Competitiveness: some basic macroeconomics of monetary unions

From comments on an earlier post, it is clear how many people do not understand how a monetary union works. Thinking about it, I also realise that while the macroeconomics involved is entirely straightforward and uncontentious, it may only be obvious to someone who is used to working with models. As I do not want to restrict my readership to those with such knowledge, I thought a brief primer might be useful.

We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. This is what economists might call a basic neutrality proposition, and there is plenty of evidence to support it. The Eurozone as a whole is like a flexible exchange rate economy. So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.

So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. If Germany makes up a third of the monetary union, then overall EZ prices and wages will fall by 1%. Given the logic in the previous paragraph, the Euro will appreciate by 1%. That means that Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world.

That may seem complicated, but to a first approximation it is in fact very simple. The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. For the union as a whole, it is what economists call a zero sum game. Germany gains, but its EZ neighbours lose.

One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. An idea sometimes expressed that it represents healthy competition is wide of the mark. The only incentive it provides is for other countries to try and emulate this behaviour. If they all achieved that, nothing would be gained. The Eurozone inflation rate would, other things being equal, be lower, but other things would not be equal: the ECB would cut rates to try and get inflation back to its target.

The reason there are no formal rules about all this is straightforward: you cannot legislate about national inflation rates. What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it. Once again, this is a symmetrical case to what should have happened in the periphery countries. But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.

Flooding and the fiscal charter

We now know that at least one of the flood prevention schemes that was axed when spending was first cut back in 2011 was in one of the areas of the recent flooding. It always angers me when journalists of a right wing persuasion argue that the the public has not noticed any effect from austerity under the coalition. As if increasingly missed NHS targets and crises in A&E do not count, because NHS funding has been ‘protected’. In the case of flooding earlier disasters may not have been connected to austerity because hardly anyone in the media made those connections.

My impression is that the media has been a bit more inquisitive this time around. For example the BBC’s Newsnight showed a chart of actual spending, revealing clearly the cut backs from 2011. Their subsequent interview with Neil Parish, now Conservative chair of the Environment and Rural Affairs select committee, was interesting. He suggested that maybe we (his government) should be spending more money on flood defences. The reason he gave was, to an economist, compelling: the estimated rate of return on such projects is very high.

Yet this kind of logic is completely anathema to the framework in George Osborne’s fiscal charter. This has an overall budget surplus target, which includes spending on public investment. As a result, if a strong investment opportunity like this arises, it can only be funded by cutting back on other items of public expenditure, which is always politically difficult.

Ministers argue that over the next five years capital investment in flood prevention has been ‘protected’ in real terms. With the impact of climate change on extreme weather events becoming increasingly apparent, that is completely the wrong reference point. We should be substantially increasing spending on flood defences, and those schemes should not be built to specifications that are based on past weather patterns. That kind of flexible response to recent disasters is all but ruled out by the fiscal charter.

Defining austerity

In my recent talk in Dublin, I defined fiscal austerity in a way that is not generally applied, but which I think makes sense. The most common usage is simply an attempt to reduce the budget deficit by cutting spending or raising taxes. The problem with that, as I remember Nick Rowe complaining, is that it becomes identical to the term fiscal consolidation. We could say that austerity is just lots of fiscal consolidation, but that seems weak.

Common usage tends to assume that austerity does some harm: not just to the individuals affected by any cuts or tax increases but for the economy as a whole. Indeed if you look at what google says when you ask for a definition, we get:

“difficult economic conditions created by government measures to reduce public expenditure”

That is different from fiscal consolidation, because consolidation in itself need not lead to ‘difficult economic conditions’. If fiscal consolidation is offset by monetary expansion, there is no reason for the economy as a whole to experience any difficulties.

What I suggest is making this definition a little more precise. I want to define austerity as

“fiscal consolidation that leads to a significant increase in involuntary unemployment, or perhaps more formally but less colloquially as leading to a noticeably more negative output gap.”

If you think this is what most economists mean in practice, I would agree. But they do not always define it this way, even when they should know better. In addition, under my definition the term ‘expansionary austerity’ would make no logical sense, but the term is widely used. Last and probably least, Wikipedia define it as fiscal consolidation rather than the way I suggest.

The advantage of my definition is that I am able to make two clear statements. First, for the global economy or for an economy with its own central bank and floating exchange rate, austerity is generally completely unnecessary, because fiscal consolidation can be delayed until a time when monetary policy is capable of offsetting it. This means that austerity could have been completely avoided over the last five years in the UK, US and the Euro area as a whole. Second, for a member of a monetary union which requires more fiscal consolidation than union members on average, austerity will follow fiscal consolidation, but only to the extent that it enables the internal devaluation necessary to bring about the real depreciation required to offset that consolidation. Austerity will only be limited in this way if the union’s central bank follows appropriate policies. It seems highly likely that excessive austerity occurred in the Eurozone periphery because the ECB delayed introducing these appropriate policies.

To see me give chapter and verse justifying these statements, you will have to wait until I write up the paper!

UK flooding, austerity and the media

UK flooding again tops the news, and I’m reminded of a series of posts I wrote after Christmas 2013. The first showed how austerity led to a sharp cut back on flood prevention. The second pointed out that the consensus was that spending on flood prevention should be rising because of climate change, but the environment minister was a climate skeptic. The third noted how the government had managed to deflect any significant criticism until now, but I thought surely that cannot last. At the time it became one of my most widely read posts, but when the government thereafter continued to avoid serious criticism except for a handful of articles I realised how weak our media had become in holding the government to account.

I have no idea if any of the most recent floods can be directly connected to the post 2010 cuts, but that is not how these things work. We cannot prove that each of these severe weather episodes are linked to climate change, but we work with probabilities. Unfortunately the media find it hard doing the same.

Here is the time series for spending that I found in the House of Commons library.

The impact of austerity is clear, but by including spending already committed in 2010/11 and choosing the right dates ministers managed to get away with saying that spending had not fallen on their watch. Anyone with these figures could have blown that cover, but I hardly saw this chart anywhere else in the media. Equally almost no one picked up on the fact that spending should have been on a rising trend because of climate change, and linked that to the views of the then environment minister.

Until then I had thought that the government had got away with austerity partly because the impact of the cuts had not been very visible. Flooding was highly visible, yet the links with austerity were completely absent from the media beyond the Guardian and FT. So, in that rather negative sense, this episode became an education for me. An education the public was denied.