The real obstacle for the Brexit negotiations

I’m not going to say anything about the content of yesterday’s speech: I talked about the likelihood of a transition arrangement that involved us staying in the Customs Union and Single Market back in March. My only uncertainty then was whether May could be pushed to a No Deal outcome, but as the government has done absolutely nothing to prepare for that outcome it now seems an empty threat. As for a two year transition period, its an insider joke. You have to have no idea about trade negotiations to imagine it could be done in that time, but as that includes most Brexiteers it serves its purpose.

Instead I want to talk about is what could be the real obstacle to the negotiations moving on to the next stage, and that is the Irish border issue. Many have noted that putting it as a first stage issue seems illogical, because what happens to the Irish border will depend on future trade arrangements between the UK and the EU. There obvious answer to why the Irish border question got put in the first stage is that the EU want to force the UK into staying in the EU’s Customs Union precisely to avoid recreating a border between the two parts of Ireland.*

The UK’s paper on this question makes it clear that there is no realistic compromise on this issue, as Ian Dunt’s discussion makes clear. There is a third way, which is for Northern Ireland to remain part of the Customs Union while the rest of the UK is not, but the DUP will have none of that. This was a major implication of the election result and May’s bribes to obtain a confidence and supply arrangement with the DUP.

A key political question will therefore be whether the Irish government and the EU will play this card that they have dealt themselves. The Irish government would like to, but I suspect (from past experience) that if they came under pressure from the rest of the EU they would back down. But the EU would also like the UK to remain in the Customs Union to resolve the border issue. Indeed everyone would be better off if the UK committed to staying in the Customs Union on a permanent basis. The only obstacle to this are the fantasies of Brexiteers, personified in the department led by Liam Fox.

I said I was not going to talk about it, but perhaps this was one reason why May gave her speech yesterday. By confirming that there could be a transitional deal (which Richard Baldwin might call a pay, obey but no say period), she hopes to dampen the resolve of the Irish government and the EU to make this a sticking point in the negotiations. Will either party think to itself 2 years will become 5, by which time we will have a different government that is likely to make the transitional permanent, or will they use their dominant position in the negotiations to try and force the UK to stay in the Customs Union to avoid creating a border (and perhaps also force the resignation of Fox and others)? At the moment we do not know, but I suspect once again Mrs. May and her cabinet have misjudged the EU side.

*I've added to this sentence and elsewhere compared to the first version of this post, which might have been construed as implying the border was being used as an instrument to achieving an economic goal. I do not think that is the case.     

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 ….

The ECB as sovereign lender of last resort

Understandably the element of my talk at the Royal Irish Academy which generated most discussion was the role of the ECB. (Here is a media report, but ignore the last two paragraphs which are confused/wrong. Abstract for the talk is here. Paper will follow.) The proposition I put forward was that the ECB’s OMT programme should have been put in place in 2010, and if it had been countries outside Greece could have implemented a more efficient austerity programme (one that produced less unemployment) and might have retained market access (interest rates on government debt would have remained reasonable). [1]

There are two serious and related arguments against this view. The first is that it is unrealistic for the ECB to act as a sovereign lender of last resort because of the transfers between countries that this might lead to. (A sovereign lender of last resort is a central bank that is always willing to buy its government’s debt.) [2] The second is that in practice OMT is bound to be coupled with a requirement for austerity programmes that might have simply duplicated what was actually put into place by national governments. Both arguments speak to a real problem that remains unresolved within the Eurozone, but do not nullify the argument that things should have been done much better.

Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default. The second is that an individual investor does not need to worry about market beliefs, because if the market panics and refuses to buy the government’s debt the central bank will step in (hence sovereign lender of last resort). If the central bank did not do this, the government might be forced to default because it cannot roll over its existing debt.

It makes sense for the central bank to act as a sovereign lender of last resort, because it avoids self-fulfilling market panics. Doubly so because such panics will be more likely to occur after a large recession when the social value of government borrowing is particularly high. The complication in the case of the ECB is the following. If the market panic is so great that the ECB was forced to actually buy a ‘distressed’ government’s debt (normally the threat to do so is enough), it is possible that this government might choose to default even with ECB support. If it did that, the ECB would make losses which would be born by the Eurozone as a whole (the transfer risk).

