Austerity, Nominal GDP targets and the Zero Lower Bound

                One part of my earlier post on monetary policy and austerity was a little cryptic. OK, it was largely unintelligible to nearly everyone (see, for example, Arnold Kling here).  My apologies. As it’s an important point, let me elaborate. What I want to show is that with monetary policy aiming to hit some level for nominal GDP (NGDP), if we are at the Zero Lower Bound (ZLB) for nominal interest rates today, austerity today will reduce welfare (by, in part, raising inflation tomorrow), and fiscal stimulus will increase welfare. I will not use maths, as even when I use the most simple of equations, my posts are described by well known blogging economists as nerdy.

                Output today depends on real interest rates today. Anything else that changes output today is called a shock. There is no Quantitative Easing (QE). For simplicity we will assume no direct linkage between output across periods. Inflation today depends on output today, but also expected inflation tomorrow. Prices were on target yesterday, and let’s assume that inflation the day after tomorrow is fixed. Now hit output today with a negative demand shock, a shock which is not repeated tomorrow. If that shock is small enough, we can offset it entirely by lowering interest rates today. Inflation today is unchanged as a result. Nothing changes tomorrow. Everyone is happy: monetary policy has done its job, by lowering nominal and real interest rates today.

                Now suppose the negative shock today is so large, that even with nominal interest rates at zero, output remains too low. This reduces inflation today. With a target for NGDP, not only would this mean we missed our target today, but it would also mean that we would miss our NGDP target tomorrow, because lower inflation today would mean lower prices tomorrow if inflation tomorrow was unchanged. So monetary policy cuts interest rates tomorrow in order to raise tomorrow’s output and inflation. If this response is expected (we assume rational expectations throughout) it does two things. It raises inflation today directly (because inflation today depends on expected inflation tomorrow), and it reduces real interest rates today (real interest rates today are nominal rates today minus expected inflation tomorrow), which raises output today which in turn raises inflation today. This is why NGDP targets can be very helpful to combat the ZLB. If we instead targeted inflation, then monetary policy tomorrow might do nothing, because policy would still hit the inflation target tomorrow.

                Now suppose that, despite relaxing monetary policy tomorrow, we still hit the ZLB today. Output and inflation are too low today, even though we hit the NGDP target tomorrow. There is absolutely no reason why this might not happen. Although inflation is higher tomorrow to compensate for low inflation today, real interest rates today are still not low enough to prevent output falling today. Sure, we could relax monetary policy tomorrow by yet more (assuming we are not at the ZLB tomorrow), and this could increase inflation tomorrow by enough to get real interest rates low enough today. But that would mean we overshoot our NGDP target tomorrow.

                So, we hit the ZLB today, undershoot the NGDP target today, but meet it tomorrow. Now let output also depend on fiscal policy, and add some austerity today. This reduces output by yet more today. Interest rates are at the ZLB today, so monetary policy today can do nothing about it. Lower output lowers inflation today still further, but because this reduces the price level tomorrow, monetary policy relaxes by more tomorrow. This is good, because higher inflation tomorrow raises both inflation and output today, which moderates the impact of austerity. But the end result must be that the net impact of austerity is to reduce output and inflation today, and raise inflation tomorrow. (If output and inflation are not lower today, inflation will not change tomorrow. But if inflation tomorrow is unchanged, why has austerity not reduced output and inflation today?)

                That is how a negative demand shock today, like austerity, can raise inflation tomorrow. It only happens because we have a target for the level of NGDP, and we cannot use interest rates to kill the impact of the demand shock today, because we are at the ZLB. But the latter is where we currently are, if you ignore QE.

                It follows directly that excess austerity today reduces welfare, even with NGDP targets. We still hit the NGDP target tomorrow, but only by having additional excess output and inflation tomorrow, and a bigger recession today. People are clearly worse off both today and tomorrow.

                This little experiment also shows us why fiscal stimulus can be more effective than a NGDP target at stabilising the economy at a ZLB. Just put the story in reverse. Instead of excess austerity, now have a fiscal stimulus today sufficient to get NGDP back to target today. As there is no shock tomorrow (fiscal or otherwise), we also hit NGDP tomorrow. We are back to where we want to be. Now the fiscal stimulus may have meant more government spending than we might have wanted in the short term, so it’s not cost free. But in terms of output and inflation, we are clearly better off as a result of the fiscal stimulus, even though we have a NGDP target.

