Balanced budget tax cuts

In his press conference yesterday, Mario Draghi said the following:

Within the Stability and Growth Pact, one could do things that are growth-friendly and also would contribute to budget consolidation, and I gave an example of a balanced budget tax cut. Reducing taxes that are especially distortionary, where the short-term multipliers could be higher, and cutting expenditure in the most unproductive parts, so mostly, actually not mostly, entirely, current government expenditure.

There are at least three possible interpretations of this statement.

1. Draghi genuinely thinks that balanced budget multipliers are negative, which I find hard to believe. A balanced budget tax cut under current circumstances would be contractionary, not expansionary; at least, that is what we teach our students.

2. Draghi genuinely thinks that the Eurozone’s problems right now are on the supply side, and that tax cuts will help address these problems. I also find that hard to believe. The major problems facing the Eurozone right now are pretty clearly on the demand side.

3. Despite its nominal independence, the ECB is in fact the most politically constrained of the major central banks. If Draghi is going to push the ECB towards QE, and question the overall fiscal stance of the Eurozone, he has to come out with this sort of stuff from time to time, to appease the Germans.

I find the last of these three explanations entirely plausible, and it helps explain the ECB’s poor performance in the crisis to date. But why should a nominally independent central bank feel that its hand are tied in this way? Ultimately, perhaps, because the Eurozone is not a political union, and because democratic legitimacy resides at the level of the member states. This means that exit from the Eurozone is always an option, even if it is not openly acknowledged.

Another reason to think that monetary union without political union is a bad idea.

Comments

comments

34 thoughts on “Balanced budget tax cuts”

  1. One could also argue that (i) politics is the art of the possible (ii) the euro is a political undertaking and (iii) Draghi is going to the limit of what its central bank can do under the present agreed rules.

    While he denies that he was involved in the construction of any kind of grand bargain (a position queries by Gavyn Davies) there can be little doubt about the fact that he is sketching out a credible road map which a gaggle of inadequate European politicians have proved incapable of doing.

    On taxes, he also said the following;

    “Is our monetary stimulus going to be effective without structural reforms? Last time I gave an example: we can provide as much monetary stimulus as we want, as much availability of credit as we want. But if the person who has planned to use this credit for a new business has to wait eight months before he or she can open this new business, and then once he does it she has to pay lots of taxes, this person will not apply for credit. So the presence of structural reforms, the enactment of such reforms, is important for the effectiveness of monetary policy. And, by the way, also for fiscal – for some fiscal policies for sure – especially for tax cuts.”

    http://www.ecb.europa.eu/press/pressconf/2014/html/is140904.en.html

    The politics of the euro are anchored in national politics. It could hardly be otherwise cf. Derek Scally in today’s IT

    http://www.irishtimes.com/business/economy/germany-and-france-in-austerity-vs-stimulus-stand-off-1.1918115

  2. Germany is already engaged in public spending on construction projects from underground transit to office buildings, hospitals, intercity railways….
    The German manufacturing sector has ceased to be an assured source of jobs and cash as wages in the US decline and China overpowers both North America and Europe. The German gov’t did not sit on its hands while gazing at its navel, it ramped up public spending. With the cost of money at less than 1% it would not be wise to pass up what is the opportunity of 500 years, soon to end as the US chickens out and interest rates ramp up.

    Ireland of course cannot differentiate the difference between an operating budget and a capital budget. The Tiger income was frittered away on Cell Phones, Tablets, bars, restaurants, weekends abroad, vacations involving sex, sand sun and warm weather. Boozing it up in Temple bar was out, for a few months Edinburgh was one of the in places to be hung over. I won’t get into what went up noses.

    Is the Irish gov’t putting forward its position that we and the rest of the PIIGSF do not have a supply problem, we have a demand problem. Further financialisation of stagnant economies is not the solution, public spending on capital projects is needed to jump start demand. This has to be done directly by gov’t not dribbled down through banks that cannot find sound collateral to lend against.

