Is it all Gordon Brown’s fault?

                Someone reading my recent post on major UK macro policy errors asked whether my blog was becoming more political. I hope not, in the sense of being party political for its own sake. However, when the issue involves macroeconomic policy, then I do my best to say what I think is right rather than what is politically expedient. This is in part because I have very negative views about the role of ideology (left or right) in influencing economics. (Incidentally, I do react badly to those who say ‘ah, but all theory is ideological, it’s just that you pretend what you do is ideology free’. I guess this makes me one of those old fashioned fogeys who believe in the possibility of evidence based social science.)

                Perhaps this is why I have not so far explicitly commented on the oft repeated refrain by the current government that austerity is necessary to ‘clear up the mess’ left by excessive deficits under Gordon Brown? It is nonsense of course, but like all the best slogans it contains a half-truth. I think it is certainly true in hindsight, and almost certainly true ex ante, that spending in the later Brown years was underfunded (or excessive, depending on your viewpoint). By exactly how much I plan to explore in more detail for a paper over the next few months. The untruth, of course, is that this problem had to be corrected immediately and quickly during a recession.

                This issue arose from my recent post where I listed what I considered to be the three major UK macroeconomic policy errors over the last 30 years. I said that underfunded spending by Brown was an error, but that I did not consider it a major one because it did not lead to the same scale of welfare losses that occurred when unemployment became unnecessarily high (like now). Chris Brown commented that “The loss in social welfare [caused by excessive deficits in a boom] is never felt at the time of the increase in government spending (the reverse is true) but after the party is over (i.e. today)”.

                I think this comment is right in two ways, but nevertheless it does not imply that Brown’s underfunding was a major error. Let’s start with where I agree. First, additional spending paid for by debt which is then paid off at some future date by cutting spending clearly raises welfare today but reduces it tomorrow. If the additional debt is paid for by raising future taxes (i.e. we are permanently increasing the size of the state) then the situation is more complicated. If consumers are completely Ricardian then the timing of the tax increase does not matter for welfare, but let’s leave that complication to one side. Second, I agree that pro-cyclicality in spending decisions is a common vice, and that because it tends to be asymmetric (it happens more often in booms than recessions) it can lead to deficit bias. This is certainly bad policy.

                But are the welfare costs of this that high? Not, in my view, if the subsequent correction is done at the appropriate time. To take a simple case, suppose monetary policy is able to completely offset the demand impact of both the excessive spending, and the subsequent cut in spending designed to pay off the additional debt. The only welfare cost then is an intertemporal misallocation of public goods. It is my judgement that these costs are of an order smaller than the costs created by raising unemployment by a few hundred thousand for a few years when unemployment is already high. (I have to say judgement here, because most formal analysis of measuring the welfare costs of business cycles takes place in representative agent models where ‘unemployment’ just means everyone working a few less hours. This does not begin to capture the true impact of unemployment on well being.)

                Now if it was true that the additional unemployment caused by austerity today was an inevitable consequence of underfunding in the Brown years, then the comment would be exactly right. But it is not. Paying off the debt created by the underfunding should be done during the next boom, and not now. As a result, Gordon Brown’s error gets relegated to minor status when compared to what is happening now.                

Polarising Essays

                Its sometime in the 1970s. Inflation is rising, and the monetary authorities are failing to raise interest rates by enough, so real rates are failing. A large number of academic economists are urging governments or central banks to raise rates by more. But other economists argue otherwise, and partly as a result, policy appears unresponsive.

In that context, an eminent economist writes an article looking at what they see as the key structural problems that have been developing in the economy over the last few decades. But they start the piece by saying that excess demand is not the most important problem right now. Instead inflation reflects deep structural imbalances in the economy that have been building up for years. They write that governments cannot use unemployment as a way of regulating inflation: the relationship is all over the place, and raising productivity would be a more effective way of reducing inflation.

                Articles like that did get written at the time and look a little foolish today. But as some of you will have guessed, I’m trying to make a point about what I see as a similar thing happening today, except its fiscal policy at the zero bound and unemployment, rather than monetary policy and inflation. If it was really true, as Rajan writes, that “this narrative—the standard Keynesian line, modified for a debt crisis—is the one to which most Western officials, central bankers, and Wall Street economists subscribe today”, and if policymakers were acting accordingly, then I doubt anyone would get too upset by what could be discounted as a rhetorical device to catch attention. But instead governments are implementing austerity around the globe. This article is not an isolated case: see this($) recent FT piece by Sachs .

