A comment on the European Commission’s Box 1.5

The Commission has provided a useful contribution to the size of fiscal multiplier debate.    The disagreements between different analyses are not really surprising given the limited number of observations everyone has to work with.   A particularly useful addition is the addition of controls for sovereign default premia.    The literature on sovereign default has emphasized the output costs associated with default (see here), even if the channels of causality are murky.   This is likely to lead to a significant “fear of default” effect on growth, underling the importance of lowering default risk in the broad crisis-resolution effort. 

But in one important respect the Commission lets itself off the hook too easily.   Rightly recognising the importance of lowering sovereign bond yields (and with it the perceived probability of a default on private bond holders), it emphasises the importance of lowering debt to GDP ratios.

When discussing the negative short-term output costs of consolidation it is important not to lose sight of what the counterfactual would be. For the most vulnerable countries, exposure to financial market pressures means there is no alternative than to pursue consolidation measures. The alternative of rising risk premia and higher borrowing costs would be worse for these countries, and consolidations are needed to restore fiscal positions and put debt projections back on a sustainable path.

However, for countries without their own central bank to act as lender of last resort (LOLR) in extremis, and with high debt/deficit levels and weak/uncertain growth prospects, creditworthiness will be fragile for the foreseeable future.   Central to creditworthiness will be design of euro zone LOLR arrangements.   Modest reductions in official debt will not change this underlying fact – though would certainly help.   I think Ireland stands a reasonable chance of avoiding a formal second bailout programme.   But we should not forget that if it does avoid such a programme, it will be significantly because of the available of a quality LOLR backup, possibly through the OMT programme.  

The fiscal adjustment conditions underlying this back up should be: (i) reasonable (i.e. do not push the capacity of a government to deliver fiscal adjustment beyond breaking point; (ii) reliable (i.e. investors should be confident that the support will be there without a forced private-sector default); (iii) flexible (i.e. the conditions should not be designed so that the country is forced to pursue ever larger fiscal adjustments if growth disappoints; and (iv) the link between bank losses and sovereign debt should be broken (taking away a lingering source of uncertainty about the country’s true fiscal position.  

The Commission clearly believes that it is critical for credibility that governments meet the nominal budget deficit to GDP targets set down in their programmes.   But what it is really important is that it is credible that the government will meet its conditions – which could be made growth contingent.  

It has to be recognised that such arrangements do require that the stronger euro zone countries take on substantial risk.   We have to accept that the quid pro quo for this will be stronger collective rules and surveillance.   It is a two-way process. 

For the Irish case, there is a common interest in supporting a “well-performing adjustment programme” to demonstrate that this approach can work.   Part of this could be relieving the burden of official debt, with a restructuring of the PN/ELA arrangements holding the most promise.   But the design of ongoing LOLR arrangements is also critical.   The good thing about a mutual advantage argument is that it does not depend on allocating blame for past “sins”.   There is plenty of blame to go around.   But as Derek Scally argues today, arguments based on blame are unlikely to get us very far.  

European Commission Forecast: Not so good for Ireland

The EC is out today with their autumn forecast, (here’s Ireland specifically (.pdf)) and the numbers don’t look great for Ireland in the short term.

Headlines:

Domestic demand to remain, ahem, subdued, until 2014;

Labour markets weak, especially construction.

Fiscal pressures to continue.

They’ve revised downward their forecast for growth from 1.9% to 1.1% for next year.

Super.

Behavioural Economics Readings

There will be an event in the ESRI on November 30th on behavioural economics and public policy, co-organised by ESRI and the UCD Geary Institute. Keynote speakers are Robert Sugden, Professor of Economics at University of East Anglia and David Halpern, head of the behavioural insights team at the Cabinet Office. Details of how to register for the keynote sessions are on the ESRI website here (though the event is fully subscribed so just a waiting list for now).  There will be a full day of talks prior to this and details of that programme are here.

My main purpose with this post is to point to some literature. People attending might be interested in some of the following links and reading:

Russell Sage Foundation reading list on behavioural economics here

Publications of the Behavioural Insights Team in the Cabinet Office are available here

The Chicago Law Review piece “Empirically Informed Regulation” by Cass Sunstein is a detailed account of the ideas and applications in this area over the last number of years.

The Brookings Institute publication “Policy and Choice: Public Finance through the lense of behavioural economics” is one of the best available introductions to this area.

New book on behavioral foundations of public policy edited by Eldar Shafir will likely be a required text in this area in the future. It covers many areas of policy and the behavioural science underpinning them.

Nudge by Thaler and Sunstein is a very influential account of the libertarian paternalism idea of how behavioural economics should be applied

What Caused the Eurozone Crisis, & Does it Matter?

 

The outline of a future European monetary union less vulnerable to crises than the current Franco-German design is beginning to emerge. It will need a banking union, including centralised supervision and resolution, as well as some common system of deposit insurance to curtail destabilising runs. It will also need stronger bank equity with minimum non-equity capital that can be bailed in when banks get into trouble. Sovereign debt ratios are now so high that future rescues by national treasuries will simply not be feasible, so the cost of debt to European banks will unavoidably be higher. The monetary union could do with a common macroeconomic policy – Europe as a whole is almost as closed an economy as the US.

