Mario Draghi’s speech at the annual symposium of central bankers in Jackson Hole is causing a bit of a stir. It is seen by many as admitting that the economy is entering dangerous territory in the form of weak economic performance, too low inflation and unstable inflation expectations.
Moreover, by openly calling for action to “boost aggregate demand”, Mario Draghi is fuelling hopes that Europe will change course by launching a “large public investment programme” so as to trigger a strong recovery and steer the economy away from deflation.
This is all remarkable and represents a big change from what was being said only a few weeks ago about the recovery being on track and about long-term inflation expectations remaining “well anchored”.
As usual, however, the devil is in the detail. There are at least two things in Draghi’s speech that give reason for concern. The first has to do with the strategy of fiscal austerity, a point that Simon Wren Lewis also picked up. The second concern is the peculiar twist Draghi is giving to the interplay between structural reforms, demand side policy and the problem of debt deflation.
Austerity, dressed up as demand side policy
Even if Mario Draghi acknowledges that fiscal policy needs to play a greater role in supporting the demand side of the economy, the way he is proposing to do so is ambiguous.
To start with, limiting the discussion to the flexibility that already exists within the rules of the Stability Pact, as Draghi does, is not helpful. While some degree of flexibility is indeed written into the rules, it is nevertheless difficult to use it as the rules also say that this flexibility can only be granted provided certain conditions are met.
For example, the Commission and the Council can give member states an additional year to bring the deficit down under 3% of GDP when the economy is in a crisis. However, this exception is only granted if member states have shown they have delivered “serious consolidation efforts’ (For a good description of all the complicated rules of the Stability Pact, see here).
So, even if a member state is facing a deep economic crisis, it is still under the obligation to operate fiscal cuts of ‘at least’ 0.5% of GDP and run the risk of deepening the recession by doing so. Afterwards, the Commission will grant an exception, thereby avoiding to impose austerity upon austerity so as to respect the initial deficit objective for that particular year.
The following year, however, austerity starts up again. This way, the economy is being pushed into a state of prolonged recession or stagnation. If you want an example of this, just look at France where the government is now looking for yet another extension of the deadline for reaching the 3% deficit because of a recovery that is basically absent. And the recovery is absent because France stubbornly continued with austerity squeezing an additional 0.7% of GDP out its economy in 2014.
In other words, it is like saying the following to governments: ‘We know that it will be impossible to reach the deficit target, we know that this will risk making matters worse for your economy but do it anyway so that you can show us your good faith’. This is then not so much about ‘flexibility’ but, as a former president of the Commission once said, about a ‘stupid’ policy that is repeated year after year.
Is this still Alesina’s hour?
Moreover, the President of the ECB is raising the stakes. Indeed, Draghi’s second proposal to ‘boost’ aggregate demand is to reduce taxes by cutting what Draghi calls, ‘inefficient’ public spending. The thinking is that cutting expenditure has a lower negative impact on aggregate demand whereas cutting taxes would have a higher positive impact. While such an operation would be neutral for the (structural) deficit, the net effect on aggregate demand is thus positive, or so the President of the ECB hopes.
Here, however, Draghi is playing with fire by ignoring the lessons of the 2011/2012 crisis. If there is one thing what this austerity-induced crisis has taught us, it is that the impact of austerity on economic activity is much more pronounced than previously thought, in particular when fiscal consolidation takes place in the middle of an economic downturn and is being done by cuts in public expenditure.
There are multiple and logical reasons for this result: in a downturn, many more households are ‘cash-constrained’ and unable to access bank credit so that it is difficult for them to cope with reduced government transfers and continue consumption by reducing savings. Also, interest rates will be much closer to the zero lower bound when the economy is already in the doldrums, making it very difficult for the central bank to counteract the fall in aggregate demand by loosening monetary policy.
Moreover, we know that welfare states as they exist in Europe work to lower market inequalities and redistribute income from higher to lower income earners. Draghi’s proposal then boils down to redistributing income to those households that have a relatively lower propensity to consume by removing income from those households that would consume their entire income. This will depress, not relaunch, aggregate demand.
Here, work done by the IMF (a source which one cannot be suspected of being biased in favour of public expenditure) can be used to illustrate the danger of Draghi’s proposal. In its 2012 paper, the IMF estimates that cutting public expenditure in the Eurozone when the economy is in crisis and activity is below its potential carries with it a multiplier of minus 2,5. In other words cutting 1% of GDP gets you a drop in aggregate demand and economic activity of 2,5 % of GDP. On the other hand, the IMF estimates a multiplier of minus 0, 35 when changes are made on the public revenue side. Adding the two estimates together gives the result that the combination of a 1% of GDP cut in public expenditure together with a 1% of GDP cut in taxes will depress demand and activity by 2,15% of GDP. So, if European policy-makers follow Draghi on this, there will be a one to one relationship with economic activity. For example, a 100 billion cut in expenditure that is followed by a similar cut in taxes will result in 215 billion of lost GDP and corresponding jobs.
It seems unlikely that Mario Draghi would be unaware of the IMF research on these multipliers. Draghi probably prefers to ignore it and base himself instead on research that fits his set ideas much better. Indeed, Draghi refers in his speech to work done by Italian economists such as Alberto Alesina. This research finds that expenditure cuts only have weak negative effects on aggregate spending and economic activity whereas revenue measures have much larger effects. This then seems to provide the President of the ECB with the scientific basis for the proposal he is making.