                I really do think we should try and keep discussions of long term trends and short term problems distinct as far as possible. If economists are good for anything, it is in abstraction of this kind. To the extent the issues are linked then they are more likely to be complements than substitutes. In the UK, according to the OBR, public sector investment fell by 13% in 2011, as the initial thrust of the government’s austerity programme. This included abandoning plans to rebuild dilapidated schools.

                Tyler Cowen suggests they are competing stories because “any given dollar must be spent somehow and “the stimulus model” and “the long-term investment model” are indeed competing visions for the allocation of resources.” The above example suggests they need not be competing. In addition my fictional writer from the 1970s could have made the same point. Higher interest rates are raising the cost of government borrowing, they might say, which is squeezing resources for tackling our longer term structural problems. That would be a very bad argument for not raising interest rates in the 1970s, just as I think ‘where is the money coming from’ is a bad argument against stimulus today.

            However I agree with Tyler when he writes: “Any Martian visiting the economics blogosphere, or for that matter Krugman’s blog, could tell you that most of micro is a more or less manageable topic, whereas macro induces economists to start thinking of each other as idiots and fools.” I have written about why this might be elsewhere, but as long as a large section of the profession, and the majority of policymakers, appear to ignore what mainstream macro tells us, then any writing that encourages this amnesia will get some of us annoyed.

                

Budget Madness in the Netherlands

                While all the current focus is on the challenge to austerity thrown up by the French and Greek elections, it may be salutary to look at an equally recent challenge that failed. Towards the end of April the Dutch conservative coalition government collapsed, when the far right party refused to discuss further budget cuts. The Prime Minister resigned. And yet a few days later other parties rallied round to give their support to a similar package of austerity measures, which now have majority support in parliament.

                This austerity was not required by the bond markets. The government can borrow at very low interest rates:  2.3% on 10-year bonds. (Predictably a ratings agency made noises about the country losing its triple AAA after the government collapsed, although not the same one that infamously downgraded US debt last year.) It is definitely not required by the state of the Dutch economy: GDP is expected by the IMF to fall by 0.5% this year (that’s a -0.5% growth rate), with unemployment rising from 4.5% to 5.5%. So what could have led a government to try and cut spending and raise taxes at such a time to the extent that it brings the government down? The answer is the ‘Excessive Debt Deficit Procedure’ (EDF) of the EU’s Stability and Growth Pact. The budget deficit as a percentage of GDP was 4.7% in 2011, down from 5.6% in 2009. Without these measures it would probably have stabilised at around 4.5% of GDP, and the objective of these additional cuts is to bring it down to 3% by 2013.

            This is worse than trying to balance the budget in a recession – it is trying to reduce the budget deficit in a recession. (A small caveat – part of the package is an increase in VAT, which if delayed and phased could stimulate demand in the short run.) Now these measures, like raising the retirement age, may be perfectly sensible from a longer term perspective. But, VAT aside, they should not be introduced in a recession. What is really depressing from a Eurozone perspective is why the package appears to have been implemented now at such great political cost. The timing is all about the EU’s deficit limits, and a belief that Netherlands has to show the rest of Europe an example. The finance minister said the plan would send Europe “a signal of solid government finances”.

            An irony here is that the Netherlands has a longstanding and very well regarded fiscal council in the form of the Central Planning Bureau (CPB). One of things the CPB does is cost both government and opposition budget plans before an election, something Simon Johnson has recently suggested the CBO could do in the US. So the argument that austerity has to be implemented now rather than later because institutions are weak is even flimsier in the Netherlands than elsewhere. Unfortunately, it appears the CPB has not managed to educate the majority of politicians about the foolishness of pro-cyclical fiscal policy.

            From a Eurozone perspective this is a disaster. The Eurozone is cutting its cyclically adjusted deficit faster than the US or even the UK and heading for a second recession, and possible political disintegration. As I and others have discussed, with Germany there is at least an argument that with unemployment falling there is no scope for any fiscal stimulus there. Yet unemployment is rising in the Netherlands. There is no, and I repeat no, good macroeconomic reason why a stimulus package should not be implemented here. And yet we get exactly the opposite.

