Does politics dominate economics in Eurozone crisis management?

Athanasios Orphanides, leading academic macroeconomist and from 2007-12 Governor of the Central Bank of Cyprus, does not hold back in a recent paper. Here is just one quote: 

“During the crisis, key decision makers exhibited neither political leadership nor political courage. Rather than work towards containing total losses, politics led governments to focus on shifting losses to others. The result was massive destruction in some member states and a considerably higher total cost for Europe as a whole. European institutions could have been the last line of defense against this destructive dynamic but instead served to facilitate and enable the destruction.”

His complaint will resonate with many from the smaller Eurozone economies. The text of the paper suggests that the way decisions are made in the Eurozone allows large countries to screw smaller countries, for short term economic gain, even if this damages the Eurozone as a whole.

He focuses on two ‘blunders’. The first was the meeting between French President Sarkozy and German Chancellor Merkel in Deauville in 2010, where these leaders suggested that a haircut should be imposed on private sector lenders to solvent governments that got in to funding difficulties. Ireland lost market access for its debt within weeks. However Orphanides notes that German debt became less costly as a result.

The second was in 2013, when the Eurogroup decided to impose a haircut on deposits of Cypriot banks, insured and uninsured. Although the decision was almost immediately recognised as a blunder, Orphanides justifiably asks how such a blunder could have been made. He suggests that it can be explained by the forthcoming German elections, and a need for the government to appear tough. The result was the destruction of Cypriot banks, which in turn gave Germany leverage to end the low Cypriot corporate tax rate.

It has not escaped at least one reader of this paper that such decisions invariably favour Germany. This is not the message Orphanides highlights. The abstract says that the paper is about how politics has dominated economics in crisis management. But what exactly does that mean? And is it really the case that economics is blameless here?

Take the Deauville decision. It is true that this hardly helped calm market nerves at the time, although Ashoka Mody argues that its impact on spreads was not that great. However it does seem to stretch credibility that this was a deliberate ploy by Germany to reduce its own borrowing costs. If it was, did Sarkozy also think it would reduce interest rates on French debt? A much more plausible explanation for this blunder is that Germany wanted to reintroduce some form of no bailout regime into the Eurozone. This may indeed have been a clumsy attempt to do so, but the real culprit was the absence of any clear economic mechanism that would allow the Eurozone to distinguish between sovereign debt crises where default was unavoidable, and sovereign debt crises which represented a self-fulfilling market panic, where the government’s fiscal position was in fact sustainable if support from other governments or institutions was forthcoming.

This problem had not been addressed in the design of the Eurozone, under the pretence that the Stability and Growth Pact would mean that such issues would never arise. It has still not been addressed today: the problem has simply been shifted on to the shoulders of the ECB in consultation with governments, who have to jointly decide whether OMT will be invoked, and under what conditions. It remains unclear under what circumstances, if any, a Eurozone government will be left to default.

It seems quite reasonable to argue in this case that politicians are left floundering, and make the occasional blunder, because the economics of the problem have not been thought through. Orphanides argues that “the domination of politics over economics has led to crisis mismanagement.” I suspect this is a little unfair on politics, and far too forgiving on economics.  

John Williams on bubbles and monetary policy

I have always found what John Williams writes interesting, from long before he became president of the Federal Reserve Bank of San Francisco. So this post just reviews a speech he recently gave at the Bundesbank’s delightful conference centre on the banks of the Rhine. For me he said three interesting things.

1) He first emphasised the dangers of deviating from monetary policy’s primary goals because of a concern about financial stability. What was interesting for me is that he did this by example, looking at what had happened in Sweden and in Norway. Now my impression is that central bankers do not make a habit of publicly criticising their colleagues in other countries, but Williams’ verdict is hardly nuanced. He is particularly concerned that inflation expectations in those countries have fallen sharply away from the target. (I discussed the dangers that could arise from this here.) He concludes “If the anchor were to slip, it would wreak lasting damage to a central bank’s control over both inflation and economic activity, at considerable cost to the economy.” We are used to hearing this about positive deviations of inflation from target, so it’s nice to hear it applied equally to negative deviations (ECB please note).

2) He then talked about asset market bubbles. What he had to say was not too controversial, but it is of immediate relevance to the UK. After looking at some persuasive empirical evidence, he said:

“Low interest rates boost fundamental valuation of assets. In a world of rational expectations, asset prices adjust and that’s it. But, if one allows for limited information, the resulting bull market may cause investors to get “carried away” over time and confuse what is a one-time, perhaps transitory, shift in fundamentals for a new paradigm of rising asset prices.”