    A vote buying orgy by the Irish gov’t has to be punished severely at the polls.

  3. @ Mickey Hickey

    That’ll be the day!

    Your point about what Chris Johns described as our infantile approach – in failing to distinguish adequately between capital and current expenditure – is spot on.

    The other point you make about public spending is equally valid. This seems to be where the difficulty arises; the CDU wanting a balanced budget by hook or by crook and the SPD going with the interests of its basic electoral constituency; the organised German industrial labour force.

    From Scally’s report.

    “Over at the SPD-controlled economics ministry, meanwhile, officials have devised a 10-point emergency plan, including tax concessions and other stimulus measures to boost investment in German companies.”

  4. Explanation no.3, no question, with an additional support that seeing as Europe is not the same political-fiscal union that either the US or UK (Scotty-Indies notwithstanding) is, that more restrictive fiscal rules (ie balanced budget) have at least some merit in order to maintain some form of political harmony.

    The ECB is interesting in that it is neither as restricted as its hawks suggest, nor as free to act as its dove would also argue. Generally it threads a path down the middle of political-economic reality, with it now free-of-centre under Draghi as opposed to restricted-of-centre (and verging on outright hawkish in 2011, with disastrous consequences) under the unfortunate Trichet regime. History may well view Draghi as the man who saved the Euro if we make it another 15-20 years in place.

  5. @Kevin O’Rourke

    I would have thought that like every other piece of economic and monetary policy advice given by an official in an European Union institution this is a set of right wing economic policy goals with a rationale tacked on afterwards.

    So Draghi recommends cuts in taxes and current expenditure because that is the neoliberal agenda and it is currently compatible with creditor country interests (ie: the Deutsche Bloc).

    Whether the policies have a contractionary effect or not is neither here nor there. After six years of various failed supply side solutions and structural reform drives I think we can safely say that the policies are not motivated by the missing beneficial effects on the overall Eurozone economy but by the elimination of social democracy and the protection of the national interests of Germany and hangers on. In those terms the policies have been a tremendous success so perhaps we should view them in that light?

    Not to bad mouth Draghi, he is one of the least useless of our new rulers, but he says what he says because of class and institutional interests.

  6. In lieu of a thread on ABS purchases etc, can everyone have a read of this super piece by Adam Posen, delivered to the ECB back in May, in the purpose and impact of ABS purchases in the Eurozone. First few paragraphs particularly strong on the headline backdrop

  7. @ KOR

    Going outside my pay grade here but was not Draghi merely saying that for those on balanced budgets, repositioning tax and expenditure can still provide financial stimulus. Seems sensible to me.

    Perhaps you are interpreting his remarks from too parochial a standpoint. Of course if Ireland went immediately for a balanced budget that would be contractionary no mater what the tax/spend split or what structural reforms are implemented.

  8. Draghi’s comments reflect exasperation at at some of the more ridiculous aspects of practices in parts of the EZ. Its a bit like the photocopying allowances and cheque presentation allowances that featured in the CP negotiations – they may be minor but are a real wind-up for the other side, in this case the Germanic core.

    Probably reflects the political reality that certain things have to be conceded by his home country and others before there is a likelihood of general buy-in on fiscal stimulus, otherwise that would just cement things the Germans regard as unsustainable.

    I thought the comment about current expenditure was odd without more specifics, and not obviously politically feasible. The politics within the ECB CG and on the streets of Italy are not very similar.

  9. @unfeasiblycharming

    Its an Alesina I haven’t waded through yet…

    I would have though that the very last person on Earth who anyone should be reading on the effect of “consolidation” in the Eurozone was Alberto “Expansionary Austerity” Alesinia. The very last one.

  10. @ All

    Gregory (Scotland Yard detective): “Is there any other point to which you would wish to draw my attention?”
    Holmes: “To the curious incident of the dog in the night-time.”
    Gregory: “The dog did nothing in the night-time.”
    Holmes: “That was the curious incident.”

