The IMF as a transmission mechanism for academic knowledge

In my recent post on the ‘biggest policy mistake of the last decade’, I emphasised the irrelevance of the academic consensus on austerity if politicians did not want to listen. It was, inevitably, a picture painted with a broad brush.

I did not discuss, for example, an element that should form part of the transmission mechanism for academic knowledge but didn’t, and that is European central banks. As I have discussed here, these central banks are full of economists applying state of the art macroeconomic knowledge, so they should be a source for the current academic consensus. But these central banks are also very hierarchical, and if the senior staff want to give out a different message they can. In Europe that message was that austerity was necessary, and worse still that the lower bound for interest rates was no impediment to their ability to control the economy.

This was a serious mistake for two reasons. First, central bank leaders were going against the knowledge that their own economic models and analysis gave them. Second, their implication that the lower bound for interest rates didn't matter was not only very wrong but also encouraged politicians to continue with austerity.

But there was a perhaps surprising route by which the academic consensus did get through, and that was the International Monetary Fund. The IMF itself wavered on austerity. At first (before 2010) it encouraged coordinated fiscal stimulus. As the Eurozone crisis began to unfold it changed its mind, and advocated austerity. But this did not last that long. I remember visiting the IMF in September 2012, and being told of empirical work by their Chief Economist Olivier Blanchard and Daniel Leigh that suggested multipliers might be much larger than the received Fund wisdom at the time. It was nice for me, because one of the talks I gave was why from a theoretical point of view multipliers might be large when interest rates were stuck at their lower bound.

This was not the only piece of Fund work that undermined the case for austerity. This analysis questioned the empirical case for expansionary austerity, as I discussed here. Economists at the IMF also showed clearly how unusual the behaviour of government spending after the Global Financial Crisis was compared to previous recoveries: austerity, far from being the norm, was an untried experiment. Indeed I think it is fair to say that if you wanted a source of empirical analysis on the impact of austerity, the IMF was your first port of call.

As Ben Clift discusses here, the IMF have also pioneered analysis of how inequality, and perhaps even large financial sectors, may be bad for growth, and much more that you would not have expected from the IMF of the last century. But he also points out something I emphasised in a post I wrote after my visit. The IMF is extremely heterogeneous. Alongside more modern views of the role of fiscal policy you will also find traditional fiscal hawks. The IMF also has its hierarchy with more political masters, but the difference is that at the IMF today there is no rigid control of what gets published by its economists.

For example, the IMF have an Independent Evaluations Office, which appears to be lead by economics rather than politics and which is often critical of IMF practice. I noted here, for example, a 2014 analysis of austerity, which criticised the support the IMF gave to austerity from 2010. The report essentially suggested that parts of the IMF had been panicked by the Eurozone crisis, which also presumably gave the fiscal hawks in the institution the upper hand. The report also explains why this panic was unwarranted given what we now understand about the Eurozone specific causes of that crisis, and this together with the Blanchard and Leigh analysis helped turn the tide against a belief in the virtues of austerity in the IMF.

All this IMF work was clearly very helpful to those economists like myself who were arguing against austerity at the time. It didn’t change policies in the UK and among Republicans in the US because those policies were ideologically based. I doubt it had much impact in Germany either. However it might be possible to argue it had some influence in softening the line taken by the EU Commission. If you look at the OECD’s estimate of underlying primary balances, 2013 was the last year of fiscal contraction in the EU as a whole.

Fiscal council developments

As longstanding followers of this blog will know, I have a particular interest in what are called either ‘fiscal councils’ or ‘independent fiscal institutions’. As I have been and will be preoccupied with other issues for a while, I thought I would try and squeeze in one post on recent developments both in the UK and abroad.

In the UK we had Dave Ramsden’s Treasury review (pdf) of the OBR. The most positive aspect of the review is the recommendation for more resources. I guess the headline news was that the OBR would not be asked to cost opposition policies before elections, as the Dutch fiscal council has done for some time, and as the Australian PBO now does. I would have liked a different decision, but my disappointment is mitigated by three factors:

• the report does recommend the “OBR should ensure greater availability of tools and data to allow third parties to cost alternative policy options”.
  
• in the UK we have the IFS, which does do this and currently (and rightly) has a quasi-official status
  
• the level of the fiscal debate in the UK media is currently so poor that I’m not sure how much such a development would improve things.

This last point raises something of a paradox. People like me hoped that fiscal councils like the OBR would improve the public debate. This paradox reflects in part the particular nature of the OBR, which would not be allowed to say - for example - that the fiscal charter is economically illiterate (i.e. no economist agrees with it). Fiscal councils in some other countries can do that, and indeed were set up to do that. This is a gap the IFS cannot fill. I guess the OBR will not be allowed to comment on the economics of different fiscal rules until the UK gets a more sensible rule. I think it is quite likely that if the OBR was able to say such things, we would not have had this particular fiscal charter and we would all be better off as a result.

