Friday, July 26, 2013

More on the eurozone and the need for stimulus

In the previous post, I neglected to mention that Simon Wren-Lewis provides a longer version of his argument cited in his post I discussed. It's his paper, Macroeconomic Stabilisation in the Eurozone: Lessons from Failure Global Policy 4/Supp 1 (July 2013). There he explains the basic macroeconomic dilemma of a currency union this way:

The macroeconomics is straightforward. For example, if an individual country in a monetary union experiences a positive demand shock that is not shared by the other members, not only will its output increase but inflation will rise relative to other union members and it will become uncompetitive. Eventually, this decline in competitiveness will itself reduce demand, but this process may take time. More seriously, to restore competitiveness inflation will have to be below that in other union members for a period, and to achieve this a recession may well be required. There is, of course, no option to regain competitiveness through devaluation. So the country that experiences this idiosyncratic demand shock suffers first from excess inflation, and then from the period of below-normal activity required to reduce inflation and restore competitiveness.

Fiscal policy can reduce these costs. By tightening fiscal policy following the demand shock, the initial increase in inflation, and therefore the subsequent need for correction, will be reduced. Note that a quick response is important here (particularly given institutional lags in fiscal policy). The aim is to reduce demand during the early stages of a boom, when the self-correcting influence of competitiveness is weak. In the later stages, where a country has become significantly uncompetitive, this deflationary force may be sufficient in itself and help from fiscal policy may not be required. [my emphasis]
What happened in the case of the eurozone, in which capital moves freely from country to country in a primary tenet of the neoliberal faith, capital could move into countries like Spain and create a housing bubble. But then when the Lesser Depression hit Europe in 2008, there was no quick adjustment measure to counteract its macroeconomic effects. The balance within the currency zone is restored under the (not-so-)invisible hand of the normal functioning of a currency union. But if fiscal policy in the currency union as a whole isn't stimulating new growth, then the adjustment has to take place by real deflation in the countries that have become less competitive. But this condemns Cyprus, Greece, Ireland, Italy, Portugal and Spain to years of stagnation or depression, possibly decades.

As he explains, the original Stability and Growth Pact (SGP) setting the rules for the eurozone was heavily biased toward notg "allowing governments to adjust fiscal policy for stabilisation purposes," i.e., heavily biased against Keynesian countercyclical spending in a recession. The Fiscal Suicide Pact (aka, Fiscal Compact) adopted in 2012 takes that bias to a new extreme.

In practice, the neglect of fiscal policy not only applied in recessions but in the boom time, as well. Wren-Lewis argues that Ireland, Portugal and Spain in particular needed countercyclical fiscal policies in 2000-7 to restrain the speculative boom. Wren-Lewis doesn't stress it here, but the EU rules on the free movement of capital would have created problems for such policies, which is not to say that it would have completely neutralized them. In any case, "the loss of competitiveness that most
countries had accumulated relative to Germany would have presented a major challenge even without a global recession."

The following is is a vital point that has been obscured by the political rhetoric about fiscal propriety in both the US and Germany:

The recession had a more important contributory role to the problem of debt discipline. This was not only the familiar point that deficits increase in a recession. In Ireland, and subsequently in Spain, the state chose to bail out failing banks, which had become insolvent as a result of imprudent lending in the boom years. For these two countries at least, what had started as a problem of macroeconomic imbalance was transformed into a problem of excessive government debt. Furthermore, the need for subdued growth in these countries as part of the competiveness-adjustment process meant that these countries could not grow their way out of their debt problem.
Ireland and Spain did not have debt problems prior to the crisis. And their bank-friendly approach to the financial crisis was the biggest immediate factor in creating theirs. "In the case of Spain and Ireland, it was largely a banking crisis caused by excess demand that led to a debt crisis, something that the SGP did nothing to prevent."

Here is how he describes Angela Merkel's muddling-along approach to the Greek debt crisis, which allowed what should have been a relatively easily-managed problem into a existential crisis for the euro that continues:

The initial response of policy makers was a triumph of hope over judgement. There was a reluctance to contemplate the idea that a eurozone government might default, perhaps because of fears that this would raise interest rates for other vulnerable countries. (Rather less charitably, default would also have meant significant losses for banks in these other eurozone countries.) Monetary affairs commissioner Joaquin Almunia is reported as saying 'no, Greece will not default. Please. In the euro area, the default does not exist'. As a result, private-sector holdings of Greek debt were gradually replaced by loans from the ECB, IMF and other eurozone governments. These loans came with strict conditions, which involved substantial fiscal retrenchment. [my emphasis]
Plus, the Confidence Fairy never arrived: "The idea that cutting government deficits would increase demand by adding to confidence has proved illusionary."

Wren-Lewis makes clear he sees the current solution in a return to national fiscal stimulus policies. He's highly skeptical of the ability of the central EU bodies to handle it, both because of their current lack of democratic legitimacy and because "the recent crisis has shown clearly how poor decision making can be at the eurozone level, in part because of the lack of direct accountability." I don't know if that is meant to be a euphemism for saying that as long as Angela Merkel is calling the shots, the results will be a mess.

Tags: , , , , , , ,

No comments: