Germany: Too Much Virtue Is A Sin

On 30 October the Office of International Affairs of the US Treasury issued its customary semi-annual Report to Congress on “International Economic and Exchange Rate Policies”, in consultation with the Fed’s Board of Governors and IMF management and staff. The Report usually concentrates on China bashing for the undervaluation of the renmimbi, and this time is no exception: “The RMB is appreciating on a trade-weighted basis [by 6.6% on a real effective basis], but not as fast or by as much as is needed [an additional 5-10%]”. But the Report in addition vigorously criticizes Germany for its record trade surplus, which is regarded as a brake on the recovery of the Eurozone countries that experience a corresponding trade deficit and on global growth.

Among the Report’s Key Findings (p.3):

“Within the euro area, countries with large and persistent surpluses need to take action to boost domestic demand growth and shrink their surpluses. Germany has maintained a large current account surplus throughout the euro area financial crisis, and in 2012, Germany’s nominal current account surplus was larger than that of China. Germany’s anemic pace of domestic demand growth and dependence on exports have hampered rebalancing at a time when many other euro-area countries have been under severe pressure to curb demand and compress imports in order to promote adjustment. The net result has been a deflationary bias for the euro area, as well as for the world economy.”

The main text of the report develops this proposition further: much of the decline in global current account imbalances that occurred in recent years reflects a demand contraction in deficit countries rather than strong domestic demand growth in current account surplus countries. Germany in particular has continued to run a very large and persistent surplus, raising the eurozone's overall current account, which was close to balance in 2009-2011, to a surplus of 2.3 percent of GDP in the first half of 2013. “Germany’s current account surplus rose above 7 percent in the first half of 2013, while the current account surplus for the Netherlands was almost 10 percent. Ireland, Italy, Portugal and Spain are all now running current account surpluses as import demand in those economies has declined. Thus, the burden of adjustment is being disproportionately placed on peripheral European countries, exacerbating extremely high unemployment, especially among youth in these countries, while Europe’s overall adjustment is essentially premised on demand emanating from outside of Europe rather than addressing the shortfalls in demand that exist within Europe.”

The section on the Euroarea emphasises the point: “Expansion was supported by domestic demand growth in Germany - though growth in Germany still continues to rely on positive net exports, which continues to delay the euro area’s external adjustment process – and on domestic demand in France.”

Nobody can argue with such propositions, which are based on a correct interpretation of well established facts, and are not at all new. The adoption by Germany of more expansionary policies has been advocated by many economists, from Martin Wolf (FT) to Paul Krugman (Those Depressing Germans, NYT 3 November 2013), from Jean Pisani-Ferry (Bruegel) to Mario Seminerio (La Cura Letale, Rome, 2012), to the IMF Managing Director Christine Lagarde as well as several IMF documents. What is extraordinary is that the criticism should come from the US government and from research circles before it is raised by the European Commission. 

EC practice suffers from a totally arbitrary and unwarranted asymmetry in treating surpluses and deficit countries: a current account deficit of 4% of GDP triggers off a disciplinary procedure for the offending country, while a 6% surplus averaged over three years is necessary before the EC takes any notice of that imbalance, and even then only perfunctorily. In 2012 Germany recorded a 7% record surplus but the three year average was just under 6% and nothing was said.

This is a general problem that Maynard Keynes had tried to address at the Bretton Woods Conference (1944). His Plan assigned to every country a “bancor” maximum overdraft facility equal to its average trade over five years; a penalty interest rate of 10% would apply to deficit countries above that limit, as well as to surplus countries on anything over and above any surplus exceeding the size of the permitted overdraft by more than a half, forcing compensatory exchange rate adjustments or capital flows, and subject to confiscation of residual excess reserves above the permitted surplus at the end of the year. “Nothing so imaginative and so ambitious had ever been discussed", commented Lionel Robbins. But the US was then the world’s biggest creditor and the Plan by the US representative Harry Webster White was preferred by the 42 countries attending the Conference. The burden of balancing trade was placed on deficit countries and no limit was set on surplus countries, thus necessarily impressing a deflationary bias on the nature of trade adjustments. The replication of this approach by the European Union is one of the many EU original sins. 

There is a well known tenet of Keynesian economics, resulting from national income accounting and not at all dependent on the validity of Keynesian fiscal policies, and therefore unchallenged: the excess of exports X over imports M, plus the excess of government expenditure E over taxation T, plus the excess of private investment I over savings S, must necessarily add up to zero. Thus a country experiencing a trade deficit must necessarily run a government deficit and/or a compensatory excess of investment over savings, hard to accomplish in the face of an otherwise shrinking demand. In other words, the German trade surplus makes it all that much harder for its deficit trade partners to balance their public accounts.

On 2 November the Economist’s Charlemagne column Fawlty Europe commented on “Germany’s obsession with competitiveness”… “For Germany booming exports are the measure of economic virility.” It is true that Germany is reaping the benefits of wage and price reductions (the internal devaluation) undertaken before the crisis; in the middle of the crisis any country adopting the same policy would pay the price of worsening that crisis. Germany also benefits from earlier structural reforms politically hard to replicate, and from the relatively price-inelastic demand for its high technology exports. But surplus countries like Germany, the Netherland and Austria are also benefiting from an artificially low exchange rate, with respect to the increasingly stronger exchange rate that would prevail if those countries were using their own currency instead of the euro. And, be that as it may, by holding down wages and failing to promote investment and growth they make trade adjustment in Italy, Spain, Ireland, Portugal and Greece – which has occurred – deflationary. Debtor nations were forced, mostly under German pressure, into austerity eliminating trade deficits at the cost of perversely rising debt/GDP ratios (see our earlier post on the subject), while German surpluses persisted and their failure to adjust magnified the costs of austerity and contributed to keep the world economy depressed.

Charlemagne notes that Germany has also benefited from straight protectionism, having failed to liberalise its construction and services.  While these sectors are not a significant share of German exports, a recent OECD study stresses that in general services have a much bigger impact on trade and trade competitiveness if we look at their inputs actually embodied in exports, i.e. adopting a Value Added approach to trade accounting. Charlemagne also recommends too that Germany could do more to invest in education and infrastructure, and make child care available for working women. 

