A European Monetary Fund

Sapir and Schoenmaker at Bruegel have a discussion of what a European version of the IMF might look like and do. Here are my thoughts on the sovereign debt (not banking) side, which I am sure will be regarded once again as radical and will therefore be ignored.

I think some new Eurozone institution is necessary, but not for the reason that most people might think. The idea that the Eurozone might have a common fund that lends to Eurozone countries in fiscal difficulties with associated conditionality, as the IMF does, is a terrible idea. We know it is a terrible idea because of Greece.

Think of the following scenario. A country getting into difficulties is lent some money by the EMF. That sum increases as existing private investors take fright. For whatever reason the ‘recovery plan’ imposed by the EMF goes wrong, and it becomes clear to all neutral observers that the country needs to default on its debts, including those to the EMF. As the EMF loan is regarded as ‘our money’ by a good part of the EZ electorate, this default is resisted and punitive austerity is imposed on the country so that the EMF can get its money back. This does not happen to the IMF because the electorate in any individual country do not think of their loans as ‘their money’, but it is naive to believe that wouldn’t happen with an EMF. It is exactly what happened in Greece, and it is also why moves to a political union are far too premature..

This raises an obvious question: why have an EMF, when we have an IMF? The wrong way of thinking about that question is that the Eurozone needed to supplement the IMF during the last crisis. The last crisis is not a good example because the ECB did not operate OMT until September 2012. The right way to think about the past is what would have happened if OMT had been operating from the start.

The ECB is (rightly) only prepared to operate OMT for a country that is returning its financing to some sustainable level. For some countries that may not be possible, or desirable, without default. That was the case for Greece. For others that will be possible without default, as Ireland and Portugal have shown. You need somebody, or some institution, to decide which category a country finds itself in. But whether default is needed or not, a recovery plan (austerity) has to be put in place to return the public finances to sustainability and once that plan is in place OMT then operates.

Once that happens, I think any lending should be done by the IMF for the reason I have already given [1]. However it may well be that as long as the austerity is sensibly mild and drawn out [2], private sector lending will resume because of OMT.

I think a new institution to do both the job of initially deciding about default and to create the recovery plan would be a good idea. But both decisions have to be kept as far away from politicians as possible. The reason again comes from history: the loans to the government that may require default are likely to be from banks or institutions in other EZ countries. That creates a serious bias towards ‘lend and pretend’, as we saw with Greece. 

How can you achieve such independence in the EMF? In addition, how do you justify giving an institution staff and resources when it hopefully will be hardly ever needed? One answer could be to use the IMF, although at the moment the IMF is not sufficiently independent of EZ politicians. Another is to utilise the network of independent fiscal institutions or fiscal councils that every EZ country now has. If those institutions live up to their name, they should be independent of politicians. In addition, they have exactly the expertise to decide on any default and to put together a recovery plan.

Now the great thing about this set-up is that it allows fiscal autonomy in countries that have not got into fiscal difficulties. Fiscal discipline through the market is restored, because there is a clear default risk (but not the self-fulfilling default risk that operated before OMT). There would be less of a feeling in countries like Germany that they had to worry about fiscal policy in other EZ countries because they will pick up the tab because there will not be any tab to pick up. In that sense the no bail out rule is restored. 

What would the Brussels machinery that currently monitors each EZ country do? Am I proposing to put some Brussels bureaucrats out of a job? Not necessarily. A potential problem with the system I suggest is that fiscal councils will be captured by their governments. Brussels could ensure that the fiscal councils are independent, which would involve checking their assessments and forecasts (or even supplying them with forecasts).

I can predict with almost certainty that some comments will be that I am taking crucial decisions away from democratically elected politicians and giving them to technocrats. We have enough of that in the Eurozone as it is they will say. There are two simple responses. First, in the absence of the Eurozone, governments that were no longer able to borrow would face the technocrats at the IMF. Second, we have tried the democratic route and it has failed spectacularly for reasons that will not go away in a hurry. 

There you have it. A feasible plan to increase sovereignty in the Eurozone and mitigate another Eurozone crisis and avoid another Greece. Now tell me why we have to move to fiscal and political union.

[1] Obviously in that case the IMF would also have to approve the recovery plan.

[2] A short sharp shock will almost inevitably lead to damaging negative feedback on output, perhaps creating another Greece.

Lexit

I often find that arguments for Lexit have many structural similarities to right wing arguments for Brexit. Take Larry Elliott’s latest piece for example. This includes

1. Sweeping exaggerations that seem designed to trigger nationalist sentiments. We are told that “under Tony Blair, the feeling was that globalisation had made the nation state redundant.”
   
