Boone, Johnson and Wolf on the euro zone’s future

Peter Boone and Simon Johnson raise an alarm here.  

Martin Wolf reviews Germany’s options here.   From Martin’s piece:

Now turn to the second issue: how does Germany want the euro zone to be organised? This is how I understand the views of the German government and monetary authorities: no euro zone bonds; no increase in funds available to the European Stability Mechanism (currently €500 billion); no common backing for the banking system; no deviation from fiscal austerity, including in Germany itself; no monetary financing of governments; no relaxation of euro zone monetary policy; and no powerful credit boom in Germany. The creditor country, in whose hands power in a crisis lies, is saying “Nein” at least seven times.

How, I wonder, do Germany’s policymakers imagine they will halt the euro zone’s doom loop? I have two hypotheses. The first is that they believe they will not. They expect life for some of the vulnerable economies will become so miserable that they will leave voluntarily, thereby reducing the euro zone to a like-minded core, and lowering risks to Germany’s own monetary and fiscal stability from any pressure to rescue the weak economies. The second hypothesis is that the Germans really think these policies could work. One possibility is the weaker countries would have so big an “internal devaluation” that they would move into large external surpluses with the rest of the world, thereby restoring economic activity. Another is that a combination of radical structural reforms with a fire sale of assets would draw a wave of inward direct investment. That could finance the current-account deficit in the short run, and generate new economic activity in the longer run. Maybe German policymakers believe it will be either harsh adjustment or swift departure. But “moral hazard” would at least be contained and Germany’s exposure capped, whatever the outcome.

I still believe there is a third “hypothesis”.   Germany is willing to move (if hesitantly) from some of these “no” positions, but requires certain assurances and demonstrations of intent.   Will these assurances be forthcoming?   Will it be enough?

John McCartney: “Short and Long-Run Rent Adjustment in the Dublin Office Market”

below is a summary of a new paper by John McCartney (CSO)

Research just published in the Journal of Property Research provides a
number of new insights into Ireland’s commercial property market.
The  paper “Short and Long-Run Rent Adjustment in the Dublin Office Market”
reveals  that  office demand in Dublin is quite elastic –  a 1% increase in
rents  brings about a 1.13% decline in the quantity of space demanded.   In
comparison,  a  similar  rental increase would only reduce office demand in
London  by  between  0.20-0.54%.   Author  John  McCartney  said  that this
difference  was unsurprising given the relative status of Dublin and London
as  global  business locations;  “London is a major world city and a global
financial  services  centre.   As  such  many  corporations  simply have to
maintain  a  physical  presence  in  London  –  irrespective  of rents.  In
contrast,  despite the advantages of our 12.5% corporation tax rate and our
young,  English-speaking  workforce,  Dublin  is a less compelling business
location.  Therefore,  if  rents rise too sharply occupiers will find other
suitable locations.”

McWilliams on the Fiscal Treaty

David McWilliams summarizes his main arguments against the Fiscal Compact in the FT today.

Update, and in the interests of balance, thanks to commenter Scorpio, here’s a summary of 44 economists on the Treaty.

Exporting electricity

UPDATE2 Over on Twitter, Antoin argues that the plan as interpreted by me would violate EirGrid’s statutory monopoly.

Minister Rabbite yesterday announced plans to export wind power to Great Britain. This is a result of the energy summit organized shortly after the last elections. It now appears ready for public discourse.

The plan is simple. Build a load of wind turbines in the Midlands, where the relative lack of wind is made good by the relative lack of tourists and nature reserves, on land owned by Bord na Mona and Coillte. Build dedicated transmission lines to Great Britain. (The Spirits of Ireland hope that there will be pumped storage as well.)

The plan makes half sense from an English perspective. It is hard to get planning permission for onshore wind turbines in Great Britain. Onshore in Ireland plus transmission is cheaper than offshore in British waters. On the other hand, the plan is driven by the EU renewables target, which is pretty tough on the UK. With Germany abandoning its green energy plans (following earlier such decisions by Portugal and Spain) and with Theresa May wishing to ban Greeks from the UK, it is not immediately clear why the UK obeys the EU with regard to renewables.