Moreover German energy-intensive producers are benefiting from an implicit subsidy on their electricity consumption, through exemption from the expensive surcharge used to finance Energiewende, the accelerated introduction of renewable energy scheduled to reach 35% by 2020 and 80% by 2050. Earlier this year European Energy Commissioner Günther Oettinger told a group of industry leaders that the price concessions for energy-intensive companies in Germany clearly amount to “inadmissible” subsidy levels. German business are concerned that they might have to repay hundreds of millions of euros to the German government.

Only on 13 November did Jose’ Manuel Barroso, the EU President, announce an “in depth analysis on the high German trade surplus”, with a view to understand whether Germany can make a larger contribution to the re-balancing of the European economy”. There is the prospect of a continued trade surplus of 7% in 2013, and the upwards revision of the 2012 trade surplus brings already the three year average above 6% in 2010-2012. Indeed “Following statistical revisions, the indicator has exceeded the threshold each year since 2007” and “the surplus is expected to remain above the indicative threshold over the forecast horizon, thus suggesting that it is not a short lived cyclical phenomenon” (EC 2013). German savings exceed investment, and despite boasting the second lowest share of private sector debt in GDP (firms and households) and low interest rates, private sector de-leveraging has continued, failing to boost demand; capital formation has declined last year. This calls for some action, not least to reduce the pressure for euro revaluation. But the bottom line of the EC document is simply that “Overall, the Commission finds it useful to conduct an in-depth analysis with a view to assessing whether imbalances exist” (italics in the original). This is a grotesque existential problem: what additional evidence is needed to establish that an imbalance exists, other than the imbalance itself?

German press and politicians have reacted to the US Treasury accusations and to the EC initiative with a combination of denials, hubris and cries of victimisation. The German Economics Ministry issued a strongly worded statement, saying that Germany's surplus is "a sign of the competitiveness of the German economy and global demand for quality products from Germany." It dismissed the accusations as “incomprehensible” and challenged the US to "analyze its own economic situation."

A memo to finance minister Schäuble reads: "The German current account surplus offers no reason for concern for Germany, the euro zone or the world economy"; Berlin is pursuing a course of "growth-friendly consolidation," and there are no imbalances "that would require a correction of our economic and fiscal policy." See also “Complaints about German Exports Unfounded”, by Jung-Reiermann-Schmitz,Spiegel.de 5 November, and “Raw Nerve: Germany Seethes at US Economic Criticism” by Alessi, Spiegel.de 31 October.

It has been pointed out that the prospective new grand coalition between the CDU, its Bavarian sister party, the Christian Social Union (CSU), and the Social Democratic Party (SPD) has already agreed to increase government investment and the minimum wage, both of which should stimulate domestic demand.  But the formation of that government – let alone its programme – is still under negotiation.

The real issue is an EU governance deficit. The worst thing that could happen to Germany as a result of an adverse “in depth analysis” by the Commission is a reprimand by Marco Buti's Directorate-General for Economic and Financial Affairs. No comment seems necessary.

Winter chill in Hungary

Note: This is a guest post contributed by Yudit Kiss, a Hungarian economist based in Geneva, author of several academic publications dealing with the post-Cold War economic transformations of Central Europe. Her articles of wider interest have been published by the Guardian, Lettre International, El Nacional, Nexos, Gazeta Wyborcza & Eurozine.

The only electoral promise Fidesz has fulfilled has been the “restoration of order”, through a myriad of laws, decrees and regulations, a particularly harsh new Penal Code and several new organizations.

On October 23, Hungary commemorated the anniversary of the 1956 revolution, but few Hungarians had cause to celebrate except the ruling Fidesz party, which is eagerly looking forward to next spring’s parliamentary elections.

Fidesz has learned the lessons of its previous spell in power, when in 2002 general disenchantment with its performance lost it the elections. Back in power since 2010, all measures have been taken to avoid a similar defeat. The Fidesz–led government granted voting rights to Hungarian minorities living abroad, changed the election system, redesigned electoral districts, eliminated checks and balances built over the past two decades, reshaped the juridical system and has gained nearly full control over the media and all state institutions.

In addition to a tax system that favours the rich, economic assets from land to productive capacities and infrastructure have been re-distributed to create a new class of loyal, privileged crony capitalists (and large and growing numbers of the poor and very poor). By extending state control over key companies, expropriating the private pension funds and recently, the Savings Cooperatives, by channeling EU money and using the economy’s remaining reserves, the government is able to lavishly finance its own projects and distribute money to its clients through public procurement policies. A recent Transparency International report describes a “state captured by private interest groups”.[i]The government can also finance large-scale publicity campaigns to convince citizens that it acts relentlessly on their behalf, from “defending the country’s independence” to artificial lowering of utility charges.

The economy is at a standstill, with the bulk of investments financed from EU funds. Unemployment is officially close to 10%. Half of those without work are long-term unemployed, and joblessness among youth is nearly 30%. The government’s “solution” to a stagnating labour market has been an expensive and inefficient “public work” system in which job-seekers are employed by (predominantly Fidesz-led) local authorities and compelled to accept whatever work is offered them, often in primitive conditions at less than the official minimum wage.

In September the Statistical Office reported that 3.2 million persons, nearly 33% of the population, live in poverty, including half a million in deep poverty and deprivation.[ii] The drastic reduction of unemployment assistance, welfare benefits and social services, coupled with punitive measures against the poor, homeless and marginalized make their situation desperate. 70% of the country’s approximately 700,000 Gypsies, who under the former system at least had work but have now been brutally expelled from the labour market, live in abject poverty.[iii]

The only electoral promise Fidesz has fulfilled has been the “restoration of order”, through a myriad of laws, decrees and regulations, a particularly harsh new Penal Code and several new organizations, like well-equipped special anti-terrorist units, fancily dressed Parliamentary Guards to discipline MPs, special bodies to supervise public workers and even a school police force with rights to control and search school-age kids.

Through a complex system of regulations, economic pressure, intimidation, propaganda and hand-outs the government has extended its control over its citizens’ life from the cradle to the grave, from economics through the education system to artistic creation, including the private sphere, with measures that spread from encouraging marriage and child birth to the reform of state funeral services, going as far as authorizing itself to spy on state employees and their families.

