The Euro crisis

According to Paul Krugman, the Euro is one of the main factors behind the crisis in Greece and other European countries. The fact that Greece (and Portugal, and Spain and Ireland) cannot devalue their currencies is having a negative impact on their growth which lowers tax revenues, increases government deficits and raises the possibility of default. Martin Feldstein goes one step further and argues that if Greece could devalue, they would easily avoid default.

I understand their argument, that exchange rate misalignments can have negative economic consequences but I think that blaming the Euro for the imbalances in government accounts is misleading.

The work of Reinhart and Rogoff, summarizing eight centuries of financial crises is full of examples of countries with flexible exchange rates where governments default. There are also plenty of cases of countries with fixed exchange rates and large devaluations that not only do not avoid default but might be responsible for it (as liabilities where denominated in a foreign currency).

Anyone who looks at the history of Greece (or any of the other Souther European countries) knows that crises come in variety of forms and the anchor of the European Union and the Euro has led to additional constraints on the government that have probably avoided crises, rather than creating them. This is what Reinhart and Rogoff conclude:

"Interesting recent cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting from the anchor of the European Union."

One thing that I am missing in the arguments of those who blame the single currency for the current European "crisis" (at least of confidence) is their recipe for the US in terms of exchange rate policy. The US government has debt levels that are likely to grow faster over the coming years (and decades) than in the case of Ireland or Spain (if we believe the OECD). The current US government deficit is similar and the projected US budgets for the next years in the US do not show a strong sense of restraint. There is no doubt that US fiscal policy is on an unsustainable path and there is a need to cut spending or raise taxes substantially over the coming years. In addition, the US has also displayed very large current account deficits in the last decades a sign (according to them) of the lack of competitiveness of an economy. How will the flexibility of the US exchange rate help the US going forward? If their recipes for Southern Europe are applied to the US, what should the US dollar do over the coming years? Depreciate? Relative to which currencies? Who will engineer that depreciation?

As an academic, it is easy to find arguments against a certain exchange rate system (flexible or fixed). But we need to go one step further and suggest an alternative taking into account the empirical evidence we have accumulated over the last decades or even centuries. In my view, arguing that the Euro is one of the key factors behind the Greek crisis ignores the economic history of these countries and the true trade offs that they face between different exchange rate systems.

Antonio Fatás

Bringing government debt under control: how painful will it be?

Last week I participated in an academics consultant meeting at the Board of Governors of the Federal Reserve to discuss the question of achieving fiscal sustainability. I have posted the note I wrote for the meeting on my web site, but here is a quick summary of some of the points I made:

1. There is no doubt that governments in advanced economies will have to go through major fiscal policy changes in the coming years to keep the debt-to-GDP ratio under control. Given current policies, debt-to-GDP ratios are likely to explode in some cases to 300 or 400% of GDP over the next decades.

2. The required changes are large. The recovery will bring deficits somehow under control but this goes nowhere in terms of achieving sustainability. Most advanced economies need to find additional revenues (or cut spending) by a large amount, somewhere in between 4 and 10 percentage points of GDP depending on the country -- and this has to happen every year for the foreseeable future (we are talking about many decades here).

3. There is no mystery to what needs to happen: governments need to increase taxes and reduce spending. Both have economic and political consequences and we need to be as smart as we can to choose changes that are efficient and have limited negative consequences on the economy (and growth).

4. Good news: We have seen large adjustments in government debt before so this adjustment is feasible. No need to go to the post-WWII decades, in the 80s and 90s we saw very large reductions in government debt in many advanced economies. We are talking about reducing the debt to GDP ratio by up to 40 percentage points in a short period of time, such as 10 years.

5. Good news (2): Some of these prior adjustments had limited consequences on growth. We normally tend to think about reductions in government spending and increases in taxes as having negative effects on growth but in several of these adjustments, growth accelerated rather than decreased (we refer to these events as "expansionary fiscal consolidations"). And when growth accelerates, this becomes a virtuous cycle as faster GDP growth reduces the debt-to-GDP ratio, generates tax revenues, etc.

6. Expansionary (growth promoting) fiscal consolidations tend to be associated to decreases in spending rather than increases in taxes and they tend to come together with a series of pro-growth reforms in other areas of the economy (Ireland post-1985 is a perfect example of this).

7. So can we hope for a nice, painless, expansionary fiscal consolidation over the next decades? Not obvious. There are several reasons why those experiences might not be easily replicated this time:

- In some countries, government spending levels have come down relative to where they were in the 80s or 90s. It is not easy to produce a significant decrease in government spending without affecting some basic services provided by the government. More so in the US where government spending is low relative to other (European) advanced economies.