It is not clear what is in it for Ireland: English-owned turbines generating power for England, transported over English-owned transmission lines. Dedicated transmission means that there are no benefits for Ireland in terms of supply security or price arbitrage. If the new transmission would be integrated into the Irish grid, Irish regulations would apply — and subsidies too, so that you Irish would sponsor my electricity bill. Ireland does not have royalties on wind power or transmission (and if it would, the same royalties should be levied on Irish turbines and power lines). That leaves some jobs in construction, fewer in maintenance, and 12.5% of whatever profits are left in Ireland for taxation.

It may well be that this plan is a quid pro quo for the UK contribution to the bailout of Ireland.

I am not convinced that the plan will go ahead. The English power market is in turmoil, and the companies may not be interested in an Irish adventure. Recall that the UK government also confidently announced that private companies would build new nuclear power. Well, they did not. The comparative advantage of Ireland in this case is the relatively lax planning regulations. Pat Swords may have put an end to that. But even the current planning regime can be used to block to an English adventure with no Irish spoils.

It is early days for this project still. It is worrying that the minister seems to think that more state intervention is required, and that the state still has money to waste. UPDATE: Paul Hunt points out that it is indeed the Government’s plan to intervene and subsidize: See the new energy strategy.

More academic thoughts on interconnection are here.

Guest Post by Timothy King: Keynesian Policies Under the Fiscal Treaty

The Stability and Growth Pact of 1997 permitted Eurozone countries to run a general government deficit of 3% of GDP.   The only economic innovation of the Fiscal Treaty is the replacement of this deficit measure by one that restricts the “structural budget deficit”—the deficit that that would be incurred if the economy was operating at full capacity—to 0.5% of GDP where the national debt is greater than 60% of GDP, and 1% otherwise.

The measurement of the structural budget deficit is to be cyclically adjusted, which will permit larger deficits in times of economic recession.  So far from outlawing Keynesian fiscal policies, as some of its opponents have alleged, this explicit acceptance that deficits may reflect cyclical factors will allow governments to cut taxes and/or increase expenditures as anti-cyclical policies require.  One-off or temporary payments such as those to the Anglo bondholders are also excluded from the deficit calculation.

Much depends, of course on how the adjustments are made.  The IMF, the OECD and the EU, all make estimates of the structural deficit, and the first two of these agencies both regularly publish these together with other data on government lending and borrowing.  I believe all three agencies use very similar methods of estimation.  (Knowing nothing about this topic I found Box 1 in the paper Tony McDonald, Yong Hong Yan, Blake Ford and David Stephan, Estimating the structural budget balance of the Australian Government in the Australian Treasury’s Economic Roundup 2010, Issue 3  (http://archive.treasury.gov.au/contentitem.asp?NavId=&ContentID=1881) very useful as an introduction.   This gives references to more technical papers describing the estimating processes of each of the agencies in detail.

Potential output is derived using two-factor constant-returns-to-scale Cobb Douglas production functions with some assumed rate of growth of total factor productivity.  If you are an international agency needing to make regular internationally comparable estimates of the potential output of scores of countries, this may be the best you can do, but this method of calculating potential output seems particularly inappropriate for Ireland, where the sudden arrival and departure of foreign firms and fluctuating rates of international migration can change the productive potential of the economy very quickly.   The agencies can presumably also use only very approximate rules of thumb when trying to calculate how tax revenues would increase to the achievement of this potential output.  The only expenditure that is held to be cyclically determined is unemployment compensation.

The inevitable imprecision of these calculations makes it unsurprising that agencies can differ quite markedly in the proportion of a given government deficit they attribute to non-structural causes.  For example, averaging estimates for Ireland for 2000-2009, the IMF had an average structural balance of -4.4% of GDP; the OECD had -2.2%.  In 2010, the OECD had a structural balance of 25.5% where the IMF had 9.9% (presumably reflecting different treatments of payment obligations under the banking bailout scheme.)   Unfortunately I do not know of a readily available internet source of EU Commission estimates.

