Month: May 2012

Thanks to Jagdip Singh for pointing to Michael Taft’s response to an earlier post of mine on the implications of fiscal rules – including the structural balance rule – on the need for additional austerity post 2015.  

It is worth reiterating two critical points before responding to Michael’s critique.   First, the Fiscal Compact does not imply additional constraints beyond what we are already signed up to under the revised Stability and Growth Pact.   Ireland already has a medium-term budgetary objective of a structural balance of 0.5 percent of GDP.   I believe the No campaign is being disingenuous on this point.  Second, the main driver of austerity measures in Ireland is not the fiscal rules: it is that Ireland has a large deficit, substantial debt that needs to be rolled over in the coming years, and is not creditworthy.   The only reason Ireland does not have substantially greater front-loaded austerity is that we have been able to obtain official-funding support at low interest rates.   However, this support is conditional on pursuing a phased deficit-reduction programme. 

Michael’s main objection to my post relates to the definition of the structural balance.   He claims that the only way to reduce the structural balance is through additional discretionary measures.  However, what he does not note is that his assumed baseline of “no policy change” involves expenditure rising at a rate equal to the underlying nominal potential GDP of the economy.   Assuming total tax revenue rises at the same rate as potential GDP growth, expenditure rising at this rate would keep primary structural deficit constant as a share of potential GDP.   Using the European Commission’s coefficient of 0.4, in the absence of expenditure growth, the nominal structural deficit would fall by 0.4 times the change in nominal potential GDP due to the rise in tax revenues at constant tax rates as the economy expands.   In my calculation, I allowed for expenditure increases equal to half the projected rise in tax revenues, so that the nominal structural deficit falls by 0.2 times the increase in nominal potential GDP.   I think most people view austerity measures as involving higher tax rates (or new taxes) combined with cuts in expenditure.   What my calculation shows is the even with nominal expenditure rising (though at a slower rate than nominal potential GDP), the structural deficit target could be met by around 2019.   As Seamus Coffey emphasises, the annual rate of improvement would be approximately 0.7 percentage points of GDP per year, which is above the SGP’s requirement of 0.5 percentage points. 

In sum, if your definition of austerity involves government expenditure – public-sector pay rates, social welfare rates, etc. – growing at a rate less than nominal potential GDP, then you should agree with Michael that hitting the structural deficit target will involve additional austerity measures.   However, if your definition is what I see as the more natural one of additional cuts and tax rises, then, even with relatively conservative assumptions about growth, moving back to structural balance would not require additional austerity.

The site is live here, the programme looks excellent, and the guest speakers are world class. From the site:

2012 is a special year for us. It will be the 10th year of running the INFINITI Conference on International Finance, in conjunction this year with the Journal of Banking and Finance. Over the last ten years, we have been privileged to have had keynote speakers such as Ike Mathur, Raman Uppal, William L Megginson, Edward Kane, Andrei Shleifer, Robert Engle, Maureen O’Hara, and Elroy Dimson. We have also been fortunate to have been joined by many other leading academics, students and practitioners who have openly shared and discussed each others’ latest research.

Our keynote speakers for 2012 are Carmen Reinhart and Iftekhar Hasan.

We hope that you will be able to join us this year, and to that end are pleased to announce that the Call for Papers has been sent out and the online paper submission facility is now open. Please see the full call here.

We would also like to draw your attention to a call for papers for a special issue of RIBAF.

2012 will be a great year, and we hope to see you here at Trinity College Dublin for yet another fantastic INFINITI Conference on 11-12 June.

A DRAFT of the conference paper sessions is available at https://www.openconf.org/infiniti2012/openconf.php. Note however that this is not finalised, and that it omits as yet the details of a number of special sessions on the future of the euro, financial regulation etc.

Jeff Sachs explains his position in this FT piece.

There is an important debate taking place across the European economics blogosphere on the policy mix required to resolve the euro zone crisis.   Simon Wren-Lewis provides a good overview here, with many useful links.   The election outcomes in France and Greece will provide further impetus to this debate, though the likely direct results – e.g. a scaled-up European Investment Bank – are probably going to be of just marginal significance, even if they make good headlines. 

The core problem is the difficulty of reconciling there fundamental goals of key actors: saving the euro; avoiding a large-scale transfer union that would involve significant transfers from core to the periphery; and sticking with current definitions of euro zone price stability.   

The vulnerability of the euro has been demonstrated by the susceptibility to self-fulfilling runs on sovereigns (and banks) when they do not have their own central banks to act as lenders of last resort to the government in extremis. 

As a partial replacement, the euro zone has developed lender of last resort mechanisms (e.g. the ESM and the ECB’s bond-buying programme).   But these mechanisms entail risk of significant transfers from the strong to the weak within the euro zone.   The stronger countries have shown a (limited) willingness to run the risk of such transfers, but have required greater assurance that countries will pursue reasonably disciplined policies.  The Fiscal Compact must be seen in this light.  (See Jacob Funk Kirkegaard here.) 

Unfortunately, the massive growth challenge faced by the periphery casts grave doubt over whether this approach can work.  As noted in an earlier post, a higher euro zone inflation target could significantly ease the growth challenge.  But Germany in particular will be reluctant to allow this given their commitment to the overwhelming importance of price stability. 

In the post linked to above, Simon Wren-Lewis provides a possible mix of policies that he thinks could be acceptable and would make a significant difference: (i) the ECB accepts a symmetric inflation target around 2 percent; (ii) the need for inflation above 2 percent in stronger countries such as Germany is explicitly recognised; (iii) the ECB stands ready to cap individual-country bond yields, potentially giving easing the market constraint on their fiscal policies; and (iv) if monetary policy is not sufficient to achieve the 2 percent inflation target, the aggregate fiscal policy stance of the euro zone is used to ensure the target is met. 

On the last point, the message from Marco Buti and Lucio Pench in this Vox piece is important.   (Marco Buti has been an important intellectual force behind the development of the Stability and Growth Pact.)   They note that the EDP is sufficiently flexible to allow the aggregate fiscal stance in the euro zone to be taken into account.  

Concerning the response to shocks, it needs stressing that the Stability and Growth Pact explicitly allows for the playing of automatic stabilisers around the adjustment path, that is, the adjustment is formulated in structural terms. Acknowledging the problems inherent in the measurement of structural balances, the framework calls for an ‘in-depth analysis’ of the reasons behind a country’ s failure to meet the budgetary targets, including revisions in potential growth and endogenous changes in revenue elasticities. To these elements of flexibility, the recent reform has added the possibility of extending deadlines for the correction of the excessive deficits irrespective of a country’s individual predicament, if the situation of the Eurozone or the EU as a whole calls for a relaxation of fiscal policy.

Saving the euro, avoiding large-scale transfers and sticking with the current definition of price stability may be an “impossible trinity”.   The effort to find economically workable and politically saleable combinations of policies shows the European blogosphere at its best.