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

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

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

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

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

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

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

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

Eurozone fiscal policy - still not getting it

The impact of fiscal austerity on the Eurozone as a whole has been immense. In my recent Vox piece, I did a back of the envelope calculation which said that GDP in 2013 might be around 4% lower as a result of cuts in government consumption and investment alone. This seemed to accord with some model based exercises of the impact of austerity as a whole, but others gave larger numbers.

We now have another estimate, which can be thought of as a rather more thorough attempt to do what I did in the Vox article. This paper by Sebastian Gechert, Andrew Hughes Hallett and Ansgar Rannenberg uses multipliers and applies them to the fiscal changes that have occurred in the Eurozone from 2011. Apart from the later start date, the first difference compared to my back of the envelope calculation is that they include all fiscal changes, and not just government consumption and investment. As a large part of the fiscal consolidation in the Eurozone has involved reducing fiscal transfers, this is important.

The second, and more interesting, difference is that rather than pluck a multiplier out of the air, as I did, they use a meta analysis of other studies. I have previously mentioned this meta analysis by Gechert: this paper is based on a follow up by Gechert and Rannenberg. [Correction from original post.] The studies on which these meta analyses are based are not ideal from my personal point of view (more on this later), but what this second paper shows is that fiscal multipliers are larger in depressed economies. Applying these ‘meta multipliers’ to the Eurozone fiscal consolidation implies that GDP was 7.7% lower by 2013 as a result. These numbers are more in the ballpark of the Rannenberg et al paper that I have discussed before.

All these estimates point to huge losses, which monetary policy has neither been willing or able to counteract. Yet the speed at which those in charge of the Eurozone begin to realise the mistake that they have made is painfully slow. Take this recent Vox piece by Marco Buti and Nicolas Carnot. Thankfully they ignore all the Eurozone’s tortuous and sometimes contradictory rules, and just look at two numbers: a measure of ‘economic conditions’ (like the output gap), and a measure of the fiscal gap, which is the difference between the actual primary balance and what it needs to be to get debt falling gradually.

They argue that policy needs to balance the need to reduce both gaps. Looking at these two numbers, they conclude that Germany is overachieving on fiscal adjustment and has a need to increase activity, but although France and Spain also need to increase demand they have a long way to go to eliminate the fiscal gap, so this should dominate. The conclusion is that Germany should go for fiscal stimulus, but “moderate consolidation appears warranted in both France and Spain”. Overall “the Eurozone should conduct a close-to-neutral fiscal stance”.

Let’s deal with that last conclusion first. The mistake there is simple. When monetary policy is stuck at the Zero Lower Bound, it is crazy to balance the output gap with what is your main instrument for correcting that gap, which is fiscal policy. Getting the fiscal gap right is important in the longer term, but in the short term it is the means by which you get the output gap to zero. As the studies mentioned at the beginning of this post show, the current recession is the result of trying to correct the fiscal gap at completely the wrong time. The right policy is to get the output gap to zero, so interest rates can rise above the ZLB, and then you deal with the deficit. Readers of this blog and the blogs of others must be sick and tired of seeing us make this same point over and over again, but the logic has yet to get through to where it matters.

The same principles apply to countries within the Eurozone, except with an additional complication of within Eurozone competitiveness. If a country is too competitive relative to the rest of the Eurozone, it needs to run a positive output gap for a time to generate the inflation that will correct that position, and vice versa. For that reason Germany needs a large positive output gap at the moment (compared to an estimated actual negative gap), and therefore a much more expansionary fiscal policy - not because it is overachieving on debt adjustment. France and Spain now look roughly OK in terms of competitiveness relative to the average (see chart below, and assuming that entry rates in 2000 were appropriate), so there we need fiscal expansion to close the output gap.

So at both the aggregate and individual country level, the inappropriate bias towards fiscal contraction that caused huge losses in the Eurozone in the past continues to operate. Which means, unfortunately, that the needless waste of resources caused by austerity continues to get larger by the day.