  11. Very good points. Of course central bank independence is only sacrosanct when policy actions are hawkish.

    A couple of questions:

    There has been an intellectual battle going on the EZ for the last number of years, between people that understand the economics of financial and debt crises on the one hand and the Germans, Rehn and Vichy-Trichet on the other. Is it really a good idea for Draghi (as well as economists closer to home) to indulge the moralist superstitions of the Germans in this way? Wouldn’t it be better to try to defeat the hard money dogma? Is everyone really that worried that German will just leave the EZ as a result?

    Also, a question regarding
    “Another reason to think that monetary union without political union is a bad idea”,
    Would it really be a good idea for small countries like Ireland to enter into a political union dominated by Germany, with its awful policy record throughout the crisis?

    Finally:
    Can anyone imagine what would be happening around now if we had an ECB President Weidmannm, or similar? That day will surely come and we in Ireland will have absolutely no say in it.

  12. One possible explanation is that when Draghi said “things that are growth friendly” he meant things that aid long-run trend growth, rather than things that impact short-term GDP through Keynesian stimulus. Some packages of targeted tax cuts + expenditure reductions (targeted to be long-term growth friendly) could meet that definition of “things that are growth friendly” even if bad in terms of medium-term Keynesian stimulus. Obviously in the long run we are all dead, etc.

  13. Breaking newz:

    Huge excitement in talmud/biblical/koranic studies at the mo. A lost page of the Book of Job has been found inscripted on a cave in torabora. Its two paragraphs are devoted entirely to the heinous crme of ‘monetary financing’. Pragmatic scholars have declined to make the content known as it would almost certainly fall into the hands of monetary terrorists. tbc

    p.s.
    Blind Biddy & Paddy Zhukov are having a quiet nightin in Novorossiya!

  14. @DOCM
    “One could also argue ….. (ii) the euro is a political undertaking …..

    I have seen this comment on more than one occasion, but it is simply incorrect, a misstatement of reality.

    The Euro is first and foremost the currency of 18 nations, and because of disparities and imbalances in the countries that use the currency, it is no longer fit for purpose in its primary role.
    Describing the euro as a political project does not enhance its functionality or make it more workable. [It may encourage people to tolerate it for a little longer, but that is not a lasting solution].

    If one country has a €200 billion annual surplus and the rest are either barely in surplus or in deficit, then the only way a common currency will work, will be to impoverish the BOP deficit countries, so that they can no longer afford to buy the surplus of the current winners. The poorer countries become little Michigan’s and their people decamp to wherever.

    Regarding the new ECB ‘measures’ promised, they are unlikely to work. The Scrooge philosophy has now been inculcated into the hearts and minds of even the most profligate of spenders. In case any of them have misunderstood the philosophy, they are continually reminded that their pensions will be reduced they must work longer etc etc.
    The only sensible approach that a person can take, faced with such an attack on their future, is not to spend any money and save as much as possible.
    This is probably what people have been doing and will continue to do. The end result is lack of demand and investors, like the Biblical man with one talent, are now putting the money in the safest hole they can find.
    Nobody should be surprised. It hausfrau economics.

  15. @ Joseph Ryan

    I think that we may be at cross purposes. Everything that you say may well be correct. But the statement that the euro is first and foremost a political undertaking also remains correct. As Article 3.4 TEU states “The Union shall establish an economic and monetary Union whose currency is the euro”. While the countries of the EU obviously thought, and may still think, that there is economic advantage to having a single currency, the primary impetus in establishing it was clearly political. (The euro is also often seen as implying that some countries have agreed to it an others have not. This is simply incorrect. Two countries – the UK and Denmark – have a formal opt-out from the obligation to adopt it).

    The point that I am attempting too make is that the crisis must ultimately also be dealt with at a political level and not just in terms of economic advantage (which lies overwhelmingly with Germany and the other creditor countries). The “curious incident” to which I referred above is the muted reaction from Berlin and Frankfurt to the actions taken by the ECB under Draghi’s inspiration. Whether it is an indication of a fundamental shift in position remains to be seen.

