Why not Earlier?

Mario Draghi presented yesterday one more plan with great promises but short of details (as usual) to save the Euro. Markets are happy, but will this plan follow the fate of the previous announcements? Will the excitement die out in a matter of weeks or days?

The ECB is now finally sending a strong message that they will do whatever it takes to defend the Euro. In many ways this is a game changer and it is difficult to understand why this was not done earlier. When we think about monetary or fiscal policy as stabilizing tools we see them as forces that can make recessions shorter and recoveries stronger. Clearly what we have seen in the last years is a slow moving process towards the inevitable solution, the only way this crisis could be resolved.

Did it really take that long for the ECB and European authorities to realize that this was necessary? Or was this a strategic move to push countries to do reform? My guess is that there is some truth in both. Even today some still believe that ECB intervention is a bad idea. And it is also quite possible that from the beginning some understood that this move had to happen but they wanted to wait until things got worse to extract concessions from the other countries before saying yes.

Will the positive effect of this announcement vanish with time as it has happened with some of the previous ones? I doubt it, there will still be swings in the market mood but this time it can be different. The nature of unlimited intervention by the ECB to support the Euro is very different than any of the previous vague statements about creation of bailout funds without real support and no details on when and how the money would be disbursed. Here we have a statement from the central bank saying that they will do whatever it takes to keep the Euro alive and that they are willing to fight market distortions on bond yields (this is always a very risky statement to make for a central bank).  The same way the Swiss Central Bank has been successful in its recent effort to stabilize the Swiss Franc or the same way the German and French central banks managed to defend the French Franc / German Mark exchange rate during the crisis of 1992/93, central banks can be very powerful when they want.

Of course, the statement of Mario Draghi was very carefully drafted with strong references to price stability and sterilizations of interventions. If this signals a strong level of disagreement within the ECB, one that could potentially lead to an institutional crisis if the plan needs to be implemented at a large scale, then there is a risk that the announcement will not be effective. But it is hard to imagine this scenario. If the announcement has been made it must be that there is enough political support within the ECB (and the Euro area governments) to make this a reality, if necessary. And the beauty of credible statements of unlimited support is that they might work even if the ECB never has to intervene in bond markets.

Antonio Fatás

Excess Reserves Explained

I have written before about the confusion that exists in the press about the interpretation of the excess reserves that commercial banks currently hold at central banks as money that is being "parked" there as a safe investment. The level of reserves is ultimately determined by the Central Bank as it decides on the optimal size of its balance sheet.

A recent post (via Mark Thoma) at the Federal Reserve Bank of New York presents this argument in detail.

"The language used in the press and elsewhere is often imprecise on this point and a source of potential confusion. Reserve balances that are in excess of requirements are frequently referred to as “idle” cash that banks choose to keep “parked” at the Fed. These comments are sensible at the level of an individual bank, which can clearly choose how much money to keep in its reserve account based on available lending opportunities and other factors. However, the logic above demonstrates that the total quantity of reserve balances doesn’t depend on these individual decisions"

The full post is required reading for those who want to understand how the level of excess reserves is determined.

Antonio Fatás 

Draghing their feet

Mario Draghi disappointed markets yesterday by not offering a clear commitment to any concrete policy action to resolve the turmoil in European financial markets. Nothing new: the inability of European policy makers to resolve the crisis continues as markets keep going back and forth between excitement and depression.

My reading of his statements (a few days ago) and yesterday is slightly different and possibly more optimistic. Mario Draghi has made very concrete statements about what the ECB is willing to do that go beyond what was said before. In particular, what I heard yesterday is that

"Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible."

These are strong statements in support of the Euro (not that surprising) but also about mispricing of certain risks in bond markets (this is more surprising). Some are disappointed that he only talks about risks related to the reversibility of the Euro and not about default risks, but central bankers need to choose their words carefully. It would be difficult to expect from a central banker an explicit statement about specific country default risks.

He was also as explicit as one can be about intervention in bond purchases:

"The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures."

These are strong words and open the door for a more flexible discussion on seniority of debt. Less concrete than what some wanted but they clearly signal further actions in the coming weeks.

Some found it surprising that he established a connection between ECB actions to involvement of EFSF/ESM.

"The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions."

This is not ideal but understandable. Fundamentally, the Euro/EU area has a very complex set of institutions. They might play a role in certain occasions but when it comes to reacting quickly to economic events they are slow (very slow!). The EFSF/ESM were created to deal with economic circumstances like the ones Europe is going through. Some national governments would love to see the ECB intervening in financial markets to reduce their risk premium without having to involve any supervision from European authorities. But the political reality is that intervention by European institutions requires some risk sharing to be successful. And risk sharing requires some recognition that we are all in the same boat and as such the decision on the directions in which the boat has to go have to be made together. If the disagreements about these directions are that strong, then the Euro project is bound to fail.

Compromises are necessary on all sides. Some need to understand that sharing risks is the only way to move forward even if it exposes them to loses on debts originally accumulated by other countries. And those countries which are being helped need to acknowledge that the help comes with a price and certain amount of interference in internal political decisions. This has proven to be a very tough dialogue among all European countries where blame should be assigned to all parties involved (how much blame you assign to each party is another issue...).

I do not expect miracles going forward but I see progress on several fronts: the words by Draghi yesterday are reassuring and bond yields in Spain or Italy are under pressure but contained. To find an exit we are waiting for more actions and they will require additional dialogue between all governments involved and a sense of even larger compromise than what has been agreed so far. Progress will be painfully slow and costly but at least we are moving in the right direction.

Antonio Fatás

The Difficulty in Accepting "Discretionary Stabilizers"

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

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

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

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