            "This is an unbelievable achievement," the now caretaker Prime Minister told MPs after clinching the new deal.

             

What the ECB needs to do

                What would a hypothetical Eurozone government (or, to use jargon, a Eurozone social planner) do with monetary and fiscal policy in the current crisis? An initial discussion along these lines involving  Kantoos and myself has widened recently (e.g. Kantoos, Tim Duy and others in Kantoos). Although this may appear a purely academic exercise, I think it is very useful, because it indicates what the ECB is failing to do.

                Let us start with two blocs, Germany and non-Germany, and recognise that there is a competitiveness gap between them which is unsustainable. Let this gap in terms of consumer prices be labelled G. The first choice the government/social planner has is how quickly to reduce this gap: in years, call this y. For simplicity assume this is done in a uniform way, which implies that inflation in Germany has to be G/y above that in non-Germany for the next y years. The next choice the social planner has is the aggregate inflation rate for the area as a whole: call this x%. These two choices give us the targets for inflation in the two parts of the Eurozone: x+G/2y in Germany and x-G/2y in non-Germany.

                The two choices (of x and y) are not independent because of the difficulties in achieving very low, or even negative, inflation rates. If x, the average Eurozone inflation rate, is only 2%, then it probably makes sense to try and reduce the competitiveness gap slowly, so that x-G/2y does not become too low or negative. In other words, 3% and 1% over a protracted period may be less costly than 4% and 0% over a shorter period.

                Having established the targets, how should they be achieved? The average inflation rate x is set by the ECB. Conventionally we think that this is all monetary policy can do, but in the current situation this is not the case. First, the debt crisis means that monetary policy is tighter in many non-German countries, and the ECB has the power to influence, and probably control, what these risk premiums are. Second the Bundesbank and other countries may soon have the ability to at least influence domestic monetary conditions through various financial controls.

                Fiscal policy comes in to the extent that the targets cannot be achieved by monetary policy. For the average inflation rate x, fiscal policy may be required because of familiar zero lower bound problems. National fiscal policies play a more conventional (if neglected) role in determining inflation differentials. Whatever monetary policy cannot do, fiscal policy can fill the gap. (In retrospect I think the initial disagreement between myself and Kantoos related not to the choice of x and y, but to the question of what particular instrument adjustments are likely to be required to achieve them.)

                But, you may be thinking, what about the government debt crisis. Isn’t the whole point about the Eurozone that government debt is issued by national governments who do not have their own currency, and so are at much greater risk of default? Yes and no. No, because the ECB can act as each country’s central bank. Once this is recognised, the importance of the debt crisis in the Eurozone becomes the same as in the US, or the UK: in other words it need not prevent policy achieving its conventional stabilisation objectives x and y.

                There is just one caveat to this argument, and it is called Greece. There the actions of the Greek government before the credit crunch may have made default inevitable. However Greece is the exception, not the rule. Government debt only looks unsustainable elsewhere if you assume crisis levels of interest rates forever, or that austerity eliminates growth, or that national banking sectors are completely bailed out by national governments. None of these three things need happen. None will happen if the ECB does what it needs to do.

                This is why this ‘academic’ exercise of imagining a Eurozone social planner is so revealing. Although there is no such government, there are institutions and mechanisms that could approximate it, and in particular there is the ECB. It helps us see that, contrary to the thoughts of some who should know better (as reported here and here), the current strategy is flawed (see here and here), and there is an alternative. What the ECB needs to do is the following:

1) Make 2% a symmetrical target, rather than the target being 2% or less. (We might wish something higher than 2% for a while, but I’m being realistic.)

2) State publically that this implies 3% inflation in Germany for a protracted period, rather than suggesting otherwise. (Jean Pisani-Ferry makes the same point here.)

3) Announce a form of QE which aims to prevent interest rates on government debt exceeding, say, 4% in each Eurozone country.

