Eurozone Asymmetries

Suppose a large Eurozone country – let’s call it France - decided that it needs to substantially increase its minimum wage in order to reduce poverty. The increase is sufficiently large that it leads to a sustained increase in average French wage inflation, which in turn decreases the competitiveness of France relative to the rest of the Eurozone. France cannot be permanently uncompetitive, so the obvious consequence would be that France has to endure a subsequent period in which its relative inflation was below the Eurozone average.

However this would require a period where French unemployment was above its natural rate. French politicians declare that this would be politically unacceptable to French voters. Instead they suggest French inflation should remain at 2%, and the remainder of the Eurozone should increase their inflation rate to 4% for a time (giving an average Eurozone inflation rate of over 3%) to ensure France regains competitiveness. Now this would not normally be possible, because the ECB’s inflation target is 2%. However the influence of France on the ECB is such that the ECB fails to raise interest rates in time to prevent 3% average inflation, and subsequently keeps interest rates low because they repeatedly forecast inflation falling back down to 2% in due course.

The rest of the Eurozone would understandably be upset at having to endure 4% inflation. Some countries might suggest that perhaps, in the absence of ECB action, they could tighten fiscal policy to get their inflation below 4%. However France refuses to countenance changes to agreed fiscal targets, and instead suggests that what is really required is for other countries to adopt a similar increase in the minimum wage to the one originally undertaken in France. The French head of the ECB gives a speech where he intimates that the ECB might be prepared to raise interest rates a little bit in exchange for other countries introducing this ‘structural reform’ to their minimum wage levels. The French government also hints that it might be prepared to allow very limited fiscal contraction outside of France, but only if this took the form of tax increases rather than public expenditure cuts.

Your reaction to this little imaginary story is that it couldn’t possibly happen because other Eurozone countries would not permit it to happen. My suggestion is that Germany rather than France is doing exactly this at the moment, except that in their case it started with a period where German wage inflation was below the Eurozone average (for reasons discussed by Dustmann et al here). [1] German control of the ECB might not be as complete and simple as I imagined French influence in the story above, but it has the advantage that interest rates have hit the zero lower bound, and the threat that anything unconventional could be declared illegal. And in this real world story I too wonder why other Eurozone countries allow Germany to get away with it.

[1] In fact what Germany is doing is worse, because inflation asymmetries and debt deflation mean that the output costs of achieving zero inflation outside Germany to regain non-German competitiveness are far greater than the costs associated with 4% inflation in my story. 

Has Cameron blown the austerity cover?

What I had expected to happen was that the Conservatives would keep to the line that spending had to be reduced because debt and the deficit were too high. The need for austerity because you have borrowed too much was a simple message that everyone understood, even if it didn’t make much sense when applied to a government during a recession. There would be appropriate nudges and winks that, once elected, this tough fiscal line might be modified to make room for tax cuts, but the official line would be ‘debt implies austerity’.

Those who are better informed about the macroeconomics, whether on the right or left, have always understood that this was cover for a desire to shrink the size of the state. However this perspective hardly ever saw the light of day in the media. It is tempting to lapse into conspiracy mode at this point - to believe that the rules of mediamacro are whatever suits a particular set of interests. I suspect this is too simple. For myths to work well they have to be based on half-truths, and they have to obey some internal logic.

So when John Snow berated Ed Miliband for forgetting to talk about the deficit, I think he actually believed that the deficit was this all important constraint that was driving austerity. People understand that when they borrow too much, hard times have to follow. That cornerstone can support many other beliefs. The bank manager who says you must reduce your spending is not popular, but you know he is being responsible. I suspect a great deal of the advantage that the Conservatives enjoy in terms of economic competence in the polls simply comes from this idea (and associating Labour with creating the debt problem). It is difficult to see where else it comes from, with deficit targets missed and stagnant real wages and productivity.

Now that Cameron has promised large tax cuts, does this blow away the cover? Nice if it happened, but unlikely. The Conservative line that only they were prepared to take the debt problem seriously still works. For every person who, as a result of the promised tax cuts, begins to question whether the size of the deficit really was such a major problem, there will be many more that continue to believe it is and will scold the Conservatives for not being responsible enough (but still vote for them).

As a result, I do not think it will change how voters see the past. Looking to the future, on the other hand, it is will be very difficult for Osborne to argue that his future austerity is a painful necessity, and the plans of others dangerously profligate. The retort ‘how come there is room for large tax cuts’ is too strong. If they have any sense Labour will turn the tables. Whereas they have costed all their new commitments, Cameron’s tax cuts are to be paid for by yet unspecified spending cuts (the ‘magic asterisk’). The political danger of the magic asterisk is that it is left to the voter’s imagination to fill them in. If Labour are clever (which may be a big if) they will make appropriate suggestions depending on the audience. Furthermore, interviewers with any self respect will press the Conservatives to outline exactly where ‘the money will come from’ to pay for the tax cuts.

