainties. But being modest and humble should never mean leaving politicians unchallenged when they proclaim economic nonsense. 

Economists and the Euro: for the record

Almost every time I write something about Brexit, I get at least one comment along the lines of ‘you economists got it wrong on the Euro, so why should we take any notice of you on Brexit’. This is beginning to annoy me, because in reality the opposite is true: it was because of economics and economists that we didn’t join the Euro in 2003. So the next time someone says the same to you, send them this blog post.

As far as I can see, the source of this ‘you got it wrong’ line is a poll that the Economist magazine did of academic economists on whether the UK should join the Euro in 1999. In that poll 65% said yes, and 35% said no. It was a good piece of journalism and a sensible survey, and it roughly corresponds with how I viewed academic opinions at the time. Claims by Andrea Leadsom that the Bank and IMF also recommended joining are simply wrong.

This poll has zero relevance to the Brexit issue for the following reasons:

1. Academic economists split 2 to 1 in favour of joining in 1999. In the case of Brexit, for every one economist that thought leaving was a good idea, there were 22 that said the opposite. So while a majority of economists favoured joining the Euro, the overwhelming consensus was that Brexit would involve economic costs.
   
   
2. Ask any academic about the Euro, and they will tell you that there are pros and cons, and it is largely a matter of judgement whether the pros or cons win. A key issue which I did some work on (with Rebecca Driver) was whether countercyclical fiscal policy could deal with asymmetric shocks. Our work suggested they could to a significant extent, but that made the proposed Stability and Growth Pact a concern. Others, looking at other types of risk, might come to a different conclusion.
   
   The contrast with Brexit is total. There are no major economic pros that need to be compared with the cons. Instead there are just economic costs, and the debate is about how large these will be.
   
   
3. Euro membership involved macroeconomics. Membership of the EU is mostly about trade. These are different branches of economics with little in common. Brexit involves the impact of geography on trade (gravity equations) and the impact of trade on productivity, while Euro membership involves the macroeconomic response to asymmetric shocks. It is a bit like refusing to have your hip replaced because your flu jab didn’t stop you getting flu.
   
   

The poll was in 1999. The UK did not decide to make a decision whether to join the Euro or not until 2003, and thankfully it did more than take a poll of economists on the issue. The Treasury was given plenty of time to analyse the pros and cons of entry, and it did so by undertaking a large number of studies. This is how policy advice should work in the absence of delegation: you do not ask the expert what the decision should be, but instead ask what the issues are and let the politician make the decision. I have discussed the so called 5 tests process, overseen by Dave Ramsden, in detail here. Most of the studies were done ‘in house’ by Treasury economists, but advice was sought from a large number of leading academics in the field. Peter Westaway was brought in from the Bank to write a couple, and I wrote a study on the optimal entry rate, extending and developing work I had begun back in the days before we entered the ERM.

The analysis was at the highest level, and I could detect no overt bias one way or the other. Some studies found significant benefits from joining, and others found significant costs or concerns. Although it is easy to be cynical, I have talked to some of the actors involved and it does seem as if the economics, encapsulated in these various studies, was critical in first convincing Gordon Brown and then Tony Blair that now was not the right time to join.

So the reality is that studies that summarised state of the art academic economic analysis stopped the UK joining the Euro. Without that, the decision on UK entry would have been down to politics, much like the formation of the Euro itself, and who knows how that would have gone. The economic analysis anticipated some of the problems behind the Euro crisis but not all. Economics is far from perfect, but that is no reason to ignore it when it says things you do not like to hear.

Why rejoining the EU is so problematic

In his latest piece Wolfgang Münchau writes that if Brexit happens then

“the EU you may wish to rejoin will be different from the one you are leaving. From a British perspective, the EU was little more than a customs union and a single market. If the UK ever decides to rejoin, it would have to do so under Article 49 of the Treaty on European Union. That would be the full Monty — with the euro, the Schengen zone, EU involvement in home affairs, no opt-outs, and no budget rebates.”

He is probably right. Probably because no one can be sure how the EU will evolve, but its history suggests it is unlikely to evolve in the direction of reducing its scope.

However he draws the wrong implication from this. He says that those arguing for Remain should give up, accept that the UK will leave the EU, and start thinking about making the case for rejoining. Münchau has gone from misunderstanding the economic arguments to simply discounting them.

If I was asked whether the UK should rejoin the EU on the terms in Article 49, which means joining the Euro, I would not know how to respond. Joining the customs union and Single Market is unquestionable beneficial from an economic point of view, but joining the Euro with its current structure is almost certainly bad for the UK.