                  

                 

What if Ireland voted no to the Treaty

                On Thursday Ireland votes on the Fiscal Stability Treaty. Polls suggest the result will be yes. Will this be a solid endorsement for the clauses of the Treaty, and the vision that lies behind it? I doubt it very much. What may be much more decisive is a clause that only allows access to Europe's new bailout fund to states that ratify the treaty. Given Ireland’s current situation, you could say that voters have very little choice but to vote yes. In addition, I have read quite a few posts over the past few weeks (e.g. John McHale here) suggesting that the Treaty does not impose any additional burdens to the austerity Ireland is already implementing. In that sense, there is no immediate cost in voting yes, if you think the current austerity is unavoidable.

If that is the immediate cost benefit calculus, what about the longer term? Philip Lane writes “My own take is that, if the Treaty is implemented in an intelligent, cyclically-sensitive manner (consistent with the flexible, holistic interpretation laid out in the “six pack” regulations), the new fiscal framework will be a positive force, helping Ireland and other European countries to gradually exit from high debt levels and avoid destabilising pro-cyclical fiscal policies in the future.”

                Unfortunately, I think you could also argue exactly the opposite. If the Treaty is implemented in an unintelligent manner, with an attempt to satisfy all its numerous rules and clauses without regard to macroeconomic context, the results could be disastrous. (If you want an example of how this can happen, see the Netherlands.) As I have suggested before, the Treaty is similar to the Stability and Growth Pact (SGP). True, compared to the original SGP, the emphasis on cyclically adjusted deficits gives formal acknowledgement of the importance of automatic stabilisers. More generally, whereas in the original Pact there were two main criteria for budget deficits, now there are many more (see here, or here). That can be read as flexibility, or it can be interpreted as confusion, muddle and bad economics. Hence both optimistic views like Philip’s and more pessimistic readings (see Karl Whelan here for example) are possible.

                What I believe is clear is the overall vision that the Treaty represents. It sees the essential problem with the Eurozone as being public sector indulgence. This is a profound misreading of what happened before the recession. By far the bigger problem for most periphery countries was private sector indulgence fuelled by cheap borrowing. In Ireland, and now in Spain, this transforms itself into a public sector problem because banks are bailed out.

                The fact that it was excess private sector borrowing that was the ultimate cause of the crisis does not mean that fiscal policy was appropriate. Far from it. Fiscal policy should have been much tighter than it was, because it needed to be countercyclical. However, the idea of countercyclical fiscal policy was nowhere to be found in the original SGP, and hardly figures in the Treaty. If the Treaty had been a realistic response to the current crisis, issues to do with macroeconomic stability (e.g. relative inflation rates, real exchange rate disequilibrium) would be at its centre, rather than as the vaguely worded single paragraph that is Article 9.

                This failure in both the original SGP and the new Treaty to recognise how important countercyclical fiscal policy is to the viability of the Euro is a major, perhaps the major, design flaw. (I have written about this before, but for a similar message see here.) What is worse, the obsession with public sector profligacy has diverted Eurozone policymakers from understanding this, both before and during the crisis. It has also discouraged recognising the scale of the problems facing the banking sector, and indeed the obsession with austerity has probably made this problem worse.

                One response to this argument is political. Yes, the Treaty is a distraction, but it is a pre-requisite for other important reforms of the euro system.  In simple language, the Treaty is needed because without it there is no chance of persuading Germany to even think about Eurobonds and the like. But perhaps what has to change is this German (and Dutch, and Finnish) mindset. As long as the ‘fiscal irresponsibility’ story remains the dominant narrative, we will get either continuing policy inertia, or worse still games of chicken being played with national electorates. That road may lead to disaster, as Boone and Johnson argue here. There needs to be a collective realisation that the causes of the crisis are not as originally advertised. There are solutions (e.g. Nick Stern here), but they require Germany and others to put Euro survival ahead of national self interest. With the election of Hollande, there is a chance of this happening. In this context you could argue that an Irish yes vote does nothing to help change the austerity mindset, whereas a no vote might have contributed to the mindset’s demise.

