Thursday, February 5, 2015

Moderate optimism

The month of January 2015 gave us several, interlocked reasons for moderate optimism about the prospects for economic recovery in the Eurozone and in Italy.

First, the further fall in oil prices, strengthening the trend already present from last summer. From mid-June 2014 to the end of January 2015 the price of crude oil fell by as much as 60 percent, reducing the energy costs of Eurozone producers in spite of the parallel but much lower depreciation of the euro against the dollar (on which more below). Quantitative estimates of the effect of this cost reduction on the rate of GDP growth are uncertain and vary around 0.5% -0.8%, but undoubtedly the positive effect is present and is not negligible.

The second reason for moderate optimism is the ECB decision on 22 January to implement Quantitative Easing, albeit with the disapproval of the Bundesbank president Jens Weidmann and a minority of other representatives of the Nordic  member states of the Eurorozone: € 60 billion per month for 19 months, from March 2015 to September 2016, and if necessary even further, until the Eurozone inflation target "below but close to 2 percent" is reached.  This amount however includes other interventions already decided previously, so that the additional amount really is not €1,140bn but only about €900bn, and the surprise effect (important for example in the Swiss frank large appreciation of 15 January) had been diluted by months, indeed years, of announcements, discussions and debates. However the size of the intervention was still greater than earlier expectations, of the order of €500bn, and therefore there still was some element of surprise. The provision that National Central Banks should take on 80% of the risk of default on 80% of their country’s bonds purchased by the ECB is an important limitation of the Monetary Union but an acceptable price for this massive intervention.

Third, the depreciation of the euro down to a rate of $ 1.11, then stabilized at $1.13 (below the rate of $ 1.17 at which the euro was first introduced and a far cry from its peak of $1.47), for several reasons: ECB Quantitative Easing; the expectation of the Fed raising interest rates, repeatedly announced and now postponed probably to next June; expectations - rightly or wrongly - of the worsening of the Greek crisis and even a possible exit of Greece from the Eurozone (Grexit).  Such devaluation should have a significant impact on the competitiveness of all member countries and therefore their exports and growth, improving the relative position of those who like Italy have seen labour productivity stagnate or even decline over the last decade. Predicting the quantitative impact of euro devaluation on the rate of GDP growth is difficult and risky, but this effect could have an order of magnitude of 0.8-1%.

Fourth, the resounding victory of Alexis Tsipras and his party Syriza in the Greek elections of 25 January, which has called into question the austerity policy adopted by European institutions under the hegemonic influence of Germany as the only strategy response to the Great Recession of 2007, along with so-called "structural reforms".  These last are a euphemism for the dismantling of the welfare state, privatization of under-valued public assets and the cancellation of decades of achievements of the labour movement.

The first moves of the new Greek government were reassuring: Greece has no intention to leave the euro (a choice supported by 60% of the Greek population), nor to press for further cancellation of public debt, nor to request additional aid.  At the end of February Greece expected to receive €2 bn aid from the European Union and €5 bn from the IMF, conditionally on reform implementation.  Now the Greek government requests only €1.9bn from the ECB as reimbursement of the additional interest earned by the Bank on the Greek bonds in its portfolio. As Finance Minister Yannis Varoufakis rightly said, "A Monetary Union responding to a serious financial crisis by granting more loans to deficit countries on condition that they shrink their national income is not sustainable”.  Varoufakis proposes a " menu of swaps " of Greek bonds with new bonds of two types: one indexed to nominal economic growth, whose service therefore would be conditional on the resumption of growth, and the other a "perpetual bond" that would replace the Greek government bonds in the hands of the European Central Bank. The Greek budget would remain in primary surplus, but only on a more modest scale of 1-1.5%, thanks to the decision to pursue big tax evaders.  In this way Greece could effectively honour existing commitments, while creating a fiscal space sufficient to finance the reconstruction of the welfare state, to increase the minimum wage and pensions, as well as to grant the benefits in kind or subsidies (for example in electricity and transport) promised and partly already introduced by the new government.  Otherwise, Varoufakis says, "Greece will become deformed rather than reformed." Varoufakis' plan was received favorably at its presentation to the City of London, and provides an excellent and credible basis for discussions and negotiations with the European institutions.

Why, then, the "moderate" nature of optimism rooted in so many positive developments?

