Coordinated Fiscal Contraction

The new issue of the IMF fiscal policy monitor is out. As usual, a great reading to understand the state of fiscal policy in the world. There are many issues I could highlight from the report but here is one that caught my attention: below is a summary of what fiscal policy has been doing since 2009.

The red dot in the chart represents the change in the cyclically-adjusted primary balance as a % of potential GDP in advanced economies during the period 2009-13. This variable is the best way to capture discretionary fiscal policy, as the balance is adjusted by the cycle and we use potential output (instead of output) to avoid the ratio to be influenced by cyclical variations in GDP (the blue and yellow columns just show how much of the action comes from expenditure cuts of increases in taxes).

Not only we see a majority of countries reducing budget balances (a coordinated fiscal policy contraction) but the numbers are extremely large. Greece is an outlier (16.3%), but many others are large (Spain, Portugal and Ireland close to 10%), the UK around 7% and a significant number of countries around 4%.

How this coordinated fiscal policy contraction is affecting the pace of the recovery (or the likelihood of another recession) depends on your views on the fiscal policy multipliers (see my previous post), but what remains a fact is that the amount of coordinated fiscal policy contraction during the current cycle is  very large and I doubt that we can find a similar experience in any of the previous recoveries.

Antonio Fatás

Underestimating Fiscal Policy Multipliers

The October edition of the IMF World Economic Outlook is out with very strong warnings about risks to growth (full report can be found at the IMF web site). In Chapter 1 there is a nice analysis about whether in our most recent growth forecasts we have recently underestimated fiscal policy multipliers. Quoting from that chapter:

"With many economies in fiscal consolidation mode, a debate has been raging about the size of fiscal multipliers. The smaller the multipliers, the less costly the fiscal consolidation. At the same time, activity has disappointed in a number of economies undertaking fiscal consolidation. So a natural question is whether the negative short-term effects of fiscal cutbacks have been larger than expected because fiscal multipliers were underestimated."

And the answer is yes and here is my reading of what has happened. About eleven years ago there was a series of academic papers that estimated fiscal policy multipliers. The conclusion of the earlier papers is that multipliers were somewhere in the range 1-1.5. In other words, a 1% increase in government spending raised GDP by somewhere between 1% and 1.5%. This was the conclusion I reached together with my co-author back in 2001 (paper is available at my web site).  This was also the conclusion of the paper written by Oliver Blanchard and Roberto Perotti written around the same time and available here. The academic literature on this issue grew very fast with a large number of papers confirming the earlier estimates but also with a set of other papers that challenge the size of fiscal multipliers. In particular, papers that used events such as wars tended to find smaller multipliers. Because this is about fiscal policy, the debate has not gone away and there are still those who believe that multipliers are close to zero or even negative (i.e. when public spending goes up, private spending goes down by the same amount).

Despite the debate, my reading of the literature up to that point was that there was a significant amount of consensus around multipliers being around or slightly above 1.

As soon as the 2008 crisis started the debate went from a simple academic discussion to an urgent policy issue. What will be the impact of fiscal stimulus? The Obama administration produced a report (co-authored by Christina Romer) that suggested multipliers around 1.5 to justify the need for fiscal policy stimulus. These multipliers were criticized by those who believed that there is no room for aggregate demand management even in the presence of a large crisis. Since then the debate has become much more ideological than academic. We have had a series of additional academic papers that, if any,  suggest that multipliers are even larger than the initial estimates because of the special circumstances we are in (monetary policy stuck at the zero-lower bound and a deep recession caused by develeraging forces that reduce private demand).

But these new (and old) academic results have simply be displaced by the ideological debate that followed the fiscal policy stimulus of the 2008-2009 period, which somehow led to the conclusion that those policies did not work and that what we now needed was more austerity. And when over the last two years we forecasted GDP growth rates in the face of coordinated austerity by many governments we somehow forgot to consider that multipliers can be large.

This is what the IMF suggests now in their analysis, which, by the way, is also self critical. They look at their recent forecasts for global growth and they suggest that their model was implicitly using fiscal policy multipliers around 0.5 when measuring the impact of fiscal consolidation. Given that their GDP growth forecast has been overestimating growth, the IMF now wonders whether multipliers are higher than 0.5. The analysis in the current World Economic Outlook suggests that multipliers might be within the range 0.9 to 1.7. A range which happens to be very almost identical to the one produced by the early papers and confirmed by the most recent academic literature. It is also not far from what most economic models would predict given current economic conditions.

Antonio Fatás

Cyclical Zombies

Stephen Roach argues in this article that the "current medicine being applied to America's economy" is wrong. The real disease is a "protracted balance-sheet recession that has turned a generation of America’s consumers into zombies – the economic walking dead. Think Japan, and its corporate zombies of the 1990’s. Just as they wrote the script for the first of Japan’s lost decades, their counterparts are now doing the same for the US economy".

This is an argument that has been used before during the current crisis: we are trying to fix a structural problem with medicine that can only deal with cyclical misalignments. Using Roach's words: "Steeped in denial, the Federal Reserve is treating the disease as a cyclical problem – deploying the full force of monetary accommodation to compensate for what it believes to be a temporary shortfall in aggregate demand."

There is no doubt that asset bubbles and excessive optimism during the pre-crisis years are now reflected in weak balance sheets that will take time to fix and will represent a drag on growth. And this clearly is not a mere cyclical issue. But there is something else that is going on: advanced economies have gone through a deep recession and are still producing below potential. This is not structural, this is cyclical. And finding a solution to the structural problem in the middle of a recession is not easy. While households have to reduce spending to repair their balance sheets, doing so at the same time that income is below potential just becomes more painful. Monetary and fiscal policy cannot eliminate the effort that is associated with deleveraging but they need to ensure that this happens in the least painful way. And this requires producing a path for output and income in the short run that is as close as possible to the level of potential output. We can debate about what this level should be but it is hard to argue that given current economic conditions and high levels of unemployment we are close to potential.

