Extending the (EMU) Stability and Growth Pact to take care of global imbalances

Last week Eswar Prasad had an interesting article in the Financial Times on how to deal with global imabalances. As the G-20 seems to be taken the issue of global imbalances seriously, there is the question of how to make their commitment operational.

Reducing global imbalances requires a reductio in national imbalances between income and spending or, in other words, between saving and investment. The difficulty is that this imbalance is the result of both government and private sector imbalances. Because it is difficult to think about how to effectively impose a balance on private income and spending, the only valid alternative seems to be addressing large imbalances in government spending.

This is the suggestion of Eswar Prasad:

"The scheme would work as follows. The G20, in consultation with the IMF, develops a simple and transparent set of rules for governments on policies that could contribute to global imbalances - for instance, that government budget deficits and current account balances (deficits or surpluses) should be kept below 3 per cent of national GDP"

If deficits go beyond 3% there is a financial penalty (implemented through the SDR holdings of the IMF). If we focus on budget deficits, this looks like the Stability and Growth Pact under which EMU governments have lived for several years. There is a limit on budget deficits (3%) and a set of mechanisms to enforce this limit.

The history of the Stability and Growth Pact has shown us that it does not work. While it provided some discipline in the earlier years, we soon realized that there were many issues associated to its implementation that have led to failures to comply with the limits and a revision of the Pact that has left very little power over national government balances. The issues were many:

- What do you mean by 3%? You probably want to adjust this by the cycle, but then how do you adjust it by the cycle? Do you allow for exceptional circumstances?

- How do you punish government? Who decides that governments should be punished? (in the case of EMU, it was the council of finance ministers who had to punish some of its own members, not very effective).

In practice, many countries ended up with deficits above 3% without significant consequences. There were also periods where the government deficit was below 3% but the government was clearly helping create a current account imbalance (i.e. the government should have had a large surplus as opposed to let's say a 2% deficit).

The G-20 commitment to address global imbalances is no doubt a good step in the right direction but it is unclear how this commitment will translate into specific outcomes or actions.

Antonio Fatás

Content of economic blogs

Here is a snapshot of recent content of some economic blogs (thanks to Wordle).

Greg Mankiw

Mark Thoma

Brad de Long

Casey Mulligan

Antonio Fatás

How low is 1.48 (USD/EUR)?

As we witness increasing signs of economic optimism about the recovery, the focus of the analysis turns into the exact form that the recovery will take and how to ensure that it is as fast and smooth as possible. One of the areas that has received recent attention is the evolution of the US dollar. In recent months the US dollar has gotten weaker and there are many questions about whether this is a trend that will continue and how far the US dollar will fall.

In an FT article yesterday Wolfgan Munchau made the case for a weaker dollar. Many of the arguments are not new and we had heard them before the crisis when global imbalances were on their way up. As the US current account deficit got larger and larger there was the question of how those deficits would be reduced. Given that (US) consumption rates looked unsustainable, it seemed that a price adjustment (through a change in the exchange rate) was the only way to produce that adjustment. In addition, now that the crisis has started, and if one takes the perspective of the US economy, a depreciating currency can help with the economic recovery, an argument made by Wolfgan Munchau in yesterday's article

"A lower dollar is desirable because it would help America achieve the right kind of recovery. The US economy is severely constrained by household and financial sector deleveraging and possibly by a permanent fall in potential growth. In the absence of another housing bubble and consumer boom, an export-led recovery is the best growth strategy the US could employ."

This argument is similar to the one made by Krugman to oppose those who are voicing concerns about the fall in the value of the US dollar.

I will not argue here with this textbook logic of how currency movements can help address current account imbalances and business cycles (although I must admit that I find the empirical evidence much weaker than most people). But I have some concerns about blank statements that argue that the US dollar has to get weaker:

1. It is not enough to say that the US dollar has to get weaker you need to say how weak it should get, we need a number, there is a need for a medium/long-run anchor. As the chart below shows, the US dollar is already weak by historical standards. Sure, it has room to get to the historical low of 2008 but was is the right reference value?

As a technical and historical explanation of the chart: this is the nominal exchange rate between the US dollar and the Euro (before 1999 the German Mark is used as the Euro) and the upward trend is a reflection of the differences in inflation between Europe/Germany and the US. But even if we were to correct for inflation differences, the US dollar is still weak by historical standards. Also notice that some of the waves that we see were reversed by some statement coming from central banks and government officials, such as the September 1985 Plaza Accord, the February 1987 Louvre Accord and the interventions of November 2000. By historical standards, we would have expected similar statements in 2008 when the US dollar reached the 1.60 USD/EUR level. We did hear some comments about "excessive volatility" but not about the actual value of the currency.