                That is easy for me to write. It is also easy for me to conjecture from the other side of the Irish Sea that if Ireland voted no, this would make no difference to their ability to receive bail-out funds. Ireland has been the poster boy for the ‘austerity’ cure, and for this and many other reasons the Eurozone is not going to let the little matter of a popular referendum make them throw Ireland to the market wolves. However, I can quite understand that, given what Ireland has been through, it would not want to take that risk for what would, I admit, be little more than a gesture. It may also be that, ironically, Ireland’s opportunity to argue that the Treaty is a dangerous distraction is greater if it votes yes. If the vote is yes, it must take that opportunity.  

Does Monetary Policy make Austerity Irrelevant?

                There are three variations of this question that I have come across in recent posts and comments.

1) If monetary policy had targeted nominal GDP, it could have been successful whatever fiscal policy had been.

2) Even within the context of inflation targeting, Quantitative Easing (QE) allows monetary policy to overcome the problem of the zero lower bound (ZLB) for nominal interest rates. So inadequate demand can be put down to not enough QE.

3) Less austerity would have led to higher inflation, which given the recent behaviour of monetary policy makers  would have led to higher interest rates, leading demand back to where it now is.

On (1), I have said that the possibility of moving to a different monetary target has a lot to commend it, and that this should be discussed much more actively in the UK right now. However I do not think targeting nominal GDP means that the monetary authorities can achieve that target at all points in time. The main way I think it overcomes the zero lower bound (ZLB) for nominal interest rates is by promising to create higher inflation in the future, which is itself a cost. The more austerity reduces current demand, the more inflation we will have in the future to counteract it.

                Argument (2) in effect says that the ZLB does not matter: monetary policy just switches from one instrument to another. I think this is seriously wrong. Although recent studies suggest QE has some effect, everyone I talk to who is involved with monetary policy thinks the uncertainties and limitations of QE are of an order above those of conventional policy. If I had to choose between QE and fiscal policy as a way of regulating demand, I would choose fiscal policy.

                Argument (3) suggests that if we had not had austerity, inflation would have been higher, and monetary policymakers would have raised interest rates. There are two uncertainties here. First, we cannot be sure that if there had been less austerity, inflation would have been significantly higher. In the UK there is a very simple reason for this – part of the additional austerity was to raise VAT. But more generally, what we may be seeing today is that inflation is much less sensitive to the output gap when inflation is low.

Second, we cannot be sure how monetary policy makers would have reacted. As I have argued before, sensible monetary policy targets both inflation and the output gap, so when the latter is large and negative, you should be very tolerant of moderate and temporary excess inflation. You certainly do not appear to ignore the output gap. Unfortunately that is exactly what monetary policy makers did do in the Eurozone in 2011, and I really hope this decision is now regretted by the ECB. In the UK they nearly did the same, and I have discussed this episode at length. So I know what monetary policy should have done if we had had less austerity (not raise interest rates), but I do not know what they would have done.

                So I agree that, if demand was stronger because we had had less austerity and more fiscal stimulus, inflation might have been higher, and interest rates might have increased as a result. However not only am I uncertain about this, but the monetary policy response would have been a policy choice. In this situation, should I say that austerity does not matter? Should I instead blame the monetary authorities for something they might have done, had austerity not happened? This seems a bit odd to me.

                I’m also a bit concerned that all three arguments hark back to a place too many were at before (and even during) the recession, which was to believe macroeconomic stabilisation was only about monetary policy.  Now my own writing and research has been quite supportive of what I call the conventional assignment, under the right conditions. But those conditions do not apply at the ZLB, and they obviously do not apply to members of a currency union. There are also other circumstances where fiscal policy could in principle assist monetary policy in its stabilisation role. This tendency to discount the short term macroeconomic effects of fiscal policy is part of the reason we are in our current situation.

Government debt and the burden on future generations

                In an earlier post, I looked at how we might think about the ‘cost’ of additional public debt, if that debt financed public investment, and our concern was intergenerational equity. Here I want to examine the question of how great the burden of extra debt is on future generations, if that debt financed not investment, but consumption spending or tax cuts that had only current period benefits.

                Our initial instinct would be that this burden is bound to be positive. The current generation gets the benefit of additional spending, or a tax cut, but future generations pay the cost in terms of finding the money to pay the interest on the debt. However, if the additional debt is never paid off, and remains a constant share of GDP, then there is a situation in which it is not a burden, which I discussed in that earlier post. Let the ‘growth corrected real interest rate’ be r-g.[1] Suppose r-g=0. In that case the interest on the outstanding debt each year could be entirely paid for by issuing new debt such that the total debt to GDP ratio remained unchanged. The debt is only a burden on the final generation, but there is no final generation.

                Normally r>g, so taxes do have to rise (or government spending has to fall) to pay part of the interest on the debt. Debt is a burden on that account. There is a trap that we can fall into here, which is the following. Suppose all the debt is owned domestically. What the government does is raise taxes to pay interest on the debt, so this is a transfer from tax payers to debt owners. The government is just taking with one hand and giving back with the other. If society is just paying itself, how can debt be a burden?

                It’s an easy mistake to make – I should know, because I made it in an earlier post, which Nick Rowe pointed out in a comment.  Incidentally, Nick has two excellent posts on these issues, here and here. The argument above is wrong because it can still involve a transfer between generations. This becomes very clear if we consider an unfunded pension scheme, which I will do in a later post. Someone who just gets interest on their wealth is clearly better off than someone who also has to pay tax increases to get that interest.

                If you are still not convinced, think of the following. Suppose the current generation gets a debt financed tax cut, but in a fit of conscience it decides to put it all into a trust fund to compensate future generations. (This is what happens under Ricardian Equivalence.) Suppose also that there is a final generation when all the extra debt is repaid, and it gets the complete trust fund. In real terms the size of the debt will cumulate up at the rate g, as each year a bit of new debt is issued to keep its total a constant proportion of GDP. However the trust fund cumulates with the real interest rate r. If r>g, the trust fund will exceed the amount of debt to be repaid, and so the final generation will be better off. As all this just involves intertemporal transfers, the final generation being better off must mean that the generations in between should have got some of the trust fund – they were losing out too.

                If there is a final generation (when the debt is paid off), then the answer to the question ‘is debt a burden’ is obvious. It is only if we think about never paying the debt off that we need to worry about the r>g condition. The argument I made in one of the earlier posts, and want to repeat now, is that there should normally be a final generation – the debt should be paid off eventually. This argument has nothing to do with intergenerational equity.

                Creating additional debt has two negative consequences aside from any intergenerational equity concerns. First, increasing taxes to pay the interest adds to the scale of tax distortions in the economy. Second, it seems likely that additional government debt will to some extent crowd out investment in productive capital, and this is a cost if, as also seems likely, we currently have less than the optimum amount of productive capital. (Economists will know that I am here assuming we do not have complete Ricardian Equivalence, and that the economy is not dynamically inefficient.) For both reasons, even if we ignored issues of equity, we should not be indifferent to the level of debt.

                So these arguments suggest we should aim to bring debt back to some target level. Those economists familiar with this area will know that there is one special, but frequently used, case where that is not true, and this paragraph is for them. As a consequence of Barro’s famous tax smoothing hypothesis, the short term costs of bringing debt back to some target can outweigh the long term benefits of doing so, if the real rate of interest is not greater than impatience (the rate of time preference). My own view is that this is a ‘knife edge’ result which really tells something different, which is that any adjustment towards a debt target should be very gradual. For more on this see another earlier post of mine.

                What the ideal level of debt should be is a complex question. But once we accept that in theory there is some ideal level of debt, this means that doing thought experiments where we forever depart from it are just that: thought experiments rather than practical policy. To put the same point more topically, if we accept that current levels of government debt are too high, we must have in mind some lower target for debt. If debt rises above this target, it should fall back towards it. In effect, that means there will be a final generation: any additional debt will eventually have to be repaid.