With the rapid growth in the number of fiscal councils around the world, the case for some kind of international network has become much stronger. It is therefore good news is that one is about to be established for those in the EU. There are at least two important roles such a network can have, apart from the obvious one of spreading best practice.

First, it can help establish and maintain independence for individual fiscal councils, which may be put under various kinds of pressure by their national governments. Sometimes this pressure is just verbal, and often indicates that the council is doing its job. I have just come back from Ireland, where the Irish fiscal council criticised a pre-election giveaway by the government. Its chairman John McHale also suggested that it might break the Commission’s fiscal rules. The government then revealed that it had obtained agreement from Brussels, but had not told the fiscal council. It managed to spin this as an error made by the council, which journalists dutifully parrotted. Substantive criticism was thereby deflected. That kind of thing from governments is only to be expected. It becomes more serious when governments react to criticism in financial or even existential terms, as has happened in Canada and Hungary. In those cases, the council needs all the defence it can get.       

Second, a network can act as an important pressure group on the Commission. The Commission itself has recently established an Advisory Fiscal Board, which if nothing else can increase the dialogue between the fiscal councils and the Commission. I talked about the dual system of fiscal monitoring within Europe here, and how I hope we will see a gradual reduction in central control and more discretion given to national governments monitored by strong national fiscal councils. If Daniel Gros is right and German hegemony is coming to an end, then maybe it might just happen - one day.     

 

Cyclically adjusted deficits and instability

Jean Pisani-Ferry, currently advising the French government and former director of Bruegel (the Brussels-based economic think tank) has written a heartfelt plea for more stability in the Commission’s estimates of potential output. The reason is straightforward. The Eurozone’s fiscal rules require meeting targets for cyclically adjusted deficits within the next year or two. Every time estimates of potential output change, the target for the actual deficit also changes, and policy often has to respond immediately to meet the new targets.

Pisani-Ferry of course understands why this happens, and why cyclical adjustment makes sense in principle. He is not advocating returning to the days when targets ignored the economic cycle. However the problem he clearly has is in communicating to policy makers who are not economists why they need to change actual policy simply because someone in Brussels has revised their estimate of potential GDP. He writes

“Members of parliament – who are not technicians – are understandably disturbed when they are asked to pass a revised budget in response to an updated estimate. Not knowing the whys and wherefores, they end up perceiving such revisions as a source of artificial instability.”

However an obvious objection to his proposal might involve the following scenario. To meet its target the government is embarking on austerity which is also reducing GDP. The Commission gets new information which leads it to revise up its estimate of potential GDP, implying the need for less austerity. Should the Commission ignore this information for the sake of stability?

I would suggest that the ‘non- technical’ instincts of policymakers are right in this case, but the reason is more basic. Short term fixed date targets for the deficit are a source of instability. There is no economic reason to have such short term deficit targets, and there are plenty of very sound economic reasons not to have targets of this kind. In essence this is because the deficit should be a shock absorber, but by targeting it you make taxes or spending the shock absorber. Hence the perceived, and actual, instability.

It would be much better, as Jonathan Portes and I argue, to have deficit targets for 5 years ahead. Whether these should be fixed date or rolling targets would depend on how trustworthy the government was, and whether there was an independent and robust fiscal council that could provide an ‘implementation incentive’ for the government. (We would argue in addition that fiscal policy in the Eurozone needs to play a countercyclical role, both at the individual country level to correct imbalances within the zone, and at the aggregate level if interest rates are at the Zero Lower Bound.)

Would such targets need to be cyclically adjusted? In the context of an economy with its own monetary policy we would argue not, because within five years the central bank should have eliminated any output gap (in expectation). Whether cyclical correction via competitiveness effects works so quickly is less clear, and if it does not cyclical correction would still be required. However I suspect that if targets were for five years ahead, revisions caused by new estimates of potential would be less problematic, because the need for an immediate policy change would be reduced. (As an example, when the OBR first revised its estimate of potential in the UK, Osborne’s response was to extend austerity into the next parliament, rather than intensify current austerity.)

The key point is that targets for the deficit just one or two years ahead are foolish things to have, and cyclically correcting the target only makes them slightly less foolish. Indeed, I would go so far as to say they are primitive in macroeconomic terms. It is like telling consumers that they shouldn’t smooth their consumption, but instead vary their spending or income to keep their wealth at some fixed target level. You would only want to do that to a child, and policymakers should not be treated as children.

The view from Germany

As an exemplar, take this article that appeared in Spiegel (HT MT). It defends Germany against criticism of its current account surplus, but its main worry is not harsh words from the US government, or Paul Krugman, or Martin Wolf, but from Marco Buti of the European Commission. But before saying something about that, or the article itself, we need to be clear about the basic facts. (I have talked about the myths elsewhere.)

