The Real Eurozone Scandal

Imagine that it was revealed that 10% of the European Union budget (the money that goes to the EU centre to fund the common agricultural policy and other EU wide projects) had been found to be completely wasted as a result of actions by EU policymakers. By wasted I do not mean spent on things that maybe it should not have been spent on (rich farmers, inefficient farmers, infrastructure projects whose costs exceed benefits etc), but literally money that went up in smoke. Imagine the scandal. Heads would roll, and some might find themselves in jail.

10% of the EU budget is about 0.1% of EU GDP. Yet sums at least ten times that figure are currently being wasted in the Eurozone, as a result of actions by Eurozone policymakers. Here is the latest OECD assessment of output gaps across eleven Eurozone countries, for both 2013 (blue) and 2014 (red).

A negative output gap means that output could be the amount of the gap higher without raising inflation above target. Of course Greece is a nightmare, and things in the other PIIGS are really bad, but the output gap in the Netherlands is around 3%, in France over 2% in 2014, and even in Germany the output gap exceeds 1%. Estimating output gaps is an imprecise science, but gaps of at least this size are consistent with inflation well below target (currently 0.3%). So output could be at least 1% higher across the Eurozone with no ill effects. This is the equivalent of the entire EU budget going up in smoke.

Sometimes negative output gaps are the result of shocks which were not anticipated by policymakers (like the financial crisis). Sometimes they are engineered by policymakers to bring inflation down. It is unfortunate that these things happen, but they always have. However the output gaps we have in the Eurozone today are neither of these. Instead they have been created by policymakers for no good reason. That is why they can be called a scandal.

At this point you might think I’m being unfair. Surely this is all about tight fiscal policy required to bring down government debt. I agree that it is all about fiscal policy, and in particular the crazy fiscal rules imposed within the Eurozone. However where is the urgent need to bring down debt outside the periphery? The OECD estimate that the primary structural budget balance in the Eurozone will be a surplus at around 1% of GDP in 2014 compared to a deficit in the OECD as a whole of just over 1%. So even if you think that we need austerity to bring deficits down rapidly – which I do not – why should policymakers in the Eurozone be doing this so much more quickly than in the UK, US or Japan? To achieve this goal, they are wasting resources on a colossal scale.

If you think anything has changed as a result of Juncker’s ‘E315 bn’ investment plan, you should read this post from Frances Coppola. As she makes clear, there is not a penny of new EU money in this proposal. Instead money earmarked for existing projects is being used to provide insurance to private sector investment (which may or may not happen). There are so many issues with this kind of stimulus. Besides those raised by Frances, there is also the question of how to prevent firms simply getting insurance for schemes they would have undertaken anyway, and how exactly will the Commission select when to allocate its insurance. Those of a neoliberal persuasion who think government is bad at spending its money cannot feel any more comfortable with the government selecting what private sector projects to back. However a scheme like this will come as no surprise to someone like George Monbiot, who thinks states are increasingly being used to serve corporate ends.

Equally embroiled in this scandal are those making monetary policy decisions at the ECB. Here I can simply defer to an excellent post by Ashoka Mody. In particular he points out why it is misleading to simply look at the ECB’s balance sheet as an indicator of the force of unconventional monetary policy. There is an important difference between creating money to bail out failing banks, as the ECB has done, and creating money to buy bonds to force down long term rates, which is Quantitative Easing (QE). He argues that the “ECB is set to remain—by far—the central bank with the tightest, most conservative monetary policy among the major central banks.” I thought I would quote the following paragraph in full, for reasons that will be clear to regular readers.

“Others play by the rules of the cognitive frame. Thus, despite the serious concerns with the June 5th measures—documented carefully by my Bruegel colleagues—journalists have no interest in asking ECB officials: “What exactly are we waiting for?” The financial markets have no interest in public policy: once the rules are set, they seek opportunities for short-term bets. On July 9th, the International Monetary Fund’s Executive Board somewhat incredulously concluded: “Directors welcomed the exceptional measures recently taken by the European Central Bank (ECB) to address low inflation and strengthen demand, as well as its intention to use further unconventional instruments if necessary.” Belatedly, on November 25th, the OECD became a lone official voice calling for more urgent steps.“

To those who say that QE, as operated by the BoE or Fed, would have limited effectiveness in the Eurozone, I have a lot of sympathy. However there is a relatively simple way of making QE much more effective and predictable, and that is for central banks to create money not to buy financial assets but to transfer directly to citizens, which Friedman called helicopter money. John Muellbauer calls this QE for the people. Conventional QE involves buying a large amount of assets with potential losses for the central bank (if the asset price falls) but uncertain effects on demand. Helicopter money involves small transfers with a certain loss to the central bank but much more predictable positive demand effects. [1]

As an institutional innovation, helicopter money has two major drawbacks in countries with their own central bank. [2] First, why innovate when you can implement exactly the same policy through existing means: in macroeconomic terms helicopter money is equivalent to QE plus tax cuts when you have inflation targeting. Second, a fiscal stimulus in the form of temporary additional government spending is likely to be more predictable in its impact than transfers or tax cuts, because you eliminate the uncertainty caused by how much of the transfer or tax cut will be spent.

But if countercyclical fiscal policy is effectively illegal in the Eurozone, these objections do not apply. QE for the people may have additional legal merits within the Eurozone. The ECB is constrained to some (uncertain) extent in its ability to buy government debt. But, as John Muellbauer suggests, mailing a cheque to every EZ citizen using electoral registers would seem to circumvent these legal difficulties.

One objection to the ECB embarking on ‘QE for the people’ is that it goes well beyond the remit of a central bank. [3] Yet the ECB appears to have no qualms on that score: besides routine references for the need for fiscal consolidation and ‘structural reform’, the letter discussed by Paul De Grauwe here shows the ECB requiring detailed changes to labour market regulations and institutions in Spain. So you have to ask why is it OK for the central bank to override the democratic process in this way, but giving money directly to the people is somehow beyond the pale.

If you think that mailing a cheque to every voter in the Eurozone as a solution to continuing recession sounds too good to be true, then you have just rediscovered why recessions caused by demand deficiency when inflation is below target are such a scandalous waste. It is a problem that can be easily solved, with lots of winners and no losers. The only reason that this is not obvious to more people is that we have created an institutional divorce between monetary and fiscal policy that obscures that truth. It was a divorce that did a reasonable job in steering the economy in normal times, and it might discourage fiscal profligacy when demand is strong, but since 2010 it has led to a scandalous paralysis in the Eurozone.

[1] These losses are notional only, as the central bank is not in the business of making money. They matter only if they compromise the ability of the central bank to do its job of controlling inflation in the future. There are various ways that danger can be avoided, but my point here is that costs to the central bank can arise with any form of QE.

[2] Central banks routinely pass the profits they make (through seigniorage) to governments. So the innovation is that the central bank rather than the government decides how to disperse this money.

[3] Another objection is that, because the ECB is free to define its own targets, changing the monetary policy framework to target the level of nominal GDP would be a better innovation. I agree this would be a useful innovation. I would argue that it would be better still to allow countercyclical fiscal policy, because only this can deal with country specific shocks. But if, for whatever reason, these changes are ruled out, then a helicopter drop should be implemented. If you are a market monetarist, think of it as an insurance policy.

This column was first published on Mainly Macro