                So the burden of additional government debt for future generations involves the debt itself, and not just the growth corrected interest on that debt. However, the practical importance of this point for any particular generation is not great, because adjustment towards a debt target should be slow. Getting debt right is likely to be a cost for our children’s children as well as those generations currently alive.         

             

               

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[1] If r is the nominal interest rate, g is the growth in nominal income. If r is a real interest rate, g is the real growth rate.

On not taking sides, and forecast uncertainty

                The last time I can remember Chris Giles of the FT writing about fiscal policy, I came down on him pretty hard. It was the phrase “..the area in which Britain still leads the international debate is fiscal policy” that really got to me then. So before taking up something in his latest piece, let me say two things. First, after my earlier critical post, Chris took the time to send me a lengthy email defending his position. It didn’t change my view, of course, but I did appreciate the effort. It confirmed my belief that Chris is serious about trying to get things right. Second, the article today is more sensible. It basically takes the IMF view I described recently here, which is that we need more monetary expansion, and that if things become worse than expected we should have bond financed fiscal expansion. Not as far as I would want to go, and I would disagree with his arguments for keeping to current fiscal plans, but Jonathan Portes takes on that task here. What I can say is that I approve of his direction of travel, and that he is prepared to make it!

                  What I want to discuss now is a remark Chris makes about economists taking sides. The article starts by chiding the Prime Minister when he claims that low interest rates represent the result of his tough decisions. Chris argues, as Jonathan has said many times, that low rates reflect the poor prospects for UK growth. He goes on: “The prime minister must know that what he is saying is silly, so it suggests he holds the intellectual capabilities of his audience in contempt.” I have recently expressed sentiments along similar lines. He then goes on to examine a recent statement by Labour’s Ed Balls. To quote again: “Blaming changes in deficit forecasts on the pace of austerity alone is not worthy of a serious politician.” If you take the statement Chris quotes as implying that the deficit is higher just because of austerity, then that does indeed make little macroeconomic sense.

                It is what Chris says next that is interesting. “In the current hysterical climate, economists should be wary of taking sides. We know that austerity hurts, but we have little idea how much of the current economic pain is caused by deficit reduction.”  If by taking sides he means trying to argue that everything said by one political party is wrong and everything said by another is right, then this has to be sound advice in an age of macroeconomic spin.

                However, I would also argue that in a hysterical climate, economists really should go public with what they believe to be true, particularly if that belief comes from years of study. If their view reflects what is taught to students up and down the land, then I might go so far as to say that they owe it to their discipline to tell the world what they tell their students.  What in my view makes the austerity announced in 2010 a major policy error was that it attempted to deny this knowledge. We do know with reasonable certainty that fiscal contraction in the form of spending cuts will, ceteris paribus, reduce output by a significant amount. We also know that when interest rates are at their lower bound, what monetary policy can do to counteract this fiscal impact is highly uncertain. Not all macroeconomists will agree with these statements, but I would conjecture that the vast majority do. Given this, it was highly likely that additional austerity would reduce UK output compared to what it otherwise would have been, and if this led to weak or zero growth then it was a huge gamble to hope that monetary policy would put things right again.

                It was in part this belief that macroeconomics had important things to say that current policy seemed to ignore that started me blogging some five months ago. I’ve also found that among the macroeconomic blogs I read there is refreshingly little partisan commentary. OK, maybe that is partly self selection – there is a popular US blog that I do not read for this reason – but only partly. There is a bit more ideology in what I read, but unfortunately that reflects the discipline itself.   

                I also agree with the second sentence from Chris that I quote above in the following sense. Although there has been no growth since the coalition started to influence macroeconomic events, we should never claim that we know that this is all due to their fiscal plans. There are too many unknowns here – in particular, it is hard to know how much future austerity might have influenced current expectations among firms and consumers. I hope that in the past I have simply claimed what I said above, which is that austerity has just made things worse. To say that we know precisely what a policy has done to the economy is almost as bad as saying that we can accurately forecast.[1]

                What all macroeconomists know is that forecasting is a very imprecise game. Study after study has shown that macroeconomic forecasts are little better than guesswork. Forecasts are worth doing, because getting things a bit better than guesswork has benefits that exceed the costs. A corollary of being just better than guesswork is that whether you get forecasts right or wrong is largely down to luck. So to infer, as is frequently done – even in blogs – that because the Bank of England has been consistently overoptimistic about inflation this must reflect some kind of incompetence is simply wrong. Equally, to assert that the OBR were overoptimistic about UK growth because they must have been somehow infected by the government’s beliefs is wrong. Both things are possible but, given what I know in each case, highly unlikely. Given the state of our current, and in all probability, future macroeconomic knowledge, forecasts are generally wrong because the economy is too damn unpredictable. That makes it all the more important that we do not ignore the things we do know.