From 2000 to 2007, the periphery of the Eurozone (EZ) enjoyed a boom, while Germany did not. As a result, inflation in the periphery (and much else) of the EZ exceeded inflation in Germany by a significant and persistent amount. By 2007, this meant that Germany had become too competitive in relation to the rest of the EZ. This situation is not sustainable. The large German surplus is a symptom of that situation.

Under flexible exchange rates, the German currency would have been able to appreciate against the other EZ countries, eliminating the competitive advantage. In a currency union, the only feasible outcome is for German inflation to run ahead of the rest of the EZ by a significant and persistent amount for a number of years. If the ECB was willing and able to target 2% inflation, then that would mean future German inflation significantly and persistently above 2%. That would require excess demand in Germany, to balance deficient demand in the rest of the EZ. There is really no way around this consequence of a 2% inflation target - it is just arithmetic.

The problem arises because the ECB is unwilling or unable to target 2% inflation. That in theory allows Germany to attempt to force the EZ as a whole to make the required internal adjustment without inflation in Germany exceeding 2%. It can do this by a restrictive fiscal policy. This is exactly what it has done. The figure below shows the underlying primary financial balance in Germany and the whole EZ (including Germany). (Source: Oct 2013 OECD Economic Outlook.) The projected German surpluses are expected to bring down the debt to GDP ratio from 51% of GDP in 2012 to 48.5% of GDP in 2014.

Other EZ countries are defenseless against this deflation, because of imposed austerity or the EZ Fiscal Compact. As a result, the path we seem to be on involves German inflation at around 2% and average EZ inflation well below 2%. This may be in Germany’s narrow national interest, but for the EZ as a whole it is much more costly, partly because of the difficulties of reducing inflation when it is close to zero. Deflation in the EZ as a whole is also costly for those outside the EZ when everyone’s interest rates are near zero (see Francesco Saraceno here).

Much of the Spiegel article is about the pointlessness of blaming Germany for its success in exporting. This of course completely misses the point, but if outside criticism focuses on Germany’s current account rather than its inflation rate it is perhaps not a surprising reaction. The German current account surplus is a symptom of the underlying problem, which is a tight fiscal and monetary policy in the EZ. Whether the tight monetary policy (bringing EZ inflation below 1%) is an unforced or forced error (because interest rates are near zero) is not crucial here, except to the extent that German pressure is behind any reluctance until recently to cut interest rates. 

At one point, however, the article does note that criticism of Germany “holds that the Germans live and consume below their means, which is detrimental to foreign companies because there is less demand for their products in Germany.” But its response is to say that this is the fault of “countries like Greece, Italy and Spain, [who] have only themselves to blame for their troubles because they spent years living beyond their means and at the expense of their own competitiveness.” In other words, why should Germany suffer above 2% inflation because the rest of the EZ allowed themselves to become uncompetitive.

Mapping macroeconomics into a morality play is almost always a mistake. So let’s just stick to the rules of how the EZ is supposed to work. The ECB is supposed to have a (‘just below’) 2% inflation target. If it was able to meet that target, Germany would have to suffer 3%+ inflation for a number of years. Now you might respond that the ECB is within its mandate if it targets 1% inflation to allow Germany to only have 2% inflation, because below 2% inflation is allowed. I think that would be stretching the mandate rather a lot (see Andrew Watt here), but even so, if that were true, why didn’t the ECB target 1% inflation from 2000 to 2007 to avoid inflation outside Germany exceeding 2%?

A more reasonable interpretation would be that Germany is either putting pressure on the ECB so that its policies are favourable to the German national interest, or that it is taking advantage of the inability of the ECB to target inflation in a liquidity trap to force inflation below target through a restrictive fiscal policy. It is either trying to circumvent the rules, or take advantage while the referee's whistle is broken. [1]

Which brings us to one referee, which is the European Commission. I have been quite critical of the Commission in the past, and particularly of European Commissioner Olli Rehn (e.g. here). In March I also wrote a post criticising a paper co-written by Marco Buti, Director-General for Economic and Financial Affairs at the European Commission. That paper included the following quote: “In Germany, the fiscal stance is now broadly neutral, hence consistent with the call for a differentiated fiscal stance according to the budgetary space.” I was therefore slightly surprised to see Buti cast as chief German tormenter in the Spiegel article. To quote (my italics): “The chief economist of the European Commission, a native of Italy, has a tendency to blame many euro-zone ills on the nature and effects of German economic policy.” I find it tricky to reconcile Marco Buti’s March paper with this Spiegel description, but perhaps events in the intervening months (and the Commission’s own analysis) have strengthened views which could not have been expressed openly in public. (There are other constraints on the Commission, as John McHale notes here.) Whatever, I hope the Spiegel article is right, and those working for the Commission are applying all the pressure they can to change the view from Germany.

[1] It would be interesting to compare this deflationary bias in the EZ, reflecting a combination of the Fiscal Compact and the Zero Lower Bound, with Keynes’s worries about the Bretton Woods system, which helped create the IMF. Barry Eichengreen draws an analogy between current policies and the 1930s here.

The ‘official’ cost of austerity

Well, not quite, but probably as close as we will ever get.[1] In a new paper, Jan in‘t Veld uses the European Commission’s QUEST model to estimate the impact of fiscal consolidation in the Eurozone (EZ) from 2011 to 2013. The numbers in the table below include spillover effects from other EZ country fiscal consolidations, so they are best interpreted as the impact of overall EZ fiscal consolidation over this period. There are at least two important things to note about the exercise. First, they do not attempt to analyse the impact of the particular mix between cuts in spending and increases in taxes applied in each country. Instead the ‘input’ is simply the change in the general government primary structural balance each year, which is assumed to be equally balanced between expenditure and revenue measures. (More on this below.) Second, to a first approximation this fiscal consolidation is assumed to lead to no change in short or long term real interest rates during the 2011-13 period.

GDP losses due to Eurozone fiscal consolidation (including spillovers) 2011-13. Source European Economy Economic Papers 506, Table 5.

	Impact on GDP 2013	Cumulative Impact 11-13
Germany	3.9%	8.1%
France	4.8%	9.1%
Spain	5.4%	9.7%
Ireland	4.5%	8.4%
Greece	8.1%	18.0%

Of course many would argue that had countries like Spain or Greece not undertaken this degree of austerity, long term interest rates might have been even higher than they actually were. (Perhaps short rates might have also been higher, if with stronger growth the ECB had raised short rates, but remember that tax increases also helped raise EZ inflation.) However a significant amount of fiscal consolidation took place in Germany, and this had significant spillover effects on other EZ countries. It is difficult to see why that consolidation was required to ease funding pressures.

One slightly surprising aspect of the exercise has already been noted. To quote: “As detailed information about the composition of the actual consolidations is not available, it is assumed the composition is equally balanced between expenditure and revenue measures.” As other institutions like the IMF publish exactly that kind of information, I’m puzzled. What the paper does report is that QUEST shows that consolidation implemented through spending cuts has about twice the short run multiplier as consolidation through higher taxes, but of course this is exactly what theory would suggest. In a forward looking model like this it also matters a great deal how agents perceive the permanence of these policy changes.

Of course QUEST is just one DSGE model, which just happens to be maintained by the Commission. An earlier study (pdf) by Holland and Portes at NIESR had important differences in detail, but the bottom line was similar: EZ GDP was 4% lower in 2013, and the cumulated GDP loss was 8.6%. These numbers are of course large, and so it is quite reasonable to say that the proximate cause of the second EZ recession is simply austerity.

Now many would argue that much of this was forced by the 2010 crisis. There seems to be a mood of fatalism among many in Europe that this was all largely unavoidable. I think that is quite wrong. Some fiscal tightening in Greece was inevitable, but if EZ policy makers had taken a much more realistic view about how much debt had to be written off, we could have avoided the current disaster. What ended the EZ crisis was not austerity but OMT: if that had been rolled out in 2010 rather than 2012, other periphery countries could also have adjusted more gradually. And of course fiscal consolidation in Germany and some other core countries was not required at all. If instead we had seen fiscal expansion there, to counter the problem of hitting the ZLB, then the overall impact of fiscal policy on EZ GDP need not have been negative. (Section 5 of Jan in‘t Veld’s paper looks at the impact of such a stimulus.) That means that over 3 years nearly 10% of Eurozone GDP has been needlessly lost through mistakes in policy. This is not the wild claim of a mad macroeconomist, but what simple analysis backed up by mainstream models tell us.

One final point. The UK equivalent to these ‘official’ numbers are the OBR’s estimates of the impact of fiscal consolidation on the UK. While they are significant in size, they are smaller than these EZ numbers. The OBR estimate that UK GDP in 2013 is about 1.5% lower as a result of fiscal consolidation, and the cumulated GDP loss due to fiscal tightening from 2010 to 2013 is a bit above 5%. There is a good reason and a bad reason for this difference. First, the UK is a more open economy than the EZ as a whole, and we would expect openness to cushion the impact of fiscal consolidation. Second, the OBR’s numbers are more crudely derived, based on multipliers that take no account of the zero lower bound or deep recession. The numbers from the QUEST model allow for both, which of course raises the size of the fiscal impact. 

[1] As the disclaimer says, “The views expressed are the author’s alone and do not necessarily correspond to those of the European Commission.” A good example of the official line is Buti and Carnot, but this line does not tend to be backed up by model simulations, which I think is revealing. 

How not to run fiscal policy: more lessons from the Eurozone

In my last but one post I noted the case of European Commission estimates of the output gap as an example of what can happen if you do not allow for the asymmetry implied by firms’ reluctance to cut nominal wages. Their methodology implied that the natural rate in Spain had more than doubled in a decade, which seems nonsensical. However the economists at the Commission at least came to recognise the problem, and had proposed making some changes to get more reasonable numbers. As I will explain, the methodology they use is reasonable given the state of macroeconomic arts, which is why in that earlier post I used this as an example of a failure of macroeconomics generally, rather than economists at the Commission. In this post I want to note what happened next, which in contrast does seem to reflect badly on how the Commission works.

But before getting to that, a few background points. First why this matters. As part of the “two pack” (don’t ask), Eurozone economies will now have to submit their budgets for approval by the Commission. Approval will depend, among other things, on the Commissions calculations of the structural budget deficit, which is the deficit corrected for the cycle. Measuring this is difficult, because we do not observe the output gap, which itself depends on both the natural rate of unemployment and the underlying trend in productivity (technical progress), which we also do not observe.

You can say at this point why bother - just stick to looking at the actual deficit. That’s an overreaction. For most Eurozone countries we are pretty clear about the sign of the output gap, so making some adjustment should be better than doing nothing. To see the kind of stupidity that arises from just focusing on actual deficits, see the Netherlands.

In principle we can use information on what we do observe, like wage inflation, to make inferences about what the natural rate of unemployment is. So if wage inflation depends on the gap between actual unemployment and the natural rate (called the NAWRU by the Commission), we can switch things around to make this an equation telling us what the natural rate is, given observations on actual wage inflation.

There are three kinds of problem that arise in doing this. The first is that our estimates will be only be as good as the specification of the wage equation. If we leave important factors out of the specification of the wage equation (like a reluctance to cut the nominal wages of existing workers because of morale effects - see this paper by Eliaz and Spiegler for example), we will get our estimates of the natural rate wrong. The second is that some of the things that we are sure do determine wage inflation, like inflation expectations, may be difficult to measure. Paul Krugman discusses the possibility that inflation expectations in Spain might have become anchored here. Finally no equation is perfect, and if we do not allow for these inevitable errors we will get a ridiculously bumpy series for the natural rate. So we need to apply some kind of smoothing.

The way the Commission tackled these problems is described in detail here. The fact that they use a Kalman filter to deal with smoothing issues seems sensible to me: I’m quite fond of the Kalman filter, ever since I wrote a paper with Andrew Harvey, Brian Henry and Simon Peters that used it to estimate labour productivity back in 1986. [1] I suspect they are getting the implausible results for one of the other two reasons. But the key thing to take away is that there are no easy answers here, and this kind of problem requires quite specific macroeconomic expertise. Furthermore, the importance of particular issues may vary between countries, so country specific expertise should be helpful.

Following on from this last point, it is clear that this is not just an issue for Spain. As the Irish Fiscal Advisory Council notes here (p68), the Commission estimates for the natural rate in Ireland also look implausibly high. So it is not surprising that the Commission would want to adjust their methodology to give more plausible numbers. (Matthew Dalton looks at the implications of their methodology for the US here.)

This all matters. If the Commission underestimates the output gap because it overestimates the natural rate of unemployment, then it will overestimate the structural budget deficit, and the country concerned will come under considerable pressure to undertake further austerity. Readers will know why I think that will be a very costly outcome. (More on this from Cohen-Setton and Valla here.)

At least economists at the Commission have now recognised the problem, and changed their estimates. But as Matthew Dalton reports

“The change was approved by technical experts at a meeting last week and was expected to be supported at a Tuesday meeting of more senior officials in Brussels. But an article published in The Wall Street Journal about last week's decision generated concern in some national capitals about its effects on budget policies, an EU official said. The new methodology will be sent back to the expert committee for further discussions, in an effort to understand what its impact will be on all 28 EU countries, the official said.”

Reassuringly, Dalton adds that "The commission is fully on board with the new methodology," the official said. "We believe it is superior." But he also notes that the new methodology “was supposed to have been used by the commission in its next round of estimates of the structural deficit, to be published in November. Now that will have to wait, if it is approved at all.” As one of my commentators pointed out, this article in a leading German newspaper may have contributed to this official hesitation.

So the Commission will go on making estimates that it knows are overestimating structural budget deficits, because of ‘concern in some capitals’ about the implications of using better estimates! None of this does the Commission any good in terms of its competence to help determine national fiscal policy. (Of course nothing can top the incompetence recently shown by the US congress, but that is no excuse.) 

Luckily there is an obviously better way to proceed, even within the confines of the deeply flawed Fiscal Compact. Many Eurozone countries already have their own ‘fiscal councils’: independent bodies set up to provide scrutiny of national fiscal policy. It should be central to the mission of these bodies to estimate the output gap and structural deficit, as it is impossible to look at fiscal sustainability without doing so. So why not get estimates of the output gap from these institutions who will be able to take into account country specific factors, and use the academic expertise that exists in those countries to maximum effect. (Spain and Ireland are hardly short of good macroeconomists.) Unlike the governments of those countries, fiscal councils should not be prone to bias in producing these estimates. The Commission can play a coordinating role, getting experts from the national fiscal councils together to share ideas and expertise. This seems to me a clearly better way to proceed, unless of course your goal is to maximise the influence of the Commission.

[1] Harvey, A., Henry, S.G.B., Peters, S. and Wren-Lewis, S. (1986), Stochastic trends in dynamic regression models: an application to the employment output relationship, Economic Journal, vol 96 pp 975-985.

Nominal wage rigidity in macro: an example of methodological failure

This post develops a point made by Bryan Caplan (HT MT). I have two stock complaints about the dominance of the microfoundations approach in macro. Neither imply that the microfoundations approach is ‘fundamentally flawed’ or should be abandoned: I still learn useful things from building DSGE models. My first complaint is that too many economists follow what I call the microfoundations purist position: if it cannot be microfounded, it should not be in your model. Perhaps a better way of putting it is that they only model what they can microfound, not what they see. This corresponds to a standard method of rejecting an innovative macro paper: the innovation is ‘ad hoc’.

My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages. There is overwhelming empirical evidence for this phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer Smith at Warwick). The behavioural reasons for this are explored in detail in this book by Truman Bewley, which Bryan Caplan discusses here. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioural economics.

Yet debates among macroeconomists about whether and why wages are sticky go on. As this excellent example (I’ve been wanting to link to it for some time, just because of its quality) shows, they are not just debates between Keynesians and anti-Keynesians, so I do not think you can put this all down to some kind of ideological divide. I suspect nearly all economists are naturally reluctant to embrace cases where agents appear to miss opportunities for Pareto improvement - I give another example related to wage setting here. However in most other areas of the discipline overwhelming evidence is now able to trump these suspicions. But not, it seems, in macro.

While we can debate why this is at the level of general methodology, the importance of this particular example to current policy is huge. Many have argued that the failure of inflation to fall further in the recession is evidence that the output gap is not that large. As Paul Krugman in particular has repeatedly suggested, the reluctance of workers or firms to cut nominal wages may mean that inflation could be much more sticky at very low levels, so the current behaviour of inflation is not inconsistent with a large output gap. Work by the IMF supports this idea. Yet this is hardly a new discovery, so why is macro having to rediscover these basic empirical truths?

There may be an even more concrete example of the price paid for failing to allow for this non-linearity in wage behaviour. For all it inadequacies, the Eurozone Fiscal Compact does at least include a measure of the cyclically adjusted budget deficit among its many indicators that are meant to guide/proscribe fiscal policy. However, as Jeremie Cohen-Setton discusses here, the Commission now think they have been underestimating the output gap. As he suggests, the reason is pretty obvious: they have overestimated how much the natural rate of unemployment has risen in this recession. Here is the example he gives for Spain.

Actual unemployment and European Commission estimates of the NAWRU for Spain, from European Commission, 2013 spring forecast exercise. Source Jeremie Cohen-Setton

How could the Commission have been so foolish as to believe the natural rate had risen from 10% to 27% in a few years? Might it be because they looked at nominal wages in Spain, and inferred from the fact that nominal wages were not falling that therefore actual unemployment must be close to its natural rate? If empirical macromodels as a matter of course allowed for the absence of nominal wage cuts, would they have made such an obvious (to anyone who is not a macroeconomist) mistake?

I think this example illustrates why it can be dangerous to rely on DSGE models to guide policy. Yet the influence of DSGE models in policy making institutions is strong and growing. The Bank of England’s core forecasting model (pdf) is a fairly basic DSGE construct, and as far as I can see its wage equation is a standard New Keynesian specification, with no non-linearity when wage inflation approaches zero. Now I know the Bank have many other models they look at, and they will undoubtedly have looked at the implications of a reluctance to cut nominal wages. (I discuss the Bank’s ‘new’ model in more detail here.). However default positions are important, as the examples I discussed earlier show. Focusing on models where consistency with fairly simplistic microfoundations is all important, and consistency with empirical evidence is less of a concern, can distort the way macroeconomists think.   

France and the Commission

The platform I use for this blog gives my ‘pageviews by country’. One surprise is that, using this criteria, the country which comes third in the list, after the US and UK respectively, is France. (Over the last month, for example, about 12,000 pageviews compared to about 36,000 in the UK and around double that in the US, with a whole group of countries below France at around 5,000.) This is really nice, particularly as I have only once written a post specifically about France, over a year and a half ago.

So a recent post by Ronald Janssen in the Social Europe Journal allows me to make up for that. First some background if you do not live there. France is subject to the Fiscal Compact’s 3% budget deficit target like everyone else in the Eurozone.  European Commissioner Olli Rehn is the chief enforcer of these rules. In May the Commission granted France, along with a few other countries, 2 years grace before they needed to achieve that target. The Netherlands was given only one year, with consequences I talked about most recently here.

The chart below shows OECD numbers and forecasts for various fiscal measures in France. The financial balance relates to the 3% target. The underlying balance essentially cyclically adjusts this. As you can see, the key reason that France is not meeting the 3% target is depressed output. The OECD estimates the output gap in 2013 will be nearly -4%, rising in magnitude to -4.5% in 2014. The underlying primary balance is the best indicator of what government policy is doing: fiscal policy has been tightening ever since a sharp expansion following the 2008/9 recession.

  

So far, so typical of the Eurozone and elsewhere. However what makes France relatively unusual is the pattern of this tightening. As the IMF clearly showed in analysis I discussed here, it has achieved this fiscal contraction entirely through tax increases rather than spending cuts. The first best thing to do, of course, is to delay fiscal tightening until the output gap has closed. The Eurozone’s fiscal rules will not allow that, and instead in the current context encourage pro-cyclical fiscal policy. I have never met a macroeconomist who advocated pro-cyclical fiscal policy, but of course those behind the Fiscal Compact know best.

If you have to follow the Fiscal Compact, then I have always argued from the point of view of doing least damage to the economy in a recession any temporary fiscal tightening should focus more on tax increases than spending cuts. You might, for example, try to meet the Fiscal Compact rules in the short term through temporary tax hikes, and follow with more permanent spending cuts and/or tax increases once the economy recovers. To a first approximation that appears to be what the left wing government in France is trying to do (most notoriously by temporary increases in the top tax rate).

My argument has always been based on straightforward macroeconomic theory, but as Ronald Janssen points out in his post, this is fully supported by recent IMF empirical work. It is therefore entirely predictable that European Commissioner Olli Rehn should take completely the opposite point of view. He is quoted as saying that new taxes would “destroy growth and handicap the creation of jobs." “Budgetary discipline must come from a reduction in public spending and not from new taxes,” he added.

Now I'm not sure whether that counts as advice or instruction: within the Eurozone it is increasingly difficult to tell. I suppose you could argue that Rehn’s concern is more about the longer term size of the French state, and that his obvious belief that the French state is too big comes purely from worries about the implications for macroeconomic performance. But what struck me was simply this. In the election of April 2012 the French people elected a left wing government that had a clear platform of achieving fiscal consolidation partly through tax increases. Even if the Commissioner thinks that is a foolish thing to do, that is their choice.

It is one thing to have a set of fiscal rules that focus on overall budget deficits: however misguided those rules may be, the French government did agree to them. What I do not think any Eurozone government signed up to was having the Commission tell them what the size of their own state should be. With these remarks, together with its insistence that various Eurozone countries undertake certain ‘reforms’, the Commission appears to be doing its best to create a de facto fiscal union. The only problem, of course, is that the French did not elect Olli Rehn.

  

The View from Brussels

When incomplete ideas get embodied in institutions and the people in them

As I have said before, its too easy to be rude about austerity. It is harder to put yourself in the mindset of reasonable individuals who take a different view, and pinpoint exactly - in ways that they will understand - why their view is wrong. So this paper from Marco Buti and Nicolas Carnot (HT Philip Lane) is useful because it shows us that mindset. [1]

The argument in the paper is essentially this. “We recall that large adjustments are needed

in most economies to restore sustainable fiscal positions, not because of the arbitrary will of the markets or of EU institutions.” So the debate is about the precise speed of adjustment, and the Commission is trying to strike the “right balance”. In particular, it recognises the need for different speeds in different countries. I think this view characterises the position of many international organisations, including the OECD, and many in the IMF.

There is a big mistake being made here. It essentially involves the prioritisation of issues. Fiscal adjustment is seen as the overriding priority. Issues involving the state of the economy are secondary: they are one factor in judging the appropriate speed of adjustment. This is the wrong way around.

The major priority at the moment should be doing something about the demand led recession in the Eurozone (and other countries like the UK). The budgetary position of some countries is a secondary factor that may influence the country by country balance of any fiscal actions required to deal with this priority.