4) If the current recession suggests that forecasts for aggregate Eurozone inflation are likely to fall below 2% because short term interest rates cannot be reduced further, publically state that aggregate fiscal policy is preventing the ECB from fulfilling its mandate. (If the situation was reversed, and fiscal policy was leading to rising inflation and interest rates, would the ECB be silent then?)

It is only if (4) comes to pass, and German inflation is below 3%, might the fact that the Eurozone is not one country get in the way of achieving the targets outlined above. While the debate referenced at the beginning of this post largely focuses on this case, it should not distract from current failures in monetary policy. Policy makers at the heart of Europe need to change the way they think about the situation they are in. Perhaps they need to think about the Eurozone as one country.

On Major Macroeconomic Policy Mistakes

            I have spent the last week on a farm south of Matera in the Basilicata region of Italy. Wonderful scenery, sun, hospitality and food, but no internet access. Returned to find a very wet UK, and that the economy has officially entered a second recession.

When UK GDP fell in the last quarter of 2011, I wrote that the 2010 Budget should rank as one of the major UK macroeconomic policy errors since the war. A number of comments on that post and since have asked why I single out fiscal policy rather than monetary policy for such criticism? This is a good question, which has much more general applicability than to just the UK.

There are three charges that could be made against recent monetary policy.

1)                          That it could have done something to prevent the financial crisis itself, by raising interest rates by more in the middle of the last decade.

2)                          Following the crisis, central banks could have cut rates more quickly, or done more in terms of ‘unconventional’ monetary policy.

3)                          Policy should have moved to some form of price level or nominal GDP target. 

Let me take each in turn.

            Policy was clearly at fault in allowing the financial excesses that preceded the crisis. There is also a strong case that monetary policy should have reacted to excess leverage, as my recent post summarising Woodford’s new NBER paper suggests. There is plenty to debate about who should have seen the danger signals and ‘shouted from the rooftops’ about them. However I see the financial crisis as primarily a failure of financial regulation, and not conventional monetary policy. A laissez-faire attitude to the financial sector, rather than the setting of interest rates, was the major policy failure here.

            The second criticism is also probably valid. If the Bank of England had cut interest rates as rapidly as the US Fed, or if it had tried to orientate its Quantitative Easing policy to where the credit constraints were most acute, then this might have improved things somewhat. However I’m reluctant to label this a major policy error. Monetary policy, in contrast to fiscal policy, did move in the right direction. My view would be different if the UK had followed the ECB in raising interest rates in 2011, as they nearly did. 

The most serious charge against current monetary policy is that it is being too conservative in sticking to low inflation targets rather than moving to some form of price level targeting with, for a time, an implicitly higher inflation target. In 2009 or even 2010 such a change would have been seen as radical, but there now seems to be a growing weight of academic opinion (for example here) behind such a move. However, in the UK there is very little pressure to make any change. In part this is because – unlike the US - any move to price level or nominal GDP targeting would have to come from the government rather than the Bank of England. The government sets the Bank’s mandate, which has the 2% inflation target at its centre. Most academic expertise on UK monetary policy works through the Bank. One possibility would be to ask the Treasury Select Committee to take up this issue. If any UK academics reading this blog feel this would be a worthwhile thing to try and do, please contact me.

            So in retrospect the failure to move to some form of price level targeting may come to be seen as a major policy error. However, at least in the UK, in the absence of any great pressure from either academic economists or the opposition to make such a change, this error may reflect ignorance as much as anything. This was not the case with fiscal austerity in 2010.

            As I have noted before, the Conservative Party opposed the government’s countercyclical fiscal policy following the recession. They bought the idea of expansionary austerity, which many have pointed out contradicts basic macroeconomic theory in a liquidity trap. There can be no excuse that the right policy was new, untried and radical – the appropriate policy was simple and well understood. When a government chooses to ignore mainstream academic theory, and the economy suffers as a result, it has made a major error and it should be held to account for that.