    Derek Scally put it well IMHO.

    “Frustration with France can’t mask serious worries in Germany about its oldest European partner. But Berlin is unsure how to give Paris a hand without the French trying to take the whole the arm.”

    That uncertainty applies to more than just the French!

  16. @docm

    But why would you anticipate reaction from Germany? The interest rate reduction looked a bit panicky given his prior statements but it was very small and really tinkering at the margin. Everything else was a version of pre flagged stuff.

  17. @ UFC

    The question is whether Draghi is acting with or without the implicit blessing of the trio of Merkel, Schaeuble and Weidmann. (He did, after all, have a “comfortable majority”). They have not been backward about coming forward when such was not the case. What Draghi has done may, indeed, be a very small baby but that is not the general appreciation.

    What puzzles me, and has for some time, is the failure of the “intelligentsia” of a client state – because that is what we are – to recognise that politics does not cease at our borders but continues in the state on whose goodwill we have become dependent, a fact of which Draghi is fully aware.

    From the Draghi Q and A

    “And secondly, you’re due to meet the Irish finance minister next Tuesday. Ireland wants to repay the IMF portion of its IMF loan from its bailout early. Are the European lenders comfortable with taking on the risk, the entire risk, of Ireland repaying its loans?

    Draghi: Well we take note of this. We will examine it in the Governing Council. And we’ll certainly monitor very, very closely what is being done with the sale of assets so that the, what we call, monetary financing concerns are being properly and significantly addressed. That’s the response to the second question.”

    These remarks have somehow been seen as sibylline when their import is quite clear. When the deal on the PNs was agreed, the reaction of the government parties was the equivalent of poking one’s partner in the eye with a stick i.e. by trumpeting the “savings” when the aim of those agreeing to it was to avoid any suggestion of monetary financing. The sudden conversion to Scandinavian budgetary virtue suggests that the error will not be repeated and Draghi was driving the point home.

    Or maybe not!

    http://www.irishtimes.com/news/politics/coalition-sees-imf-loan-deal-as-payback-1.1919625

  18. @docm

    Ah yes, the “they learned not to tangle with me” school of diplomacy.

    “This initiative, which could yield annual savings of some €375 million, comes more than two years after European leaders promised to compensate the Government for rescuing the banks at the height of the financial crisis.”

    er: “European leaders promised to compensate the Government for rescuing the banks”

    I think that is what is known as an urban myth. The wording of that promise would be…?

    fyi here is another Irish Times link:

    http://www.irishtimes.com/business/economy/ecb-resists-irish-plan-to-repay-imf-bailout-loans-early-1.1918250

  19. @ Joseph Ryan.

    I agree with you wrt peoples attitudes and spending. I find it a bit odd that ‘structural reforms’ are held up as a medium term panacea. When a lot of what the term ‘structural reforms’ refer to is more labour market ‘flexibility’ i.e. less rights for employees.

    I mean consider you average private sector or new public sector contract employee in Dublin. Probably in his/her 30s. Should be spending. If lucky he/she is working 1, 2 or maybe 5 year contracts. Has a DC pension, if very lucky. Is likely a migrant from elsewhere on the island or outside it. Will easily have to work like this till he/she is 67 (if they can get another contract after 50). Rent rising very fast in a country with very poor tenant rights. If they have decided to have 1 or 2 children they are exposed to very high childcare costs (with no grandparents nearby).

    I can’t imagine he/she is going to be interested in spending money or taking on credit too easily.

    Again, I’m no economist but surely people spend more when they feel safe and secure? It also seems obvious to me that people won’t feel safe and secure doing contract work living in poorly protected rental accommodation with rising rents.

  20. @BEB

    Many thanks for that fascinating Posen link. He claims, however:

    ‘The euro area’s macroeconomic challenge is not just that we are in a low and declining inflation state. It certainly should not be defined as just trying to calibrate monetary policy in terms of how much liquidation versus how much moral hazard we will induce. It is that we have moved from one state of blissful ignorance, moral hazard and credit boom in combination, to an already protracted state of huge risk aversion and dysfunctional financial markets.’