Each of these measures has chilling details that reveal the nature of the system. Teachers, whose work conditions have significantly worsened, have to join a government-created ‘National Teachers’ Body’ and are expected to sign an ‘Ethical Code’ created by it; youngsters can risk two years of prison if they share a joint at a school party; the poor are offered a “social burial” - an (initially) free site in a separated section of the cemeteries, with uniform graves fabricated by prisoners - provided they bury their dead themselves.

Protest, dissent and criticism are actively discouraged, neglected or dealt with by one of Fidesz’ basic methods of governing: ‘divide et impera’. The government’s outspoken critics come under virulent, orchestrated attacks. Criticism abroad – including from the EU institutions in Brussels - is dismissed as “unfounded” or ‘fuelled by international capital and business’ or by the internal opposition that “betrays” the fatherland. And if all this were not enough to secure a next mandate, the government has less elegant methods. In a recent municipal election in Baja, Roma families were paid and driven to the ballot box to cast their vote for Fidesz. (Some over-zealous opposition activists forged a video to “prove” the fraud - when they were caught, Fidesz was able to turn the whole affair to its advantage.)

Nevertheless, Fidesz probably wouldn’t need to use its heavy weaponry, since its opposition is pathetically weak and divided. The ‘Együtt 2014’ (Together 2014) electoral platform that evoked high hopes when it was founded a year ago has failed to come out with a convincing alternative vision for the country. But even if the opposition miraculously pulls itself together to win next Spring’s elections, the new government’s hands would be tied by Fidesz legislation and Fidesz appointees who occupy all key state positions, from the juridical system to media supervision, with long mandates stretching over election cycles. The case of Esztergom, where since 2010 the Fidesz-dominated city government has paralyzed the whole city to obstruct an independent mayor, is a sinister foreboding.

According to recent polls[iv], the large majority of the population believes that things are bad and will deteriorate further in Hungary. However, 42% of potential voters don’t know who to vote for and probably won’t participate in the next elections. Absenteeism mixed with massive disappointment in mainstream political forces is a dangerous cocktail, like the advance of the far right in Europe shows. Jobbik, the Hungarian party of the extreme right, is looking confidently forward to next Spring, like Fidesz. At present 26% of potential voters would vote for Fidesz - enough for them to win the elections and have again an overwhelming majority in Parliament, thanks to the electoral system they’ve installed.

This year’s commemoration of the 1956 revolution and its aftermath played out the worst-case scenario for the coming election year. Prime Minister Victor Orban used the national holiday as his Party’s first electoral rally, greeting the “spontaneous” masses of the “Peace March” (organized and sponsored by loyal Fidesz supporters) from a platform decorated with a sea of national flags and surrounded with armed soldiers. His speech was a violent call for battle against the country’s external (‘colonizers, speculators and international financiers’) and internal enemies (former, present and would-be “Communists”, including their “comrade”, ‘tavarish’ Tavares) ‘who sold the country’ and ‘would shoot at us today …if they could’. [v]

In front of the building of the Technical University, where the first student rally that set in motion the mass protest movement in October 1956 started, a large crowd of opposition supporters gathered hoping to revive hope in a free and democratic country – the real message of 1956. Instead of the so much needed demonstration of unity, the event turned into a disheartening manifestation of division and in-fights in the ranks of the various opposition formations that has been going on since. The day after the national holiday, a government official and media close to Fidesz launched yet another attack against the philosopher Agnes Heller, who dared to criticize the government in an interview with Swedish television.

A couple of days later a government-backed march was held all over the country to demand autonomy for Sekler’s Land (a part of Transylvania with a large Hungarian population that belonged to pre-WW1 Hungary) organized by a civil society organization and some of the Peace March organizers. By the end of the week, a bronze statue of Admiral Miklós Horthy[vi], a former ally of Hitler, the leader of Hungary between 1920 and 1944, was unveiled at the entry of a Reformed Church located in the centre of Budapest, by the Church Minister, well-known for his extreme-right views and by the same Jobbik MP who some months ago demanded the listing of Jewish members of Parliament. In his first reaction, the Fidesz mayor of the district only managed to regret the fact that this provocation might fuel further ”anti-Hungarian” criticism in western “leftist” media. 

This is a rather pernicious preview of a possible future for the country. Hopefully it will serve as a wake-up call for those who want to live in a different Hungary.

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[i] http://www.transparency.hu/National_integrtity_study

[ii] http://www.ksh.hu/docs/hun/xftp/idoszaki/laekindikator/laekindikator12.pdf

[iii] http://www.romadecade.org/cms/upload/file/9270_file9_hu_civil-society-monitoring-report_hu.pdf; http
[iv] http://hvg.hu/itthon/20131017_Ipsos_nott_az_ellenzek_tabora  & http://median.hu/object.aa1da5a0-e054-4ffb-8e6f-784e318108e1.ivy
[v] http://www.kormany.hu/hu/miniszterelnokseg/miniszterelnok/beszedek-publikaciok-interjuk/a-nagysag-dicsoseget-hagytak-orokul-1956-hosei
[vi] http://hungarianspectrum.wordpress.com/2013/11/05/political-controversy-over-the-role-of-regent-miklos-horthy-1920-1944/

Perverse Fiscal Consolidation

Between 2011-2013 IMF documents and research papers have revised upwards earlier estimates of fiscal multipliers, which throughout 1970-2009 were assumed by the IMF and other international organisations to be on average about 0.5 for advanced countries (Blanchard and Leigh 2012, 2013, Batini et al. 2012, Cottarelli and Jaramillo 2012 and other researchers associated with the IMF).

The upward revision applies from 2010 and was justified by: the ineffectiveness of countervailing monetary expansion close to the zero floor of the interest rate, lack of opportunities for exchange rate devaluation especially in the Euroarea, by a large gap between potential and actual income (for fiscal multipliers are higher in a downturn than in a boom); and by simultaneous recent consolidation across countries.  Moreover, the fiscal multiplier for expenditure cuts – contrary to earlier claims - turns out to be much (up to ten times) higher than for tax rises.

This means that fiscal consolidation is more expensive in terms of output loss than previously believed.  But there is worse: the higher are fiscal multipliers, the higher is the probability that fiscal consolidation will have the perverse effect of actually raising the Public Debt/GDP ratio. 