Here, however, some historical perspective on these authors and their work is warranted. Indeed, it isn’t the first time that the work of Alesina and colleagues has inspired European macroeconomic policy makers. Mark Blyth, in his excellent book “Austerity, the history of a dangerous idea” describes how earlier work by Alesina was used back in 2010 to make the fatal decision of going full steam ahead with the strategy of austerity in Europe. In April of that year, Alesina was invited to address the ECOFIN Council, actually telling finance ministers not to fear any political backlash from applying austerity in the middle of a recession since fiscal consolidation, especially when implemented by expenditure measures, would boost confidence and result in higher not lower economic activity.
In Alberto Alesina’s world, fiscal consolidations are expansionary, not contractionary. This view was subsequently taken up in the final communiqué of ECOFIN ministers as well as by Jean-Claude Trichet, the then ECB President. We know what happened afterwards. Austerity was followed through and it was biased in favour of expenditure cuts (see here). This then succeeded in killing the ongoing recovery and thrusting the Eurozone into a new recession lasting almost two years.
Today, Alesina and co are a bit more modest in their new work. They no longer come to the conclusion, as in their 2010 work, that expenditure cuts are expansionary. But they do maintain the idea that such expenditure cuts will only have a very small negative effect on the economy. This result, however, is very far removed from the estimates other research, such as for example from the IMF, arrives at. And so the question is whether European policy-makers are willing to again base their macroeconomic policy strategy on research and researchers that already failed them once and with such disastrous results.
Fighting a liquidity trap with deflationary structural reforms?
Let us now turn to the second issue, the issue of structural reforms. Here, Mario Draghi does start out with identifying the problem correctly: against the background of a large private and public debt overhang and with the economy operating at low inflation rates and close to zero interest rates, monetary policy is no longer effective in launching aggregate demand. The economy finds itself in what Keynes called a liquidity trap. In this liquidity trap, the money the central bank prints does not find its way into increased investment or consumer spending. Hearing this typical Keynesian argument from the side of the ECB is something of a positive surprise.
Unfortunately, the remedy that Draghi has in mind to get the economy out of this liquidity trap leaves one speechless. To have monetary policy regain traction over demand, the ECB’s President is proposing to have more structural reforms, in particular labour market reforms that increase both wage as well as job flexibility. The idea is that these reforms will reduce structural unemployment and raise the level and the trend growth of potential GDP. This would reduce the relative burden (relative to GDP and incomes that is) of high debt loads, thereby restoring the usual transmission channel of monetary policy where low interest rates lead to more credit being taken up by private actors.
Draghi, however, is confusing potential GDP and potential employment with the actual state of the economy and the labour market. In doing so he is taking a serious shortcut and ignores how the process of structural reforms actually works.
Structural reforms, and certainly the type of reforms mentioned above, basically imply that more workers are willing to work at lower wages. This puts downwards pressure on prices. Lower prices improve the competitive position of the economy so that jobs are poached from trading partners. Lower prices or falling inflation also push the central bank to lower interest rates, thereby stimulating business and households to undertake more investment and consumption spending. The initial shock (‘lower wages’, rising unemployment) is then slowly digested by these two processes bringing the economy gradually back into better shape.
The key thing to understand here is that it is an illusion to think that these two processes can function in present circumstances. Poaching jobs from your trading partners may work for one individual economy but it cannot work for the whole of Europe. Eurozone member states are mainly exporting to each other so that a generalised policy of squeezing wages does not improve relative competitive positions while, by compressing domestic demand dynamics in each country, undermining exports prospects for all. Europe, in the end, cannot steal jobs from itself.
The other channel is also blocked since, as Draghi himself is now acknowledging, monetary policy cannot come to the rescue. The ECB cannot lower interest rates any further since they are already near zero. Nor will quantitative credit easing (as the ECB is now planning to undertake in the coming weeks) rekindle credit demand much since private sector debt loads remain substantial.
That leaves the initial effect of prices being lowered. This is actually the last thing the economy needs right now. With inflation already running as low as 0,4%, a further lowering of price pressures means that the economy is moved even closer to a situation of outright deflation. When that happens, the situation becomes extremely dangerous. Negative inflation rates will automatically push up real interest rates and drag an economy that is already in the doldrums further down.
It’s as if the ECB President, by resorting to the traditional mantra of structural deregulation of labour markets, is busy painting himself into a corner of the room. Instead of empowering monetary policy, this policy agenda will disempower the ECB even further. The way out of a liquidity trap is not more of the same policy that has brought us into this trap in the first place.
Three arrows or three spades for the Euro Zone?
Nouriel Roubini, never shy of inventing a good slogan, compares Draghi’s speech with the three pillars or “arrows” of Abenomics combining medium-term fiscal consolidation, quantitative easing and structural reforms.
Unfortunately, however, the concrete policy measures Mario Draghi is putting on the table resemble more of a spade than an arrow. When analysed more closely, ‘Draghinomics’ boils down to continuing fiscal consolidation, dismantling welfare states, and further deregulating wages and worker rights. The combined result will be to push our economies further in the direction of outright deflation and triple dip recession.
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