   
2. Confusing the EU with the Eurozone. Larry talks about the problems with the ECB, the SGP, and mass unemployment, but these are all valid criticisms of the Eurozone. There is no attempt to say why that has any impact on the UK as part of the EU.
   
   
3. Inferring that all the UK’s problems are somehow down to the EU, without providing any evidence that they are.
   
   
4. Asserting that the EU prevents the UK doing what it needs to do to tackle (c) in ways that are economical with the truth (see more below).
   
   

But I also have complaints that I think are unique to Lexit arguments. When some people mock the use of the term neoliberalism, they should use the Lexit debate as ammunition. When I use the term, it is to signal a project that in various ways subordinates the state to the market. Yet we are told that the EU had neoliberalism hardwired into it. The EU is fundamentally about trade liberalisation, not about the role of the state. It is trade liberalism that is hardwired into the EU, not neoliberalism. (The Lexit advocacy here is more honest about that.)

Is levying a huge fine on Google because its search engine gives preference to its own shopping comparison site an example of neoliberalism? Is a maximum working week? Are their environmental standards? [1] These are all examples of a collective of states interfering with firms and the market. One of the strong and left wing arguments for the EU is that only at this level can you avoid large multinational corporations blackmailing states that attempted to challenge them in similar ways. I am sure there are many examples where the EU could do this more effectively, but at least they are trying.

The argument for Lexit is therefore similar to the argument against globalisation. The problems that a combination of globalisation and technical change has created for many communities are real enough. But Lexit arguments typically ignore two key points. First, globalisation has brought huge gains for many poorer countries. That applies as much to the poorer states of the EU as it does to China and India. Of course what is being done to Greece is appalling (and I have not hesitated to say so on many occasions), but this once again is a result of a common currency, not trade liberalisation under the EU. Indeed, one of the reasons the Eurozone’s blackmail of Greece worked is that a majority of Greeks want to stay in the EU.

Second, the gains for the UK that have followed most trade liberalisation are real enough, which is why there are large costs to leaving the Single Market or customs union. Larry spins this by saying the “left needs to be very careful about running with the idea that business should be able to veto decisions made by the electorate.” This is a line that shows the left at its worst. The costs of Brexit do not necessarily fall on business (which is often mobile) but on ordinary UK citizens. What proponents of Lexit have to show is that the benefits of the policy freedom Brexit gives you outweigh these costs.

The most promising way to help the losers from trade liberalisation (and technical progress) is through an active industrial and regional policy. Proponents of Lexit argue that the EU would prevent such a strategy. If we are talking about giving aid to declining uncompetitive sectors, then many would argue that it is a good thing that the EU does stop that happening. But to suggest that the EU is opposed to any kind of regional aid seems to conflict with the existence of the EU’s Cohesion Policy, that has benefited many areas in the UK. For a more general discussion of the justifications the EU gives for intervening in the market, see William Davies here. The set of policies that the EU prevents but which any reasonable trade deal with the EU would allow are pretty small, with the key exception of controlling immigration.

Larry says that freedom of movement has not benefited workers. I think he would find plenty of EU workers in the UK who would disagree (at least before Brexit). Just as the movement of goods across borders benefits all, so can the movement of people. Most of the analysis I have seen has shown that recent immigration into the UK has been beneficial to UK workers once you take everything into account. Ignoring all that by talking about the ‘lived experience of ordinary people’ (from here) suggests an attitude to knowledge and evidence worthy of UKIP. Which brings me full circle.

[1] The first of these interventions could reflect an ordoliberal rather than neoliberal view, but the second two not so much.   

Why German wages need to rise

An interesting disagreement occurred this week between Martin Sandbu and the Economist, which prompted a subsequent letter from Philippe Legrain (see also Martin again here). The key issue is whether the German current account surplus, which has steadily risen from a small deficit in 2000 to a large surplus of over 8% of GDP, is a problem or more particularly a drag on global growth.

To assess whether the surplus is a problem, it is helpful to discuss a key reason why it arose. I have talked about this in detail many times before, and a similar story has been told by one of the five members of Germany’s Council of Economic Experts, Peter Bofinger. A short summary is that from the moment the Eurozone was born Germany allowed wages to increase at a level that was inconsistent with the EZ inflation target of ‘just below 2%’. We can see this clearly in the following chart.

Relative unit labour costs, source OECD Economic Outlook, 2000=100

The blue line shows German unit labour costs relative to its competitors compared to the same for the Euro area average. Obviously Germany is part of that average, so this line reduces the extent of any competitiveness divergence between Germany and other union partners. By keeping wage inflation low from 2000 to 2009, Germany steadily gained a competitive advantage over other Eurozone countries.