But getting to first base in a re-designed monetary union means sorting out the current mess, and the willingness to accept and distribute losses is absent, largely because of the persistence of the belief that the crisis was caused principally by fiscal excess, and that sinners should pay. Sinners in this case means debtors. 

There have been numerous papers arguing that the origins of the crisis were not fiscal, but principally monetary. Here’s another one, with references to some more: 

http://www.hnb.hr/dub-konf/18-konferencija/mccarthy-ocallaghan.pdf

The European economy faces a re-building task on a scale corresponding to the aftermath of a (small) war. One of the lessons of twentieth-century European history is that allocating blame is not a good re-construction strategy after wars. The current impasse bears comparison to the ‘sinners should pay’ response to WW 1. 

After WW 2, with lessons learned, the blame-game was avoided to a considerable degree. It does not matter (except perhaps to lawyers) what caused the mess. What is the feasible allocation of costs  (infeasible allocations include pretending that the Greek default was big enough, for example) that offers the best prospects of economic recovery?

The costs have not all been incurred – failing to distribute the costs already incurred lets them grow.

Colm McCarthy: Let’s write off monetary union and start afresh

Colm can correct me, but I think the title of the article does not capture the substance of the piece.   I don’t think Colm is advocating abandoning the euro, but rather fixing its current inadequate structure, including putting in place an adequate banking union and effective lender of last resort to states.  

From the article:

The broken Eurozone project needs two sets of policy actions. The first, for the long term, is a re-engineered monetary union designed to survive, which means a banking union and a more centralised system of macroeconomic management. The second, and more contentious, is a clean-up operation to restore prospects of economic recovery, especially in the growing list of financially distressed members.

To date, the performance of the Eurozone political leadership has been dismal, inviting unfavourable comparisons to the more decisive actions of the US Treasury and Federal Reserve.

The clean-up operation needs a coherent macroeconomic strategy at European level as well as an acceptance that the debt burdens remaining on several Eurozone members need to be relieved. The macroeconomic strategy should see a relaxation of fiscal consolidation in those countries which retain good access to bond markets, as well as a deliberately expansionary monetary policy from the European Central Bank. Some weakening in the external value of the euro should be seen as a minor concern. If the current growth standstill continues it may ultimately weaken anyway.

It is fashionable in Germany to argue that Europe needs greater political union, permitting a more centralised fiscal policy. If the Eurozone were already a single country, with a normal central bank and a counter-cyclical macroeconomic strategy, it would already be seeking to bolster aggregate demand as the US has been doing. The zone as a whole does not face an imminent inflation threat, does not have a balance of payments deficit and has public debt and deficit ratios no worse than those in the US, the United Kingdom or Japan. But it remains committed to a policy stance that is exacerbating the downturn, particularly in the regions of the Eurozone facing financial distress.

In addition to a relaxation of policy at Eurozone level, a pragmatic approach needs to be taken to the debt-encumbered member states. Greece will have to undertake another debt restructuring, perhaps fairly soon. Several other countries may be unable to carry the burden of debt which has been accumulated. A partial mutualisation of excess debt burdens is the other essential component in the clean-up operation, preferably on a no-fault basis. This will likely happen in a messy and politicised manner anyway. Better to accept that debt burdens in excess of some agreed threshold be addressed, through further haircuts for private creditors in some cases, some monetisation by the ECB and some mutualisation by Eurozone rescue vehicles. Peripheral states in trouble could expect to see a reversal of capital outflows, with a consequent reduction in borrowing costs. If this kind of clean-up operation requires treaty changes, so be it. The Irish Government is understandably wary of changes given the mixed record on getting EU-related referenda passed, but if treaty change is the price of a durable solution it should be considered on its merits.

One place where I might disagree with Colm is where he calls for “further haircuts for private creditors in some cases”.   He is of course right that such haircuts cannot be ruled out; and, in the case of Greece, it is hard to see them being avoided.   But it is a truism to say that it is the fear of such haircuts that leaves a country struggling for creditworthiness.   Where there is a reasonable path through the crisis without such haircuts, the strategy should be to take the possibility off the table to the greatest extent possible.   This does not mean there should not be relief on official debts.   The Sunday Business Post piece “State edges closer to ECB deal on promissory note” (no link available) gives one encouraging note in today’s papers.

Response from Holland and Portes

Dawn and Jonathan have been kind enough to reply to the post below.   Many thanks to regular commenter David O’Donnell for bringing the post to their attention. 

We are grateful to John McHale (and others on this site ) for these very thoughtful comments.

First, we should emphasise that NIESR does not have the detailed specific expertise on the Irish economy of many of those commenting here: given that NiGEM is a global macroeconometric model, the Irish economy component is inevitably quite stylised, and can’t take account of some of the specific features of the Irish economy which John and other commenters have rightly highlighted. The fact that our calculations suggest that fiscal consolidation is less damaging in Ireland than in other countries reflects relatively low estimated multipliers, even in current circumstances. But the NiGEM multipliers may well overstate the extent of import leakages, given the specific structure of Irish trade, so actual multipliers might be higher than our model estimates suggest. We should also note that the fact that, in contrast to other countries, our estimates suggest fiscal consolidation has in fact reduced debt-GDP ratios in Ireland does not any measure imply that we think it was the optimal policy (see below).