Partly for this reason, the ECB has to have the ability not to act as a sovereign lender of last resort, or withdraw support if circumstances change. If that ability exists (a point I will come back to), then the transfer risk associated with the ECB acting as a sovereign lender of last resort are tiny. It represents the kind of minimal risk that should always be offset by the trust and solidarity that comes with the territory of being in a monetary union. I suspect those that suggest otherwise are often trying to hide other motives.

A government that is receiving ECB support of this kind will naturally want to know what it has to do to maintain it, because the threat of its withdrawal is so great. It would be unreasonable to withhold that information. Does that in practice amount to nothing more than the kind of conditions that have in practice been imposed on Ireland and Portugal anyway? Absolutely not. Just as the market does not worry about the build up of debt in a recession in countries like the UK or Japan, a rational ECB would have no reason to impose fiscal consolidation at the time it would do most damage. The time a rational ECB might withdraw its support is once a recovery is complete and the government refuses to embark on fiscal consolidation.

So a sovereign lender of last resort in a monetary union must have the ability not to provide that support. In other words it has to sort Greece from Ireland. That decision is a huge one, because in effect it is a decision about whether the country will be forced to default. It is natural that the ECB wants to share that responsibility with member governments, but as we have seen with Greece member governments are hopeless at making that decision (particularly when their own banks may be compromised by any default). We have also seen that European central bankers are far from rational on issues involving government debt (compared with at least one of their anglo-saxon counterparts), so giving the decision to someone else other than the current ECB would seem like a good idea. However at present there is no institution that seems capable of doing this job.

In this post I suggested contracting out this task to the IMF, although that presumed a reduction in the political influence of European governments on that institution. I have also wondered about whether a body like the newly created network of European fiscal councils could play this role. Another possibility is to reform the ECB so that it is not subject to deficit phobia, and is more accountable. It seems to me that this is where current research and analysis should be going, rather than into schemes involving greater political union.

The existence of various alternatives here means that we should not take what has actually happened in the Eurozone as some kind of immutable political constraint beyond which economics cannot go. There is no intrinsic reason why the OMT that was introduced in September 2012 could not have been introduced in 2010. There is no intrinsic reason why any conditionality that went with that could not have been much more efficient in terms of unemployment costs. Beyond Greece, the Eurozone crisis happened because the ECB thought it could avoid undertaking one of the essential functions of a central bank. This was perhaps the most important of the many errors it has made.

[1] For a country within a monetary union which needs to reduce debt more rapidly than does the union as a whole, a gain in competitiveness relative to the rest of the union is required to offset the deflationary impact of fiscal consolidation. That ‘internal devaluation’ probably requires some increase in unemployment, but it is much more efficient to obtain that increase in competitiveness gradually.

[2] It could be argued that the Fed does not provide lender of last resort services to individual member states. But state debt is typically lower relative to GDP and income than for Eurozone governments. Before 2000, Eurozone governments were able to borrow more because they were backed by their central bank. That means that they are inevitably subject to a greater risk of suffering from a self-fulfilling market panic. The architects of the Eurozone might have initially believed that the SGP might avoid the need for a sovereign lender of last resort, but after the Great Recession they would have known otherwise.

Fiscal council developments

As longstanding followers of this blog will know, I have a particular interest in what are called either ‘fiscal councils’ or ‘independent fiscal institutions’. As I have been and will be preoccupied with other issues for a while, I thought I would try and squeeze in one post on recent developments both in the UK and abroad.

In the UK we had Dave Ramsden’s Treasury review (pdf) of the OBR. The most positive aspect of the review is the recommendation for more resources. I guess the headline news was that the OBR would not be asked to cost opposition policies before elections, as the Dutch fiscal council has done for some time, and as the Australian PBO now does. I would have liked a different decision, but my disappointment is mitigated by three factors:

• the report does recommend the “OBR should ensure greater availability of tools and data to allow third parties to cost alternative policy options”.
  