            Does this make me a closet old fashioned Keynesian? Well for the record I think there have been only two errors of similar magnitude in the UK over the last 30 years, and both have involved monetary policy. The more recent was the decision in 1990 to enter to Exchange Rate Mechanism (ERM) at an overvalued exchange rate of 2.95 DM/£. Although an economic downturn in the early 1990s was probably inevitable given the overheating in the late 1980s, joining the ERM at an overvalued exchange rate made the recession unnecessarily sharp. On that particular occasion I really can say that ‘I told you so’. The other was the brief adoption of money targeting in the early 1980s. Once again, tightening of policy was required to reduce inflation, but the adoption of money targets led to deflation that was both too sharp and uncontrolled, and the hysteresis effects of the resulting large rise in unemployment blighted the rest of the decade. (The fiscal contraction in the 1981 budget that I have written about here was a mistake given the very tight monetary policy at the time, but a more optimal policy would probably have involved fiscal tightening and a looser monetary policy.)

            A common feature of all three episodes is that they caused increases in unemployment that were unnecessary, at a time when unemployment was already high. For reasons I have noted here, this implies a major decline in social welfare. Why have I not included any examples of errors that led to higher inflation? Well if I had gone back further then clearly the rise in inflation in the 1970s was a major policy error. The rise in UK inflation in the late 1980s was the result of policy errors, but I am being generous here because to some extent the consumer boom at the time was unexpected. (I discussed this briefly here.)

            Is it a coincidence that all three major errors were made by Conservative Chancellors? Perhaps. The catastrophic rise in inflation in the 1970s largely took place under Labour. The increase in government spending by Labour around 2005 was underfunded, but I would not call this a major policy error because I do not think it led to a large decline in social welfare.

            These three errors all had a uniquely national element. The US flirtation with money targets was briefer and much less damaging. Although German unification was the prime cause of the temporary collapse of the ERM, joining at an overvalued rate was the UK’s choice. Whereas many Eurozone countries have been forced into austerity by the markets and a lack of coordination by the ECB, the UK was never under similar pressure because it is not part of the Eurozone.    

            At least one characteristic connects all three episodes. They all get some of their appeal from simplistic macroeconomics. In 1980, it was the idea that there is a simple and reliable link between some measure of money and inflation. In 1990, it was that the medium term equilibrium real exchange rate is always equal to the PPP rate. And most recently, that private sector demand will automatically replace public sector demand (Says Law), or perhaps that monetary policy in the form of inflation targeting is always capable of stabilising demand. Most of the time I do not think sound macroeconomic policy is very complicated, but it is not that simple either. 

Microfoundations and Evidence (2): Ideological bias

               Internal consistency rather than external consistency is the admissibility criteria for microfounded models. Which means in ordinary English that academic papers presenting macroeconomic models will be rejected if some parts are theoretically inconsistent with other parts, but not if some model property is inconsistent with the data. However the motivation for a paper will often be a ‘puzzle’, which is an empirical fact that cannot as yet by explained by a model. However the paper is not required to be consistent will all other relevant facts, so external consistency is not as important as internal consistency.

               In a previous post I expressed a concern that researchers might tend to choose puzzles that were relatively easy to solve, rather than puzzles that were really important. In this post I want to raise another problem, which is that some researchers might select facts on the basis of ideology. The example that I find most telling here is unemployment and Real Business Cycle models.

Why is a large part of macroeconomics all about understanding the booms and busts of the business cycle? The answer is obvious: the consequences of booms – rising inflation – and busts – rising unemployment – are large macroeconomic ‘bads’. No one disagrees about rising inflation being a serious problem. Almost no one disagrees about rising unemployment.  Except, it would appear, the large number of macroeconomists who use Real Business Cycle (RBC) models to study the business cycle.

In RBC models, all changes in unemployment are voluntary. If unemployment is rising, it is because more workers are choosing leisure rather than work. As a result, high unemployment in a recession is not a problem at all. It just so happens that (because of a temporary absence of new discoveries) real wages are relatively low, so workers choose to work less and enjoy more free time. As RBC models do not say much about inflation, then according to this theory the business cycle is not a problem at all.

If anyone is reading this who is not familiar with macroeconomics, you might guess that this rather counterintuitive theory is some very marginal and long forgotten macroeconomic idea. You would be very wrong. RBC models were dominant in the 1980s, and many macroeconomists still model business cycles this way. I have even seen textbooks where the only account of the business cycle is a basic RBC model.