At the time most people focused on the excessive inflation in the periphery. But as the red line shows, this was only half the story, because wage inflation was too low in Germany compared to everyone else. This growing competitive advantage was bound to lead to growing current account surpluses.

However that in itself is not enough to say there is a problem, for two related reasons. First, perhaps Germany entered the Eurozone at an uncompetitive exchange rate, so the chart above just shows a correction to that. Second, perhaps Germany needs to be this competitive because the private sector wants to save more than it invests and therefore to buy foreign assets.

There are good reasons, mainly to do with an ageing population, why the second point might be true. (If it was also true in 2000, the first point could also be true.) It makes sense on demographic grounds for Germany to run a current account surplus. The key issue is how big a surplus. Over 8% of GDP is huge, and I have always thought that it was much too big to simply represent the underlying preferences of German savers.

I’m glad to see the IMF agrees. It suggests that a current account surplus of between 2.5% to 5.5% represents a medium term equilibrium. That would suggest that the competitiveness correction that started in 2009 has still got some way to go. Why is it taking so long? This confuses some into believing that the 8% surplus must represent some kind of medium term equilibrium, because surely disequilibrium caused by price and wage rigidities should have unwound by now. The answer to that can also be found in an argument that I and others put forward a few years ago.

For this competitiveness imbalance to unwind, we need either high wage growth in Germany, low wage growth in the rest of the Eurozone, or both. Given how low inflation is on average in the Eurozone, getting below average wage inflation outside Germany is very difficult. The reluctance of firms to impose wage cuts, or workers to accept them, is well known. As a result, the unwinding of competitiveness imbalances in the Eurozone was always going to be slow if the Eurozone was still recovering from its fiscal and monetary policy induced recession and therefore Eurozone average inflation was low. [1]

In that sense German current account surpluses on their current scale are a symptom of two underlying problems: a successful attempt by Germany to undercut other Eurozone members before the GFC, and current low inflation in the Eurozone. To the extent that Germany can make up for their past mistakes by encouraging higher German wages (either directly, or indirectly through an expansionary fiscal policy) they should. Not only would that speed adjustment, but it would also discourage a culture within Germany that says it is generally legitimate to undercut other Eurozone members through low wage increases. [2]

From this perspective, does that mean that the current excess surpluses in Germany are a drag on global growth? Only in a very indirect way. If higher German wages, or the means used to achieve them, boosted demand and output in Germany then this would help global growth. (Remember that ECB interest rates are stuck at their lower bound, so there will be little monetary offset to any demand boost.) The important point is that this demand boost is not so that Germany can help out the world or other union members, but because Germany should do what it can to correct a problem of its own making.

[1] Resistance to nominal wage cuts becomes a much more powerful argument for a higher inflation target in a monetary union where asymmetries mean equilibrium exchange rates are likely to change over time.

[2] The rule in a currency union is very simple. Once we have achieved a competitiveness equilibrium, nominal wages should rise by 2% (the inflation target) more than underlying national productivity. I frequently get comments along the lines that setting wages lower than this improves the competitiveness of the Eurozone as a whole. This is incorrect, because if all union members moderate their wages in a similar fashion EZ inflation would fall, prompting a monetary stimulus to bring inflation back to 2% and wage inflation back to 2% plus productivity growth.    

The academic consensus on austerity solidifies, but policymakers go their own sweet way

With yet another study showing how damaging austerity can be, you would think that at some point some politicians would eventually get it. This tepid economic recovery has been a huge vindication of Keynesian economics, which also happens to be mainstream economics. The textbooks and state of the art macroeconomics said cutting public spending while interest rates were stuck at their lower bound was a very bad idea. And sure enough pretty well every ex post analysis of this period finds that it was. It is particularly ironic that at a time when countless articles have appeared about the ‘crisis in economics’, a massive experiment by policymakers has seen an important part of it vindicated.

There were three countries or areas that adopted austerity in spades: the US, the UK and the Eurozone. Are any of these likely to recognise the error of their austerity ways anytime soon? The conventional wisdom is that this will happen in the US, but this is to confuse actions and the reasoning behind them. Any fiscal expansion in the US would not be for Keynesian reasons. This is partly for the obvious reason that interest rates are rising, and the central bank has shown no clear sign that they would not meet any further expansion with additional increases. There remains a clear and rather urgent need for a large increase in public investment financed by borrowing, but that seems unlikely to happen. What we are sure to get is tax cuts, particularly for the rich, because that is nowadays the main goal of Republican economic policy. Among Republicans, Keynesian economics remains the work of the devil.