It also lets Labour free of all those questions about the commitments they do have, and whether the country can really afford them. The choice becomes should we spend money on the NHS or on tax cuts, and that I think is ground Labour should be happy to fight on. (There is also the danger that these tax cuts, which mainly benefit the better off, will be viewed in the same way as the cut in the 50p rate.) It is also a more honest debate. Hopefully Labour will spell out exactly how they will achieve their fiscal targets, so that the contrast between their fully costed plans and the Conservative’s uncosted plans will be crystal clear. Add to this the uncertainty created by the proposed EU referendum (see Roger Liddle here reinforcing some of my own thoughts), and perhaps the Conservatives will no longer be seen as the safer pair of hands. (For an example of this train of thought, see these remarks about UK credit ratings.)

For these reasons, I do not think that announcing large tax breaks was always part of the Conservative’s plan. Of course offering tax cuts will gain some votes, but it puts at risk one of their main political assets, which is the perception of future economic responsibility. This in turn may suggest that the Conservatives are far from confident about winning in 2015, as the polls so far have not shown the hoped for pre-election drift to the governing party. Whatever happens, watching how mediamacro develops just got more interesting.   

Disagreements between nations

My recent posts on the Eurozone and German attitudes have attracted a lot of hostile comments, and generated a lively debate. Sometimes I feel the debate is skating on the thin ice of national stereotypes, and occasionally the ice breaks. Some people just plunge straight in! For more debate on the desirability or otherwise of fiscal union, which I hope does not fall into that trap, there is an interesting discussion of various proposals by Yanis Varoufakis and James Galbraith at OpenDemocracy, plus two responses from myself and Frances Coppola.

Another clash between nations is described in Ed Conway’s account of the Bretton Woods summit that created the IMF, World Bank and the post-war international macroeconomic framework that lasted until 1971. I must admit my preconceptions about the impossibility of making macroeconomics fun to read about have been thoroughly shattered over the last year. First there was Tim Harford’s guide to macroeconomics that I talked about here, and now a book about a three week conference discussing macroeconomic institutions and exchange rate regimes that manages to be a great read. Admittedly this particular conference had as it central characters two intriguing individuals: Keynes I knew about of course (although I felt I learnt a lot more here), but Harry Dexter White, the maybe spy, I did not. If you think I’m biased because I’m a macroeconomist, read Peter Preston’s review here.

There are numerous little surprises. I had not realised how, perhaps because of the war, economists were often central in international negotiations. James Meade writes at one point: “Ten years ago at Oxford I should never have dreamed that an economist could live in such a heaven of practical application of real economic analysis!”. Though the detail is fascinating, I was left wondering just how important the conference really was. Although it created both the IMF and World Bank, neither was actually that important in the decade that followed the war, and their eventual roles were rather different from that intended by the Bretton Woods agreement. I also wonder just how much the prosperity and stability of the Bretton Woods era was caused by that agreement.

What I think will surprise many is just how inconceivable an era of floating exchange rates was to those taking part in that conference, Keynes included. Of course the debate over fixed versus floating will never end: some might argue that the demise of Bretton Woods in the early 1970s sowed the seeds of subsequent financial instability, but the current troubles of the Eurozone also remind us of the dangers of fixing exchange rates. One clear impression I got from the book is that when exchange rates are fixed, the creditor nation (or nations) call the shots. This was evident in the asymmetric influence of White versus Keynes in their various negotiations, and it helped me understand more clearly just why the influence of Germany is so strong within the Eurozone right now.

Why uncosted tax cuts are apparently a problem for Labour

Just a short addition to today’s post. I had assumed that the Conservatives’ macroeconomic pitch for the next election was going to be based on prudence and ‘responsibility’. Only we will achieve a budget surplus by 2020, because only we recognise how dangerously high the current level of government debt is. We will achieve this, because unlike the other parties we do not go around making unfunded spending commitments. Of course the Conservatives would plan targeted tax breaks for the (very) well off, like the one on pensions announced earlier this week and well described by the Economist here, but these would be sufficiently specialised that they would not dent the public image.