Namely:  a fiscal consolidation (tax increases plus government expenditure cuts) will always necessarily result in an increase instead of a decrease of the Public Debt/GDP ratio, with respect to what that ratio would have been in the absence of fiscal consolidation, as long as the fiscal multiplier – or more precisely the weighted average of fiscal multipliers applicable to the composition of the fiscal package – is greater than the inverse of the country’s Public Debt/GDP ratio. Thus in such circumstances fiscal consolidation, contrary to received wisdom, will make Public Debt more rather than less costly to re-finance, and therefore less instead of more sustainable. In plain words, fiscal consolidation works only in those countries that, having a sufficiently low Public Debt/ratio, do not actually need a consolidation.

Here is the proof. Given D=Public Debt, Y=GDP, d=D/Y, x=the size of fiscal consolidation (tax rises plus expenditure cuts of given composition) expressed as a share of GDP, 

ΔD=-xY

ΔY= -mxY

where m is the appropriate fiscal multiplier,

Δ(D/Y) = [(ΔD)Y – (ΔY)D]/Y² = 

= [(-xY)Y – (-mxY)D]/Y²

= -x Y²/Y² + mxY D/Y² =

= -x + mxD/Y = mxd – x  and therefore                 

Δ(D/Y) = x(md – 1) = xd(m – 1/d)

from which we can see that the ratio D/Y must increase,
i.e. Δ(D/Y) >0,  if and only if m>1/d.  Q.E.D.

The interest of this proposition is in the fact that the inverse of the D/Y ratio is naturally all the smaller the more heavily indebted a country is, and particularly small with respect to the kind of fiscal multipliers estimates that have been produced in recent literature (such as Blanchard and Leigh 2012, 2013, Batini et al. 2012, Cottarelli and Jaramillo 2012 and other researchers associated with the IMF). Thus the counterproductive nature of fiscal consolidation in advanced economies, especially in highly indebted countries with high fiscal multipliers, is an absolute certainty.   

Figure 1. Illustration of perverse fiscal consolidation raising the Public Debt/GDP ratio (CLICK TO ENLARGE): Δ(D/Y) >0 for plausible values of m and as an increasing function of D/Y. 

The figure above (for which I am indebted to my colleague Marilena Giannetti) illustrates the impact of a fiscal stabilisation package of 5% of GDP, relatively modest by the standards of the current crisis, on the Public Debt/GDP ratio, Δ(D/Y)= x(md – 1), as a function of the current d=D/Y ranging from 50% to over 200% of GDP and for alternative values of fiscal multipliers ranging from 0.5 to 3.5.  At high D/Y ratios and relatively high multipliers still within the range estimated by recent IMF sources, the rise in D/Y can be devastating. 

By way of example, a country with d=1.20, m=3, undertaking a stabilisation of x=5%, would raise its d by 0.05*(1.20*3-1)=13% of GDP, from 1.20 to 1.33.  In a country like Japan, for a Public Debt at over 200% of GDP, a fiscal consolidation package of 5% would lead to an increase of the Public Debt/GDP ratio of the order of 30% of GDP. For a perverse effect of fiscal consolidation on such a massive scale the claim that “The short-term effects of fiscal policy on economic activity are only one of the many factors that need to be considered in determining the appropriate pace of fiscal consolidation for any single economy” (Blanchard and Leigh, 2013, p.6) is facile and disingenuous. Such a regime switch cannot be ignored.

Table 1. Threshold of the fiscal multiplier over which fiscal consolidation necessarily leads to higher Public Debt/GDP ratio for selected countries (calculated as the GDP/Public Debt ratio, from the data estimated by US-CIA, The World Factbook, 2013, for 2012), ranked by increasing value of the multiplier threshold.

Country    Public Debt/GDP      GDP/Public Debt

Japan            214.3                        0.47
Greece          161.3                        0.62
Ireland          118.0                        0.84
Italy              126.1                        0.79
France             89.9                        1.11
UK                  88.7                        1.13
Spain              85.3                        1.17
Germany         81.7                        1.22
Hungary          78.6                        1.27
Austria            74.6                        1.34
US                  73.6                        1.36
Netherland       68.7                       1.45
World  average 64.0                       1.56
Albania            60.6                       1.65
Poland             53.8                       1.85
Finland            53.5                       1.87
Slovakia          48.6                       2.06
Czechoslovakia 43.9                       2.21
Denmark         45.3                        2.21
Sweden           38.6                        2.56
Romania          37.2                        2.69

We have seen above that before the crisis the value of fiscal multipliers generally assumed by the IMF for advanced economies for forty years (1970-2009) was on average 0.5.

This leads to the presumption that – if national fiscal multipliers were all identical to the group average of 0.5 – only in Japan (with a GDP/Public Debt ratio as low as 0.47 in 2012 and 0.43 in 2013) would fiscal consolidation have raised the Public Debt/GDP ratio, and only very marginally at that. In all other countries fiscal consolidation would have worked, lowering both D and the D/Y ratio. 

The lower bound of the fiscal multipliers revised by Blanchard and Leigh (2012 and 2013), at 0.9, would imply a perverse consolidation pattern in 2012 not only in Japan but also in Greece, Ireland and Italy; while the upper bound of 1.7 would add to the list of perverse consolidation also France, the UK, Spain, Germany, Hungary, Austria, the US, the Netherlands and Albania.

The lower bound of the expenditure multipliers estimated by Batini et al. (2012), 1.6, would remove only Albania from the list of perverse fiscal consolidation, but its higher bound 2.6 would include – in addition to the previous list, also Poland, Finland, Slovakia, the Czech Republic, Denmark and Sweden, leaving out Romania as the only country in table 1 in which consolidation would not raise the Public Debt/GDP ratio and reduce GDP growth.  Using the range of estimated multipliers for tax rises, 0.16-0.35, on the contrary, that kind of fiscal consolidation would always work, i.e. would reduce both the absolute level of Public Debt and its ratio to GDP.

For the multiplier estimated by Auerbach-Gorodnichenko (2012b), near zero in normal times to about 2.5 during recessions, fiscal consolidation would work always in a boom, and never in a recession except in Sweden and Romania.  Finally, for Christiano et al. (2011), with the multiplier at 3.2 once the interest rate approaches the zero interest lower bound, all the countries in Table 1 would experience perverse fiscal consolidation. 