First, the fall in the oil price is the result of lower demand in the recession, the Saudi decision not to cut production to match lower demand, and the significant growth of the US production obtained from bituminous shale.  But the price reduction undermines its causes: not only does it stop investment in the development of alternative energy sources, but at the current price of around $ 50 per barrel it makes most of the production to be sold at a loss and therefore not sustainable. On 30 January the announcement of the closure of one hundred high-cost wells in the United States raised the price of oil by more than $ 8 in a single day although production had continued to rise. And if the low oil price were maintained there would be - and are already experiencing them - negative effects on the demand for imports by oil-producers and therefore on income and employment in the non-oil-exporting countries.

Second, in the opinion of many observers and businessmen, monetary easing by the ECB was "too little too late", in comparison with the $ 4.5 trillion mobilized by the Fed already commenced in 2008, and further, in view of the greater use by US companies of credit and securities to finance investments, compared to the larger component of profit reinvestment by companies in Europe and especially in Italy.  But there is no doubt that monetary easing - in addition to its impact already mentioned on euro devaluation - will facilitate the recapitalization of banks that have an excess of government bonds in their portfolios.

Third, the devaluation of the euro could unleash a war between currency areas with rounds of competitive devaluations, and the associated de-stabilization of financial markets.

Finally, European and German economic authorities have immediately taken rigid and hostile positions adverse to any form of restructuring of Greek debt.

Matteo Renzi has been likened to Alexis Tsipras but unfortunately we are not so lucky, all they have in common is their young age; Italy also has €40bn credits towards Greece, and our excellent Pier Carlo Padoan has neither the imagination nor the tenacity of Yanis Varoufakis.  If anything Alexis Tsipras has something more in common with our new President Sergio Mattarella: immediately after their election both went to visit a monument to the victims of Nazi atrocities, a gesture that cannot have been greeted with enthusiasm by Angela Merkel.  The French are watching from the sidelines; in order to widen the breach in European austerity opened by Syriza we will have to wait for a parallel Podemos victory in the next elections in Spain.

The danger is that the game of chicken played by Germans and Greeks might lead to a lethal crash, perhaps in the form of an "accidental Grexit" (an expression coined by Wolfgang Munchau): the expiry of any deadline before a new agreement is reached, the loss of Greek access not only to Quantitative Easing but also to emergency liquidity provided by the ECB, capital flight and a panic run on the banks by the public seeking to withdraw cash from their accounts.  At that point, a severe liquidity crisis could force Greece to issue some form of national currency, perhaps initially notes issued by the Treasury circulating in parallel with euro cash now in short supply: from there to a formal exit is only a small step. Cyprus came within a breath of this predicament.

Marcello De Cecco noted that while a Greek exit from the Eurozone could very well happen in the way I described, it would be the result of a deliberate policy of not wanting to help Greece, instead of a series of casual fatalities, when there is will there is always a way, and if deadlines are not met this means that Greek exit is not so much feared but wanted.

In any case, a possible Greek exit from the Eurozone – whether accidental or deliberate - cannot be ruled out completely, and would be catastrophic for the entire Eurozone, with contagion spreading first to Portugal, then to the other southern countries including Spain and Italy, eventually turning against Germany itself and the other Nordic countries. That is enough to temper anybody’s optimism.


On 4 February the ECB Governing Board decided that Greek government debt will no longer be accepted as collateral starting next week.  This appears to be like undue ECB interference in Greek negotiations with the EU, but 1) it is well within the Bank’s discretionary powers; 2) it is likely to be part of the price paid by Mario Draghi for the large size of his Quantitative Easing and 3) it is also a way of raising the stakes which might, in the end, favour Greece by raising the cost of a Greek exit for Germany and the hawks as well as for Greece.  After all, Yanis Varoufakis is an accomplished game theorist and should know what he is doing (see Varoufakis Y., Rational Conflict. Oxford, Blackwell, 1991; Varoufakis Y. and S. Hargreaves-Heap, Game Theory: A critical text. London and New York, Routledge, 2004).  At least, this is what we might still hope.

For assessments supporting this last point see the excellent post by Frances Coppola, What on Earth is the ECB up to? and the other posts listed at the end of it.


Alberto Chilosi said...

