As the debate on the appropriateness of doing more fiscal and monetary stimulus continues, here is a reflection on something that I never understood in that debate: even those who strongly oppose the idea of additional stimulus rarely question the workings of automatic stabilizers. This is surprising because under most economic models, a change in taxes or fiscal spending has a similar effect on GDP and unemployment whether this is built into the tax code or it is a discretionary decision of the government (this is even more true if everyone expects the government to react like that during recessions). Somehow, automatic stabilizers are seen as normal and effective (here is a 2008 WSJ piece by John Taylor arguing that automatic stabilizers should be allowed to work). But discretionary changes are ineffective and can only do harm.
The moment one admits that there is a good reason to have automatic stabilizers, then the discussion on how large they should be and how they should be complemented with discretionary fiscal policy is a natural one and cannot be avoided. Automatic stabilizers are not equal across countries and there is strong evidence that countries with smaller automatic stabilizers use discretionary fiscal policy more aggressively to compensate for this (which makes sense from an economic point of view). A few months ago we wrote a paper on this: the similarities between automatic stabilizers and discretionary fiscal policy. In addition to presenting evidence of how automatic stabilizers and discretionary policy can be seen as substitutes, we also show that among OECD economies the largest automatic stabilizer comes from stable government spending in the presence of falling GDP. In particular, in countries where government spending is large (and stable) we see strong automatic stabilizers. Finally, we also estimate fiscal policy multipliers but we do so by taking into account our argument that automatic stabilizers and discretionary policy are part of the same policy.
Antonio Fatás
Thursday, June 7, 2012
Monday, June 4, 2012
Fiscal Federation or Fiscal Policy
Can a monetary union work without being a fiscal federation? This has been a question that has been repeatedly asked since EMU became a project. Economists consider a fiscal federation a way to share risks through a common (large) budget. Risk sharing allows for smoothing of business cycles at the regional or national level. In the absence of monetary policy (and exchange rates) the theory says that adjustment must come from either price adjustments (internal devaluation), labor mobility (towards regions/countries that are doing well) or fiscal transfers through a common budget.
Back in 1998 when EMU was about to be launched I wrote an article with the title "Does EMU need a fiscal federation?" My conclusion was that while it would be nice to have one, the costs of not having one where not that high (and the implementation costs seemed too high at that point). The main argument of that paper was that business cycles have become so synchronized that the costs of losing national monetary policies was small (there was limited risk to insure at the national level).
Has the current crisis changed the logic of that analysis? Clearly this crisis is more asymmetric than all the previous ones in the Euro area. The 92/93 recession was very similar across countries. And 2001-2003 was a period of low growth for some of these economies but there was no deep recession in any Euro country. But since 2008 we are witnessing a recession which is very large and is not spread evenly among all Euro countries. No doubt that the benefits of any mechanism to share risks and alleviate national business cycles looks more important today than in any of the previous crisis.
But how much risk is being shared through a fiscal federation/common budget? Paul Krugman makes a comparison between Florida and Spain (as two regions/countries that have suffered a real estate boom and are now looking for help) and argues that Florida has received in the years 2007-10 about $31 billion from "Washington" via the federal budget and programs. These funds are a "a transfer, not a loan". Spain has not received any significant transfer from other Euro countries because of the small and unresponsive EU budget. $31 billion is a large number but my reading is that this number overestimates the benefits of the US federal budget.
Here is my reading of the same numbers: most of the funds behind the $31 billion figure come from the lower tax payment that Florida did to the federal budget during 2007-10: about $25 billion. But there is no risk sharing (and certainly not a transfer) if all states decrease their contribution to the budget by the same amount. A quick look at the data says that Florida tax revenues went down by 12% while overall tax revenues went down by 8.4%. So there is some asymmetry, but this asymmetry does not amount to $25 billion. What is happening is that the federal government is running a large deficit. This deficit is the main way in which tax revenues are being smoothed in Florida. For this, you do not need a fiscal federation, you just need a government (national is good enough) that is allowed to run those deficits. The difference between 8.4% and 12% can be thought of as risk-sharing although this might not be a "permanent" transfer. Unless we believe that this is a permanent change in Florida's GDP, we expect this pattern to be reversed when Florida's growth is higher than the average (possibly it already happened in the period before 2007). So this is a transfer in bad times that originates in a payment that Florida did during good times to the Federal system (once again, assuming this is just a transitory event). In other words, this is insurance, which is great to have but it is smaller than the smoothing provided by the fact that the federal government is running a large deficit.