I was wrong, as Cameron revealed today with commitments to large tax cuts mainly for middle and high income earners by 2020 whatever. These commitments are totally unfunded, in the sense that we are not told how they would be paid for (except that it will not be by additional borrowing). So the pretence that government spending had to be cut to get debt down has gone - we now have lower government spending (which, given existing commitments, has to mean additional money from the working poor and disabled) in order to cut taxes.

I mentioned last week the drubbing the supposedly left leaning Channel 4 news gave Ed Miliband because he forgot to mention the deficit. As anticipated, John Snow’s interview with Cameron was an altogether more friendly affair. But today their economics editor Paul Mason, whose journalism can be very good, was forced to acknowledge that this unfunded tax give away broke from the recent tradition where particular fiscal pledges were fully costed. But no fear, even Mr. Mason lives in mediamacro land. His final thought on this unfunded tax pledge - it puts Labour in a very difficult position!?! Unbelievable.

  

How many UK elections can a nasty party win?

This last month I wrote my most widely read post in this blog’s nearly three years existence. Over 20,000 read this on Scottish independence. Yet I wrote that post with some regret, because I was acting as the typical economist killjoy. I had a lot of sympathy behind much of the support for the Yes campaign, which was to avoid being governed by a fairly extreme right wing party. I hope no one ever writes that the No vote was a victory for David Cameron’s Conservatives, because that would be a truly Orwellian distortion of reality. One of the most telling contrasts for me was Gordon Brown’s impassioned speech for the union compared to Cameron’s opportunistic attempt to appease his own MPs the morning after the result.

A post I have no regrets writing is this about Theresa May’s one time concern about the Conservative party being seen as the ‘nasty party’. Everything in the months since I wrote it, including the current party conference, confirms that this image no longer worries the leadership. The puzzle I raised in that post is why as late as 2010 Cameron was still keen to foster the idea of a more compassionate conservatism. What has changed so completely in just four years?

One answer is UKIP. Yet trying to prevent losses to another party of the right should not alter the traditional logic that a party needs to occupy the centre to win an election. Another answer is the recession, which has perhaps led to a hardening of attitudes among the electorate as a whole. The hypothesis is that in a recession people are more inclined to believe those on welfare are scroungers, and that immigrants steal their jobs. This hardening should reverse as the economy recovers, but we also know that real wages are still likely to be lower in 2015 compared to 2010.

That was where I ended that previous post. I wrote “although nastiness might accord with voter sentiments today, at some point in the future voters in more generous times will have no problem forgetting this, and just remembering the Conservatives as the nasty party.” But in writing this I might have been both unfair to the British electorate and to the strategy of the Conservative party.

To see why, take a temporary detour from welfare to macro. Chris Dillow rightly questioned the “groupthink bubble” that sees George Osborne’s stewardship of the economy as the Conservative’s strongest card. Yet those in the bubble could respond that they were simply reflecting what the public appear to be saying in the polls. The problem here is establishing cause and effect. What I call mediamacro believes that the last Labour government seriously mismanaged the public finances, when in reality its sins were relatively minor. Mediamacro thinks that the deficit somehow helped cause the recession, whereas in reality the causality goes the other way. Mediamacro thinks that the deficit is the most important problem of today, and largely ignores the stagnation of productivity. Mediamacro celebrates the 2013 recovery as vindicating austerity, which is an argument only the most politically committed academic economist would endorse.

So why do those answering polls think the Conservatives are more competent at managing the economy? It can hardly be because of their own experience, with real wages falling since 2010 compared to steady increases before then. While they might think that Labour allowed excessive leverage by UK banks which helped cause the recession, they are unlikely to also believe that the Conservatives were urging much greater caution at the time! Or could it be that their answers about competence are influenced by what mediamacro itself believes?

If there is this huge disconnect between reality and media portrayal for the macroeconomy, could the same thing be happening with attitudes to welfare? There is no doubt that the representation of disability in the print media has changed substantially over the last decade or so. Television has, after a lag, followed this trend. There is scant evidence that this reflects any significant change in the degree of benefit fraud. It could reflect a ‘hardening of attitudes’ as a result of the recession, but causality could also run the other way. Do people vastly overestimate the amount of benefit fraud because they want to do so, or because of the information they get through the media? Is this overestimation a reflection of a recession induced hardening of attitudes, or a cause of it?

This is crucial to answering the question posed in the title to this post. If squeezing the poor and disabled is a policy that reflects a recession induced change in public attitudes, then the party that follows this change may be vulnerable when the recession ends (although perhaps not before 2015). If it reflects misinformation provided by the media, then the relevant question is whether this misinformation might continue well beyond the economic recovery. If it does, the Conservative party may have a much more durable election strategy. 