2. Related to the point above, but more from a theoretical point of view: how much do we want to introduce price distortions (changes in relative prices via changes in the exchange rate) to ensure that the spending patterns of different countries are sustainable? The textbook logic of currency depreciations to smooth recessions is one that applies to countries that are suffering an asymmetric shock. Today we face a global recession, so according to the textbook, most advanced economies need an exchange rate depreciation. We might argue that all these currencies need to depreciate relative to countries that are doing well (China and other emerging markets) but we cannot simply argue that the US dollar has to get weaker. It is interesting how many criticisms China has gotten for "manipulating" the value of its currency to affect economic outcomes and now we are willing to argue that the US should be doing something similar. Just to be clear, I am not arguing that currencies cannot be a good adjustment mechanism, but the context matters and one needs to be explicit about the difference between an asymmetric recession and a global recession and the difference between smoothing business cycles and addressing structural imbalances.

3. The perspective of the other countries. A weak dollar can help the US increase its exports, which goes in the direction of reducing the current account deficit, but why would other countries see this as a "return to equilibrium"? Wolfgang Munchau argues that "A strong Euro would nicely take care of of Germany's persistent current account surplus". I am not sure all the Germans agree with this statement. I am also not sure that a fall in revenues (i.e. fall in German exports) would lead to a decrease in the saving rates in Germany. It might lead to the opposite behavior - an increase in saving rates because the decrease in income leads to more uncertainty and precautionary savings (which will make the current account surplus even larger not smaller).

Antonio Fatás

More on the medium-term outlook for the recovery

The magazine The Economist has an article this week on the persistence of the current recession and whether output will return to its trend. The arguments that the article present are similar to those made in the Chapter 4 of the recent World Economic Outlook by the IMF (see our previous post on this matter): it is likely that the current recovery is not strong enough to bring output back to trend. In a recent NBER working paper, Cechetti, Kohler and Upper also provide empirical evidence suggesting that financial crisis leave long-lasting (negative) effects on output.

The question on the connection between recessions (or business cycles in general) and potential output ("the trend") is one that has not been studied much in economics. Most of the models we use tend to think about the trend as being independent of business cycles - so recoveries always bring output back to the pre-crisis trend. Policy makers tend to use the concept of the output gap, the deviation of output from its potential, to think about the strength of the recovery under the assumption that in a "normal" year the output gap should be back to zero.

The strongest evidence one can find in favor of this hypothesis (that recessions are temporary) comes from the US economy. The US economy has displayed a surprising tendency to return to trend even after some major events such as the great depression, World War II or the recessions of the 70s. Below you can see a chart that shows the evolution of GDP per capita in the US during the period 1870-2008. The red line represents a (log-)linear trend using data up to 1928. It is remarkable how close the blue line is to the red line and how the economy recovers to return to trend.

In fact, using 1870-1928 data, a prediction using that (log-)linear trend leads to an error of only 1% for the level of GDP per capita in 2008. Of course, the picture is misleading in the sense that in some cases it took a long time for the economy to come back to this trend, but it is still interesting that it returned to the same trend. It could have returned to the same growth rate but at a different level but that's not what we see, we see that the output loss is always recovered after a number of years. This suggests that the supply side of the economy (innovation, technology) is unaffected by output fluctuations.

If one looks more carefully at the data, the evidence becomes much weaker. In contradiction to what we see in the picture above, empirical economists know that output fluctuations are very persistent. In fact, one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy. If we suffer a recession, output never goes back to trend, it remains at a lower level forever (this is what is known in the academic literature as the existence of a "unit root" in output).

From a theoretical point of view, there are two ways to justify the fact that recessions always leave permanent effects:

1. Technological changes are the cause of business cycles. Recessions are period where we are not good at innovating and this causes both a recession and a permanent loss in output. This is what we know as "real business cycle theory".

2. Innovation is affected by recessions. During recessions firms invest less and this lead to a temporary slowdown of technological progress, so the economy never returns to the same trend. It will go back to its normal growth rate but the temporary effects on growth will leave a permanent scar on the economy. This is the argument that we hear these days to support the fear that the current recovery will not be strong enough. A few years ago I wrote a couple of academic papers that presented this theory and some international evidence in favor of this hypothesis (the papers can be found here and here). This is an area of macroeconomics that I believe deserves more attention in terms of academic research (but I am biased, given that I have written on the subject). And it is not just about financial crisis but, more generally, about what happens to innovation, technology and growth during recessions.

Antonio Fatás