There are two important general points John makes.

First, he points out that while our simulations show that debt-GDP ratios will be higher in 2013 (in all countries except Ireland!) than they would have been without fiscal consolidation, primary deficits will be lower, and in the long run the binding solvency constraint is the intertemporal government budget constraint. This is absolutely correct. Postponing fiscal consolidation doesn’t mean that it isn’t ultimately necessary in EU countries – almost all of them – that have significant structural primary deficits. The main point of the paper is that the negative impact on GDP, and hence on the amount of consolidation required, is much larger if you frontload consolidation during a period when multipliers are much larger. Later consolidation could have been both smaller and less damaging. We have not attempted to illustrate such an alternative path (and of course the “optimal” path depends on future economic developments) but certainly delaying would have been better. This is also true for Ireland.

Second, he notes that we omit any analysis or discussion of hysteresis. We agree entirely that this is a very important issue when considering the impact and timing of consolidation. In an earlier paper, Bagaria et al (see Vox here) we perform a similar, but more detailed, analysis for the UK, incorporating labour market hysteresis effects (but ignoring spillovers). In this (in contrast to Delong and Summers), we do exactly what John suggests, which is to assume that hysteresis effects matter but decay over time. Ideally we would indeed do the same for Ireland and other EU economies, but this is a somewhat more complex exercise.

A comment on Holland and Portes

As the note by Holland and Portes linked to earlier by Stephen is likely to be influential in the fiscal policy debate, it is worth taking a closer look at the findings with the Irish case in mind.   The note is based on a more detailed (and very useful) analysis by Dawn Holland (available here). 

Although the main message on the impact of (coordinated) fiscal adjustment is quite negative, the fact that Ireland is the only country for which the adjustment leads to a (small) fall in the debt to GDP ratio might appear to give some comfort.   But I don’t think we can take comfort on the score.   Not surprisingly, the reason Ireland stands out as an outlier in this analysis is because of relatively small (normal-case) multipliers.   (The multipliers are assumed to be higher in the context of the current crisis, but the precise “crisis multipliers” used for Ireland are not given in the paper.)  The assumed normal-case multiplier is -0.36 for a decrease in government consumption and -0.08 for an increase in income taxes.   I would guess that the relatively low assumed normal-case multipliers for Ireland reflect Ireland’s high imports as a fraction of GDP.   But as discussed here, a large fraction of imports in Ireland are used as inputs into the production of exports.   As a result, the high import share can give a misleading view of the marginal propensity to import out of domestic demand.   Controlling for exports, a simple regression shows that a one euro increase in domestic demand is estimated to raise imports by 0.23 euro, indicating substantially less leakage from expansions in domestic demand than the crude import share would suggest. 

While I don’t think we can get any comfort from Ireland being an outlier in the analysis, I do have concerns about the broad conclusion of the paper.   This conclusion is that fiscal adjustment has actually raised debt to GDP ratios.   To the extent that the debt to GDP ratio is critical for creditworthiness, this suggests that efforts have been self-defeating on this central measure.  Continue reading “A comment on Holland and Portes”

Ireland Stat

check it out here.

From PER’s announcement:

Ireland Stat is the new pilot whole-of-Government level performance measurement website.  It aims to meet the Programme for Government commitment for accountability and transparency and to answer the question “How is Ireland doing?”

Ireland Stat presents a hierarchy of measures to show Ireland’s performance.  The website will show:

  • Achievements – what has Ireland achieved?
  • Actions – what has Ireland done?
  • Costs – what has it cost Ireland?
  • International comparisons – how is Ireland doing compared to other EU and OECD countries?
  • Trends over time – are the measures improving, staying the same or getting worse?

Ireland Stat has evolved from the Performance Budgeting process and draws on existing publicly available measures gathered from Statements of Strategy, Annual Reports, CSO, OECD, EuroStat, etc.  It brings the measures together into one website in a clear and logical way; it is based on international best practice.

Pilot website

The pilot website covers the following:

Policy areas Programmes
Economy Jobs & Enterprise Development; Innovation; Agri-food
Transport Land Transport
Environment Rural Economy; Flood Risk Management; Food Safety

Self Defeating Austerity? Not in Ireland, Apparently

Dawn Holland and Jonathan Portes present the results of their macro-econometric model of the EU in this Vox column. Specifically they argue that because of the times we live in, large scale and largely uncoordinated fiscal consolidations across the EU will lead to a collective fall in GDP and an increase in debt to GDP ratios. The increase in debt is obviously the opposite of what was intended.

The figure below shows their scenarios.

Scenario 1 is a fiscal consolidation with a working financial system, scenario 2 models a constrained financial system and so is a bit closer to reality.

Meanwhile, this paper just published in the Economic Journal (unpaygated .pdf here) tells essentially the same story using a New Keynesian model with all the bells and whistles.