The entirely predictable recession

Sometimes when I write about the Eurozone, I get comments about how inappropriate it is to apply ‘an anglo-saxon model’ of how that economy works. I think the best translation of ‘anglo-saxon’ is Keynesian. In an important sense this is rubbish. All I am doing is using the framework that is used by most applied macromodellers everywhere. That framework says that if you have a large fiscal contraction like this

Underlying Government Primary Balances: source OECD Economic Outlook

without a large compensating relaxation in monetary policy, then you will get the stagnation in output that I showed at the top of this post, and a substantial increase in unemployment.

Can this scale of fiscal contraction in itself fully account for the second Eurozone recession? There are various ways of answering this question: see, for example, this work by Jordà and Taylor, or the analysis by Holland and Portes that uses a structural econometric model. A very recent paper (available here) by Ansgar Rannenberg, Christian Schoder and Jan Strasky does something different. It uses modified versions of three different DSGE models to analyse the impact of the Eurozone fiscal contraction from 2011 to 2013. One of these models is QUEST III at the European Commission, which Jan in‘t Veld used in analysis I described here. The other two are FiMod, developed by staff of the Deutsche Bundesbank and the Banco de Espana, and NAWM, the ECB’s New Area Wide Model. All very ‘anglo-saxon’!

The modifications the authors make to the models, and the details of their analysis, would probably only be of interest to inveterate macromodellers like me, so those who want to know more should read the paper. Here I will just quote the key conclusions:

“We find that fiscal consolidation caused a cumulative GDP loss of between 14% and 20% of annual baseline GDP over the 2011 to 2013 period in the Euro Area [EA], implying a cumulative multiplier between 1.5 and 2.2.” and “As a result, the simulated GDP effects of the EA’s fiscal consolidation are large, and would be more than sufficient to explain the recent recession in the EA.”

The idea that a large fiscal contraction shortly after a huge financial crisis would lead to a second recession is not the wild imagining of a group of ‘anglo-saxon’ economists, or a particular macroeconomic ‘school of thought’. It is just mainstream macroeconomics. And we must never forget that this is not the unfortunate cost of having to get debt down in a few periphery countries: as the chart above shows, this fiscal contraction occurred everywhere in the Eurozone. As the simulations described in this link (pdf) show, using the Belgian NIME model, these costs could have been largely avoided if the fiscal consolidation had been delayed until monetary policy was in a position to offset them. It is not just a predictable recession; it is a recession made by policymakers without good cause and therefore an entirely avoidable recession.

More mediamacro

What was the most important point about Ed Miliband’s speech to the last Labour party conference before the election? The UK media had no doubt. It was that he forgot to mention the deficit. No matter that Ed Balls had spent much of his previous day’s speech laying out their policy on the deficit, which has been intelligently discussed by the IFS and others. Miliband had in his speech forgotten the paragraph where he says how important the deficit is, and he was going to be taken to the cleaners for it.

I’m not just talking about the right wing press here. Channel 4 news likes to think of itself as being a little more highbrow than other news programmes, and I’ve no doubt that conservatives would describe it as left wing. So here is a link to John Snow’s interview with Miliband yesterday (skip intro and question on middle east to about 3 minutes in). He asks Miliband what the greatest issue facing the next British government is. Miliband responds that it is getting the country to work for most working people rather than be stuck with a more unequal country. Interesting answer, but inequality is not an issue mediamacro recognises. It was a trick question. Now that is twice that you have forgotten to mention the deficit, responds Snow. How could you not mention paying off this appalling deficit? Snow continues. Surely it is the most important issue of all. It is the essence of our economic crisis. And so on.

Now my point here is not about bias, and how this interview could have been scripted by George Osborne. It is about the banality of it all. If you are going to talk about the deficit, ask some real questions about the differences between Labour and Conservative plans. Ask why Labour thinks that debt should not come down more rapidly. There are lots of meaningful questions you could ask. But trying to make a great issue out of a forgotten part of a speech is just silly. It is gotcha journalism for those who get their economics from listening to political commentators. The implication that the deficit is all important, and linking it in a causal way to the recession, is mediamacro at its worst.

What is the really important thing that has happened in the UK economy over the last six years? It is not that the deficit went up and then has started coming down. It is that UK productivity has stalled, and as a result real wages are lower than when the recession began. That is what really matters. That is not a ‘political judgement’; it is what most economists and most ‘ordinary people’ will tell you. But not in mediamacro land. So when Cameron gives his speech to the Conservative party conference, and does not mention this terrible productivity performance, I doubt if one single journalist will even bother to ask why that was not in his speech. This is journalism at its most pathetic.