It is reasonable to presume that all the IMF researchers involved in this kind of work must have been aware of such devastating implications of the upward revision of fiscal multipliers.  My colleague and good friend Giancarlo Gandolfo helped me to work out the proof of the proposition above linking the multiplier to the inverse of the Public Debt/GDP ratio, for which I am most grateful, but in all honesty he would be the first to point out that the proof does not involve the use of rocket science.  Cottarelli and Jaramillo (2012) who discuss the feedback loops between fiscal policy and growth, get remarkably close to that proposition, but use an obscure turn of phrase, and stop short of stating it in so many words, or mathematically:

“a deceleration of growth prompted by a fiscal consolidation could result in a rise in the government debt-to-GDP ratio. This is found to be the case if the initial stock of debt is large and the fiscal multiplier is high. The effect of fiscal tightening on debt (the numerator of the ratio) in percentage terms is smaller the higher the initial stock of debt to GDP. Meanwhile, the negative effect of fiscal tightening on GDP (the denominator of the ratio) is larger the higher the fiscal multiplier.”

The point is that although the participants in the debate "should not be reported as representing the views of the IMF", as stated in all IMF publications, naturally their writings are taken as a pointer to the way IMF views are evolving.  Therefore they must be anxious not to suggest that their upwards revision might result in perverse fiscal consolidations in all or near all advanced economies, and baulk at saying in so many words that fiscal consolidation backfires precisely in those highly indebted countries on which it is pressed most energetically. Thus Blanchard and Leigh (2013) are adamant:

“... our results should not be construed as arguing for any specific fiscal policy stance in any specific country. In particular, the results do not imply that fiscal consolidation is undesirable.”

And Cottarelli and Jaramillo (2012) make a case against abrupt, front-loaded and simultaneous fiscal consolidations (like Blanchard and Cottarelli had done separately in 2011 and 2012 respectively).  “It is imperative to lower Public Debt over time”, though:  “However, in the short-run, front-loaded fiscal adjustment is likely to hurt growth prospects, which would delay improvements in fiscal indicators, including deficits, debt, and financing costs. A measured, although not trivial, pace of adjustment, based on a clear medium-term plan, is therefore preferable, if market conditions allow it.” Nevertheless, they claim that fiscal consolidation and economic growth go “hand in hand”.

All researchers advocate structural reforms, precisely to offset the recognition that fiscal adjustment will slow down growth.  “Reforms in goods, services, and labor markets that improve economic efficiency will boost potential growth, in turn serving as important tools in the fiscal adjustment process” (Cottarelli and Jaramillo 2012). These cover a multitude of sins and virtues that have mixed and ambiguous effects, if any, and in any case only in a distant long-run.    The notion of a virtuous circle in which “pro-growth fiscal adjustment measures, other structural reforms, and lower debt boost growth and the latter facilitates fiscal adjustment” (ibidem) is pie in the sky, and a dangerous vision if it is used to justify perverse fiscal consolidation.

The proposition that fiscal consolidation harms development only when it is abrupt, front-loaded and internationally coordinated is a non-sequitur.

At this point two further considerations are in order.  First, we know – not least from Cottarelli and Jaramillo (2012, Appendix on Short-run Determinants of CDS Spreads in Advanced Economies) – that a country’s cost of borrowing tends to rise with the Debt/GDP ratio and with the fall in the growth rate, both phenomena being associated with “perverse” fiscal consolidation i.e. with the near totality of consolidations.  For “a deceleration of growth prompted by a fiscal consolidation could trigger nervousness in financial markets” and “...markets seem to have been focusing recently on short-term growth developments.”  “The possible increase in spreads when fiscal policy is tightened creates a problem for upholding a fiscal adjustment strategy, not only because higher financing costs increase the overall deficit, but also because of political economy reasons. If painful fiscal tightening is accompanied by early evidence of an improvement in credibility, the adjustment is more easily sustained, but if markets do not reward the effort, the resolve of the government to carry on the fiscal adjustment may be undermined.”  Therefore fiscal consolidation can and often does generate a vicious circle that makes Public Debt more and more unsustainable. 

Second, we know that in a prolonged depression productive capacity does not just stand idle but is actually destroyed: factories close down with no more than a fraction of their productive capital being re-deployed elsewhere, if at all, in other productive uses; human capital is also destroyed, as workers made redundant are dispersed, and their skills are lost or forgotten or made obsolete.  When actual output falls below potential output, at some point gross investment stops and net investment falls below zero as unused or obsolete capital is not replaced, thus reducing not only employment but the number of those “employable”, pulling down the growth path of potential output (Vianello 2005). “An insufficient demand protracted over time unavoidably generates a slowdown in the formation of new productive capacity and therefore of potential income” (ibidem). Discouraged workers will stop looking for work and the rate of participation will fall.  As Nicholas Kaldor (1983) had argued, “It is illegitimate to assume that there exists a long run equilibrium growth path, for a single country or even the world as a whole, determined by population growth, capital accumulation and the rate of technical progress, all taken exogenously [italics added].” (p. 95).

In such conditions, in the world as we know it, fiscal consolidation definitely can harm economic growth and development, even if it is not abrupt, front-loaded and internationally coordinated.  This is not to say that there are no limits to a country’s or even a group of countries’ ability to sustain a fiscal stimulus.  But fiscal consolidation has to be avoided absolutely as long as the GDP/Debt ratio is smaller than the fiscal multiplier – even if otherwise the country is growing less fast than the interest rate on its debt, for with perverse fiscal consolidation the country would continue to raise its Debt/GDP ratio even faster than with continued fiscal stimulus. 

This is true even if government expenditure consists of Keynes’ proverbial policy of hiring some workers digging holes and others filling them, that Tanzi (2012) would relegate “to the museum of old and wrong ideas” (p. 11).  Obviously the replacement of unproductive expenditure with productive investment has significant additional benefits over a continuation of unproductive investment such as digging and filling holes or building pyramids or cathedrals, but even the continuation of such unproductive investment is superior to fiscal consolidation.  

REFERENCES

Auerbach Alan, and Yuriy Gorodnichenko (2012a), “Fiscal Multipliers in Recession and Expansion,” in Alberto Alesina and Francesco Giavazzi, Fiscal Policy after the Financial Crisis, University of Chicago Press.