This point about priorities is not an expression of political preferences. It is about what basic macroeconomics tells us. The recession is a problem right now. If it is not dealt with now, the loss of resources is permanent and irretrievable, and in addition there is likely to be a more permanent scarring effect through hysteresis. Given the imbalances within the Eurozone, and the political tensions generated by creditor/debtor relationships, the costs of a recession could be greater still. Budget consolidation is a permanent, long term issue, and there is clearly a right and a wrong time to deal with it. Recessions are the wrong time, not just because it conflicts with other priorities, but because it may not even work, because of hysteresis effects, or political effects, or banking effects.

So why is this obvious to me, but not to those running policy? To repeat, my own view is in no sense about the relative importance, in some abstract sense, of deficit bias versus avoiding recessions. As regular readers will know, on deficit bias and long run goals for debt I am something of a hawk. I just do not see why we cannot avoid recessions and bring down government debt.

In some cases those running policy take a different view because of ulterior political motives, but not in all cases. I’m prepared to give those in the Commission, and other international organisations like the OECD and IMF, the benefit of the doubt on this. I believe an important influence on their mindset is that they are working in a framework in which overall demand stabilisation is not their problem. That is monetary policy, not fiscal policy. It is very revealing that in the Commission paper two phrases do not appear at all: they are  ‘zero lower bound’ (ZLB) and ‘liquidity trap’. Too few in government have recognised that when we hit the ZLB, the rules of the macroeconomic game fundamentally change, and the institutions of government - and those in them - have to adapt too.

This is hardly a novel point, but as Paul Krugman keeps stressing, it is absolutely central. It is why I get annoyed by those who insist that, if only we did monetary policy differently, all would be well - what I call ZLB denial. Few (unfortunately not all) deny the central role and importance of monetary policy in getting us out of recessions. When monetary policy fails - which it patently has, mainly [2] because of the ZLB - fiscal policy has to take its place. Countercyclical fiscal policy becomes as important as monetary policy normally is. Institutions, and habits of thinking, that are set up for normal times must adapt. The IMF recognised this in 2009, but I’m not sure the OECD or European Commission ever did.

We can see how this failure to change priorities influences the subsequent discourse by looking at two issues that are covered by the paper: OMT and Germany. The paper recognises the importance of OMT in altering market expectations. But they then say “As is clear as well however, the OMT announcement per se does not address the underlying sustainability concerns.” Of course OMT does not directly change the outlook for future primary balances. However it is a game changer in allowing periphery countries to change priorities. When you cannot sell your debt, this has to take priority over recession concerns (although fiscal consolidation can still be designed to try and avoid recession). What OMT allows countries to do is change priorities. If it had been implemented earlier, priorities could have been changed earlier. The paper does not see this, because for them fiscal consolidation remains the key priority.

The paper says “In Germany, the fiscal stance is now broadly neutral [3], hence consistent with

the call for a differentiated fiscal stance according to the budgetary space”. Which makes perfect sense (albeit using the rather tortured language of international organisation space), except at the ZLB. At the ZLB we need overall fiscal expansion in the Eurozone. The differentiation point still stands, so from an overall Eurozone perspective the Commission (and the OECD, and the IMF) should be arguing for substantial fiscal expansion in Germany. However, if your priority is fiscal consolidation, advocating doing nothing can seem quite radical and brave.

Right at the end there is a hint of recognition, but in a way that reinforces my point. To quote in full:

“A dedicated stabilisation fund could improve the conduct of fiscal policies throughout

the cycle by enforcing tighter policies in good times and providing additional leeway for cushioning downturns. Such a tool could strengthen the existing automatic

stabilisers while maintaining a credible rule-based framework. It would be particularly useful in the current predicament characterised by large cyclical differentials across the zone as well as a not insignificant average output gap. However, according to the Commission blueprint such a tool should only be considered in the longer term in the context of full fiscal and economic union.”

In other words countercyclical policy at the overall Eurozone level would be useful right now, but it needs to wait until we have the institutional change that can accommodate it. [4] Which tells me that those in the Commission think institutions are very important, but it does not tell me why existing institutions (and those within them) have to be behave in such a blinkered way.

[1] This can be seen as a companion piece to two others that looked at the power austerity has over politicians, and why some economists are suspicious of Keynesian fiscal stimulus. This post is about economists working in policy institutions.

[2] Unfortunately the ECB often gives the impression that as long as consumer price inflation is around about 2%, then nothing else (like other measures of inflation, or a recession) has anything to do with them. However I doubt very much that if the ECB had done what the Fed is now doing, a Eurozone recession would have been avoided.

[3] Whether this is true is another matter: see here for example. The latest OECD Economic Outlook has the German debt to GDP ratio falling steadily since 2011, despite a widening output gap.

[4] That institutional change will come too late for the current recession. I take a critical view of whether fiscal union for the Euro is either feasible or desirable here.