In the UK there is also a desperate need for public investment. In addition, the NHS is crying out for a substantial tax financed fiscal expansion, which would help get interest rates off their lower bound. But UK policy makers only have one thing on their minds at the moment. It is Brexit at any cost. We know that because they show no interest in any other options. Right now God could reveal to climbers on Ben Nevis that Brexit would cost the average UK household 20% of their income, and policy would not change. [0] While some in the government may be tempted by fiscal expansion as a way to hide those costs, the Treasury seems to be keeping an iron grip on the purse strings. Never has the UK government seemed so politically secure, and never has it been further from sensible economics.

Not all of the Eurozone’s problems are due to a failure to recognise Keynesian macro. As Martin Sandbu argues here, what has been done and continues to be done to Greece is the age old story of the creditor refusing to admit that they have made bad loans, and therefore squeezing the debtor for every last drop and not realising that doing so only makes things worse. But even here a failure to understand Keynesian economics contributes to this lack of understanding. A country that is allowed to recover from a demand led recession will be far more able to find resources to pay back debt.

However if you look very hard there are signs that things might be improving in the Eurozone. Fiscal austerity at the aggregate level seems to have come to an end. Some key actors, even in EC institutions and governments, are beginning to see how austerity policies may only encourage the rise of the populist right. But that is a long way from the key reform that is required, which is replacing the existing fiscal architecture with something more Keynesian that recognises the mistakes of the past.

If anything is going to happen at all, I doubt if it will be the abandonment of the stability pact and fiscal compact, desirable though that would be. What seems more likely is a gradual adaptation of the mess that all these rules already are. The adaptation does not even need to look like Keynesian policy. National fiscal and macroprudential policies need to focus on inflation differentials between the individual country and the Eurozone average. This focus could be embodied in a rule, which still allowed debt or the deficit to be guided by a target when inflation was at the zone average. This rule has to be symmetric in inflation differentials, prescribing fiscal expansion if a country’s inflation is lower than average.

Equally disappointing has been the complacency of independent central banks. We have had the most prolonged recovery from recession, with lasting damage to long run supply, but you might be forgiven for thinking that we were still in the Great Moderation. Central banks should be busy comparing the four main ways of avoiding another Zero Lower Bound episode: a higher inflation target, negative nominal rates, nominal GDP targets or helicopter money. They also have to stop being so discreet about fiscal policy. Keeping quiet itself makes another ZLB episode more dangerous.

Occasionally people ask why my blogs seem to be as much about politics as economics these days. I agree, there has been a change since 2015. Before that, I would have greeted a new paper on fiscal multipliers by comparing it to the existing literature, and examining its strengths and weaknesses. These days there just seems so little point. I do hope all this knowledge will one day see the light of day among policymakers, but right now I wonder if there is an equally good chance that policy makers will stop paying for knowledge they have no intention of using. [1] Sometimes writing about the finer details of estimated multipliers can seem like rearranging the deckchairs on the Titanic.

[0] Here are some man-made estimates

[1] U.S. U.K.

Structural Reforms and Greece

Should the Troika - the Eurogroup, ECB and IMF - be concerned about how bread is sold in Greece? You would think they had more important things to worry about, like getting Greece out of the huge recession caused by their own policies. But no, you would be wrong. The Troika decided that standards specifying the weights that loaves could be sold at were a restrictive regulation, and demanded change.

This is one of the examples Joe Stiglitz quotes in his new book on the Euro, which I review in the New Statesman here. Now you might agree that at the very least this represents a misdirection of the Troika’s energies, and more generally that it involves unwanted interference in national sovereignty. But in Joe Stiglitz you have one of the best economists in the world, so he also tells you that there is a long-standing economics literature on how regulations like these can increase competition because they facilitate comparison shopping.

Stiglitz is very critical of many other ‘structural reforms’ that were imposed on Greece by the Troika. The only structural reforms that it might have made sense for the Troika to suggest were measures that would have moved resources into exports, thereby helping an external demand led recovery (see Ireland or Spain). As I note, even here Troika meddling may have had undesirable consequences.

As I said in a recent post, a little knowledge can be a dangerous thing. But of the three parts of the Troika, the IMF ought to have the knowledge to do better. (The ECB has apparently just created a task force to consider economic reforms.) Over 1,500 economists work at the Fund. Whether that knowledge gets to the right people at the right time is another matter. But I suspect the main problem at the fund is politics rather than economics. I have written about this recently, in the context of an Independent Evaluation Office report on the IMF’s Troika role. Here is a more substantive piece by Edwin Truman at the Peterson Institute in a similar spirit.