Auerbach Alan, and Yuriy Gorodnichenko (2012b), “Measuring the Output Responses to Fiscal Policy,” American Economic Journal – Economic Policy, Vol. 4, pp. 1–27. 

Auerbach Alan, and Yuriy Gorodnichenko (2012c), “Output Spillovers from Fiscal Policy,” NBER Working Paper No. 18578, Cambridge, Mass. 

Batini Nicoletta, Giovanni Callegari and Giovanni Melina (2012), “Successful Austerity in the United States, Europe and Japan”, IMF Working Paper 12/190, July, Washington.

Blanchard Olivier J. (2011), “Blanchard on 2011’s four hard truths”, 23 December,  http://www.voxeu.org/article/blanchard-2011-s-four-hard-truths 

Blanchard Olivier J. and Daniel Leigh (2012), “Box 1.1. Are We Underestimating Short-Term Fiscal Multipliers?” in International Monetary Fund (2012), World Economic Outlook - Coping with High Debt and Sluggish Growth, Chapter, “Global prospects and policies”, pp. 41-43., October, Washington.

Blanchard, Olivier J. and Daniel Leigh (2013), Growth Forecast Errors and Fiscal Multipliers, IMF Working Paper No. 13/1, January, http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf 

Christiano Lawrence, Martin Eichenbaum, and Sergio Rebelo (2011), “When Is the Government Spending Multiplier Large?”, Journal of Political Economy, Vol. 119, pp. 78–121. 

Cottarelli Carlo (2012), “Fiscal Adjustment: Too Much of a Good Thing?”, Posted on January 29 by iMFdirect. 

Cottarelli Carlo and Laura Jaramillo (2012), “Walking Hand in Hand: Fiscal Policy and Growth in Advanced Economies”, IMF Working Paper WP12/137 http://www.imf.org/external/pubs/ft/wp/2012/wp12137.pdf

International Monetary Fund, (2010), World Economic Outlook: Recovery, Risk, and Rebalancing, October, Washington 

Kaldor Nicholas (1983), “The role of effective demand in the short run and the long run”, reprinted in Targetti Ferdinando and A. P. Thirlwall, Eds., (1989) Further essays on economic theory and policy – Collected economic essays, vol. 9, Duckworth, London. 

Tanzi Vito (2012), Realistic Recovery - Why Keynesian Solutions Will Not Work, http://www.politeia.co.uk/sites/default/files/files/Vito%20Tanzi%20Final.pdf London, Politeia.

Vianello Fernando (2005), “La Moneta Unica Europea”, mimeo, and in Economia & Lavoro (2013), XLVII-1, pp. 27-46. 

Euroarea: Premature, Diminished, Divergent

1. Expected Benefits and Costs of a Common Currency

The formation of a Common Currency Area is usually expected to generate at least seven gross benefits for its members.  

First, a reduction of transaction costs, such as the cumulative cost of converting one currency into another (and then another). 

Second, an increase in competition, given the greater transparency and comparability of prices once they are all expressed in a common currency.  

Third, a reduction of the rate of inflation, if the management of the common currency is subjected to greater discipline by an independent Central Bank targeting low inflation.  

Fourth, the elimination of exchange rate risk in transactions among member countries within the common currency area.  

Fifth, a lower interest rate associated with both lower inflation and the elimination of exchange rate risk.  

Sixth, in addition to all these factors expected to promote trade integration within the area, the promotion of greater foreign investment, given the investors’ ability to repatriate profits freely in the same currency in which they are earned.

Finally, there are the benefits expected of greater financial integration, which would provide among other things a form of implicit insurance against asymmetric shocks.   

Conversely, there are also at least three gross drawbacks to be expected by the members of a Common Currency Area.  First, the loss of national monetary policy, potentially serious in case of asymmetric shocks.  Second, the loss of the national exchange rate as a policy instrument, especially the loss of currency devaluation as a means to enhance national trade competitiveness.  Third, the fiscal discipline involved for national governments by membership of the Area. 

On balance, there is an expectation of positive net benefits from the establishment of a Common Currency.

2. Actual Benefits and Costs of the Euroarea

The creation of the Euroarea has resulted in a mixture of actual benefits and drawbacks of different sizes, trends and net balance over time.  Savings in transaction costs in currency conversion clearly have been grossly exaggerated, since those costs are incurred only for a possible currency mismatch between monetary revenues and expenditures.  Prices can be easily expressed in any currency chosen as numéraire, so that greater transparency is a delusion.  Inflation has been tamed successfully by the European Central Bank and brought down below the best earlier performance of the Bundesbank, but by 2013 labour unemployment has reached record levels in the Euroarea.  Interest rates have fallen with the introduction of the euro and gradually have converged to roughly a uniform low level maintained for seven and half years until 2010 when the spread between national borrowing rates and the lowest rate paid by a member country (Germany on its long term Bunds) has widened spectacularly, together with the cost of insuring against country default with CDS (Credit Default Swaps).  Banking integration within the Euroarea turned into a mechanism of contagion.  Asymmetric shocks – a serious concern when the Euro was established – have not been a major problem, but the inability to implement an external devaluation has brought about alternative and costly measures of internal devaluation i.e. deflation of wages and prices.  Fiscal discipline in the form of concerted austerity, within the whole Union and not only in the Euroarea, has depressed GDP and employment in the area as a whole and especially in the Southern members states, to a greater extent than the resulting reduction of debt thus raising debt/GDP ratios and widening their divergence (on this point see below). 

Since the Greek crisis of 2010 and successive crises in other member countries the possibility has been seriously and widely discussed of the Euro-area splitting into its national components with the restoration of national currencies, or at least splitting into groups such as a Nordic and Southern group with a currency respectively stronger and weaker than the Euro as it is today.  (See Cambridge Journal of Economics, Special Issue on Prospects for the Eurozone, Volume 37 Issue 3 May 2013, downloadable free of charge). While initial calls for Euroarea break-up were initially expressed by rightwing circles, recently they were joined by leftwing circles (for a critique see Andrew Watt, Why Left-wing Advocates Of An End To The Single Currency Are Wrong, 10-07-2013).

3. The Euro-Area: three failures

The Euroarea has suffered greatly from two major design failures, which are the original sins of the Common Currency, and from the member states’ increasing divergence from a common economic pattern instead of converging.