• in the UK we have the IFS, which does do this and currently (and rightly) has a quasi-official status
  
• the level of the fiscal debate in the UK media is currently so poor that I’m not sure how much such a development would improve things.

This last point raises something of a paradox. People like me hoped that fiscal councils like the OBR would improve the public debate. This paradox reflects in part the particular nature of the OBR, which would not be allowed to say - for example - that the fiscal charter is economically illiterate (i.e. no economist agrees with it). Fiscal councils in some other countries can do that, and indeed were set up to do that. This is a gap the IFS cannot fill. I guess the OBR will not be allowed to comment on the economics of different fiscal rules until the UK gets a more sensible rule. I think it is quite likely that if the OBR was able to say such things, we would not have had this particular fiscal charter and we would all be better off as a result.

With the rapid growth in the number of fiscal councils around the world, the case for some kind of international network has become much stronger. It is therefore good news is that one is about to be established for those in the EU. There are at least two important roles such a network can have, apart from the obvious one of spreading best practice.

First, it can help establish and maintain independence for individual fiscal councils, which may be put under various kinds of pressure by their national governments. Sometimes this pressure is just verbal, and often indicates that the council is doing its job. I have just come back from Ireland, where the Irish fiscal council criticised a pre-election giveaway by the government. Its chairman John McHale also suggested that it might break the Commission’s fiscal rules. The government then revealed that it had obtained agreement from Brussels, but had not told the fiscal council. It managed to spin this as an error made by the council, which journalists dutifully parrotted. Substantive criticism was thereby deflected. That kind of thing from governments is only to be expected. It becomes more serious when governments react to criticism in financial or even existential terms, as has happened in Canada and Hungary. In those cases, the council needs all the defence it can get.       

Second, a network can act as an important pressure group on the Commission. The Commission itself has recently established an Advisory Fiscal Board, which if nothing else can increase the dialogue between the fiscal councils and the Commission. I talked about the dual system of fiscal monitoring within Europe here, and how I hope we will see a gradual reduction in central control and more discretion given to national governments monitored by strong national fiscal councils. If Daniel Gros is right and German hegemony is coming to an end, then maybe it might just happen - one day.     

 

Ireland and Greece

Ireland is often regarded as a success story for Eurozone austerity, compared to the total failure of Greece. That can lead to nonsense like this: instead of whingeing, the Greeks should buckle under and get on with it as Ireland has done. An alternative narrative is to explain the different experience of the two economies by looking at structural factors, as in these two examples.

Whether you can describe Irish unemployment rising from 12% in 2009 to 14.7% in 2012 as a success is of course moot. But Ireland does give us a clear example of how austerity is supposed to impact an open monetary union member, according to standard theory. A permanent reduction in government spending or higher taxes will increase unemployment, which will reduce wages and prices. This will improve competitiveness, leading to higher external demand for Ireland’s products (and less imports) which will eventually replace the lost demand due to austerity. However, because wages and prices are ‘sticky’, this adjustment will not happen quickly.

The fact that Ireland is now growing strongly and unemployment is falling reflects this process. The OECD estimates that growth in 2014 was nearly 5%, and this was greatly helped by a 12% increase in the volume of exports. In this sense Ireland’s response to austerity has been textbook. The interesting question is why Greece has been so different. Here is growth in the two economies (all data comes from the OECD’s Economic Outlook). .

Of course the 2009 recession affected everyone, but from 2010 until 2014 the Irish experience was bad, but for Greece it was a disaster.

The most important reason for the difference is straightforward: there has been a lot more austerity in Greece. Here is one summary measure: the underlying government primary surplus.

Looking at this measure the fiscal contraction between 2009 and 2013 in Greece has been 2.7 times greater than in Ireland. This measure is not ideal because the impact of tax changes can be smoothed, but looking at changes to government consumption gives a similar picture.

In both cases we have had what economists call ‘internal devaluation’, which is the improvement in competitiveness that I described earlier. Here is what has happened to wages.

The fall in wages in Ireland produced a significant improvement in competitiveness, which is a major factor behind why exports are now booming. With much more, and more persistent, unemployment in Greece, the fall in wages has been much more persistent. So we would expect a much larger and more persistent improvement in competitiveness and exports. But here we have a small puzzle: neither has happened. Here are export volumes in both countries.