In conclusion, countercyclical fiscal policy is good whether it happens at the local or federal level and this is the main reason for the large swing in tax revenues in Florida. Yes, there is in addition some risk-sharing between states (and unemployment benefits are even a better example, but those should also be measured relative to other states and not in isolation) which only happens via the federal budget. This mechanism is indeed absent in Europe. So can European countries do in the absence of a fiscal federation? They should rely more on standard countercyclical policy (which they do via their stronger automatic stabilizers) and possibly use additional mechanisms that take the forms of loans (as opposed to transfers/insurance). Credit in bad times is another form of achieving some smoothing of business cycles. Unfortunately we are doing the opposite: we are seeing a combination of austerity-by-faith policy combined with governments being cut access from financial markets. Under these circumstances, fiscal policy has become procyclical, exactly the opposite than what many countries need. In the absence of proper countercyclical fiscal policy any other mechanism, including a fiscal federation, would have been of great help.
Antonio Fatás
Back in 1998 when EMU was about to be launched I wrote an article with the title "Does EMU need a fiscal federation?" My conclusion was that while it would be nice to have one, the costs of not having one where not that high (and the implementation costs seemed too high at that point). The main argument of that paper was that business cycles have become so synchronized that the costs of losing national monetary policies was small (there was limited risk to insure at the national level).
Has the current crisis changed the logic of that analysis? Clearly this crisis is more asymmetric than all the previous ones in the Euro area. The 92/93 recession was very similar across countries. And 2001-2003 was a period of low growth for some of these economies but there was no deep recession in any Euro country. But since 2008 we are witnessing a recession which is very large and is not spread evenly among all Euro countries. No doubt that the benefits of any mechanism to share risks and alleviate national business cycles looks more important today than in any of the previous crisis.
But how much risk is being shared through a fiscal federation/common budget? Paul Krugman makes a comparison between Florida and Spain (as two regions/countries that have suffered a real estate boom and are now looking for help) and argues that Florida has received in the years 2007-10 about $31 billion from "Washington" via the federal budget and programs. These funds are a "a transfer, not a loan". Spain has not received any significant transfer from other Euro countries because of the small and unresponsive EU budget. $31 billion is a large number but my reading is that this number overestimates the benefits of the US federal budget.
Here is my reading of the same numbers: most of the funds behind the $31 billion figure come from the lower tax payment that Florida did to the federal budget during 2007-10: about $25 billion. But there is no risk sharing (and certainly not a transfer) if all states decrease their contribution to the budget by the same amount. A quick look at the data says that Florida tax revenues went down by 12% while overall tax revenues went down by 8.4%. So there is some asymmetry, but this asymmetry does not amount to $25 billion. What is happening is that the federal government is running a large deficit. This deficit is the main way in which tax revenues are being smoothed in Florida. For this, you do not need a fiscal federation, you just need a government (national is good enough) that is allowed to run those deficits. The difference between 8.4% and 12% can be thought of as risk-sharing although this might not be a "permanent" transfer. Unless we believe that this is a permanent change in Florida's GDP, we expect this pattern to be reversed when Florida's growth is higher than the average (possibly it already happened in the period before 2007). So this is a transfer in bad times that originates in a payment that Florida did during good times to the Federal system (once again, assuming this is just a transitory event). In other words, this is insurance, which is great to have but it is smaller than the smoothing provided by the fact that the federal government is running a large deficit.
In conclusion, countercyclical fiscal policy is good whether it happens at the local or federal level and this is the main reason for the large swing in tax revenues in Florida. Yes, there is in addition some risk-sharing between states (and unemployment benefits are even a better example, but those should also be measured relative to other states and not in isolation) which only happens via the federal budget. This mechanism is indeed absent in Europe. So can European countries do in the absence of a fiscal federation? They should rely more on standard countercyclical policy (which they do via their stronger automatic stabilizers) and possibly use additional mechanisms that take the forms of loans (as opposed to transfers/insurance). Credit in bad times is another form of achieving some smoothing of business cycles. Unfortunately we are doing the opposite: we are seeing a combination of austerity-by-faith policy combined with governments being cut access from financial markets. Under these circumstances, fiscal policy has become procyclical, exactly the opposite than what many countries need. In the absence of proper countercyclical fiscal policy any other mechanism, including a fiscal federation, would have been of great help.
Antonio Fatás
Friday, May 25, 2012
With or Without the Euro
UK GDP contracted faster than previously announced in the first quarter of 2012. What would the evolution of GDP have looked like during this crisis if the UK had been part of the Euro area? Impossible to tell as we cannot do a proper counterfactual exercise. But here is a potentially interesting comparison: the evolution of the UK and Spanish economies since the beginning of the crisis.