But perhaps common sense here is wrong, and the RBC approach is right. Perhaps, despite appearances, high levels of unemployment in a recession are just people choosing to enjoy more leisure. Unfortunately not. One of the really robust findings revealed by happiness data (see here for a recent comprehensive survey) is that unemployment increases unhappiness. As Chris Dillow notes from some recent research, unemployment appears worse than divorce or widowhood, in the sense that the happiness of the unemployed does not adapt over time to their state. Given the future earnings loss implied by spells of unemployment documented here, this is not that surprising. It is also not surprising that quits (voluntary exits) from employment are negatively correlated with unemployment, which is also difficult to rationalise with the RBC approach.

Now the RBC literature is very empirically orientated. It is all about trying to get closer to the observed patterns of cyclical variation in key macro variables. Yet what seems like a rather important fact about business cycles, which is that changes in unemployment are involuntary, is largely ignored. (By involuntary I mean the unemployed are looking for work at the current real wage, which they would not be under RBC theory.) There would seem to be only one defence of this approach (apart from denying the fact), and that is that these models could be easily adapted to explain involuntary unemployment, without the rest of the model changing in any important way. If this was the case, you might expect papers that present RBC theory to say so, but they generally do not. New Keynesian models are RBC models plus sticky prices, but that plus bit is crucial. Not only does it allow involuntary unemployment, and therefore a role for policy to smooth the cycle, but it also changes other properties of the model.

What could account for this particular selective use of evidence? One explanation is ideological. The commonsense view of the business cycle, and the need to in some sense smooth this cycle, is that it involves a market failure that requires the intervention of a state institution in some form. If your ideological view is to deny market failure where possible, and therefore minimise a role for the state, then it is natural enough (although hardly scientific) to ignore inconvenient facts. For the record I think those on the left are as capable of ignoring inconvenient facts: however there is not a left wing equivalent of RBC theory which plays a central role in mainstream macroeconomics.

In this and a previous post I have looked at two biases that can arise in the puzzle selection that drives microfoundation model development. There may well be others. Do these biases matter? I think they do for two reasons. First from a purely academic point of view they distort the development of the discipline. As I keep stressing, I do think the microfoundations project is important and useful, but that means anything that distorts in energies is a problem. Second, policy does rely on academic macroeconomics, and both the examples of bias that I use in this post and the last could have been the source of important policy errors.

One way of reading these two posts is a way of exploring Krugman’s Mistaking Beauty for Truth essay. I know the reactions of colleagues, and bloggers, to this piece have been quite extreme: some endorsing it totally, while others taking strong exception to its perceived targets. My own reaction is very similar to Karl Smith here. I regard what has happened as a result of the scramble for austerity in 2010 to be in part a failure of academic macroeconomics. It would be easy to suggest that this was only the result of unfortunate technical errors, or political interference, and that otherwise the way we do macro is basically fine. I think Krugman was right to suggest otherwise. Given the conservative tendency in any group, an essay that said maybe there might just be an underlying problem here would have been ignored. The discipline needed a wake-up call from someone with authority who knew what they were talking about. Identifying exactly what those problems are, and what to do about them, seems to me an important endeavour that has only just begun.

The EuroZone as One Country

Or does the fact that it is not matter for its overall macro policy

               The Eurozone is undertaking more austerity than either the US or the UK (see here), yet its overall budgetary position is much more favourable than either of these two countries. Can this be right, at a time when the Eurozone is in recession? If we thought about the Eurozone as a single country, then clearly it is not. Everything that is wrong with current UK policy would be even more wrong in the Eurozone. The question I ask here is whether the fact that it is not one country changes this assessment.

               The Eurozone is like one country in having a single central bank. The ECB’s nominal interest rate is stuck at their equivalent of the zero lower bound. One possibility would be for the ECB to effectively raise the inflation target, and hope that this in turn raised inflation expectations and thereby stimulated demand: NGDP targets and all that. However it almost certainly will not do this. Furthermore, its inflation target is 2% or less, and it appears to be thinking about significantly less than 2% at the moment (see the quote from Draghi reported here). So given this constraint on conventional monetary policy, what should fiscal policy do?

               For the Eurozone as a whole the situation is no different from the US, or the UK. A recession in which interest rates are at the zero lower bound is not the time to undertake austerity. The Euro area as a whole should be reducing its underlying budget deficit much more slowly. It needs a large fiscal stimulus relative to current plans. But can we translate this aggregate conclusion into action to be undertaken at the individual country level?