Recently I talked about how expectations of a prolonged period of low real interest rates could lead to sharp increases in house prices, as we have recently observed in the UK and elsewhere. What Williams is suggesting is that this process can lead to overshooting, as the market gets carried away.

3) All this seems to be leading to the inevitable discussion of macroprudential controls rather than interest rates to deal with overshooting of this kind. He says “monetary policy actions should only be a last resort.” But then his discussion took an unexpected turn, for me at least.

“One of monetary policy’s most important lessons—borne out in both theory and practice—is that the framework for policy is more important than the details of the execution. In terms of price and economic stability, anchoring inflation expectations and responding in a systematic way to economic developments are by far the most important elements of good monetary policy.

 Instead of thinking about how monetary policy should respond to risks to financial stability, we should focus on studying ways to design policy frameworks that support financial stability with only a modest cost to macroeconomic goals and anchoring inflation expectations.”

What does this mean? He is careful to say “I am not personally advocating either of these proposals, but I do view them as creative ways to think of how to bend the curve in terms of macroeconomic and financial stability tradeoffs.” Well one of the two ideas he notes is that monetary policy should target nominal income rather than inflation. “The idea that nominal income targeting could be supportive of financial stability is relatively straightforward (Koenig 2013, Sheedy 2014).” The paper by Koenig [1] I did not know, but the paper by Kevin Sheedy [2] I discussed over a year ago in this post. You read it here first!

[1] Koenig, Evan F. 2013. “Like a Good Neighbor: Monetary Policy, Financial Stability, and the Distribution of Risk.” International Journal of Central Banking 9(2, June), pp. 57–82.

[2] Sheedy, Kevin D. 2014. “Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting.” Presented at Brookings Panel on Economic Activity, March 20–21.

Good and Bad Blog Debates

One of the things I really like about blogs is that they can generate considered and informed debates about ideas. But not all blog debates are like that. Debates can get too personal - they begin to become about the people involved in the debate, rather than the ideas. They become a debating contest. Sometimes this can be a contest between two people, or it can be a contest between two groups. This may be a fun sport for those committed fans of either side, but I do not think it is a very good means of informing those who are not committed but who want to know more about the issues involved.

Take the debate involving Mark Sadowski (MS) that started with this post. MS disagreed with a number of things I said, and we had a short back and forth in the comment thread to that post. MS also combined his points as a separate post. All well and good. This debate led me to write two subsequent posts. One was about how the US recovery had continued despite fiscal contraction. The other, actually written following a subsequent post by Giles Wilkes, was an attempt to try and explain in very general terms where the two sides agreed and disagreed on fiscal policy. I wrote neither as sequels in a debate between MS and myself, because they were not intended to be that. I wanted to talk about facts in the first case and ideas in the second, rather than have a debating contest.

I think MS saw it differently. Here he responds to my post on the US recovery, imagining it to be a ‘response’ to his earlier post. Here he responds to my second post. Both are written in a quite personal style, as the titles suggest. Not a style I like, but so what?

Well, if you are going to do this kind of thing, you need to be especially careful that you get your facts right, because it has become personal. In the second half of the second post, he writes:

“At what point will fiscalists stop wringing their hands over the “liquidity trap” and start to worry about what is the consensus assignment of fiscal policy, which is debt stabilization? What I sense is they aren’t really interested in the consensus assignment of fiscal policy.

 And who can blame them? Debt stabilization is dull. It is *really* dull. Why worry about something so dull when you can worry about something which is so much more exciting, which is obviously aggregate demand stabilization.

 And this I think is the crux of the real asymmetry. Monetarists are genuinely interested in the consensus assignment of monetary policy, which is aggregate demand stabilization. Fiscalists show no interest at all in the consensus assignment of fiscal policy, which is debt stabilization.”

Now here he talks about ‘fiscalists’ rather than mentioning me by name, but anyone reading this post would assume that I was among the people he is talking about. Another fiscalist named in this debate is Jonathan Portes. Now it just so happens that Jonathan and I have just written a substantial paper, which is all about debt stabilisation! Whoops.

An unlucky error? No, it’s much worse. A quick look on my homepage will show you that much of my academic research since 2000 has been about debt stabilisation. Unlike MS, I do not think the subject is really dull. Issues like what the long run target for debt should be, how quickly we should get there, what happens to monetary policy when debt is not controlled by the fiscal authority, seem to me rather interesting.