Austerity may have ended in the aggregate Eurozone, but the lessons from the Eurozone crisis have hardly been learnt. The fiscal rules that EU countries are meant to follow are a disaster. The ECB was forced to create OMT, and therefore can act as a lender of last resort, but whether it invokes OMT or not remains entirely in the hands of this largely undemocratic and unaccountable institution. No other central bank in the world has this kind of power over whole countries, power that we have seen it deploy against EZ members during the crisis and after the crisis.

None of this means that the Euro has to fail. As we have seen, there is no popular will to leave the EU in Ireland or Greece. In addition most countries have no desire to formalise a two speed EU (which is in my view a shame). As a result, a country like the UK should think very seriously about giving up so much of its freedom by adopting the Euro. This is why the decision not to join in 2003 was correct, and why the opt out from the Euro within the EU was so useful to us. The arrangement that we had, and which we have decided to leave, is so valuable it is worth fighting for every inch centimetre of the way.  

Economists are losers so ignore them on Brexit

That essentially is the argument of the Telegraph’s Allister Heath, expressed as Donald Trump might. Heath says we have a been failures for over a century, “yet they now have the chutzpah to behave as if they should be treated like philosopher kings, an all-knowing “profession” that we are all supposed to bow down to uncritically.”

Actually right now I think we would settle for being heard. Ironically the only people in the media who seem to have noticed our Times letter are those supporting Leave. This matters. Recent polling evidence suggests voters have taken on board the Bank of England’s view that we will be worse off in the short term. But when it comes to the economy in 10 to 20 years time, as many voters think we will be better off by leaving as think otherwise. That the overwhelming majority of academic economists think there are significant long term costs to leaving might therefore be useful information for voters: information many currently do not have. So much for “philosopher kings”.

Of course economists have many faults and do make mistakes. But it remains the case that economists do know more about what determines trade and foreign investment and the impact of migration than most. We certainly know more than political journalists.

Should our expertise be ignored? Let’s look at some of the evidence Heath uses to suggest we nearly always get it wrong. The first is a poll conducted by the Economist in 1999 about whether the UK should join the Euro. Here the split was basically 2 in favour for every one against. But there is a crucial difference from Brexit. In the case of the Euro every economist would acknowledge (see the Economist article) that there were good arguments for and against. In the case of Brexit the only matter to discuss is how big the costs of leaving are. Our trade can only decrease following Brexit. Foreign direct investment can only decrease. Migration, which is also a plus for the economy as a whole, is likely to decrease following Brexit.

The main argument those supporting Brexit use to suggest the economy will do better is that we can get rid of all those pesky regulations that are holding business back. Which was exactly the argument the Conservatives and those in the financial sector made when they championed reducing regulations on finance before 2008. It worked for a few years, and then we had the financial crisis that led to the biggest post-war recession. Mr. Heath has the chutzpah to lay all the blame for that on economists.

But let’s roll the Euro story on to 2003. The government had to make a decision, and this focused on the economics. It commissioned a huge amount of work looking at all the evidence, consulting widely among academics. These studies flagged up some (not all) of the vulnerabilities of the Eurozone that became evident in subsequent years. This persuaded first Gordon Brown and then Tony Blair to say no. I would count that as a definite win for economists.

Of course he mentions what he calls the ‘infamous’ letter from 364 economists in 1981 criticising the Conservative deflationary budget. We are told that the 364 got it wrong because the economy started growing shortly afterwards. This is mediamacro logic, just like when we were told austerity was a success in the UK because the economy grew in 2013. As Steve Nickell pointed out in this speech, unemployment peaked not in 1981 but 1986. The combination of monetary and fiscal contraction in 1981 was overkill, and on that fundamental point the letter was right.

But I will concede this. Mr. Heath and his colleagues on the neoliberal right are much better at PR than economists. They have managed to create the perception in the media that the letter was wrong and Mrs. Thatcher was right. Their strategy is that if the evidence is against you, distort the evidence.

This is the real beef that Mr. Heath has against economists: we mostly follow the evidence and not an ideology. Most economists were indeed wrong about the Great Depression, but that led to the creation of macroeconomics as a separate discipline under the guiding light of Keynes. This helped produce a golden age of growth after WWII, a fact that Mr. Heath ignores. It was brought to an end by stagflation, but that was not the surprise to economists that Mr. Heath imagines.

The irony is that the ideology Mr. Heath follows is itself based on economics: economics as understood by a first year student who only listened to a third of their lectures. For Heath economics is fine as long as it is explaining the virtues of the market and competition, but if economists look at market imperfections then they are “obsessed”.

When I see Heath and his compatriots extol the virtues of the regulation free world that will be possible once they are freed from the shackles of the EU, I am reminded of the Troika and Greece. The Troika has been effectively running Greece for 6 years, yet unlike Ireland or Spain the economy remains in depression with no signs of hope. But rather than question what they have done, they blame the Greeks for not pursuing the prescribed policies rigorously enough. The UK is one of the least regulated OECD economies, and has recently had 6 years of government spending cuts and corporation tax cuts, but productivity growth since the crisis has been painfully slow. Rather than question the efficacy of the medicine, the ideologues blame the EU from preventing them doing even more.

It also reminds me of the Scottish referendum, where those in favour of independence just did not want to hear the bad news about the short term fiscal outlook. Some decided that those bringing that news were part of some Westminster conspiracy, and all preferred to believe the wishful predictions of the SNP. I’ll repeat now what I said then: do you really want to be ruled by people who prefer make believe stories to evidence, and who are so desperate for votes they tell you to ignore an entire academic discipline.           

Can central banks make 3 major mistakes in a row and stay independent?

Mistake 1

If you are going to blame anyone for not seeing the financial crisis coming, it would have to be central banks. They had the data that showed a massive increase in financial sector leverage. That should have rung alarm bells, but instead it produced at most muted notes of concern about attitudes to risk. It may have been an honest mistake, but a mistake it clearly was.

Mistake 2

Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.

Monetary policy makers do not see it that way. They will cite the use of unconventional policy (but this was untested, and it is just not responsible to pretend otherwise), the risks of rising government debt (outside the ECB, non-existent; within the ECB, self-made), and during 2011 rising inflation. I think this last excuse is the only tenable one, but in the US at least the timing is wrong. The big mistake I note above occurred in 2009 and early 2010.

What could be mistake 3

The third big mistake may be being made right now in the UK and US. It could be called supply side pessimism. Central bankers want to ‘normalise’ their situation, by either saying they are no longer at the ZLB (UK) or by raising rates above the ZLB (US). They want to declare that they are back in control. But this involves writing off the capacity that appears to have been lost as a result of the Great Recession.

The UK and US situations are different. In the UK core inflation is below target, but some measures of capacity utilisation suggest there is no output gap. In the US core inflation is slightly above target, but a significant output gap still exists. In the UK the output gap estimates are being used to justify not cutting rates to their ZLB [1], while in the US it is the inflation numbers that help justify raising rates above the ZLB. (The ECB is still trying to stimulate the economy as much as it can, because core inflation is below target and there is an output gap, although predictably German economists [2] and politicians argue otherwise.)

I think these differences are details. In both cases the central bank is treating potential output as something that is independent of its own decisions and the level of actual output. In other words it is simply a coincidence that productivity growth slowed down significantly around the same time as the Great Recession. Or if it is not a coincidence, it represents an inevitable and permanent cost of a financial crisis.

Perhaps that is correct, but there has to be a fair chance that it is not. If it is not, by trying to adjust demand to this incorrectly perceived low level of supply central banks are wasting a huge amount of potential resources. Their excuses for doing this are not strong. It is not as if our models of aggregate supply and inflation are well developed and reliable, particularly if falls in unemployment simply represents labour itself adjusting to lower demand by, for example, keeping wages low. The real question to ask is whether firms with current technology would like to produce more if the demand for this output was there, and we do not have good data on that.

What central banks should be doing in these circumstances is allowing their economies to run hot for a time, even though this might produce some increase in inflation above target. If when that is done both price and wage inflation appear to be continuing to rise above target, while ‘supply’ shows no sign of increasing with demand, then pessimism will have been proved right and the central bank can easily pull things back. The costs of this experiment will not have been great, and is dwarfed by the costs of a mistake in the other direction.

It does not appear that the Bank of England or Fed are prepared to do that. If we subsequently find out that their supply side pessimism was incorrect (perhaps because inflation continues to spend more time below than above target, or more optimistically growth in some countries exceed current estimates of supply without generating ever rising inflation), this could spell the end of central bank independence. Three counts and you are definitely out?

I gain no pleasure in writing this. I think a set-up like the MPC is a good basic framework for taking interest rates decisions. But I find it increasingly difficult to persuade non-economists of this. The Great Moderation is becoming a distant memory clouded by more recent failures. The intellectual case that central bank independence has restricted our means of fighting recessions is strong, even though I believe it is also flawed. Mainstream economics remains pretty committed to central bank independence. But as we have seen with austerity, at the end of the day what mainstream economics thinks is not decisive when it comes to political decisions on economic matters. Those of us who support independence will have to hope it is more like a cat than a criminal.

Postscript (11/04/16). If you think that those who are antagonistic to central bank independence are only found on the left, look at the Republican party, or read this. 

[1] Unfortunately I think some of this survey data is not measuring what many think it is measuring. More importantly, not cutting rates after the Conservatives won the 2015 election was a major mistake. That victory represented two major deflationary shocks: more fiscal consolidation, plus the uncertainty created by the EU referendum. So why were rates not cut?

[2] But not all German economists, as this shows.         

Germany and pre-recession cost cutting

In a recent post I argued that many of the Eurozone’s current problems stem from low nominal wage inflation in Germany before 2008. In that post I also noted that this could be justified if Germany had entered the Eurozone at an uncompetitive real exchange rate, but that I thought there was little evidence for this. I want here to expand on that point.

One area that I have worked on extensively in the past is what might be called the empirical analysis of equilibrium exchange rates. The term equilibrium is short for where the real exchange rate is heading over a five year or so time horizon. While predicting exchange rate movements from day to day is impossible, this is not the case over the longer term. It was for this reason that the UK Treasury asked me to analyse what an appropriate entry rate for Sterling might be if we had joined the Euro in 2003.

There are two ways of describing the approach I take in this analysis. The first is to calculate the exchange rate that will achieve ‘external balance’. As John Williamson repeatedly points out, external balance does not mean current account balance, but the current account that is consistent with medium term trends in domestic supply and demand. This is why the approach is equivalent to a second way of describing it, which is to apply the ideas of the ‘new open economy’ literature that now dominates open economy macro.

In a 1998 study with Rebecca Driver for the (now called) Peterson Institute (which contained a key contribution from John Williamson and Molly Mahar) we calculated equilibrium rates for 2000 for France in the range of 3.06-3.74 Fr/DM, and Italy 927-1133 Lire/DM. The actual entry cross rates were 3.35 Fr/DM and 990 Lire/DM, which is pretty close to the middle of those ranges. In other words, according to our analysis Germany did not enter at a significantly uncompetitive rate compared to these two major economies.

A crude way of doing exactly the same analysis is simply to look at the current account balance. Here it is for Germany, as a percentage of their GDP. The problem with this simple approach is that the current account is a noisy signal, and it is exactly this problem that the analysis described above tries to deal with. But for the sake of argument let’s say that, because of well known lags, the current account in 2001 reflected the competitive position of Germany when the Euro was created.

Germany’s current account in 2001 was in balance, and according to the OECD its output gap that year was a positive 0.7%. So Germany could only be uncompetitive on entry to the Eurozone if that current account balance was unduly influenced by one off factors, or that it really should have been running a structural surplus because of relative demographics or some other reason. But such structural surpluses are normally of the order of 1% or 2% of GDP. Looking at the current surplus of over 7% of GDP, you just have to conclude that Germany currently has a hugely undervalued real exchange rate, which is just another way of saying that it is too competitive compared to its Euro partners. It achieved that competitive advantage from 2000 to 2007.

So where did this idea that Germany entered at an overvalued (uncompetitive) exchange rate come from? I suspect it derives its force from what happened to German GDP growth after the Eurozone was created. As the chart below shows, Germany entered a recession in 2003. In addition, in 2003 foreign trade subtracted from growth. However in terms of the contribution of trade to growth this was a blip: both before and after export volumes grew faster than import volumes, reflecting the growing competitive advantage it was gaining through low nominal wage growth. (A ‘sustainable’ pattern would have domestic demand growing at the same rate as GDP, with a foreign contribution averaging zero.) So if we consider the period 2002 to 2004, for example, the recession was despite a positive contribution from trade, so trade can hardly have been a cause of it. The real reason for the depressed German economy was a decline in domestic demand, coming from both consumption and investment.

Whatever the reason for depressed domestic demand growth, it was not permanent, with healthy growth in 2006 and 2007. By that time, however, Germany had through low nominal wage growth gained a large competitive advantage compared to its Eurozone partners, which was the subject of my earlier post.

Germany’s undervalued real exchange rate - its competitive advantage compared to the rest of the Eurozone - cannot persist. It will be eroded by faster inflation in Germany relative to other Eurozone countries. The only question is whether this happens through a boom in Germany, or continued depression in the rest of the Eurozone. Yet failure to see the source of the problem as coming from Germany continues to mire the debate. There is endless discussion of the need for structural reform outside Germany that ‘must be part’ of any solution to the Eurozone’s current problem. Structural reform may or may not be desirable in many countries, and perhaps even Germany, but it has nothing to do with the need to raise the level of aggregate demand in the Eurozone as a whole. As far as competitiveness imbalances within the Eurozone are concerned, the problem is a result of a negative inflation shock in Germany. The natural place to look for a solution is not structural reform outside Germany, but a period of above target inflation within Germany, and it is in the interests of pretty well every Eurozone country other than Germany that this should happen.

Scotland and the SNP: Fooling yourselves and deceiving others

There are many laudable reasons to campaign for Scottish independence. But how far should those who passionately want independence be prepared to go to achieve that goal? Should they, for example, deceive the Scottish people about the basic economics involved? That seems to be what is happening right now. The more I look at the numbers, the clearer it becomes that over the next five or ten years there would more, not less, fiscal austerity under independence.

The Institute for Fiscal Studies is widely respected as an independent and impartial source of expertise on everything to do with government spending, borrowing and taxation in the UK. It has produced a detailed analysis (recently updated) of the fiscal (tax and spending) outlook for an independent Scotland, compared to what would happen if Scotland stayed in the UK. It has no axe to grind on this issue, and a considerable reputation to maintain.

Their analysis is unequivocal. Scotland’s fiscal position would be worse as a result of leaving the UK for two main reasons. First, demographic trends are less favourable. Second, revenues from the North Sea are expected to decline. This tells us that under current policies Scotland would be getting an increasingly good deal out of being part of the UK. To put it another way, the rest of the UK would be transferring resources to Scotland at an increasing rate, giving Scotland time to adjust to these trends and cushioning their impact. Paying back, if you like, for all the earlier years when North Sea oil production was at its peak.

The SNP do not agree with this analysis. The main reason in the near term is that they have more optimistic projections for North Sea Oil. The IFS analysis uses OBR projections which have in the recent past not been biased in any one direction. So how do the Scottish government get more optimistic numbers? John McDermott examines the detail here, but perhaps I can paraphrase his findings: whenever there is room for doubt, assume whatever gives you a higher number. In my youth I did a lot of forecasting, and I learnt how to be very suspicious of a series of individual judgements all of which tended to move something important in the same direction. It is basically fiddling the analysis to get the answer you want. Either wishful thinking or deception.

I personally would criticise the IFS analysis in one respect. It assumes that Scotland would have to pay the same rate of interest on its debt as the rUK. This has to be wrong. Even under the most favourable assumption of a new Scottish currency, Scotland could easily have to pay around 1% more to borrow than rUK. In their original analysis the IFS look at the implications of that (p35), and the numbers are large.

So what would this mean? Could Scotland just borrow more? I am all for borrowing to cover temporary reductions in income, due to recessions for example, which is why I have been so critical of current austerity. However, as the IFS show, North Sea oil income is falling long term, so this is not a temporary problem. Now it could be that the gap will be covered in the longer term by the kind of increases in productivity and labour supply that the Scottish government assume. Governments that try to borrow today in the hope of a more optimistic future are not behaving very responsibly. However it seems unlikely that Scotland would be able to behave irresponsibly, whatever the currency regime. They would either be stopped by fiscal rules imposed by the remaining UK, or markets that did not share the SNP’s optimism about longer term growth. So this means, over the next five or ten years, either additional spending cuts (to those already planned by the UK government), or (I hope more realistically) tax increases.

Is this a knock down argument in favour of voting No. Of course not: there is nothing wrong in making a short term economic sacrifice for the hope of longer term benefits or for political goals. But that is not the SNP’s case, and it is not what they are telling the Scottish people. Is this deception deliberate? I suspect it is more the delusions of people who want something so much they cast aside all doubts and problems.

This is certainly the impression I get from reading a lot of literature as I researched this post. The arguments in the Wee Blue Book are exactly that: no sustained economic argument, but just a collection of random quotes and debating points to make a problem go away. When the future fiscal position is raised, we are so often told about the past. I too think past North Sea oil was squandered, but grievance does not put money into a future Scottish government’s coffers. I read that forecasting the future is too uncertain, from people who I am sure think about their future income when planning their personal spending. I read about how economists are always disagreeing, when in this case they are pretty united. (Of course you can always find a few who think otherwise, just as you can find one or two who think austerity is expansionary.)

When I was reading this literature, I kept thinking I had seen this kind of thing before: being in denial about macroeconomic fundamentals because they interfered with a major institutional change that was driven by politics. Then I realised what it was: the formation of the Euro in 2000. Once again economists were clear and pretty united about what the key macroeconomic problem was (‘asymmetric shocks’), and just like now this was met with wishful thinking that somehow it just wouldn’t happen. It did, and the Eurozone is still living with the consequences.

So maybe that also explains why I feel so strongly this time around. I have no political skin in this game: a certain affection for the concept of the union, but nothing strong enough to make me even tempted to distort my macroeconomics in its favour. If Scotland wants to make a short term economic sacrifice in the hope of longer term gains and political freedom that is their choice. But they should make that choice knowing what it is, and not be deceived into believing that these costs do not exist. 

Taylor rules: the ZLB and Euro Diversity

John Taylor originally suggested his rule as both a good guide to what central banks actually do and also one that “captures the spirit of the recent research”. It has been used ever since as a yardstick by which to measure monetary policy. However there are well understood reasons why it is likely to be a poor yardstick in a severe recession.

First some theory. In a world of certainty, when inflation expectations are equal to the inflation target, the optimal interest rate to set is one that delivers what is called the ‘natural’ real interest rate. You can describe this as the real interest rate that would achieve a level of demand and output which eliminated the output gap, and put unemployment at its natural rate. At that point, there should be no pressure from the domestic economy for inflation to rise or fall.

In this context it becomes obvious why the output gap (or deviation of unemployment from the natural rate) appears in the Taylor rule. Yet in reality our estimates of the output gap are poor, so it also makes sense to include the difference between inflation and its target in the rule. Finally the rule also contains a constant, which is an estimate of what the natural interest rate would be if inflation was at target and there was a zero output gap. As to the coefficients on inflation and output, you want those to be modest to avoid overreacting to false signals and to allow for lags between interest rate changes and their impact on inflation.

The best way to think about the Taylor rule is as a simple ‘horse for all courses’. It is designed to be a robust rule for all situations: booms as well as busts, small as well as large deviations from target, and where we have no additional reliable information.

In the current recession we know a number of additional things. First, the natural real rate of interest is likely to be a lot lower than the constant in any Taylor rule. There are a number of reasons for this. In the short term a balance sheet recession means that consumers want to save much more than they would normally, so the natural rate has to be unusually low to offset the impact of this on demand. In the longer term we have the issue of secular stagnation, which is one reason why policymakers in both the UK and US say that even when the economy recovers interest rates are likely to be lower than they have been in the past. (Austerity is another.)

There are other factors as well. At low levels of inflation, inflation appears to be less responsive to excess demand. On its own this means that the coefficients on excess inflation in a horse for all courses Taylor rule will be too low when inflation is below 2%. (The possibility of hitting the Zero Lower Bound can also imply the same thing.) If forecasts indicate that inflation will remain below target for some time, that can also suggest we can afford to react to inflation being too low by more than the Taylor rule would suggest.

If you want a practical illustration of all this, consider this post from Zsolt Darvas at Breugel. It uses a typical Taylor rule for the Euro area, and finds that interest rates set by the ECB have been below the level implied by that rule every year since about 2001! That is a clear illustration of the problem of assuming a constant long run natural real interest rate, in this case beginning with Bernanke’s savings glut. Exactly the same points arise in trying to assess whether US monetary policy was too expansionary in the mid-00s. This same rule also implies that the ECB raised rates by too little in 2010/11, which is clearly silly in the light of what subsequently happened. (Again we had more information, in this case about austerity.)

However the Breugel post is not really about how appropriate the ECB’s monetary policy is for the Eurozone as a whole. Instead it focuses on what the rule tells us monetary policy might have been in each individual Eurozone economy, if they had retained their own currency and had floated. Or to put it another way, it tells you for which countries the ECB’s policy is too tight, and for which it is too easy. Used in this way, the analysis is a handy way of combining information on inflation and unemployment diversity across the Eurozone.

Where is the ECB’s policy too tight? There are the obvious countries: Spain, Portugal, Italy and especially Greece. But there is another, which is the Netherlands. There is no mystery here: CPI inflation is currently (May) 0.8%, the harmonised rate is 0.1%, and unemployment has been over 7% this year, compared to an average of below 4% from 2000 to 2007. As the Netherlands does not have an independent monetary policy, it desperately needs a countercyclical fiscal policy, yet instead it is locked into the austerity trap imposed by the Eurozone’s fiscal rules. All of this was horribly predictable, which is why I wrote these posts: May12, Sept12, June13, Dec13.

These fiscal rules are not going to be abolished anytime soon, even though their intellectual rationale has disappeared. The best that we can hope for is that their impact can be softened or partially circumvented by allowing additional public investment spending: see Reza Moghadam from the IMF here, or Wolfgang Münchau here and here, Guntram Wolff here, or Mariana Mazzucato here. But if in the future anyone wants to see the clearest example of where these rules led to large and completely unnecessary social costs, just look at the Netherlands.

    

Does politics dominate economics in Eurozone crisis management?

Athanasios Orphanides, leading academic macroeconomist and from 2007-12 Governor of the Central Bank of Cyprus, does not hold back in a recent paper. Here is just one quote: 

“During the crisis, key decision makers exhibited neither political leadership nor political courage. Rather than work towards containing total losses, politics led governments to focus on shifting losses to others. The result was massive destruction in some member states and a considerably higher total cost for Europe as a whole. European institutions could have been the last line of defense against this destructive dynamic but instead served to facilitate and enable the destruction.”

His complaint will resonate with many from the smaller Eurozone economies. The text of the paper suggests that the way decisions are made in the Eurozone allows large countries to screw smaller countries, for short term economic gain, even if this damages the Eurozone as a whole.

He focuses on two ‘blunders’. The first was the meeting between French President Sarkozy and German Chancellor Merkel in Deauville in 2010, where these leaders suggested that a haircut should be imposed on private sector lenders to solvent governments that got in to funding difficulties. Ireland lost market access for its debt within weeks. However Orphanides notes that German debt became less costly as a result.

The second was in 2013, when the Eurogroup decided to impose a haircut on deposits of Cypriot banks, insured and uninsured. Although the decision was almost immediately recognised as a blunder, Orphanides justifiably asks how such a blunder could have been made. He suggests that it can be explained by the forthcoming German elections, and a need for the government to appear tough. The result was the destruction of Cypriot banks, which in turn gave Germany leverage to end the low Cypriot corporate tax rate.

It has not escaped at least one reader of this paper that such decisions invariably favour Germany. This is not the message Orphanides highlights. The abstract says that the paper is about how politics has dominated economics in crisis management. But what exactly does that mean? And is it really the case that economics is blameless here?

Take the Deauville decision. It is true that this hardly helped calm market nerves at the time, although Ashoka Mody argues that its impact on spreads was not that great. However it does seem to stretch credibility that this was a deliberate ploy by Germany to reduce its own borrowing costs. If it was, did Sarkozy also think it would reduce interest rates on French debt? A much more plausible explanation for this blunder is that Germany wanted to reintroduce some form of no bailout regime into the Eurozone. This may indeed have been a clumsy attempt to do so, but the real culprit was the absence of any clear economic mechanism that would allow the Eurozone to distinguish between sovereign debt crises where default was unavoidable, and sovereign debt crises which represented a self-fulfilling market panic, where the government’s fiscal position was in fact sustainable if support from other governments or institutions was forthcoming.

This problem had not been addressed in the design of the Eurozone, under the pretence that the Stability and Growth Pact would mean that such issues would never arise. It has still not been addressed today: the problem has simply been shifted on to the shoulders of the ECB in consultation with governments, who have to jointly decide whether OMT will be invoked, and under what conditions. It remains unclear under what circumstances, if any, a Eurozone government will be left to default.

It seems quite reasonable to argue in this case that politicians are left floundering, and make the occasional blunder, because the economics of the problem have not been thought through. Orphanides argues that “the domination of politics over economics has led to crisis mismanagement.” I suspect this is a little unfair on politics, and far too forgiving on economics.  

The US and the Eurozone 2012-3

If fiscal policy is important at the zero lower bound, why did the US recovery continue in 2012 and 2013 despite a large fiscal contraction? Or to put the same question in a comparative way, why was the Eurozone’s fiscal contraction in 2012/3 associated with a recession, but not in the case of the US?

GDP growth had been reasonable in both the US and the EZ in 2010 and 2011. While US growth continued into 2012/3, EZ growth collapsed. Yet as the chart above shows, fiscal tightening was only slightly greater in the EZ in 2012, and became considerably tighter in the US in 2013.

Before discussing this, it is important to make two important points. The first is that the macroeconomy is complex, involving important lags in behaviour and expectations of future events. For that reason alone, you will not get precise matches between causes and consequences by just eyeballing the data. Second, different fiscal measures have different effects, and trying to express the fiscal stance in one simple measure will always be a crude approximation. However, despite these qualifications, I think we can provide something of an answer to this question by just looking at the numbers. 