               I do not think a social planner in charge of the Eurozone that treated all its citizens equally would have a problem. They would reason as follows. In aggregate we need a large stimulus relative to existing plans. In addition, we need a significant inflation differential between Germany and non-Germany to open up. Suppose 2% is the optimal inflation rate, and we need a 2% gap between Germany and non-Germany (which is probably a lower bound on the inflation gap required). We could have 2% (Germany) and 0% (non-Germany), or 3% and 1%. The latter will be preferred on simple convexity grounds – it is better to spread the pain equally. In addition, the difficulty of reducing inflation when it is already near zero is well known, so it would be less costly to raise inflation in Germany. A large part of the stimulus would therefore go to Germany, raising inflation above the optimal level from the German national point of view. Kantoos disagrees, but note that this would also be the effect of the ECB successfully raising the aggregate inflation target.

               However this is academic, as we do not have a Eurozone central planner. In principle non-Germany could compensate Germany to achieve the optimal aggregate outcome, but it is unclear what non-Germany has to offer. So let us take it as a constraint that Germany will not adopt a large stimulus. It may also do its best to counteract the impact of any expansionary ECB policy on its own economy (see Kantoos again). This means that we cannot have as large a stimulus for the Eurozone as a whole as we could if it was one country. We have to go for 2% and 0% rather than 3% and 1%, which means lower Eurozone output. But does it mean the current level of austerity is correct?

               At present austerity in non-Germany is being driven by each country’s bond market. If the Eurozone really was one country, which issued Eurozone debt, this would not be happening. Just as savers are happy to buy UK or US debt, they would happily buy Euro debt. (No one buying UK debt is too worried about the widening North-South divide in the UK!) The Euro is highly unlikely to default on its debt because the ECB can print Euros.

               Germany has ruled out Eurobonds, so are we back to our previous problem? No, because the ECB can act as if they existed, by (indirectly) buying national governments debt when the market will not. As Jonathan Portes notes, this is why the crisis appeared to go away over the last few months. Buyers of non-German debt are worried about default, and the ECB can rule out default by being the buyer of last resort (through proxies if necessary: for the wisdom or otherwise of this indirect approach, see here and here). The reasons why it chooses to do this in what appears to be an erratic and unpredictable way were discussed by Fred Bergsten and Jacob Kirkegaard at VoxEU, and I commented on this here. While this might have been appropriate for some countries a year or two ago, the strategy is now doing significant harm. My own view (and more important others) is that the ECB is too concerned about moral hazard, and not concerned enough about the impact of austerity on non-German output, with the result that we are seeing much more austerity than is necessary. The ECB could still exercise fiscal discipline by varying the rate at which it capped the interest rate on non-German debt. This could be done on a country by country basis, and perhaps should be (see here and here).

               Instead the ECB appears to be using market sentiment as an index of national fiscal discipline. This puts national governments in an impossible position (see, for example, this from John McHale). They can try and demonstrate that they will not default by piling on the austerity, but in the process they may actually be making their longer term fiscal positions worse.

               Using market sentiment as an indicator of fiscal sobriety is particularly inappropriate at the moment, as market concerns may be much more focused on the health of national banking systems and the knock on effects if governments are required to rescue national banks. (See this discussion of ‘sudden stops’ at Bruegel, and beware of commentators who know what the market is thinking.)  To the extent that this is true, austerity will make things worse. As the economy contracts, more loans go bad, and banks balance sheets worsen. Perhaps ($) the ECB is beginning to realise this. But without clear signals and statements from the ECB that no further fiscal tightening is required, there is a real danger that national governments may continue to tighten too quickly.

               Viewing the Eurozone as a single country clearly indicates a substantial easing of both fiscal and monetary policy. German national self interest, combined with the need for non-German competitiveness to improve, does moderate the amount of fiscal easing that can occur, but there is no reason why the ECB should reduce aggregate inflation on this account. However the amount of aggregate fiscal austerity that this implies is still considerably less than is currently being enacted. Here the ECB has the ability to remove the constraint imposed by national government bond markets, and it should do so before the degree of austerity currently being enacted does lasting damage to the sustainability of the Eurozone.