The pattern is similar, but if anything the improvement in exports has been greater in Ireland than Greece.

Is this where stories of structural weaknesses in Greece come in? In one sense yes. Greece certainly exports less than you might expect given the usual (‘gravity’) models that economists use to explain such things, as this European Commission study shows. The study also argues that you can explain this finding by institutional weaknesses in Greece’s economy. That in turn is one factor behind a very important difference between Ireland and Greece. Ireland is much more open, which means that any percentage increase in exports will have a much bigger impact on GDP and employment than in Greece. (It also receives much more foreign direct investment.)  In technical terms, if the slope of the Phillips curve is similar in both countries, Greece’s adjustment was always going to be more difficult, because it is a much less open economy.

However it is not clear why these structural differences should make Greek exports less responsive to any change in wages. What appears to explain this puzzle is that competitiveness in Greece has improved much less than in Ireland, even though the fall in wages has been greater. Theodore Pelagidis at Brookings has an explanation: other non-labour costs have gone up to offset these lower labour costs, particularly energy prices. He writes:

“part of the adjustment program Greece had proceeded to significantly increase excise taxes on energy used in productive activities…..The resulting evolution of exports in energy intensive sectors like steel and textiles is most revealing. In spite of the large fall in wages, the rapid increase in energy costs meant that exports of these commodities, price takers on the international market, plummeted…..These two sectors largely account for the stagnation of Greek non-fuel exports”

To what extent these increases in energy taxes were sanctioned by the Troika is unclear. However one of the measures imposed as part of the latest agreement is an increase in VAT for the tourist industry, which of course will also hit competitiveness in that industry. In both these cases, austerity measures have and will actively hinder the way the economy adjusts to fiscal consolidation.

To sum up, the main reason Greece has suffered so much more than Ireland is that the amount of austerity imposed on Greece has been much greater. Any recession is also likely to be greater because Greece is a less open economy, so a larger internal devaluation is required to offset the impact of austerity. One final factor is that large cuts in wages have not been translated into improvements in competitiveness, in part because of the way austerity was implemented.  

Alternative Eurozone histories

I missed this paper by Philippe Martin and Thomas Philippon when it came out last October, but thanks to Francesco Saraceno I have now read it. There is also a VoxEU post by the authors. It is particularly interesting for me because it undertakes analysis (using a model which is itself interesting but which would make this post too long to discuss) of a couple of alternative histories for the Eurozone which are related to two claims that I have made in the past:

1)    It is now widely accepted among macroeconomists (but not politicians or the media) that fiscal profligacy was only the major cause of subsequent problems in Greece, while elsewhere private excess was the main problem. I have argued that aggressive countercyclical fiscal policy before 2008 would have reduced subsequent problems.

2)    If the ECB’s OMT programme had been implemented in 2010, rather than September 2012, this would have substantially reduced the degree of austerity required outside Greece. As a result, these countries would have had a better recovery from the Great Recession. [2]

Put the two claims together and I would argue that the 2010-12 Eurozone crisis (rather than just a Greek crisis) need not have happened. OMT would have limited fears of contagion, allowing a quicker and more complete Greek default. There would have been no funding crisis outside Greece, and no need for the core Eurozone economies to immediately embark on austerity.

How does the paper address these arguments? In terms of fiscal policy, it imagines reaction functions for government spending and transfers that contain a (common) countercyclical element, but also a (country specific) positive drift term, in Greece, Ireland, Portugal and Spain. One counterfactual eliminates the drift. This does not exactly fit the scenario I had in mind, because I see actual policy as not being countercyclical but (Greece apart) having less drift. However the end result is the same: a counterfactual with much more fiscal tightening before the recession. An interesting result is that tighter fiscal policy could have substantially reduced the rise in interest rates spreads in Ireland and Spain. The pre-2008 employment boom would not have happened in Greece, and would have been substantially reduced in Ireland, but the impact in Spain would have been smaller but non-negligible.