Spain and the UK are both large (by European standards) economies. Both of them started the crisis with current account deficits and suffered a real estate bubble prior to the crisis. There are, of course, differences: the UK financial sector is larger than that of Spain; the real estate bubble was larger in Spain,... But the difference that tends to be highlighted more by economic commentary is the Euro membership. Spain could not depreciate its currency as the UK did, Spain cannot resolve its government debt problems by relying on its central bank, and Spain could not lower the interest rate to zero as the UK did. Are these factors visible in the evolution of GDP from the beginning of the crisis to today?
Not obvious. If we take the end of 2007 as the beginning of the crisis, real GDP is today at the same relative level in both economies. The UK suffered more in the first quarters and then recovered. The Spanish economy was doing better earlier and then fell faster. Since the second quarter of 2010 both economies have been moving in parallel.
This is clearly not a scientific proof that Euro membership has not made a large difference (I am not controlling for all the other factors). But at a minimum, it raises questions about the statement that membership in the Euro area is a key factor to understand the performance of Euro members during the crisis.
Antonio Fatás
Spain and the UK are both large (by European standards) economies. Both of them started the crisis with current account deficits and suffered a real estate bubble prior to the crisis. There are, of course, differences: the UK financial sector is larger than that of Spain; the real estate bubble was larger in Spain,... But the difference that tends to be highlighted more by economic commentary is the Euro membership. Spain could not depreciate its currency as the UK did, Spain cannot resolve its government debt problems by relying on its central bank, and Spain could not lower the interest rate to zero as the UK did. Are these factors visible in the evolution of GDP from the beginning of the crisis to today?
This is clearly not a scientific proof that Euro membership has not made a large difference (I am not controlling for all the other factors). But at a minimum, it raises questions about the statement that membership in the Euro area is a key factor to understand the performance of Euro members during the crisis.
Antonio Fatás
Tuesday, May 22, 2012
Ignore Competitiveness?
Wolfgang Munchau in the Financial Times argues that competitiveness is not the real problem of Southern Europe and that internal devaluation is not the solution. Paul Krugman disagrees with him and argues that the evidence is clear:
1. Prior to the crisis, inflation was higher in Southern Europe.
2. These countries displayed large current account deficits, a sign of an overvalued real exchange rate.
I have presented arguments before that support Wolfgang Munchau's conclusions. Let me repeat some of the arguments and show additional evidence.
Unit labor costs grew faster in Spain or Greece or Italy than in Germany. But Germany was the outlier here. The behavior of unit labor costs in some of the countries in Southern Europe was not too different from that of France or the Netherlands. Here is a chart from an earlier post.
It is correct that Greece, Spain and Ireland saw higher increases in unit labor costs during the 10 years of the Euro. But the difference is small compared to France or the Netherlands. For example, comparing Spain and the Netherlands the difference is about 5 percentage points over a decade. This is not a large number given how volatile exchange rates are.
Estimates of unit labor costs are very imprecise and maybe they are not capturing the true loss in competitiveness of these economies. So why don't we look at the outcome? What about the current account balance? Countries like Spain or Greece run large current account deficits during these years. Isn't this a proof that they had lost competitiveness? Possibly, but there are other potential explanations for a current account deficit, such as an increase in spending fueled by a real estate bubble. It is not clear how to tell the two stories apart but here is a piece of evidence that I find useful. What happened to exports in Spain during all these years? If the story of lack of competitiveness is true one might expect that exports did not behave well during this decade as unit labor costs grew too fast. But the data reveals the opposite pattern. Compared to France or the UK (just to pick an outsider), Spanish exports grew faster during the last 10 years.
Does it mean that competitiveness is not a problem? No, but it might be a small factor compared to many other factors that have led these economies to the crisis. And if this is true, focusing on internal (or external, via exit from the Euro) devaluation as the solution to the crisis might distract us from dealing with the real issues.
Antonio Fatás
Sunday, May 6, 2012
Germany and the Benefits of the Euro
Since the launch of the Euro, there has always been a question about the benefits that Germany could enjoy of sharing a currency with other countries. While for the other countries (the "periphery") the benefits in terms of credibility and stability of a strong currency were obvious, for Germany the benefits were simply the additional trade integration that the Euro would produce. Some believed that this benefit was too small to compensate for the potential risk of being part of a club with riskier countries. The current crisis has provided arguments for those who believed that Germany should have never been part of the Euro.