Hopefully that corrects the impression created that these particular 'fiscalists' are not interested in debt stabilisation. But has this post been very informative for someone interested in the issues, rather than the personalities? I learnt very soon after I started this blog, thanks to another market monetarist, that it is generally better to focus on the ideas rather than the individuals putting these ideas forward. This can be difficult, and I do not always get it right, but that at least was what I was trying to do in my last post.

Monetarist vs Fiscalist

Giles Wilkes (ex special advisor to Vince Cable, Business Secretary in the current UK government and LibDem) has a post that compares those he calls ‘fiscalists’ like myself and Jonathan Portes to market monetarists (MM). His post follows some comments and a post by Mark Sadowski responding to an earlier post of mine where Mark took exception to my saying “the major factor behind the second Eurozone recession is not [controversial] : contractionary fiscal policy”. You find much the same debate in this post by Scott Sumner, attacking (mainly) Paul Krugman.

I think Giles Wilkes gets a lot of things right, but I thought it might be useful to set out as clearly as I can how I see the nature of the disagreement. The first, and probably the most important, thing to say is that the disagreement is not about whether fiscal contraction is contractionary, if the monetary authority does nothing. (See, for example, Lars Christensen here.)That is actually what I meant with my statement about the Eurozone recession, which linked to a study that calculated the impact of austerity holding monetary policy ‘constant’. This is so important because, in their enthusiasm to denounce countercyclical fiscal policy, MM often give the impression of thinking otherwise.

The disagreement is over what monetary policy is capable of doing. The second thing to say is that this is all about the particular circumstances of the Zero Lower Bound (ZLB). I do not like the label fiscalist for this reason - it implies a belief that fiscal policy is always better than monetary policy as a means of stabilising the economy. (Giles Wilkes is not the first to use this term - see for example Cardiff Garcia, who includes more protagonists.) Now there may be some economists who think this, but I certainly do not, and nor I believe does Paul Krugman or Jonathan Portes. I described in this article what I called the consensus assignment: that monetary policy should look after stabilising aggregate demand and fiscal policy should be all about debt stabilisation, and there I described recent research (e.g.) which I think strongly supports this assignment. However there has always been a key caveat to that assignment - it does not apply at the ZLB.

Before talking about that, let me illustrate why language can confuse matters. Suppose we had fiscal austerity well away from the ZLB. Suppose further that for some reason the monetary authority did not take measures to offset the impact this had on aggregate demand, and there was a recession as a result. I suspect a MM would tend to say that this recession was caused by monetary policy, even though monetary policy had not ‘done anything’. (In this they follow in the tradition of that great monetarist, Milton Friedman, who liked to say that monetary policy caused the Great Depression.) The reason they would say that is not because fiscal policy has no effect, but because it is the duty of monetary policy to offset shocks like fiscal austerity. That is why fiscal policy multipliers should always be zero, because monetary policy should make them so. So Mark Sadowski got upset with my statement because in his view ECB policy failed to counteract the impact of Eurozone austerity, and could have done so, which meant the  recession in 2012/3 was down to monetary policy, not fiscal policy.

So we come to the heart of the disagreement - the ability of monetary policy to offset fiscal actions at the ZLB. This is all about the effectiveness of unconventional monetary policy (UMP), which is both Quantitative Easing and what I call forward commitment (promising positive output gaps in the future: see David Beckworth here). I do not want to go over these arguments again, partly because I have already written about them elsewhere (e.g. here, here and here). Instead I just want to make an observation about asymmetry.

Economists like Paul Krugman, Jonathan Portes and myself (and there are many others) do not argue against using UMP. Indeed PK pioneered the idea of forward commitment for Japan, and I have been as critical as anyone about ECB policy. We do not argue that fiscal policy will be so effective as to make unconventional monetary policy unnecessary, and so write countless posts criticising those promoting UCM. To take a specific example, I happen to think that the recent ECB moves will have less impact on the Eurozone than continuing fiscal austerity, but I do not say the ECB is wasting its time as a result. They should do more.   