It conducts another counterfactual which imagines macroprudential policies that eliminated the household leverage boom in each country. This has a significant effect in reducing the boom in Ireland and Spain. (There was no actual employment boom in Portugal.) By inference a combination of countercyclical fiscal policy with no drift, plus macroprudential policies, would have been ideal.

So claim (1) seems to hold up fairly well. Of particular interest is what would have happened to employment from 2008 under a purely countercyclical fiscal policy. In Spain it would have fallen as a result of the recession, but subsequently stabilised rather than continuing to fall as it did in reality. In Ireland employment would have fallen in the recession, but would have risen again from 2010 rather than continuing to fall. This is partly because countercyclical fiscal policy would have helped, but also because lower levels of debt going into the recession would have reduced the increase in interest rate spreads, easing monetary policy.

With a pure countercyclical fiscal policy the debt to GDP ratio in Greece would have stayed flat (because there would have been no boom), suggesting that the Greek crisis was essentially a result of fiscal profligacy. In Spain the debt to GDP ratio would have fallen to nearly 20% of GDP, rather than staying above 40% of GDP in reality. In Ireland public debt would have been largely eliminated. This indicates the substantial amount of countercyclical policy that was required to tackle what were very large domestic booms. (Fiscal policy would presumably have been less contractionary if combined with macroprudential controls.) It also tells us how foolish it was to have a Stability and Growth Pact which essentially ignored the need for such countercyclical fiscal policy.

Claim (2) is examined in its own counterfactual, which essentially eliminates the increase in interest rate spreads that occurred from 2008. The beneficial effects on all four periphery countries are substantial. This counterfactual is unrealistic for Greece, because OMT should never have been implemented for Greece - immediate default was the better and more sustainable option. However I think it is highly credible that, despite Greece, if OMT had existed in 2010 spreads in other countries would have stayed low. [1]

Francesco Saraceno draws the lesson that the real problems with the Eurozone are institutional, and I agree. The Stability and Growth Pact was misconceived (as some of us argued before the Eurozone was created), because it ignored the need for countercyclical fiscal policy. The ECB delayed acting as a sovereign lender of last resort for two years, creating a Eurozone crisis out of what should have been just a Greek problem. The conclusion I draw, unlike many economists, is that the concept of a European Monetary Union was not inherently doomed to fail. It was the way it was implemented that caused the crisis.

It would be very nice if this was all about history. Unfortunately exactly the same mistakes are continuing, with equally damaging effects. Fiscal policy continues to be pro-cyclical, meaning that we had a second Eurozone recession and no real recovery from that. Monetary policy is either perverse (2011), or 6 years too late (!) and continues to openly encourage fiscal austerity. That most policy makers in the Eurozone have still not understood past errors remains scandalous.

[1] The paper attributes this to the reduced risk of union break up. I suspect it does so because it wants to make interesting comparisons between Eurozone countries and US states. My own analysis has instead focused on the danger of a self-fulfilling funding crisis when there is no lender of last resort. That danger presumably exists for US states.

[2] An interesting question which I have not examined is whether, even if OMT had existed in 2010, it would still have been better for both Ireland and Spain to have written off some of their debt. 

Did Ricardian Equivalence kill the Pigou effect?

For macroeconomists

After the last time the world got into a liquidity trap, there was a debate about whether price flexibility would be sufficient to get us out of the trap. That debate tended to assume a fixed money supply. With that assumption, the answer today would be yes, if falling prices raised inflation expectations (given long run neutrality) and therefore reduced real interest rates. Back then that story was not so popular, perhaps because the debate pre-dated rational expectations. Instead the argument at the time focused on the Pigou or Real Balance effect. Falling prices raised the value of outside money, so everyone would feel wealthier and spend more.

We do not hear this argument so much nowadays. I have not seen this discussed in the advanced textbooks I know well (for example neither term is in the index of Romer or Obstfeld and Rogoff), so I was wondering why that was. Is the Pigou effect not what it was once thought to be? I could not find a clear answer to this question anywhere, but of course that may be my failing. So here are my thoughts, but they come with the possibility that I have just missed something. If I have, I will rewrite the post accordingly.