Greece is currently trapped in a debtor's prison created by the Troika. The Troika insist that debts have to be repaid. The IMF knows the prisoner does not have the ability to do this, but does not have the political will to demand that as a result the prisoner should be released. Debt repayment requires yet more austerity, which kills the chance of the recovery, so even with austerity debts are not repaid. Some debt forgiveness is probably in the interests of everyone, including the creditors, because after a recovery Greece will be in a much better position to pay any remaining debts. But it is politically unattractive for the creditors, so it does not happen.

This is a disaster for Greece, but a bad omen for Brexit. Those who advocated Leave say it is in the Eurozone's interests to agree favorable trading terms with the UK. To do otherwise would be to sacrifice economic interests to make a political point. The obvious irony of course is that this is exactly what Brexit was: sacrificing economic interests to make a political point. But Brexiteers want to believe, in their topsy turvy way, that European leaders would not be as reckless as they are. Greece is an example of how Europe's political leaders can also discard economic logic if it is in their own political interest to do so. 

Brexit and the Left

There seem to be two strands of opinion which encourages people on the left to vote Leave. The first is an intense dislike of what has happened in the the Eurozone: see Larry Elliott for example. The second is a wish to take seriously working class concerns over immigration.

I share the intense dislike over what has happened in the Eurozone (EZ). You only need to read, for example, what I have written about Greece to see that. Yet I cannot see how UK exit from the EU will change for the good how the EZ works. Crucially why should it change the current politics of Germany that has been so important in many of the bad decisions the EZ has made. As we are not part of the EZ, it is difficult to see how UK exit will help its demise, if that is what you want.

As we will be leaving the EU and not the EZ, the message Brexit sends to Europe is not that the EZ is fundamentally flawed but rather that the UK is incapable of being part of any cooperative agreement among European countries. I am internationalist by nature so I do not want that. The idea that Brexit will shock the EZ into mending its ways, then thank us for showing them the light and invite us to rejoin whatever is left is pure fantasy.

There is one way the EZ crisis has impacted on the UK, and that is migration. It seems reasonable to assume that one reason immigration into the UK from the EU is currently high is because of considerable youth unemployment in many EZ countries. Which brings us to immigration concerns.

Take this from Kate Hoey for example. She seems to be arguing that free movement in the EU is a means of keeping down the wages of the low paid. The first point to make is if labour mobility keeps wages down in the destination country, it should increase wages and/or reduce unemployment in the country the migrant came from. As migrants move from lower to higher wage countries, then migration tends to equalise incomes. This should normally count as a plus from a left wing perspective.

But does migration have this effect on the receiving country? There are many reasons why it might not, and the evidence does not point to strong negative effects on wages. But I think the case for migration is stronger than that. A pretty robust finding is that migration at the kind of levels we are now seeing does not do any harm to GDP per head, and could improve it. Another robust finding is that current migration benefits the public finances. This is both important and pretty obvious..

Migrants tend to be young, healthy and working. They provide more in terms of resources than they take out by using public services. I remember having a conversation about this with someone who lived in Spain. He said if anyone should be angry about free movement it is Spain, in having to take lots non-productive British pensioners who will be a burden on Spain’s health service. This was also one reason why Merkel could be so open to refugees: Germany is really worried about the implications of their aging population. [1]

If migration falls following Brexit (a big if), and if we add in the other negative effects of Brexit, we will have a large increase in the government’s budget deficit even at full employment. Given government policy on how holes in the deficit are to be filled, this NIESR analysis suggests you are talking about large hits to the lower paid.

None of this is to deny real grievances about reduced public services and lower pay. Once again I do not think I and many others could be accused of keeping quiet about the stupidity of current austerity. But just as the grievances are real, it is also important to understand the real causes.

A consistent result in polls is that migration is a concern mainly in areas where there is little of it. In this poll only 19% of people say they believe immigration has had a negative effect on them personally. (More believe they have experienced positive effects.) Yet over 50% say it has had a negative impact on the NHS. In reality the NHS is in crisis because of government policy, not because of immigration. But to know that you need to talk to the experts and look at the figures. Instead most people will just have read the newspapers, many of which have taken every opportunity to play up the ‘threat’ of migration. As Paul Mason nicely puts it, you can tell this is a fake working class revolt from looking at those leading it.

This is part of a more general point on migration. Migration appears to be at worst neutral and probably beneficial for medium term UK prosperity, so if there are problems for some groups that can be fixed. At which point those on the left say that is naive because it will not happen. That is a reasonable point, but the same point applies in spades to the immediate aftermath of Brexit, which will amount to yet another shift to the right. The regulations that those running the Leave campaign want to ‘free’ us from are those protecting workers and the environment.