I’m interested in this asymmetry, and where it comes from. Why do MM hate fiscal expansion at the ZLB so much? It could be ideological (see Noah Smith here), but I suspect something else matters. I think it has something to do with monetarism, by which I mean a belief that money is at the heart of issues to do with stabilisation and inflation. MM is not about controlling the money supply as monetarism originally was, but I think many other aspects of monetarism survive. My own view is more Wicksellian (or perhaps Woodfordian), whence the failure to be able to lower interest rates below zero naturally appears central. To those not trained as macroeconomists (and perhaps some that are) these sentences will appear mysterious, so if this idea survives comments I may come back to it later.   

The US and the Eurozone 2012-3

If fiscal policy is important at the zero lower bound, why did the US recovery continue in 2012 and 2013 despite a large fiscal contraction? Or to put the same question in a comparative way, why was the Eurozone’s fiscal contraction in 2012/3 associated with a recession, but not in the case of the US?

GDP growth had been reasonable in both the US and the EZ in 2010 and 2011. While US growth continued into 2012/3, EZ growth collapsed. Yet as the chart above shows, fiscal tightening was only slightly greater in the EZ in 2012, and became considerably tighter in the US in 2013.

Before discussing this, it is important to make two important points. The first is that the macroeconomy is complex, involving important lags in behaviour and expectations of future events. For that reason alone, you will not get precise matches between causes and consequences by just eyeballing the data. Second, different fiscal measures have different effects, and trying to express the fiscal stance in one simple measure will always be a crude approximation. However, despite these qualifications, I think we can provide something of an answer to this question by just looking at the numbers. 

In comparative terms, there are two obvious answers looking at 2012. The first is the EZ crisis. Although this began in 2010, it reached a critical position in 2012, when Greece was almost forced out. It is hardly surprising in these uncertain circumstances that EZ investment fell by nearly 4% in 2012. The second is monetary policy. The ECB raised rates from 1% to 1.5% in 2011, and compared to the US there was no Quantitative Easing. Combining the two, monetary conditions tightened considerably in the periphery as a result of the crisis. There was no comparable crisis in the US, which allowed investment to increase by 5.5%.

Explaining 2013 seems more difficult. Monetary policy had eased in the EZ (although of course not by as much as it should have), and OMT had brought the crisis to an end. In the US there was considerable fiscal tightening. So why did the US continue to grow and EZ GDP continue to fall?

For the EZ one proximate cause was a sharp decline in the contribution of net exports. Net exports added 1.5% to GDP in 2012, but only 0.5% in 2013. If this contribution had been more even at 1% in each year, GDP would have fallen by over 1% in 2012, and stayed roughly flat in 2013. Fiscal policy continued to tighten, which also would have reduced growth.

In the US something else happened: the savings ratio, which had been elevated at 5.5% or above since 2009, fell to 4.5%. This could have been a result of fiscal tightening, but it seems more probable that it represented the end of a prolonged balance sheet correction. (The US savings ratio averaged 4.5% between 1996 and 2007 and the OECD’s forecasters expect it to fall further this year and next.) The OECD estimates that the US output gap in 2013 was -3.5%, which was much the same as their estimate for 2012. So growth of 2% did nothing to close the output gap in 2013. This was despite a large fall in the savings ratio, perhaps bringing to an end the balance sheet correction that began with the Great Recession. So US growth in 2013 should have been very strong, and the obvious explanation for why it was not is very restrictive fiscal policy.

How to change the inflation target

The longer interest rates stay at the Zero Lower Bound (ZLB), the stronger the case (pdf) for raising the inflation target becomes. (No, that is not a good reason to raise interest rates today, but perhaps it helps explain why some are so keen to do so!) However there seem to be two political barriers to this happening. Central banks seem to live in mortal fear that any move to raise inflation targets will shatter their ‘hard won credibility’ and inevitably lead to inflation ‘taking off’ and inflation expectations becoming ‘unhinged’. Where politicians have control (as in the UK), they worry the public will interpret any increase in the inflation target as a further erosion of their living standards. Yes, I know Abe raised the target rate in Japan, but only to the 2% that has become the consensus for the major developed economies.

Tony Yates suggests a very British solution to this problem. In the past, a standard way that UK politicians have handled such tricky questions has been to establish an independent commission to examine the question. (One famous example in the past was the Macmillan committee, set up after 1929 to establish the causes of the UK depression. Keynes’s role on that committee is vividly described by Peter Temin & David Vines in their recent book.) Tony calls it the Inflation Remit Review Commission. This commission could take evidence (from the central bank and others) on issues such as what the medium term natural real interest rate is likely to be, and compute the costs and benefits of any change. This sounds like a good way of trying (as far as possible) to depoliticise the issue, and putting the central bank’s inflation paranoia in context.