                  

               

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[1] It is only ‘almost’ as bad because conditional forecasting (if something changes by x, then something else will change by y), involves less uncertainty that unconditional forecasting (something will be y). Note that my statement about fiscal policy is much weaker than a conditional forecast, because it just says that if government spending falls, output will be lower. That is why we can be much more certain about this kind of statement. 

Why I can still believe the Euro will survive, just

                Paul Krugman thinks that Greece will probably leave the Eurozone. It is generally foolish to disagree with PK, and what follows is a huge hostage to fortune, but here goes. It is clear that Greece wants to stay in the Euro. Their people do and so do most political parties, including Syriza. Their banks are losing money fast, but the Greek central bank will fill that gap, as long as the ECB allows them to. So a Greek exit will only occur if the Eurozone in some shape or form decides that Greece must go. (See John Quiggin here, for example.) This is the first reason why I think the Euro may survive. If the Greek people were less committed to the Euro, then in macroeconomic terms the option of Greece themselves deciding to leave would look quite attractive in all but the short term, so they might well take that option. (For a different view, see Jacob Kirkegaard here.)

                The spin being encouraged in Europe at the moment (and I broaden the scope here deliberately, because it includes the UK government) is that the next Greek election is in effect a referendum on Greek membership. The implication, given the previous paragraph, is that if Greece tries to renegotiate the terms of its existing loans, the Eurozone will force Greek exit.  The key question is whether this is a credible threat.

                The question is not whether Greece has some moral duty to honour its debts. Creditors will always use this type of language, because they want as much of their money back as possible. There will also be plenty of talk of moral hazard: if Greece is able to renegotiate terms on this occasion etc etc. But all this is just rhetoric. Greece has already partially defaulted. There seems to be no obvious moral reason why private creditors should lose some of their money, but governments who lent to Greece should not, particularly when the terms of the loans were largely decided by the creditors under duress.

                So is it a credible threat? The main plank of my flimsy optimism about the Euro is that the decision to abandon Greece is a Eurozone decision, rather than the decision of sections of German public opinion or particular European officials. The Eurozone remains a collection of national governments, acting mainly in their own national interests. Suppose Greece does attempt, after its elections, to renegotiate its loans. The Troika will have to decide how to respond. Let’s look at the costs and benefits of this choice.

                If it refuses to move from current agreements, and offers little or nothing in return, Greece will suspend some or all of its interest payments, and the ECB would be instructed to withdraw support to the Greek central bank. Crudely, it will stop giving Greece Euros. The outcome is forced Greek exit, which will almost surely mean that the Eurozone would lose everything it has lent to the Greek government, because Greece would default on these loans. So in these very specific financial terms, rather than restructuring existing loans to try and get something back, it would lose it all. So far, so bad.

                But, you may think, at least the Eurozone will have drawn a line in the sand, to discourage other debtor member nations to think along Greek lines. Exactly, which is why those debtor nations will not want to see Greece exit. If they have any sense, those governments will know that they too might find themselves in Greece’s current situation, and so they will not want to be treated in the same way. What about countries like France and Italy? The election of Hollande is clearly important in this respect: see Paul Mason here or Linda Barry here for example. In addition, I think both countries will fear the dangers of the contagion that Greek exit might bring much more than the benefits of discouraging future renegotiation of periphery country loans. See R.A. on this here.

                We should also not forget that the IMF is part of the Troika. The IMF knows that in every case where a borrower nation gets into severe difficulties, some flexibility has to be shown by creditors. This is usually difficult in practice because the creditors are many, with each hoping that someone else will take the hit and lose their money. But not in this case. As we saw at the recent G8, the pressure on the Eurozone to be accommodating will be huge.