- Some of the expansionary fiscal consolidations benefited from falling interest rates. As an example, Belgium reduced government debt by close to 40 percentage points in between 1996 and 2006 but most if not all of the decrease was linked to falling interest rates on government debt. Currently, there is no room for interest rates to go down. If any, they might go up.

- This time, the consolidation needs to take care of the past (the accumulated level of debt) and the future (the fact that projected deficits given current policies will be very large). The adjustment is larger than what was needed in some of those previous expansion.

8. So my guess is that a "painless" fiscal adjustment is unlikely this time. Taxes will have to play a stronger role and governments will need to strike a balance between the need for additional revenues and the potential negative growth effects that higher taxes might have. This balance will require a strong amount of political leadership and consensus.

Antonio Fatás

Health Care and Macroeconomics

Here are three charts that show the importance of the health care sector in some of the key present and future macroeconomic challenges for the US economy:

1. Health care expenditures and GDP per capita.

As a starting point, below is the correlation between per-capita expenditures on health care and GDP per capita. The US stands as an outlier. (Source: OECD)

2. Health care expenditures and imbalances prior to the current crisis. In the years prior to the crisis the US economy run large current account deficits, a sign of excess spending relative to income for the whole country. One of the components of spending that grew the fastest was private consumption. As a % of GDP it grew by about 4-5% of GDP. All of it can be accounted for by increases in health care and education as shown in the chart below (we have blogged about this before).

3. Health care and government debt. The projections for US government debt is that it will explode to a level of about 300% of GDP in the coming decades (assuming no change in policy). The biggest source of this explosion is health care costs. Yes, there are some other costs associated to aging (more need for healthcare and pension) but most of the increases in government spending comes from the assumption that health care costs will keep growing faster than GDP, as reflected in the chart below - where the units are % of GDP (Source: CBO).

So maybe health care reform was a political distraction from other issues that required the attention of US policy makers, but there is no doubt that getting health care right is a key ingredient for many of the challenges that the US will face in the years to come.

Antonio Fatás

Current account imbalances and exchange rates

The debate on the possible undervaluation of the Chinese Renminbi is in full force among politicians and academics. Most agree that the Renminbi is undervalued but there are disagreements on the effects of exchange rate misalignments (are they they ultimate cause of current account imbalances?).

Are exchange rate misalignments the main cause of current account imbalances? Here are two Nobel prize winners who disagree: Stiglitz says no and Krugman says yes. I will not resolve the debate here but there is something that I cannot understand in Krugman's argument. His argument is that current account imbalances cannot be corrected without an exchange rate change. While he does not say so, he almost implies that current account imbalances are always the result of exchange rate misalignments. This position is too extreme. The current account is the difference between national saving and investment. It is true that saving and investment will react to relative prices (which are determined by the exchange rate). But we can observe changes in saving and investment that are driven by many other factors and that have minimal impact on relative prices. Krugman's argument is that an increase in Chinese consumption will not reduce its current account surplus unless this consumption will translate into imports, and for this to happen we need a relative price change.

Krugman is right in the sense that if an increase in Chinese consumption is directed towards local goods, their price will increase, which amounts to an exchange rate appreciation. But the fundamental question is what needs to happen for the imbalance to be corrected. His view is that we first need to get prices right and then the adjustment will happen. The alternative view is that Chinese will have to get used to consume more, Americans will need to understand that they need to save more and this will be the main factor that will drive the current account adjustment. Relative prices are likely to adjust and therefore the (real) exchange rate will have to change. How much? It will all depend on how easy we can find substitutes for the goods currently produced in China. It might be that it will not take much of an increase to find an alternative location for production (with cheaper labor) and prices will change very little.

By the way, here is an interesting piece of data: while both the US and the Euro area have a large bilateral trade deficit with China (which can be interpreted as a signal of the undervaluation of the Renminbi), the Euro area has an overall current account surplus while the US has a current account deficit. You can argue that for the Euro area, an undervalued Renminbi shifts demand from other countries goods to Chinese goods. But this does not get reflected in the overall current account balance. Clearly there is more than an undervalued Renminbi in the dynamics of the current account in the US and the Euro area. And, yes, I am aware that we can argue that the Euro is undervalued relative to other currencies, as Martin Fedstein does, but then the argument becomes a tautology, every time we see a current account imbalance we conclude that it is because exchange rates are not right.

The debate has extended to the broader issue of current account imbalances and the potential blame that the countries with current account surpluses (China or Germany) have on the weakness of the economic recovery. As an example, here is Martin Wolf (FT) arguing that Germany cannot be a model for the Eurozone because of its current account surplus. Germany is accused of having kept wage growth too low and therefore forcing a "depreciation" to be more competitive. I am not sure what Martin Wolf proposes as a solution. Charles Wyplosz gets it right in his article: Germany should be running a current account surplus to save for the future and this is what many other advanced economies should be doing.

Antonio Fatás