What I did find were a few papers that appeared to suggest that Ricardian Equivalence (REq) killed the Pigou effect. Here is a quote from a paper by Peter Ireland. After talking about REq, he writes

“Less widely appreciated, however, is a closely related finding, presented most explicitly by Weil (1991) but also implicit in earlier work by Sachs (1983) and Cohen (1985). These authors show that government-issued fiat money will not be perceived as a source of private-sector wealth if the households owning that money are the same households that, first, receive all of the transfers or pay all of the taxes associated with future changes in the money supply and that, second, incur all of the opportunity costs associated with carrying the money stock between all future periods. We are used to the idea of Ricardian Equivalence implying that government debt is not net wealth. Essentially consumers internalise the government’s budget constraint. But that argument applies to outside money as much as government debt. We can replace initial values of debt and money by the discounted future stream of primary surpluses they support.”

The easiest way to describe REq is that the infinitely lived representative consumer consolidates the government’s intertemporal budget constraint (IBC) into its own. Suppose this consumer owns some nominal (non-indexed) government debt, and the price level falls. Is that consumer better off? The real value of the future interest they receive on that debt will be higher, but this will be offset by the higher taxes in real terms that the government will raise to pay for this. The same argument applies to the higher real redemption value of the debt.

Ireland argues that exactly the same points can be made about outside money. Suppose money pays no interest, but consumers hold it because of the liquidity services it provides.

But if the consumer already has all the liquidity services they need (as they do in a liquidity trap), a fall in prices that creates more of this asset in real terms does not make the consumer better off on this account. So what about the redemption value of the additional real balances?

Here I’m inclined to think that money is different from government debt. In a paper[1] that I do not think has been published, Willem Buiter argues that money is irredeemable. The government only promises to redeem money with itself. So if I get a tax cut that is financed by printing money rather than issuing debt, there is no offsetting future tax liability. For this reason, money – unlike government debt – is net wealth for the consolidated public and private sectors.

Now a standard response is to say that a money financed tax cut does not make the consumer better off because the price level will rise, reducing the purchasing power of that money. It seems to me that is a different argument to REq – it requires going beyond just thinking about budget constraints. It is also an argument that does not apply to the Pigou effect, which is what happens if prices fall, raising the value of real balances.

Does the irredeemable nature of money rescue the Pigou effect from the REq argument? Yes and no. There is a crucial difference between Buiter’s analysis and the traditional view. In Buiter, it is the present discounted value of the terminal stock of base money that is net wealth for the consolidated private and public sectors, rather than its current value. To see why this matters, consider the liquidity trap case again.

As we have already noted, there is no liquidity trap in the flexible price case when the government holds the nominal stock of money constant, because falling prices today imply higher expected inflation. We do not need a Pigou effect. But the more interesting case, which I have talked about before, is where the government or central bank has an inflation target. In this case the authorities prevent inflation expectations rising, so real interest rates do not fall.

In that case nominal money will not be held constant when prices fall. Instead, the authorities will contract the nominal money stock in line with falling prices, to make sure inflation does not rise. As a result, there will be no increase in consumption, because the terminal value of nominal money falls, and its real value stays constant. Or, to put the same point another way, higher future taxes required to reduce the money stock will offset the wealth impact of higher current real money balances. There is no Pigou effect.

This is all terribly stylised and unrealistic, so there is no need to add comments that just point this out. However, I hope I’m not the only one who thinks this thought experiment is 
interesting. I also think that the proposition that inflation targets prevent macroeconomic ‘self-correction’ even when prices are flexible has a symbolic importance.

[1] Buiter, W.H. (2003) Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap, NBER Working Paper No. 10163.

What if Ireland voted no to the Treaty

                On Thursday Ireland votes on the Fiscal Stability Treaty. Polls suggest the result will be yes. Will this be a solid endorsement for the clauses of the Treaty, and the vision that lies behind it? I doubt it very much. What may be much more decisive is a clause that only allows access to Europe's new bailout fund to states that ratify the treaty. Given Ireland’s current situation, you could say that voters have very little choice but to vote yes. In addition, I have read quite a few posts over the past few weeks (e.g. John McHale here) suggesting that the Treaty does not impose any additional burdens to the austerity Ireland is already implementing. In that sense, there is no immediate cost in voting yes, if you think the current austerity is unavoidable.