To make this clear, think of two realities (economists would call them states of the world). One (the status quo) involves those currently in charge remaining in charge. The second (left renaissance) involves left wing governments coming to power in the UK and elsewhere. It seems to me that if you stay in either one of these two realities, Brexit is clearly bad. (For a similar argument, see this by Alex Andreou.)

Under the status quo, the EU is currently a moderating influence on this right wing UK government. A post-Brexit Boris Johnson government would take away worker rights that the EU currently ensures and, as the deficit deteriorates, cut welfare benefits including tax credits. This alone will dwarf any benefit working people might get from less immigration. Under a left renaissance migration benefits the economy as a whole as well as those who migrate, and these gains could be fairly distributed. My feeling is that some Brexit supporters on the left move freely between these two realities in order to justify a vote for Brexit.

[1] One fair point made in comments on earlier posts is that migrants need to be housed, so resources are used to provide additional housing. (More generally new labour needs new capital of various kinds.) But housing also represents why migration can be beneficial to everyone. We need to build more houses anyway, but according to the industry we have an acute shortage of skilled construction workers. Of course this is an indictment of UK training programmes, but that cannot be turned around quickly. For those with construction skills, it is surely better to be building houses where they are really needed than being unemployed in places they are not.

Is the Eurozone dying?

In a recent article, Larry Elliott from The Guardian wrote this about the Eurozone:

“The eurozone is economically moribund, persists with policies that have demonstrably failed, is indifferent to democracy, is run by and for a small, self-perpetuating elite, and is slowing dying.”

He describes this as the elephant in the room in discussions over Brexit.

I have some sympathy with this, but with one crucial difference. I do not think the Eurozone is slowly dying. I also differ from many who think it will escape death by morphing into a full fiscal and political union any time soon. Instead I think the Eurozone will continue in something like its present form for some time (decades rather than years): a monetary union with fiscal and most political decisions at the national level.

In terms of macroeconomics there is no obvious crisis that will lead to its demise. As I have noted recently, I think it is more likely that we will see reasonable (or better) growth over the next couple of years. Yes unemployment will remain too high and this is a shockingly unnecessary state of affairs, but as the UK discovered in the 1980s it is not one that threatens the existing social and economic order.

The Eurozone’s treatment of one of its own members, Greece, is intolerable: I have compared the Troika’s treatment of Greece to British actions during the Irish famine. But that does not mean it will not continue. I was surprised at Germany’s willingness to countenance Grexit and the desire of the Greek people to remain. As an economist might put it, the resulting situation may be incredibly suboptimal (even in a Pareto sense), but it looks like an equilibrium. In simpler language, virtually everyone could be better off by doing something different, but unfortunately the only people who might be better off by continuing the status quo are the politicians in control.

The biggest threat facing the Eurozone right now is not economic but political. It is dealing with migration and the associated rise of the far, and often Eurosceptic, right. That challenge will ensure that no one will risk further union, even though it is indeed the prefered option of many in the governing elite. The threat to liberal democracy posed by not only these groups, but also the current governments in Hungary and Poland, is worrying indeed. But so is the possibility of Donald Trump as POTUS.

What does the likely survival of the Eurozone in something like its present form imply for Brexit? My own view is not much, because our opt out from the Euro is safe. On other matters? I have spent much time on this blog and elsewhere criticising German macro policy, but that largely influences the Eurozone. On issues that do influence in the EU, German policy often puts the UK to shame, such as on the environment or migration. It was also the EU that legislated to cap bankers bonuses, a measure which George Osborne tried everything to reverse. On issues like this political cooperation across borders is vital because we live in a globalised world where capital is highly mobile.

The Eurozone recovery

Which posted the strongest growth at the beginning of 2016: the US, UK or the Eurozone? The answer is the Eurozone. Growth at 0.6% for the quarter (about 2.5% at an annual rate) is nothing to write home about, but it is not the stuff of doom and gloom either. Reasonable growth like that should come as no surprise. The economy is receiving as much monetary stimulus as the ECB can currently muster, and fiscal contraction has come to a halt.

Inflation is still well below target, but the reason for that is straightforward enough (as Martin Sandbu points out): there is still a lot of spare capacity. Inflation will only stabilise at around the 2% target when that spare capacity has disappeared. Policy should be doing everything (more public investment!) to ensure that happens through strong growth rather than, as seems to have happened in the UK, a gradual contraction in supply. On inflation the ECB should make their target 2%, rather than the current ‘below but close to’ 2%, to avoid the Japan problem that Narayana Kocherlakota discusses here.