    ‘So if anything, what the ECB faces is not a literal deflationary cycle but a dangerous sticky state of nonfinancial businesses and investors unwilling to move out a long yield curve or out of near cash except in small ways’

    That does not describe the state of financial markets. As the Doug Nolan posts I have previously linked confirm, the volume of speculative activity and yield chasing was never greater. What has happened is that Central Banks have backstopped the gambles, and guaranteed the returns of the big players, while the SME sector hangs out to dry.

    This has all happened before. I followed Posen’s reference towards Bernanke’s 1983 paper on the non-monetary aspects of the Great Depression, and the breakdown in credit intermediation. The paper, which is generally readable for a non-economist, shows that the small guy got hit disproportionately, and that matters did not resolve without massive state intervention.

    ‘As this quote suggests, the idea that the low yields on Treasury or blue—chip corporation liabilities during this time signalled a general state of “easy money” is mistaken; money was easy for a few safe borrowers but difficult for everyone else.’

    ‘In any case, the large government intervention is prima facie evidence that by this time the public had lost confidence in the self—correcting powers of the financial structure.’

    ‘Summarizing the reading of all of the evidence by us and by other students of the period, it seems safe to say that the return of the private financial system to normal conditions after March 1933 was not rapid; and that the financial recovery would have been more difficult without extensive government intervention and assistance.’

    http://www.nber.org/papers/w1054

    Posen says:

    ‘It is not as though we are in a situation where we have the paradigmatic local credit officer, the Sparkasse manager from 1953 who is there checking in on his business buddy in a particular township.’

    SME credit allocation is driven by algorithms these days. Given the extent of financialisation, share buybacks, and general chicanery which characterises today’s markets, it seems unlike that the ABS beer will ever reach the SMEs. Insofar as it does, they will be pawns in some asset manipulation game.
    DOCM never tires of reminding us of the obstacles to coherent government action. The ECB may be a lot of things but it ain’t a government.

  21. @ PQ

    Is not the real source of the problem the essentially unstable relationship between governments and “their” banks?

  22. @ PQ

    Link does not work but I would hazard a guess it probably refers to the book “Fragile by Design”. The system is fragile alright but not as a result of any conscious design.

  23. @DOCM
    Yes it does. It’s a good, but pretty lengthy, read. Without states to ensure debt collection, there can be no banking, and without banks and their credit facilities, there can be no states.

    That fits with Bobbit’s Shield of Achilles, which adds the military dimension. One only has to look at Syria or Ukraine to see that physical force, propaganda and war is a perennial feature of the economic and political landscape. ISIS is a previously unimaginable blend of the ancient and modern, and a huge challenge for regional and global players.

    Fragile by design includes a comparative study of banking busts between the US, where banks were until the 1980s limited in size and regulated at state level, and Canada where banks were larger, fewer, and subject to centralised control.

    They show that many historic US banking busts were caused by the combination of populist politics and imprudent, speculative banking, resulting in capture of state institutions, and in the expropriation of Joe and Jane Public.

    They also show some very interesting links between the US megabanks and the kind of community-development housing policies which brought Clinton, Obama and Biden to national power. The subprime bust was a rerun of previous state level busts, only this time with vastly greater expropriation and global impact.

    What happened in Ireland and Spain fits very well with their thesis that populist politicians and crooked bankers conspire to defraud the state and many citizens. That could never happen unless the various self-regulating professional groups servicing the exercise are prepared to throw away all standards of ethics. It happened, and it’s still happening, IMHO.

    Given the fragmented nature of European democracy, it’s hard to see how the necessary European political response can be mounted.

  24. @ paul quigley

    What kind of evidence do we have for your

    “while the SME sector hangs out to dry” ?

    Very preferable: ….. link, european, you know, the whole nine yards

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