I have just one suggestion to add. This commission, at the same time, should examine whether it remains appropriate that the inflation target should just involve the consumer price index (and in particular, whether the rate of change of wages should also be targeted), and whether the target should involve the inflation rate or a path for prices (a price level target), or indeed national income. These questions naturally go together with the choice of the level of any inflation target. If there is a target for the path of prices rather than its rate of change, then the consequences of hitting the ZLB are less severe, for example. In addition, the possibility of ending the tyranny of the consumer price index, or changing to a level target, suffer from much the same conservative bias from politicians and/or central banks as the value of the target itself.

Whether the idea of a commission would work in the US I do not know. In the Eurozone there are strong grounds for setting up a similar body, not only to review the questions set out above, but also to permanently oversee the performance of the ECB. At present the ECB has minimal accountability. Appearing every three months before the European Parliament just does not count, I’m afraid. (For further discussion, see this Bruegel paper by Claeys, Hallerberg and Tschekassin.) This in itself is a strange state of affairs for an institution with such power. In addition its performance since 2011 (at least) has been very poor relative to the Fed and Bank of England. (See for example this post written over a year ago which I think reflected the clear consensus among macroeconomists at the time.)

Tony does not suggest who might sit on this commission, except to say that they should not be part of the government, or the central bank. My own view is that it is vital that at least some are academic macroeconomists, because academic macroeconomists do understand these questions better. For the UK obvious candidates are ex-external members of the Monetary Policy Committee, unless you think they have become (or were perhaps selected because they were) too indoctrinated with the central bank view. Suggestions on who might comprise an oversight commission for the ECB would be very welcome.      

What we do know

After reading all about the latest ECB moves, I happened to read this by Noah Smith (HT MT). It made me unusually irritated, but it is not really Noah’s fault. He is right that there is much that we do not know in macro, and also right that there are many different views around. Alternative assessments of how effective the ECB’s policy changes will be illustrate that. Noah puts all this down to lack of data, rather than politics. When it comes to unconventional monetary policy this is also right. However there are some things where the data is pretty clear, and where any macroeconomist with an open mind should be able to come to a clear conclusion. But somehow this does not happen.

When pouring over the detail of what are minor moves by the ECB, there is a huge elephant in the room: fiscal policy. Too often this is portrayed by those outside as a game with two sides: the PIIGS, where austerity is a necessity because of difficulties in funding debt, and Germany, where there is no domestic interest in offsetting periphery austerity with fiscal expansion. However there is a third bloc of countries in the Eurozone, where there has been no debt funding crisis, but where there exists a large amount of spare capacity. This bloc is dominated by France (2014 output gap -3.4% as estimated by the OECD), but also includes the Netherlands (output gap -4.4%), Belgium (output gap -1.7%), Austria (output gap -3.2%) and Finland (output gap -3.8%). The chart below shows what is happening to fiscal policy in those countries.

Underlying Primary Balances: OECD Economic Outlook May 2014

All of these countries are tightening their fiscal policy this year and next: in the case of France, Finland and the Netherlands quite substantially. So the focus on Germany as a country (as opposed to its influence on Eurozone institutions), where the OECD projects some very modest fiscal expansion, is misleading. Damage is being done elsewhere, and for this group of countries where negative output gaps are large fiscal policy is just perverse.

The theory and evidence behind this last statement should not be controversial. The theoretical framework used by monetary institutions almost everywhere says that fiscal contraction at the zero lower bound will do serious damage to output and unemployment (and therefore reduce core inflation). The evidence overwhelmingly confirms this proposition. While the reasons for the Great Recession may still be controversial, the major factor behind the second Eurozone recession is not: contractionary fiscal policy, in the core as well as the periphery. So this is something we really do know. Yet too many macroeconomists seem reluctant to acknowledge this. There are the anti-Keynesians who want to deny the monetary policy consensus; there are others, who want to deny the importance of the zero lower bound; and still more, who for some other reason want to deny the importance of fiscal policy.  

This allows policymakers to continue to press for fiscal consolidation in the Eurozone, largely ignoring those economists who do challenge this policy because they just represent 'one view' within the discipline. Every reluctant and far too late bit of stimulus by the ECB is undone by the actions of the Commission and the political consensus behind austerity in Europe. As far as economists are concerned, although our macroeconomics is much better than it was 50 years ago, in this case our collective influence on policy has gone backwards.