Relative Unit Labour Costs, 2010=100, from OECD Economic Outlook

Alternative Eurozone histories

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. 

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.   

The Fruits of European Austerity

                In an earlier post I argued that austerity in Eurozone countries like Ireland was not necessarily self defeating, if those governments were put in a position where they had to convince markets that they would not default. Even if DeLong and Summers were right that austerity would eventually raise the debt to GDP ratio, this was not the key issue for default risk. John McHale makes a similar point. In this post I want to add two important caveats to this argument, which I can label Spain and Greece.

                Spain first. Most of the discussion of austerity focuses on the government’s budget constraint. However, when it comes to default risk in Eurozone countries, it may be more appropriate to look at the consolidated balance sheet of the government and banking sectors. A good proportion of the banking sector in countries like Spain is fragile because too much was lent before the recession. Because this proportion is large, these banks will be seen as too important to fail, and so the government will bail them out at some point, which is why the consolidated balance sheet becomes relevant. (It is the lack of a banking union, rather than a fiscal union, in the Eurozone that is arguably the major problem, as Vallee suggests.)

                If this is the case, then we need to rethink whether austerity can actually make the current position worse. When looking at just the government, the impact of cutting spending on the deficit is very unlikely to be offset by lower taxes or higher transfers generated by lower output – multipliers would have to be extremely large for this to happen. However, when lower output generates falls in asset prices and adds to personal or company liquidations, this could make a big difference to the solvency of highly leveraged banks. If the government is going to have to bail out these banks as a result, then it would be entirely rational for the market to raise interest rates on government debt following additional austerity measures. (I will not get into how markets actually do react: when there is a lot of noise, it is too easy for casual empiricism to cherry pick the data, as this post looking at recent events in the Netherlands points out.)

                That is one reason why austerity might be self defeating. The second, which is happening in Greece right now, is that austerity is pushed so far that it loses democratic support. Demonstrations of austerity designed to show that the government will not default become pointless if those demonstrations mean the government falls to others who would default. And allowing output to remain depressed as a consequence of austerity clearly does undermine the political centre.

                Some commentary, like this FT piece ($) by Lorenzo Bini Smaghi, suggests Greek voters are being irrational. Like Kevin O’Rourke, I disagree. I might even go further than Kevin. When debtors threaten to default, creditors always want to get their money back, but whether they can achieve this depends on how powerful the position of each side is. When the debtor is a government running a primary deficit, complete default does not look attractive because additional austerity will have to be implemented immediately, and creditors know this makes the default threat weak. However in this case the creditors' position looks at least as weak.  Politicians would have to explain to their already restive electorates why they have just lost a lot of money in their failed attempts to keep Greece in the Eurozone (or, indeed, why Greece was allowed in at all). More importantly, the analogy with Lehman’s looks appropriate. If Greece left the Eurozone there would be an immediate run on other ‘vulnerable’ Eurozone country banks, and here I agree with Lorenzo Bini Smaghi that the “contagion will be devastating”.

                Greek voters are also said to be illogical in wanting to stay in the Euro but not wanting austerity. Other Eurozone governments and European officials like to present it that way – they would, wouldn’t they. But it is unclear to me who exactly will do the deed of expelling Greece, if Syriza leads a government and interest stops being paid. Germany might be prepared to force a Greek exit, but following Hollande’s election I strongly suspect that they would not find a majority of countries supporting them. Too many would fear the consequences for themselves. Instead some compromise would be put on the table.

            Now we may never get to see this poker game play out. The rest of the Eurozone hopes that their show of contemplating Greek exit will convince Greek voters not to try and call their bluff. Alternatively, as Greek banks run out of money, the ECB may feel that it has no choice but to pull the plug on Greek banks, although I could imagine it is very reluctant to do this. Whatever happens, the moral of this story is that creditors have to be very careful when inflicting austerity on debtors. In some cases, like Ireland, they may succeed in doing so on quite painful terms, and the debts will be repaid. In other cases, they may go too far, with highly damaging results for everyone. It has happened before in Europe, as Miller and Skidelsky remind us.