Since Ireland is clearly in the “excessive deficit” zone, these differences are not currently of critical importance.  But eventually this position will change, and one can envisage very considerable argument about the proportion of any given deficit which is to be considered non-structural.  It would be advisable for the Irish government to develop its own methods of estimating structural deficits, and to be prepared to defend them under sceptical questioning if they show lower structural deficits than Commission or IMF figures.  Indeed it would be worth seeking the help of one or two economics of unimpeachable international reputation, and who have not previously taken public positions in rejecting EU stabilisation policies, to guide the process of making the estimates and certifying their credibility.

There is no reason why built-in stabilisers need be confined to payments to the unemployed.  A perfectly feasible Keynesian measure would be legislation that inversely relates VAT rates to the level of unemployment.  Discretionary stabilisers, such as a list of non-essential infrastructure maintenance projects that could be speedily put into operation would be another possibility, though more likely to be challenged by the EU monitors.

Although the Treaty regards national budget surpluses with favour, they have a potential deflationary impact on the Eurozone as a whole.  If Keynes had been involved in designing this treaty, he would probably have attempted to have supplemented the “excessive deficit procedure” with an “excessive surplus procedure”, to have forced countries with large budget surpluses to reduce these, even at the expense of greater domestic inflation.  He would of course have had as little success with the Germans as he did with the Americans when he made comparable proposals about persistent creditor countries at the Bretton Woods conference in 1944 that set up the postwar international monetary system.

The concept of a structural budget deficit has been in use for decades by the IMF, but it is not one that is in general discourse, even among economists.  It does not refer to the structure of an economy, which is normally taken to be a set of productive activities, many of which are locationally fixed, and includes both capital equipment, infrastructure and human capital which can change only slowly.  The EU funds designed to help areas of high unemployment to improve their productive capacity are accordingly known as structural funds.  This structural deficit is quite different—it involves a snapshot (if a one-year flow measure can be called a snapshot) of how the existing system of taxes and public expenditures implies for an economy operating at full capacity.

It is easy to get confused about this difference.  Finance Minister Michael Noonan interviewed on RTE’s This Week on May 20th appeared to be implying that needed structural reforms—he alluded to the retraining of unemployed construction workers—were part of the programme to reduce the structural deficit.  Of course, such reforms will lead to increases in both GDP and government revenues rises (and presumably reduce the structural as well as the general deficit)  but this is to use the word “structural” in its more usual meaning, rather than in the sense used in the treaty.

When the Maastricht Treaty was first agreed in 1993, there was much criticism that it required purely monetary convergence, and paid no attention to labor market convergence, either cyclical or structural.  At that time unemployment rates in different Eurozone countries diverged sharply.  Spain had an unemployment rate of over 20%, and Finland and Ireland rates of over 15%.  In contrast, it was only 4% in Austria.  There were concerns that whole countries might find themselves saddled with uncompetitive economies unable to devalue, and become permanently depressed regions within a larger federation, rather like the Italian Mezzogiorno or the US Rust Belt.

This fear appears to have been premature.  The pre-crisis convergence of unemployment rates has been striking.  The standard deviation of national unemployment rates was 5.1% when the treaty came into force, 3.6% in 1999, the first year of the euro and only 2.1% in 2007.  Even in Spain, which appears to be the country in which unemployment has been most persistent, unemployment rates fell until in 2007 they were, at 8.3%, lower than in Germany (8.7%).  The effect of the crisis has, however, been sharp divergence among national rates. The standard deviation in 2011 was 5.4%;   Spanish unemployment was 21.7%.

None of this means, of course, that when stabilization has been achieved and a respectable rate of economic growth reestablished throughout the Eurozone, there will be no further need for reform.  The fear of permanently depressed countries has not gone away—(see, for example a recent article by Martin Wolf (Irish Times, May 21st).  This reinforces what this crisis has made sharply evident—the need for some central fiscal authority, (and also a properly empowered Central Bank).  But the 1993-2007 convergence in unemployment rates suggests that such central authorities ought to be able to adopt Keynesian policies as required.