"austerity policy adopted by European institutions under the hegemonic influence of Germany as the only strategy response to the Great Recession of 2007, along with so-called "structural reforms". These are an euphemism for the dismantling of the welfare state, privatization of under-valued public assets and the cancellation of decades of achievements of the labour movement."
In reality the so called "austerity policies" were the inevitable result of the near insolvency of a set of highly indebted countries that were unable to finance themselves on the open market in a sustainable way and required some form of assistance or were compelled anyway to try to "put their house in order" by reducing their deficits. Italy's public debt was increasing all the time (with some timid retrenchments at the time of the Prodi governments) even before the recession struck, making countercyclical policies impossible to finance at the time of recession, as the market started to suspect Ponzi play. Greece needs not be mentioned, as it was beyond the pale with false accounting 16% budget deficit and 15% deficit in the current account. Spain was suffering the consequences of an unhealthy real estate boom and the corrupted dealings of local banks with local politicians, compelling to bail out banks at the expense of the exchequer, and so on, and so forth. As to the recession, basically it was a crisis of confidence in the banking system leading to a credit crunch, this means a monetary shock. Facing a monetary shock the right textbook policy would have been a compensatory monetary policy. In this the ECB did fail: remember the ridiculous sterilization of the intervention on behalf of the debt of the countries under attack under Trichet or the ill-timed increased of the basic rate in 2011. QE should have been made much, much earlier. Those who protest against "austerity" in reality are protesting against the dictatorship of budget constraints. For some of them the souveregnity of national states should have been restored by allowing them to spend what they thought fit, while the ECB had to buy the issuance of the bonds so to keep interest rates low whatever the issuances. This would have been not only contrary to the basic founding principles of the Eurozone, but, with a bit of reflection, an absurdity from the incentive compatibility viewpoint. As to the welfare state, the only sustainable welfare state is of the Scandinavian type, financed basically through taxation. A welfare state financed through increasing indebtedness, as in the Italian case, is doomed to be eventually reversed, as soon as the Ponzi process is interrupted (what is the eventual destiny of all Ponzi processes). Finally, "the achievements of the labour movement" have been obtained (outside of Scandinavia, at least) at the cost of very high rates of long-term unemployment, low labour market partecipation and, in the case of Italy at least, increasing state debt and wholesale destruction of large industry units and stagnation. (For the relation between long-term unemployment and employment protection see "Long-term unemployment in the varieties of capitalism"

Alberto Chilosi said...

"A Monetary Union responding to a serious financial crisis by granting more loans to deficit countries on condition that they shrink their national income is not sustainable" A level of national income based on 15% budget deficit and 16% deficit in the current account is not sustainable. In terms of International trade theory the return to sustainability requires a reduction in absorption this means a reduction in aggregate demand and thus a shrinkage of national income. Only very gullible people could believe that "creating a fiscal space sufficient to finance the reconstruction of the welfare state, to increase the minimum wage and pensions, as well as to grant benefits in kind or subsidies (for example in electricity and transport) promised and partly already introduced by the new government" is compatible with 1-1.5% of primary surplus. Let us start to combat tax evasion and see the results first. To put the burden of financing current expenditure on combating tax evasion reminds one very much of the usual Italian way leading to persistent deficit and increasing debt.

Alberto Chilosi said...

Finally, European and German economic authorities have immediately taken rigid and hostile positions adverse to any form of restructuring of Greek debt.

In reality it does not seem to be so. The issue seems to be not so much the debt but rather the additional resources that the new government requires to fulfil their populist electoral pledges.

Alberto Chilosi said...

"At that point, a severe liquidity crisis could force Greece to issue some form of national currency"
A way could be Milosevic way: to have the currency be created by the local national bank, without authorisation by the federal bank, thus leading (in the case of Milosevic) to the breakdown of former Yugoslavia.

D. Mario Nuti said...

Thank you Alberto for your many, profound and provocative comments.

By austerity we mean the pursuit of fiscal policies aimed at roughly balancing the government budget over the cycle. In a highly indebted country, austerity involves running a series of budgetary surpluses in order to reduce the Debt/GDP ratio, through debt repayment and the lower cost of borrowing at a lower such ratio.
In an ideal world there would be no conflict between austerity and economic growth and development. A country would experience modest and relatively short-lived economic fluctuations, mitigated by automatic (or built-in) stabilizers, or rather by automatic “dampeners” for these can never actually stabilize the level of economic activity. If the country has the necessary fiscal space i.e. it is not already burdened by high debt costly to service, it could run an average fiscal budget close to equilibrium over the cycle, using a fine tuning approach, i.e. a discretionary or active fiscal policy imparting a fiscal stimulus in the short term during a recession and funding it out of surpluses during the boom.