There is, however, a different perspective of the first 12 years of the Euro when looking at the performance of the German economy. During those years Germany managed to engineer a reduction to its relative labor costs that paid off in terms of increasing exports, a large surplus in the current account and faster GDP growth. A model that some see today as an example for others to follow. As Paul Krugman has pointed out several times, this model cannot work for everyone, not all countries can run current account surpluses!
In his most recent article Paul Krugman argues that the current German model needed the Euro to work. Germany had tried to keep labor costs under control in the past but without success. The launch of the Euro locked the exchange rate and sent capital flows to the periphery producing inflation in those countries. Even if German inflation was still positive (so no painful disinflation), there was an inflation gap with others, one that allowed Germany to be more competitive as the periphery became less competitive.
Quoting from Krugman's article:
"Or to put it differently: Germany believes that its successful adjustment was the result of its own virtue, but in reality it was successful in large part because of an inflationary boom in the rest of Europe. And here’s the thing: the Germans are now demanding that the European periphery replicate its achievement (and actually surpass it, because the required adjustment is much bigger) without providing a comparably favorable environment — they’re demanding that Spain and others do what they never did, which is deflate their way to competitiveness."
The corollary of this argument is that Germany benefited from the Euro in a way that was not expected at the time when it was launched: by allowing an increase in competitiveness relative to the other Euro members.
I agree with this argument but I think that there is part of the story that is missing. Not all other members of the Euro area had high inflation. Let's compare Germany to France.
Since the launch of the Euro unit labor costs in France increased faster than in Germany. By the way, France resembles many of the other "periphery" countries in terms of unit labor costs, as I have discussed earlier. Here is the early chart.
But France did not lose competitiveness through higher inflation. Prices in France and Germany behaved in a similar way, there was no inflation gap.
So in the comparison between France and Germany the story above does not seem to work, adjustment did not come from inflation in other countries but by the relative control of wages in Germany (relative, of course, to changes in labor productivity and all of this relative to French wages). But here is where I the Euro could still have played a role: when Germany had its own currency, it was very difficult to engineer a "competitive devaluation". Reductions in wages or prices could easily be compensated by a stronger currency (the German Mark). This might run contrary to our intuition that competitive devaluations are easier with flexible exchange rates. For a country very committed to keep inflation low and a strong currency, it is difficult to deliver a competitive devaluation through monetary policy. But once the exchange rate is fixed, a combination of control on labor costs and the inflation that was generated in some of the periphery countries finally allowed Germany to produce a reduction in unit labor costs and growth via expansion of exports. And that is how Germany benefited from the Euro.
Antonio Fatás
There is, however, a different perspective of the first 12 years of the Euro when looking at the performance of the German economy. During those years Germany managed to engineer a reduction to its relative labor costs that paid off in terms of increasing exports, a large surplus in the current account and faster GDP growth. A model that some see today as an example for others to follow. As Paul Krugman has pointed out several times, this model cannot work for everyone, not all countries can run current account surpluses!
In his most recent article Paul Krugman argues that the current German model needed the Euro to work. Germany had tried to keep labor costs under control in the past but without success. The launch of the Euro locked the exchange rate and sent capital flows to the periphery producing inflation in those countries. Even if German inflation was still positive (so no painful disinflation), there was an inflation gap with others, one that allowed Germany to be more competitive as the periphery became less competitive.
Quoting from Krugman's article:
"Or to put it differently: Germany believes that its successful adjustment was the result of its own virtue, but in reality it was successful in large part because of an inflationary boom in the rest of Europe. And here’s the thing: the Germans are now demanding that the European periphery replicate its achievement (and actually surpass it, because the required adjustment is much bigger) without providing a comparably favorable environment — they’re demanding that Spain and others do what they never did, which is deflate their way to competitiveness."
The corollary of this argument is that Germany benefited from the Euro in a way that was not expected at the time when it was launched: by allowing an increase in competitiveness relative to the other Euro members.
I agree with this argument but I think that there is part of the story that is missing. Not all other members of the Euro area had high inflation. Let's compare Germany to France.
Since the launch of the Euro unit labor costs in France increased faster than in Germany. By the way, France resembles many of the other "periphery" countries in terms of unit labor costs, as I have discussed earlier. Here is the early chart.
But France did not lose competitiveness through higher inflation. Prices in France and Germany behaved in a similar way, there was no inflation gap.