I went further when I wrote two weeks ago (the GDP figures came out a week ago) that “I also think we may see rapid Eurozone growth before [2020]”. By rapid growth I mean something in excess of 2.5%. I said that because I was adding one other factor into the mix of fiscal neutrality and monetary expansion, which is that the Euro has been pretty competitive for well over a year. As Martin points out, that has so far not contributed anything to recent Eurozone growth.

I have read in a few places recently people saying that the impact of international competitiveness is not what it was. I agree with Paul Krugman that this pessimism is unlikely to be warranted. I have spent a significant part of my working life estimating and applying trade elasticities (the impact of international competitiveness on trade and hence demand), and this experience has taught me that this effect is a bit like Milton Friedman’s description of how monetary policy works: there can be long and variable lags. So I expect that the Eurozone’s competitiveness gain over the last year and a half will begin to impact on Eurozone GDP at some point in the next year or two, and that might just provide more rapid growth than we saw at the beginning of 2016.

Multipliers from Eurozone periphery austerity

For macroeconomists

We often see graphs relating fiscal consolidation to output growth since the Great Recession. Despite such scatter plots being very weak evidence, they appear to show that fiscal multipliers in the periphery countries like Greece have been very large indeed. At first sight this is not difficult to explain. These countries do not have their own monetary policies, and to the extent that fiscal consolidation reduces local inflation, real interest rates will rise, which increases the fiscal multiplier.

Unfortunately the basic New Keynesian (NK) model suggests this reasoning is incorrect, as Farhi and Werning show for temporary changes in government spending. While real rates might rise in the short run following a negative government spending shock, being in a monetary union ties down the long run price level in these economies. So, other things being equal, a negative government spending shock that reduces inflation now will be followed by higher inflation (compared to the no shock case) later, as the real exchange rate self-corrects. That in turn means that fiscal consolidation in the form of temporary cuts to government spending will produce a small rise in consumption for a period after the shock. (Consumption depends on the forward sum of future real interest rates, so as time progresses lower future rates dominate this sum.)

Of course that may simply mean that the basic NK model is incorrect or incomplete. As Farhi and Werning show in the same paper, with some credit constrained consumers we can get back to positive short term consumption multipliers, and therefore output multipliers greater than one. But it occurred to me, just before I was about to discuss this paper in an advanced macro graduate class, that the basic NK model could still give us what appeared to be large multipliers without such additions.

What we had in periphery countries was not just a government spending shock. In Ireland and Greece at least, that spending shock was preceded by a government debt shock. Either the government admitted to borrowing more than the official data suggested, or it had to bail out the banks. We can think of at least two types of response to a pure government debt shock. It could lead to a short sharp contraction in spending, in which case the analysis of Farhi and Werning would apply. Alternatively the government accepts that its debt will be permanently higher, and it only plans to cut spending or raise taxes to pay the interest on that additional debt.

In the latter case, assume that a significant proportion of that extra debt was owned overseas. We would have a permanent transfer from domestic to overseas citizens, and that would require a permanent depreciation in the real exchange rate. An increase in competitiveness is needed to make up for the permanently lower level of domestic demand that these transfers would produce. That in itself produces a terms of trade loss that impacts on consumption. But in addition in a monetary union, that depreciation would have to come about through a period of lower inflation, which would lead to a period in which real interest rates were higher. That in turn would decrease consumption, with the peak effect when the debt shock happened.

This is probably already written down somewhere, but it does explain why you could get apparently large multipliers in Greece and Ireland even if the simple NK model was broadly correct. What we had was a combination of a negative government spending shock and a positive government debt shock, and the latter could have led to significant falls in consumption. For these economies at least, true government spending multipliers may not be as large as they appear.

There I go again, choosing my economics to get the answer I want. Oh, wait ….

A crisis made in Germany

The headline in my latest article for The Independent may seem like a wild exaggeration. But if we are talking about a crisis that impacted on unemployment in the entire Eurozone (except Germany) rather than just the periphery, then I think it is reasonable. It was German policy makers that insisted that the Eurozone embark on general austerity in response to problems in the Eurozone periphery. It was the influence of the Bundesbank and others in Germany that helped the ECB raise interest rates in 2011, and delayed a QE programme until 2015. Those two things together created a second Eurozone recession.

Even if we stick to the periphery countries, the crisis outside Greece would have been a lot more manageable if the ECB’s OMT programme (which allowed the ECB to act as a sovereign lender of last resort) had been implemented in 2010 rather than 2012. It is politicians in Germany that have attempted to declare the OMT programme illegal. And none of this touches on the impact of Germany on Greece. I could also add (although it is not in the article) that if the Eurozone had adopted sensible countercyclical fiscal rules from 2000 the scale of the periphery crisis would have been reduced, and Germany had a large role in the deficit focused rules that were actually adopted.