The first failure consists in the Euro’s premature birth.  The Common Currency was supposed to be the very last stage of economic integration, “crowning” all the other prior stages: after political integration, after fiscal integration including a European budget on a large enough scale to allow for a European fiscal policy, after defense and foreign policy integration.  Instead of which when the euro was set up, and still today, there is no European government, but only a movable collection of national Ministers that mostly legislate in place of a Parliament which remains largely a debating Club, next to a powerful European Commission of unelected Commissioners and powerful civil servants with executive powers, while policy-making remains at the inter-governmental level.  The European budget was set at a derisory 1%-2% of European GDP (instead of around 20% as the US Federal Budget) and always balanced ex-post (thus without the possibility of a primary surplus, let alone one large enough to service bonds issued by the EU, which in any case the EU has no need or reason to issue because it is not allowed to run a deficit).  In both defense and foreign policy only the first embryonic, bureaucratic steps towards European integration were taken. 

The approach followed in Euro creation was the exact opposite of what it should have been, technically, not to mention democratically: the Common Currency was established out of sequence deliberately, precisely so as to create, through a kind of “controlled dysfunction”, the pressures and tensions that it was hoped would push forward “la finalité politique” and all the other integration stages that are still missing.  This was a risky strategy that worked only temporarily and should have been rapidly followed, but was not, by filling in the missing stages in order to succeed.

The second failure of the Common Currency design was the creation of a diminished European Central Bank.  The ECB was made independent – following the then fashionable theories of rational expectations and the alleged lack of a trade-off between inflation and unemployment associated with them – like the US Federal Reserve, the Bank of England and the Central Bank of Japan.  However – unlike these sister institutions but on the Bundesbank template – the ECB was also totally disconnected from fiscal policy.  The ECB was supposed to target inflation at a rate below 2%, though close to it; to disregard employment concerns unless and until the inflation target was met, but above all was prevented from buying government bonds whether they were issued by Europe (which the EU was not supposed to issue, other than through the European Investment Bank) or by member states.  

And when it was set up the ECB did not have any of the other traditional functions of a Central Bank: bank supervision, bank re-capitalisation and resolution in case of insolvency, deposit insurance – all functions that were retained by National Central Banks, and still are except for some devolution in progress of bank supervision to the ECB. 

Inability to fund public expenditure, to supervise, re-capitalise and resolve banks and insure deposits made the ECB only half of a Central Bank, or possibly even less than half.  There have been initiatives to establish some version of a “banking union”: strictly speaking there is no such a thing, and one would look in vain for such an institution in the textbooks on International Integration. There are only make-shift provisions to somehow alleviate the lack of those traditional Central Bank functions on the part of the ECB.

The third failure of the Euroarea is, after almost 10 wasted years of successful operation with low and uniform interest rates, the EMU member states’ failure to converge to the statutory parameters fixed by the Maastricht Treaty for EMU accession and by the euphemistically labelled Growth and Stability Pact for all EU members.  This is true both of monetary convergence – of long term interest rate on 10 year government bonds, and of the rate of inflation – and of fiscal convergence maintaining the budget deficit and public debt respectively below 3% and 60% of GDP, in addition to two-year stability of the exchange rate between the national currency and the Euro.  EMU countries also failed to converge to other, real parameters that had never been targeted but – in view of the Euroarea premature and incomplete design – should have been targeted, like labour unemployment, unit labour costs (wage rates possibly remaining uneven but proportional to labour productivity), the trade balance, the share of bad loans in bank portfolios.  Instead of converging, the relevant parameters of Euroarea members have become increasingly divergent during the recent crisis.

A premature birth would have been alright if the European Central Bank had been designed on the Bank of England or the Fed or the Bank of Japan template instead of the Bundesbank.  Neither a premature birth nor a diminished Central Bank would have mattered if member states had converged to common monetary, fiscal and real parameters.  But the combination of these three failures, including increasing divergence, is potentially lethal.  The Euroarea as it is today might be able to struggle on still for an unspecified time, but ultimately is undoubtedly doomed.

4.  Recent Developments

In 2010 the interest rate spread widened between the Southern members of EMU and the most “virtuous” Nordic members of EMU, notably Germany – indeed too virtuous in view of its excessive success in promoting net exports currently of the order of €210 bn or 6% of its GDP, without any mechanism or policy attempt in Germany or in Europe to eliminate or even reduce that imbalance that has been very damaging to all other EMU and EU members and ultimately to Germany itself.

 

The history of the following three years to date is that of partial, slow and ineffective improvements, and of the courageous and imaginative unconventional measures introduced by the ECB President Mario Draghi to make the ECB function almost like a genuine Central Bank against stern German opposition. 

In 2010-2013 two temporary EU funding programmes provided instant access to financial assistance to Euroarea member states in financial difficulties: the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM).  In September 2012 they were replaced by the permanent ESM (European Stabilisation Mechanism, while the EFSF and EFSM will continue to manage transfers and programme monitoring for the earlier bailout loans to Ireland, Portugal and Greece).  However the ESM was somewhat under-funded (€500bn) to be able to cope with a large-scale crisis that might include at least one of the larger member states, and subject to the adoption of recessionary austerity and painful reform programmes under Troika supervision (EC, ECB, IMF).

 

Two new unconventional instruments were introduced by the ECB under Mario Draghi’s leadership, in order to restore monetary transmission mechanisms: Long Term Re-financing Operations (LTROs), through which the ECB provided injections of low interest rate funding to euro zone banks against wide-ranging collateral, and Outright Monetary Transactions (OMT) through which the ECB could purchase government bonds of troubled countries in the secondary markets – a master stroke whose sheer announcement has had a stabilizing impact on financial markets without the ECB spending a single cent yet.  Recently interest rate cuts were made, down to a record low of 0.5% and announced to be persistent and possibly ready to fall further down to reach the negative range. 

These developments have been persistently opposed especially by German representatives within the ECB Board and challenged as improper or outright illegal (including by bringing complaints to the German Constitutional Court in Karlsruhe).  Germany also has been opposing vigorously any suggestion of even partial mutualisation of debt within the Eurozone through the issue of Eurobonds subject to collective and several responsibility of member states – an understandable objection as Germany would risk to end up with sole responsibility as the most creditworthy party (though similar operations both in the early stages of the United States Federation and in 1862 in United Italy are said to have been advantageous to all parties involved). 