In comparative terms, there are two obvious answers looking at 2012. The first is the EZ crisis. Although this began in 2010, it reached a critical position in 2012, when Greece was almost forced out. It is hardly surprising in these uncertain circumstances that EZ investment fell by nearly 4% in 2012. The second is monetary policy. The ECB raised rates from 1% to 1.5% in 2011, and compared to the US there was no Quantitative Easing. Combining the two, monetary conditions tightened considerably in the periphery as a result of the crisis. There was no comparable crisis in the US, which allowed investment to increase by 5.5%.

Explaining 2013 seems more difficult. Monetary policy had eased in the EZ (although of course not by as much as it should have), and OMT had brought the crisis to an end. In the US there was considerable fiscal tightening. So why did the US continue to grow and EZ GDP continue to fall?

For the EZ one proximate cause was a sharp decline in the contribution of net exports. Net exports added 1.5% to GDP in 2012, but only 0.5% in 2013. If this contribution had been more even at 1% in each year, GDP would have fallen by over 1% in 2012, and stayed roughly flat in 2013. Fiscal policy continued to tighten, which also would have reduced growth.

In the US something else happened: the savings ratio, which had been elevated at 5.5% or above since 2009, fell to 4.5%. This could have been a result of fiscal tightening, but it seems more probable that it represented the end of a prolonged balance sheet correction. (The US savings ratio averaged 4.5% between 1996 and 2007 and the OECD’s forecasters expect it to fall further this year and next.) The OECD estimates that the US output gap in 2013 was -3.5%, which was much the same as their estimate for 2012. So growth of 2% did nothing to close the output gap in 2013. This was despite a large fall in the savings ratio, perhaps bringing to an end the balance sheet correction that began with the Great Recession. So US growth in 2013 should have been very strong, and the obvious explanation for why it was not is very restrictive fiscal policy.

What we do know

After reading all about the latest ECB moves, I happened to read this by Noah Smith (HT MT). It made me unusually irritated, but it is not really Noah’s fault. He is right that there is much that we do not know in macro, and also right that there are many different views around. Alternative assessments of how effective the ECB’s policy changes will be illustrate that. Noah puts all this down to lack of data, rather than politics. When it comes to unconventional monetary policy this is also right. However there are some things where the data is pretty clear, and where any macroeconomist with an open mind should be able to come to a clear conclusion. But somehow this does not happen.

When pouring over the detail of what are minor moves by the ECB, there is a huge elephant in the room: fiscal policy. Too often this is portrayed by those outside as a game with two sides: the PIIGS, where austerity is a necessity because of difficulties in funding debt, and Germany, where there is no domestic interest in offsetting periphery austerity with fiscal expansion. However there is a third bloc of countries in the Eurozone, where there has been no debt funding crisis, but where there exists a large amount of spare capacity. This bloc is dominated by France (2014 output gap -3.4% as estimated by the OECD), but also includes the Netherlands (output gap -4.4%), Belgium (output gap -1.7%), Austria (output gap -3.2%) and Finland (output gap -3.8%). The chart below shows what is happening to fiscal policy in those countries.

Underlying Primary Balances: OECD Economic Outlook May 2014

All of these countries are tightening their fiscal policy this year and next: in the case of France, Finland and the Netherlands quite substantially. So the focus on Germany as a country (as opposed to its influence on Eurozone institutions), where the OECD projects some very modest fiscal expansion, is misleading. Damage is being done elsewhere, and for this group of countries where negative output gaps are large fiscal policy is just perverse.

The theory and evidence behind this last statement should not be controversial. The theoretical framework used by monetary institutions almost everywhere says that fiscal contraction at the zero lower bound will do serious damage to output and unemployment (and therefore reduce core inflation). The evidence overwhelmingly confirms this proposition. While the reasons for the Great Recession may still be controversial, the major factor behind the second Eurozone recession is not: contractionary fiscal policy, in the core as well as the periphery. So this is something we really do know. Yet too many macroeconomists seem reluctant to acknowledge this. There are the anti-Keynesians who want to deny the monetary policy consensus; there are others, who want to deny the importance of the zero lower bound; and still more, who for some other reason want to deny the importance of fiscal policy.  

This allows policymakers to continue to press for fiscal consolidation in the Eurozone, largely ignoring those economists who do challenge this policy because they just represent 'one view' within the discipline. Every reluctant and far too late bit of stimulus by the ECB is undone by the actions of the Commission and the political consensus behind austerity in Europe. As far as economists are concerned, although our macroeconomics is much better than it was 50 years ago, in this case our collective influence on policy has gone backwards.