                Now all this implicitly paints Germany as the odd one out. It is certainly possible, listening to some sections of German opinion, to believe that Germany will insist on taking a hard line. I suspect that in reality the German leadership is prepared to give ground to ensure the survival of the Euro in its present form, although electoral pressures may get in the way. However Germany is not in charge of the Eurozone or the ECB. Nor has it any obvious means of coercing the other Eurozone governments to take a hard line, even if it wanted to.

                So the threat of pushing Greece out of the Eurozone is not credible, if the decision to do so is made by the Troika, or the Eurozone as a whole. This makes the important assumption that the ECB will be prepared to continue to provide Euro’s to Greece. As far as I can see, there is no technical reason why they cannot. (See Marshall Auerback on this.)  I also strongly suspect that the last thing the ECB wants to do is to be seen to force Greek exit without clear political backing from the Eurozone as a whole. But the ECB is an independent body without any democratic control and little transparency, so we cannot be sure what it will do.

                To get a different perspective on the same issue, consider what might happen if the centre ‘pro-agreement’ parties do much better in the next Greek election than they did in the past. Problem over? Hardly. It is much more likely that in the near future the Greek government would still have to ask for the loan terms to be renegotiated, because its fiscal position has got much worse as a result of austerity and the crisis. So renegotiation is likely anyway. Are Eurozone countries really willing to risk so much just to get slightly better terms on restructured loans?

                If this analysis is right, it raises two questions. First, is it wise for the Eurozone to make threats which are not credible? Second (and this has some influence on the first), why does most of the media appear to act as if the threat is credible? (OK, I’m obviously talking about the media I see, and I’ve no idea how this is being discussed in Greece.) Is it lack of thought, or just because the more alarmist you sound the better the copy? I know it is a lost cause, but the media are an important part of this story. The Eurozone are hoping to influence public opinion in Greece by making these threats, and if the media called these threats as bluff, they would be ineffective and would stop being made. So they are complicit in this game of chicken. And the problem with games of chicken is that they can go horribly wrong, as the markets well know. In addition, politicians can get trapped by their own rhetoric. In which case my analysis above based on rational self interest may be worth very little at all.

The IMF calls for a more expansionary UK policy

                The preliminary findings of an IMF Article IV mission are always a highly political document, as Paul Krugman points out. That is why you can spin today’s report on the UK as support for the current government line, or implicit criticism of it. And a lot of the reporting focuses on just this political angle. This is a shame, because it misses the clear message of the report, which is that UK macroeconomic policy is too restrictive.

                On monetary policy the report is absolutely clear. A bold heading reads “Further monetary easing is required”. The detail calls for more QE, and perhaps a further interest rate cut. One reason why the economists at the Fund are prepared to make such a clear criticism of the current MPC stance may be outlined in my recent post.

On fiscal policy, the Fund continues to call for balanced budget fiscal expansion. The heading here is a little more opaque:  “There is scope within the current overall fiscal stance to improve the quality of fiscal adjustment to support growth.” However this from the text below is pretty clear: “Fiscal space for further growth-enhancing measures could be generated by property tax reform, restraint of public employee compensation growth, and better targeting of transfers to those in need. This fiscal space could be used to fund higher infrastructure spending, which has a high multiplier and raises potential output. It will also be important to shield the poorest from the impact of consolidation.” For more detail see Ian Mulheirn here.

Finally we should note that good policy is about allowing for risk, which is what the current government did not do when embarking on additional austerity. The IMF knows this, which is why it says, in another heading: “Fiscal easing and further use of the government’s balance sheet should be considered if downside risks materialize and the recovery fails to take off.” For downside risk read the Euro blows up. Now I would argue that the outlook even if the Euro survives is pretty grim: the latest OECD forecast is for growth of 0.5% this year, and 1.9% next. As a result, fiscal easing seems appropriate even without downside risk.

But the question I have is this. We are told that the government is making contingency plans if Greece exits the Euro. Presumably it is thinking about what it would do if there was a severe recession in the Euro area. Do they agree with the Fund that fiscal easing should be considered in these circumstances?