Some thoughts on crisis resolution
This post was written by John McHale
I would usually include this as a comment on my previous post. Philip has urged us to put more substantive comments as new posts on the grounds that many readers do not read the comments – I hope that is not true.
Commenters have rightly pointed to the substantial uncertainty surrounding the growth projections in the SPU. Kevin’s post also puts a question mark over near-term projections. This uncertainty is a major theme of the IFAC’s recent Fiscal Assessment Report (available here). Although it is benchmarked on the projections in Budget 2012 rather than recently released SPU, one of the things we do in the report is examine the budgetary implications out to 2015 of alternative nominal growth assumptions. The Figures on page 34 provide a sensitivity analysis based on a relatively simple simulation model that allows for two-way causality between the deficit and the state of the economy. Figure 3.3.c shows the implied additional discretionary adjustments that would be required to meet the EDP target of a deficit below 3 percent of GDP in 2015 based on alternative nominal growth assumptions.
On the question of the need for a less contractionary fiscal stance for the euro zone as a whole that Kevin emphasises, Simon Wren-Lewis had a typically thoughtful piece a couple of weeks back on the constraints on fiscal policy within the monetary union (see here). Unfortunately, I am sceptical that much will be forthcoming in this direction. While I am under no illusions about the massive – some might say impossible – political challenge, I think the best route to ease the contractionary forces within the euro zone still remain with the ECB. A credible commitment to a higher euro zone inflation target (say 4 percent) – or, even better, and price-level target based on underlying 4 percent inflation – offers a real opportunity.
While there are downsides, this revised target could accomplish a number of things: (i) with a clear mandate to achieve this single target, it is compatible with a reasonable definition of price stability; (ii) it would allow for lower real interest rates, thereby boosting interest-sensitive spending; (iii) given inevitable nominal rigidities, it would allow for a more feasible route to real exchange rate depreciations in the periphery relative to the core; (iv) it should lead to a nominal depreciation of the euro, allowing further trade-weighted real depreciation for the periphery; (v) it would help ease real debt burdens; and (vi) it would help ease the overall euro zone budget constraint through higher seigniorage revenues.
I am probably more sympathetic than many readers to the concerns of stronger euro zone countries over the large contingent liabilities and moral hazard problems that come with substantially beefed up mutual fiscal support mechanisms. But, while recognising the value that countries place on price stability, the extent of the euro-zone crisis means that a higher inflation target appears to score well on any reasonable cost-benefit analysis. Some (sensible) radicalism is badly needed.