So in the comparison between France and Germany the story above does not seem to work, adjustment did not come from inflation in other countries but by the relative control of wages in Germany (relative, of course, to changes in labor productivity and all of this relative to French wages). But here is where I the Euro could still have played a role: when Germany had its own currency, it was very difficult to engineer a "competitive devaluation". Reductions in wages or prices could easily be compensated by a stronger currency (the German Mark). This might run contrary to our intuition that competitive devaluations are easier with flexible exchange rates. For a country very committed to keep inflation low and a strong currency, it is difficult to deliver a competitive devaluation through monetary policy. But once the exchange rate is fixed, a combination of control on labor costs and the inflation that was generated in some of the periphery countries finally allowed Germany to produce a reduction in unit labor costs and growth via expansion of exports. And that is how Germany benefited from the Euro.
Antonio Fatás
Monday, April 30, 2012
Euro and US Coordinating Austerity
To add yet one more perspective on how significant the shift to austerity among advanced economies has been since 2009, I decided to add the Euro series to a chart from Paul Krugman's blog. This is real government consumption for both the US and the Euro (17 countries) area.
It is remarkable how the Euro area and the US display a strong coordinated contraction in fiscal policy starting in the first quarter of 2009 that accelerates during 2010 and 2011. This has come at a time when advanced economies (and the world) were starting a recovery from a very deep recession. No surprise that the recovery is not going as well as some thought and some countries are going back into recession.
Antonio Fatás
It is remarkable how the Euro area and the US display a strong coordinated contraction in fiscal policy starting in the first quarter of 2009 that accelerates during 2010 and 2011. This has come at a time when advanced economies (and the world) were starting a recovery from a very deep recession. No surprise that the recovery is not going as well as some thought and some countries are going back into recession.
Antonio Fatás
Thursday, April 26, 2012
Ideology and Facts in the Economic Policy Debate
The fact that ideology matters in the economic policy debate should not be a surprise to anyone. But the influence that ideology has has in some of the economic analysis we have seen since the beginning of the financial crisis has led to completely contradictory statements about the facts behind the causes and potential remedies to the crisis.
Via Greg Mankiw's blog I read a strong criticism of the Obama administration written by James Capretta. Quoting from his article:
We have all heard similar statements before which tend to be supported by references to $800 billion to $1 trillion stimulus packages and bailouts both in the US and Europe.
But have we really see an unusual expansion of government size? Quite the contrary. As I argued in a previous post, what we have seen during the current crisis is exactly the opposite. Relative to previous crisis government spending has been growing at a much slower rate this time. Paul Krugman makes an even more interesting comparison in blog, a comparison that reveals how inaccurate the above statement is. He compares government employment under the Obama administration to the Bush and Clinton administrations. The Bush administration is probably the most relevant comparison because it also started in the middle of a recession. Here is the chart from Krugman's analysis.
The data speaks for itself. 40 months into the Obama administration, the number of government employees (all levels of government) has gone down by 600,000. During the Bush administration the number had increased by about 700,000. A difference of 1.3 million. So where is the increase in government size?
Antonio Fatás
P.S. A few months ago I wrote a post with almost the same title discussing the mistaken view that some economists have of the link between taxation and labor market outcomes in Europe - another debate that seems to be heavily influenced by ideology and not enough by facts.
Via Greg Mankiw's blog I read a strong criticism of the Obama administration written by James Capretta. Quoting from his article:
When he (Obama) came into office, he favored a massive injection of new government spending into the economy in the name of “stimulus” — counter-cyclical federal activity aimed at offsetting depressed consumer demand emanating from a recession-battered private sector. The net result provides little if any boost to aggregate demand because the states — and to some extent private citizens — simply pocket the federal money and reduce their deficits and debts. Meanwhile, what federal taxpayers get is a permanent increase in the size of government.
We have all heard similar statements before which tend to be supported by references to $800 billion to $1 trillion stimulus packages and bailouts both in the US and Europe.
But have we really see an unusual expansion of government size? Quite the contrary. As I argued in a previous post, what we have seen during the current crisis is exactly the opposite. Relative to previous crisis government spending has been growing at a much slower rate this time. Paul Krugman makes an even more interesting comparison in blog, a comparison that reveals how inaccurate the above statement is. He compares government employment under the Obama administration to the Bush and Clinton administrations. The Bush administration is probably the most relevant comparison because it also started in the middle of a recession. Here is the chart from Krugman's analysis.
The data speaks for itself. 40 months into the Obama administration, the number of government employees (all levels of government) has gone down by 600,000. During the Bush administration the number had increased by about 700,000. A difference of 1.3 million. So where is the increase in government size?
Antonio Fatás
P.S. A few months ago I wrote a post with almost the same title discussing the mistaken view that some economists have of the link between taxation and labor market outcomes in Europe - another debate that seems to be heavily influenced by ideology and not enough by facts.
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