If that is the immediate cost benefit calculus, what about the longer term? Philip Lane writes “My own take is that, if the Treaty is implemented in an intelligent, cyclically-sensitive manner (consistent with the flexible, holistic interpretation laid out in the “six pack” regulations), the new fiscal framework will be a positive force, helping Ireland and other European countries to gradually exit from high debt levels and avoid destabilising pro-cyclical fiscal policies in the future.”

                Unfortunately, I think you could also argue exactly the opposite. If the Treaty is implemented in an unintelligent manner, with an attempt to satisfy all its numerous rules and clauses without regard to macroeconomic context, the results could be disastrous. (If you want an example of how this can happen, see the Netherlands.) As I have suggested before, the Treaty is similar to the Stability and Growth Pact (SGP). True, compared to the original SGP, the emphasis on cyclically adjusted deficits gives formal acknowledgement of the importance of automatic stabilisers. More generally, whereas in the original Pact there were two main criteria for budget deficits, now there are many more (see here, or here). That can be read as flexibility, or it can be interpreted as confusion, muddle and bad economics. Hence both optimistic views like Philip’s and more pessimistic readings (see Karl Whelan here for example) are possible.

                What I believe is clear is the overall vision that the Treaty represents. It sees the essential problem with the Eurozone as being public sector indulgence. This is a profound misreading of what happened before the recession. By far the bigger problem for most periphery countries was private sector indulgence fuelled by cheap borrowing. In Ireland, and now in Spain, this transforms itself into a public sector problem because banks are bailed out.

                The fact that it was excess private sector borrowing that was the ultimate cause of the crisis does not mean that fiscal policy was appropriate. Far from it. Fiscal policy should have been much tighter than it was, because it needed to be countercyclical. However, the idea of countercyclical fiscal policy was nowhere to be found in the original SGP, and hardly figures in the Treaty. If the Treaty had been a realistic response to the current crisis, issues to do with macroeconomic stability (e.g. relative inflation rates, real exchange rate disequilibrium) would be at its centre, rather than as the vaguely worded single paragraph that is Article 9.

                This failure in both the original SGP and the new Treaty to recognise how important countercyclical fiscal policy is to the viability of the Euro is a major, perhaps the major, design flaw. (I have written about this before, but for a similar message see here.) What is worse, the obsession with public sector profligacy has diverted Eurozone policymakers from understanding this, both before and during the crisis. It has also discouraged recognising the scale of the problems facing the banking sector, and indeed the obsession with austerity has probably made this problem worse.

                One response to this argument is political. Yes, the Treaty is a distraction, but it is a pre-requisite for other important reforms of the euro system.  In simple language, the Treaty is needed because without it there is no chance of persuading Germany to even think about Eurobonds and the like. But perhaps what has to change is this German (and Dutch, and Finnish) mindset. As long as the ‘fiscal irresponsibility’ story remains the dominant narrative, we will get either continuing policy inertia, or worse still games of chicken being played with national electorates. That road may lead to disaster, as Boone and Johnson argue here. There needs to be a collective realisation that the causes of the crisis are not as originally advertised. There are solutions (e.g. Nick Stern here), but they require Germany and others to put Euro survival ahead of national self interest. With the election of Hollande, there is a chance of this happening. In this context you could argue that an Irish yes vote does nothing to help change the austerity mindset, whereas a no vote might have contributed to the mindset’s demise.

                That is easy for me to write. It is also easy for me to conjecture from the other side of the Irish Sea that if Ireland voted no, this would make no difference to their ability to receive bail-out funds. Ireland has been the poster boy for the ‘austerity’ cure, and for this and many other reasons the Eurozone is not going to let the little matter of a popular referendum make them throw Ireland to the market wolves. However, I can quite understand that, given what Ireland has been through, it would not want to take that risk for what would, I admit, be little more than a gesture. It may also be that, ironically, Ireland’s opportunity to argue that the Treaty is a dangerous distraction is greater if it votes yes. If the vote is yes, it must take that opportunity.