Of course Germany did not make Greek governments behave in a profligate manner. Of course Germany did not force Irish banks into reckless lending. Their own banks may have helped facilitate both, but so did banks in other core countries like France, and in the UK for that matter. Yet German influence helped magnify the periphery crisis, and Germany was central in turning a periphery crisis into an existential event that impacted on pretty well every Eurozone country, except Germany.     

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.

Europe’s other taboo: reform of the ECB

At a recent meeting of European economists I remarked that there were two big taboo subjects when discussing how the Eurozone might be improved. The first, which I have talked about before, is countercyclical national policies, which could include macroprudential monetary policies but which also must include fiscal policy. It is blindingly obvious that such policies, if implemented, would have put the Eurozone in a much better position before the 2010 crisis, but despite this the subject remains ‘off the agenda’.

The second taboo subject is reform of the ECB. Once again, it is pretty clear to anyone outside the Eurozone that since 2010 ECB decisions have been very poor, both in absolute terms and relative to their counterparts in the US, Japan and the UK. The three big errors are well known:

1. A failure to introduce OMT in 2010, delaying it to September 2012
   
   
2. Raising interest rates in 2011
   
   
3. Delaying Quantitative Easing until 2015

No one disputes (2). Some say that (1) and maybe (3) were because the ECB had to wait until it was clear that particular countries were serious about undertaking ‘reforms’. This explanation raises more questions than it answers. The ECB’s remit does not extend to dictating national economic policies, but sometimes the ECB appears to think otherwise.

Alongside these big errors are many examples of ECB actions which are highly questionable, the most recent involving Greece. Imagine the Bank of England cutting off the supply of cash to Scotland if negotiations between the Scottish and UK governments were not going the way the UK wanted. Those who say the ECB was only following its rules neglect to observe that the ECB makes up its rules as it goes along. Even in more minor matters, actions of ECB officials which would do more than raise eyebrows elsewhere go on for years without anyone finding out.

One major error alone might not be enough to indicate reform, but three suggests that structural reform is essential. Yet the one structural reform no one in the Eurozone will talk about is at the heart of the Eurozone itself. The reason of course is also why no one will talk about countercyclical fiscal policy: it does not fit in with the dominant German narrative. What is a shame is that this taboo among policy makers is infectious: at the meeting where I talked about this taboo only one or two others mentioned the ECB.

This is a shame, because some imagination is required in thinking about ECB reform. A reasonably obvious change to make is to take monetary policy decisions away from the exclusive control of central bankers, along UK lines. But who would appoint any external members? Here we have a tricky problem - the lack of political union means that any political accountability may be too diffuse to be effective (as it is at present). But the point of this post is not to offer solutions, but to complain that not enough people are talking about the problem.

Politically impossible

An article in the Financial Times recently said of me: “He has opposed deficit reduction when the economy was weak and when it was strong.” Ah yes, this would be the same economist who has suggested the left aims to reduce the current deficit (all current spending less revenue) to zero, that pre-crisis fiscal policy in the Euro periphery should have been much more contractionary, and has championed fiscal councils as a way of eliminating deficit bias.

Should I have demanded a retraction? I didn’t: life is short, maybe it was a kind of joke, or even a misprint, and if not perhaps it said more about the writer than it did about me.

But I was reminded of it last week when I was discussing pre-crisis fiscal policy. As I noted in one of those earlier posts, I am repeatedly told that pre-crisis fiscal policy in Spain could not have been tighter. It was ‘politically impossible’, given the budget surpluses at the time. I heard a similar point made about Ireland last week. (While a big part of Ireland’s post-crisis fiscal problems were down to socialising its financial sector’s debts, a significant part was also due to relying too much before the crisis from receipts based on an unsustainable housing boom, as was the case in Spain.)

It occurred to me (and yes, I know it is obvious) that such complaints are just the mirror image of those who say we have to have austerity because running up higher government deficits is just ‘politically impossible’. The argument that governments cannot run very large surpluses because voters would demand that they be spent relies on the same logic which says that governments need to tighten their belts when the private sector is doing the same. In other words you cannot complain about austerity on the one hand and then say that it was politically impossible to run larger surpluses in a boom.

Equally it makes no sense obsessing about the need to reduce deficits in a recession and then turning a blind eye when surpluses are spent in a boom. Unfortunately just that kind of inconsistent thinking became hard-wired in the form of the Stability and Growth Pact (SGP), with its focus on a limit of 3% for deficits. Those who say that all that was wrong with the SGP is that it was not enforced have learnt nothing. This is why we need to move influence away from the Commission and towards independent national fiscal councils.