I missed this paper by Philippe Martin and Thomas Philippon
when it came out last October, but thanks to Francesco Saraceno I have now read it. There
is also a VoxEU post by the authors. It is particularly
interesting for me because it undertakes analysis (using a model which is
itself interesting but which would make this post too long to discuss) of a couple
of alternative histories for the Eurozone which are related to two claims that I have made in the past:
1) It is now widely accepted among macroeconomists (but not politicians or the media) that fiscal profligacy was only the major cause of subsequent problems in Greece, while elsewhere private excess was the
main problem. I have argued that aggressive countercyclical
fiscal policy before 2008 would have reduced subsequent problems.
2)
If the ECB’s OMT programme had been implemented in
2010, rather than September 2012, this would have substantially reduced the degree of austerity required
outside Greece. As a result, these countries would have had a better recovery
from the Great Recession. [2]
Put the two claims together and I would argue that the 2010-12
Eurozone crisis (rather than just a Greek crisis) need not have happened. OMT
would have limited fears of contagion, allowing a quicker and more complete Greek
default. There would have been no funding crisis outside Greece, and no need
for the core Eurozone economies to immediately embark on austerity.
How does the paper address these arguments? In terms of fiscal
policy, it imagines reaction functions for government spending and transfers
that contain a (common) countercyclical element, but also a (country specific)
positive drift term, in Greece, Ireland, Portugal and Spain. One counterfactual eliminates the drift. This does not exactly fit the scenario I had in mind, because I see actual policy as not being countercyclical but (Greece apart) having less drift. However the end result is the same: a counterfactual with much more fiscal tightening before the recession. An interesting result is that tighter fiscal policy could have substantially reduced the rise in
interest rates spreads in Ireland and Spain. The pre-2008 employment boom would
not have happened in Greece, and would have been substantially reduced in
Ireland, but the impact in Spain would have been smaller but non-negligible.
It conducts another counterfactual which imagines
macroprudential policies that eliminated the household leverage boom in each
country. This has a significant effect in reducing the boom in Ireland and
Spain. (There was no actual employment boom in Portugal.) By inference a
combination of countercyclical fiscal policy with no drift, plus
macroprudential policies, would have been ideal.
So claim (1) seems to hold up fairly well. Of particular
interest is what would have happened to employment from 2008 under a purely
countercyclical fiscal policy. In Spain it would have fallen as a result of the
recession, but subsequently stabilised rather than continuing to fall as it did
in reality. In Ireland employment would have fallen in the recession, but would
have risen again from 2010 rather than continuing to fall. This is partly
because countercyclical fiscal policy would have helped, but also because lower
levels of debt going into the recession would have reduced the increase in
interest rate spreads, easing monetary policy.
With a pure countercyclical fiscal policy the debt to GDP ratio
in Greece would have stayed flat (because there would have been no boom),
suggesting that the Greek crisis was essentially a result of fiscal profligacy.
In Spain the debt to GDP ratio would have fallen to nearly 20% of GDP, rather
than staying above 40% of GDP in reality. In Ireland public debt would have
been largely eliminated. This indicates the substantial amount of
countercyclical policy that was required to tackle what were very large
domestic booms. (Fiscal policy would presumably have been less contractionary if combined
with macroprudential controls.) It also tells us how foolish it was to have a
Stability and Growth Pact which essentially ignored the need for such
countercyclical fiscal policy.
Claim (2) is examined in its own counterfactual, which
essentially eliminates the increase in interest rate spreads that occurred from
2008. The beneficial effects on all four periphery countries are substantial.
This counterfactual is unrealistic for Greece, because OMT should never have
been implemented for Greece - immediate default was the better and more
sustainable option. However I think it is highly credible that, despite Greece,
if OMT had existed in 2010 spreads in other countries would have stayed low. [1]
Francesco Saraceno draws the lesson that the real problems with
the Eurozone are institutional, and I agree. The Stability and Growth Pact was
misconceived (as some of us argued before the Eurozone was created),
because it ignored the need for countercyclical fiscal policy. The ECB delayed
acting as a sovereign lender of last resort for two years, creating a Eurozone
crisis out of what should have been just a Greek problem. The conclusion I
draw, unlike many economists, is that the concept of a European Monetary Union
was not inherently doomed to fail. It was the way it was implemented that
caused the crisis.
It would be very nice if this was all about history.
Unfortunately exactly the same mistakes are continuing, with equally damaging
effects. Fiscal policy continues to be pro-cyclical, meaning that we had a
second Eurozone recession and no real recovery from that. Monetary policy is
either perverse (2011), or 6 years too late (!) and continues to openly encourage
fiscal austerity. That most policy makers in the Eurozone have still not understood past errors remains scandalous.
[1] The paper attributes this to the reduced risk of union break
up. I suspect it does so because it wants to make interesting comparisons
between Eurozone countries and US states. My own analysis has instead focused
on the danger of a self-fulfilling funding crisis when there is no lender of
last resort. That danger presumably exists for US states.
[2] An interesting question which I have not examined is whether, even if OMT had existed in 2010, it would still have been better for both Ireland and Spain to have written off some of their debt.