Of course the ECB has access to large-scale resources which are not recorded in its balance sheet, namely the present value of its seigniorage on the Euro (the profits obtained from monetary base issues, the interest obtained from the investment of past issues, the anticipated inflation tax i.e. the loss in real value of the stock of monetary base caused by expected inflation, as well as the unanticipated inflation tax).

The present value of ECB seigniorage was estimated by Willem Buiter to have a present value of the order of €3.3 trillion (in “The Debt of Nations Revisited: The Central Bank as a quasi-fiscal player: theory and applications”,  2011).  Its use to retire a sizeable part of Euroarea members’ debt in the same proportions in which they hold ECB shares would solve the Euro crisis without transforming the Eurozone into a “Transfer Union”, as it would not involve any redistribution across member states.  Potentially inflationary consequences of such an operation could be neutralized by reducing the size of the ECB balance sheet (selling assets and reducing loans), sterilizing monetary liabilities, raising obligatory reserves and raising the remuneration of excess reserves in order to induce banks to keep them inactive.  However this kind of operation would go against the grain of German and other Nordic members’ monetary conservatism and is unlikely to be undertaken.   

Hopes have been expressed of a softening of German opposition to the creative transformation of the ECB, or at least of its staunch support for austerity, after the German elections of September 2013.  But there are always frequent elections in every country at the national, regional and/or at the European level (next in 2014), and German opposition does not encourage the notion of a change of mind even in unlikely case of political alternation in power.

5. What now?

The missing integration stages and the missing institutions could be filled in, and convergence promoted more seriously and vigorously than in the past.  It is not clear whether all this could be done far enough and fast enough to resolve the current crisis, but this is unknown and is not a good reason not to try.  Or the Euroarea – as it is being suggested with increasing frequency – should and will split into its member countries, or possibly into a Nordic and a Southern currency areas with different common currencies (it has even been suggested that the two currencies might still be managed by the ECB with different targets and policies). 

By exiting the Euroarea and restoring a national currency, a country would be able to conduct its own monetary policy, presumably reflating its economy and choosing its own desired trade-off between inflation and unemployment. It could, if it wished, choose a Central Bank template still independent but also able to fund government expenditure (like the Bank of England), except that this might not be much use seeing that even by exiting EMU a country, as long as it still remained in the EU would have to adopt austerity policies, imposed on all EU members by the so-called Growth and Stability Pact. 

The exiting country could restore international competitiveness via nominal devaluation of its currency, instead of having to do it via painful and unpopular internal deflationary policies of wage and prices. And it could default – unilaterally or by agreement with its creditors – and bail-in creditors thus reducing its debt, as it could if even it remained a member but without having to agree with the Troika (EC, ECB, IMF) the terms of the bail-in and without ECB and EC (but possibly still with IMF) assistance.  Of course, EMU membership remaining one of the requirements of EU membership, a country leaving the Euroarea would sooner or later, if not at once, have to leave the EU – a non negligible cost of Euro exit. 

Exit from the Euro might be forced onto a country by a bank run, in conditions in which the ECB could not guarantee emergency liquidity assistance: such situation was approached in Cyprus in 2013 when the government initially failed to agree on the terms imposed by the Troika for bailing-in its banks.  At that point the only way to maintain liquidity would be the introduction – by the National Bank or the Treasury – of a national currency, say a National Euro, initially issued at par with the Euro.  Subsequently the new national currency would inflate and devalue, for it would have to float so that the euro does not disappear from circulation due to Gresham’s law.  Indeed the new national currency would probably inflate and devalue at shockingly high rates.  Interest rates in the new currency as a result would increase fast relatively to those of the euro.  Euro exit by several small or just one large country would probably trigger off a run on the banks of other weak Euroarea members and unleash an unnecessary domino effect.

If and when the new national currency regained parity between its floating rate and the rate at which it had been originally issued against the euro, the operation could be reversed: the country could re-join the Euroarea and the National Euro converted back into Euros.  Until then Euro cash would become foreign exchange in the hands of households and companies, current accounts and all debt and credits would be converted into the new currency at par, which by itself would reduce the size of all debt.  International debt technically would remain nominally denominated in Euro or other foreign currencies (at least for the greater part of debt incurred under English Law), but creditors would have to resign themselves to debtors’ default and to de facto bail-in.  Devaluation would improve competitiveness if it was real (nominal devaluation not being offset by higher inflation) and sufficiently large. 

Frequently there have been suggestions that the new national currency should not replace the Euro but circulate in parallel with it.  Unfortunately there are no miracles in economics, a parallel currency would be a messy and doubtful solution.  Considering that internal devaluation and default are options even within the Euro, and that fiscal discipline remains one of the obligations of EU membership even for a country exiting the Euroarea the only advantage of leaving the Euro would be greater freedom to default, at the cost of losing some European support by the EU and the ECB, but still subject to both assistance and conditionality by the IMF.

In conclusion there would not be much of a net gain from Euroarea exit, especially considering that exit with default would bar a country from access to international markets for longer (up to twenty years or so) than orderly default and bail-in as in the cases of Greece, Ireland or Cyprus.

As for Germany (and possibly other Nordic countries) leaving the Euro, as recently suggested by George Soros, their exit probably grossly under-estimates German losses from revaluation of the Nordic vis-à-vis a hypothetical Southern Euro.

6.  “If I wanted to go to Rome I would not start from here”

Clearly if one had wanted to construct a Common Currency Area one should have not proceeded in the way that was followed by the EMU, and certainly would not wish to start from the current state of affairs in the Euroarea.  But starting from here perhaps the best course is to press on as far and as fast as the limited consensus among members will take the weaker and more vulnerable members, towards filling in the missing elements: building some kind of Banking Union; supporting ECB progress towards a de facto proper Central Bank; sustaining political integration and fiscal integration, raising the size of the European Budget; trying to re-launch European investment initiatives and funding European instead of national debt.  

To these purposes it would be expedient to threaten an exit vigorously and increasingly rather than actually leaving the Euroarea.  At the same time a country could, still remaining in the Euroarea, and if democratic institutions were sufficiently robust, mimic with internal devaluation the effects of an external devaluation that leaving the Euroarea would allow – but only if this is regarded as essential to re-launch growth.