Antonio Fatás

Can you Spare a Few Trillion?

Most governments in advanced economies have been unable to deliver on debt sustainability for the last decades. In some cases increasing spending is not matched by their ability to find additional sources of revenues, in other cases taxes have been reduced without the corresponding reduction in spending. And it will only get worse going forward as worsening demographics will put enormous pressure through the corresponding increase in spending. 

As we can see in the US presidential race, solutions are not easy to find. Everyone talks about finding a sustainable path for the government debt but details on how this will be achieved are difficult to find. This is probably more obvious in the case of Mitt Romney and his promise to cut taxes. This is only compatible with debt sustainability if you find enough spending items in the budget to cut, but that is where the difficulty lies. Societies ask governments to provide certain services that are considered to be necessary. Yes, we can make governments more efficient and eliminate some unnecessary bureaucrats but when you look at the numbers, this is not going to be enough - in some cases there is very little margin to reduce spending if you just follow that route.

Here is a picture from the US that makes this point as clear as possible. Government spending on pensions and healthcare (medicare and medicaid) from 1972 until today and then extrapolated to 2030 (source: Congressional Budget Office).

What is striking about this picture is not so much the shape but the magnitude of the increase. From 4% of GDP in 1972 to about 10% today and reaching 14% in 2030. This is measure as % of GDP (not % of government spending). In the absence of a reduction in spending in some other budget items, this has to be met by increasing revenues (taxes) by a similar amount. 

This looks like an impossible task. But let's try to look at it from a different angle to see if we find a solution. Forget about governments, imagine a world where all goods are purchased by the private sector (e.g. you pay for your own healthcare). Because of changes in taste, income and technology, we continue spending more on certain sectors (such as healthcare). We have satisfied all our basic needs (food, housing), our income keeps increasing and there is a technology out there that allows us to live healthier and longer so we choose spending more on it. Sectoral changes in the composition of our spending are not rare. How visible is the above trend if we look at consumer expenditures? Do we also see a large increase in healthcare spending in the private sector? And, more interestingly, are there other components that are going down at a similar speed to ensure that budgets are not overstretched? 

Here is a quick look at Personal Consumption Expenditure by type of good (Source: Bureau of Economic Analysis). I picked the sectors that have moved the fastest and I particularly looked for two moving in opposite directions. 

This is what you find: Healthcare is the fastest growing component and has gone from 4% in 1960 to 16% today (this is measured as % of the total expenditures). The component that follows the opposite trend and almost by the same magnitude is Food and Beverages. From 18% down to 8%. So we spend less in food and beverages to be able to afford the increasing cost of going to the doctor more often and enjoying a healthier and longer life.

In some sense we expect governments to do one of these two things:

1. Either they find some spending in their budget that we do not want anymore and they reduce as fast as healthcare and pensions public spending is increasing.

2. Or they do simply pass the bill to the private sector (you will need to pay for those doctors). But if they do so, then the private sector will need to find something else to cut.

What we have seen is that #1 is not obvious. There are not that many things that governments do that we do not want them to do. And #2 is exactly what politicians do not want to do (and we do not want them to do it), to pass the bill to us in the form of higher taxes - and I am ignoring here the question of who exactly gets the bill. So we end up with debt levels that keep increasing and will do so until we find a way to deal with long-term sustainability of government finances that is very different from what we have done in the past.

Antonio Fatás

QE3 and the Fed Dual Mandate

The US Federal Reserve just announced the third round of quantitative easing (QE3) by signaling a commitment to keep rates low for a long(er) period of time and engage in additional purchases of assets at a rate of $40 Billion a month.

Reading the press commentary on this move I can see once again the difficulty in making strong and clear economic policy decisions to end the crisis. I do not want to discuss in this post the potential effects of QE3 but simply the way it is being interpreted in the context of the mandate of the US Federal Reserve.

Let me take an example from this morning's Financial Times: John Authers starts the front-page commentary by saying

"The Federal Reserve did not need to do this. Its dual mandate, to ensure full employment and combat inflation pointed in different directions. Political pressure against taking action (...) was intense".

At the end of the column, after reviewing the decision of the Fed, the author concludes that the weak US data and the fact that fiscal policy will not do much about it forced the Fed to move

"That is why, by default, the Fed felt it had to do this."

Notice the different choice of words for the two sentences. The article opens up with the statement that the Fed did not need to do this and then it tells a story of why the Fed felt it had to do it (even if they did not need to do it?).

The dual mandate of the US Federal Reserve is as explicit as it can be even if the precise definitions of full employment and price stability can be open to interpretation. Imagine that inflation had been higher than the implicit or explicit Fed target for several years with an economy at full employment. Would we be saying that the Fed does not need to raise interest rates? No. We would be screaming for the Fed to raise interest rates as aggressively as possible.

The US economy has now been producing at a level which is clearly below its potential for the last four years. The unemployment rate is at levels that are higher than any sensible estimate of the natural unemployment rate. To make matters worse, inflation and inflation expectations have been consistently below the Fed target. How do we go from here to the conclusion that "they did not need to do this"? I can imagine a discussion on the effectiveness of additional quantitative easing measures. Will they have an effect on output and employment? I can see a debate on this question but not on one about the need to find additional ways to effectively stimulate the economy.

Antonio Fatás

 

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