If fiscal multipliers are sufficiently low, say of the order of magnitude of about 0.5, as estimated by the IMF for advanced economies for the forty years before the last crisis (during 1970–2009) even in the presence of high Public Debt approaching as much as two years of GDP, fiscal consolidation would reduce not only the absolute level of Public Debt but also its ratio over GDP. This in turn would reduce the cost of servicing Public Debt and make it all the more sustainable, generating over time the fiscal space necessary to run a counter-cyclical policy with a fiscal budget balanced on average.

But the world in which we live today is very remote from this ideal. Many countries are already highly indebted, at levels unprecedented since World War II, with Public Debt/GDP ratios in 2013, for instance, of 92% on average in the EU, 100% in the US and 230% in Japan. Recessions can be large scale, simultaneous in most of the world, and prolonged turning into depressions, like the current global depression that began in 2007 and is not over yet, the most serious ever in modern capitalism. In such a crisis budget deficits may be uncontrollable because of the unforeseen and unforeseeable sudden public cost of rescuing banks and other financial institutions in order to avoid a financial melt-down. Fiscal stabilizers/dampeners have been reduced as a result of expenditure cuts, especially for welfare. Calls for strict, abrupt, front-loaded and internationally coordinated fiscal consolidations become more frequent and binding.

Moreover recent research by the IMF Fiscal Affairs Department and other IMF officials confirms that the size of fiscal multipliers has been severely under-estimated by the OECD, the European Commission and the IMF itself, thus severely under-estimating the cost of fiscal consolidation in terms of output and employment. Worse, such an upwards revision can and mostly does imply adverse effects of fiscal consolidation on the Public Debt/GDP ratio. Fiscal consolidation reduces GDP proportionally more than it reduces Debt, thus raising instead of lowering the Debt/GDP ratio, thus raising the cost of borrowing and making things worse. See my old post on Perverse Fiscal Consolidation.

D. Mario Nuti said...

Austerity is the child of neo-liberalism, of the notion that “The State is the problem, not the solution” (Reagan) and of Thatcherite policies of privatization, dismantling of the Welfare State, financial de-regulation. It found specific theoretical support in two propositions later conclusively proven to be totally false, after being first endorsed then rejected by the International Monetary Fund.

The first is the notion of “expansionary fiscal consolidation”, put forward by a number of Italian economists (Giavazzi and Pagano 1990, 1996; Alesina and Perotti 1995; Alesina and Giavazzi, Alesina, Ardagna and Trebbi, 2006; Alesina, Favero and Giavazzi 2012; and others). This was attributed to the promotion of private sector-led growth for a number of well established reasons. Government expenditure cuts would stop the “crowding out”of private investment. Ricardian equivalence between funding government expenditure by borrowing and by taxation was invoked: government borrowing leads to expectation of future higher taxes to service the debt and leads to lower private expenditure; consolidation leads to increasing confidence, a favourable impact on expectations, declining borrowing costs, a weaker currency.

Reinhart and Rogoff (2010) produced empirical evidence purporting to demonstrate that that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.” (They used a new dataset of 44 countries spanning about two hundred years, incorporating “over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances”).

Thus Keynes's proposition that “the boom, not the slump, is the right time for austerity” was falsified, austerity becoming a good policy for all seasons especially in highly indebted countries.

However the proposition of “expansionary fiscal consolidation” was heavily criticized by subsequent studies; the IMF World Economic Outlook of October 2010 (October, Ch.3) found that fiscal consolidation typically reduces output and raises unemployment in the short term (especially if it occurs simultaneously across many countries, and if monetary policy is not in a position to offset them), while its contractionary effects are “softened” but not offset in the longer term. The September 2011 IMF Fiscal Monitor warned that “too rapid consolidation during 2012 could exacerbate downside risks”, which is what punctually happened.

The Reinhert-Rogoff notion of a critical 90% threshold of the debt/GDP ratio was immediately criticized on the ground that causation run backwards, in that slower growth leads to higher debt-to-GDP ratios rather than the other way round. But the final blow to the Reinhart-Rogoff 90% dogma came from Herndon, Ash and Pollin (2013), who replicated their analysis using the original data. Apart from a coding error, which however made only a small contribution to their conclusions, available data for several Allied nations—Canada, New Zealand, and Australia—that emerged from World War II with high debt but nonetheless exhibited solid growth were selectively excluded. And summary statistics were all weighted equally regardless of the duration of high debt and growth performance. “… when properly calculated… average GDP growth at Public Debt/GDP ratios over 90 percent is not dramatically different than when debt/GDP ratios are lower.”

D. Mario Nuti said...

The Greek crisis has two main causes: unbridled expenditure in the boom years 2000-2010, public and private, for consumption and investment, and reckless lending by Nordic banks. And of course, as you mention, there was the falsification of budgetary data, the 2009 deficit of 6% of GDP turning out later to have been 15.2%; the cosmetic improvement of public accounts by means of costly derivatives operations, the doubling of state employees in 2000-2009, at salaries rising much faster than in the private sector, tax evasion lowering state revenues by 5% a year, trade deficits of the order of 15% and so on.

After the 2010 crisis Greek debt was partly cut twice, in 2011 and 2012, lengthening maturities up to 2057 and lowering the average interest burden to 2.6% of GDP; additional resources were provided by EU governments (€194bn), the IMF (€31.8bn) and the ECB (still exposed for €25bn). But these resources were used primarily to repay Nordic banks’ loans to Greece (most of them avoiding haircuts selling their bonds to public institutions), and were accompanied by punitive measures: draconian cuts in public expenditure, employment, wages and pensions, amounting to what Yanis Varoufakis has labelled “fiscal waterboarding”, leading to a 25% GDP fall since 2014, and over 50% unemployment.

If, as you say, QE had taken place much earlier, and above all if there had been higher investment at the European level or at least in the less indebted Nordic countries enjoying fiscal space and an exceptionally low cost of borrowing, the Greek predicament would have improved considerably.

In conclusion, earlier Greek governments have their large share of responsibility for the current economic mess, but this is no reason to be punitive with the entire country and with a new government that is seeking to revolutionise and resurrect it at last.

D. Mario Nuti said...

In mylast comment "over 50 per cent unemployment" is of course youth unemployment. Otherwise Greek unemployment today is 26%, which is still inordinately large.

Alberto Chilosi said...

Thank you very much for your kind reply to my undisciplined comments. I agree with everything you wrote, but according to your definition of austerity in Europe and USA there was no austerity at all. To my best knowledge no country was balancing the budget, not to speak of running a budget surplus. The fact is that 2009 came in Europe quite unexpected, with some European countries (such as Italy or France, but even Germany) too much indebted, because of previous indiscipline, to be able to run, as it would have been appropriate, an effective expansionary fiscal policy. Unlike in the USA there was no Federal budget worth mentioning (and it was even reduced by the swelling of nationalist sentiment) and there was an ECB much too timid and unable to understand the gravity of the situation. But this has been quite an experience. Unlike the natural world the social world is always full of surprises, and hopefully some learning has been made. Unlike Europe, the USA has been helped by its understanding of the lesson of the nineteen-thirties. Let us hope that the European lesson of the 2000-something will be adequately digested.

Jacob Richter said...

This January 25, 2015 marks the ushering in of what is hoped to be the world’s first workers government since the Popular Front in Spain. Coincidentally, this week also marks the ushering in of the world’s first Communitarian Populist Front since the Chartist movement and Paris Commune of the “working classes” in Britain and France, respectively, with SYRIZA working with the anti-fascist, stridently anti-austerity, but right-populist Independent Greeks.

A key factor of this Communitarian Populist Front, a framework which I have proposed but whose pre-Greek historical precedents include the Chartist movement and the Paris Commune, is that the left in this front should stick to radical, participatory-democratic overhaul (average skilled workers’ compensation and benefits, recallability, etc.) and predistributionist economic policy, while conceding “Radical Center” positions on identity and related “social” issues.

D. Mario Nuti said...

I am delighted that your optimism stretches that far; mine does not, indeed I am becoming less optimistic and more moderate by the minute.

Jacob Richter said...

Mario, the questions begged by the earlier comment were: Which populist left? Which populist right?

On the populist right, there are anti-austerity parties like ANEL, and there are pro-austerity parties like AfD and UKIP.