Options for Europe – Part 57

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).

Chapter X The Stability and Growth Pact – neither growth nor stability

[A PARAGRAPH FROM YESTERDAY AS A GUIDE TO THE FOLLOWING INSERT]

The operation of automatic stabilisers thus attenuate the amplitude in the business cycle by expanding the fiscal deficit in a recession and contracting it in a boom. However, while they lessen the negative impacts of a recession they do not eliminate them and if the recession is severe enough then additional discretionary fiscal measures are necessary to ensure the output and income losses and the increases in unemployment are kept to a minimum.

[INSERTED SECTION HERE AS NEW MATERIAL TODAY AFTER THAT PARAGRAPH]

[subheading]Structural and cyclical fiscal balances[/subheading]

Recognition of the role of the automatic stabilisers is important also for understanding the concept of a ‘structural’ fiscal balance or ‘structural’ deficit. This is one of those terms that have entered the public debate and appears to be significant but which few people, including many of the financial journalists who use it regularly, actually understand very well. As a result few people actually understand how the concept is misused and manipulated by neo-liberals to provide a legitimacy to the imposition of fiscal austerity, when such legitimacy or intellectual authority is unwarranted.

An observation that the fiscal balance goes into deficit or reveals an increasing deficit doesn’t allow us to conclude that the government has suddenly become of an expansionary or stimulatory mind. The presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.

To overcome this ambiguity, economists measure the automatic stabiliser impact against some benchmark or “full capacity” or potential level of output to allow the actual reported fiscal balance to be conceptually separated into that component which is due to specific discretionary fiscal policy choices made by the government (so-called structural decisions) and that which arises because the economic cycle has deviated from the potential level of output.

As a result, economists devised a measure they called the ‘full employment fiscal balance’ or in more recent nomenclature, the ‘structural balance’, which is a hypothetical construction indicating what the fiscal balance would be if the economy was operating at potential or full employment with the tax revenue and spending that would be forthcoming at that level of economic activity. This concept thus attempts to net out from the reported fiscal balance the ‘cyclical’ component, which arises from the swings in economic activity around full employment.

Economists thus conclude that if there is a ‘structural’ deficit then the overall impact of the discretionary fiscal policy settings is expansionary irrespective of what the actual fiscal outcome is presently. That is, the government is contributing to economic growth. If there is a ‘structural’ surplus, then we conclude that the overall impact of discretionary fiscal policy is contractionary irrespective of what the actual fiscal outcome is presently. That is, the government is putting the brakes on economic growth. We can thus envisage a situation where during an economic downturn, the fiscal balance moves into deficit but the underlying ‘structural’ position could be contractionary (that is, a surplus). And vice versa.

Where the controversy (and ideology) enters is in how the ‘full employment’ or ‘potential’ benchmark level of output is to be measured. Full employment used to be considered a state where anyone who wanted a job could find one. Accordingly, the unemployment rate consistent with full employment would be very low and reflect those workers who were moving between jobs at any point in time (referred to as ‘frictional’ unemployment).

Once the Monetarists assumed dominance in the academy and in the policy circles during the 1970s, this concept of full employment was abandoned. Neo-liberal economists, who represent the mainstream, now talk about a rather complex sounding concept called the Non-Accelerating Inflation Rate of Unemployment (NAIRU). The NAIRU became a central plank in the front-line attack on the use of discretionary fiscal policy by governments to maintain low unemployment rates. Low unemployment rates, of-course, help balance the bargaining power between labour and capital. Higher unemployment swings the balance towards the employers because they can then choose from a bigger pool of desperate workers. There is thus a strong ideological motivation among neo-liberals to inflate the unemployment they claim to be associated with full employment because that will appear to be consistent with a ‘desired’ state and therefore invoke no government intervention by way of spending increases.

The neo-liberal sophistry, argued, erroneously, that full employment did not mean the state where there were enough jobs to satisfy the preferences of the available workforce. Rather, full employment occurred when the unemployment rate was at the level where inflation was stable, neither accelerating or decelerating.

Most central banks and fiscal agencies publish estimates of the NAIRU because as a conceptual construct it is not observed. Recent history shows us that the NAIRU estimates they produce are very unreliable with large margins of statistical error. In some cases, we have seen research reports produce estimates that vary between 3 and 13 per cent for the same nation at the same time, which, of-course, makes the concept useless for policy purposes. The statistical techniques used to generate these estimates typically just produce results that follow the actual unemployment rate up and down and so there is little ‘informational’ content in the estimates produced that is separate from the cyclical movements in the unemployment rate. While the neo-liberals hang on to this concept as something meaningful because it serves an ideological purpose in their fight against government spending, a reasonable conclusion is that the NAIRU estimates put out by the IMF or the OECD or other neo-liberal agencies are much higher than any acceptable level of full employment and therefore full capacity.

Once that point is understood, it becomes obvious that the estimates of the ‘structural’ fiscal balance are biased upwards. What does that mean and why is it important? The inflated NAIRU estimates set the full employment benchmark, so we might have a situation where the true full employment state is equivalent to an unemployment rate of, say, 2 per cent but the NAIRU estimate is 5 per cent. The economists will then calibrate what they think the tax revenue and welfare spending will be at the 5 per cent level and will call that the ‘structural balance’. But, if the real full employment level of unemployment is 2 per cent, then this exercise will underestimate the tax revenue and overestimate the spending that would occur at full employment. As a result, the NAIRU-based estimates of the ‘structural’ balance will be biased towards predicting higher ‘structural’ deficits than is really the case. In turn, assessments of the policy stance of government will be biased towards concluding the government is adopting a more stimulatory stance than is the case. It could be the case that if we measured the ‘structural’ position at 2 per cent unemployment (in this example), the ‘structural’ balance would be in surplus, which would tell us that the government was actually adopting a contractionary position.

This is important because the neo-liberals claim that the ‘structural’ balance should be zero or in surplus. If they systematically estimate this component to be more expansionary than it actually is, then they will be advocating fiscal austerity (a movement towards or into surplus) at times when the ‘structural’ position of the government might already be contractionary and the actual deficit outcome just a reflection of weak private spending. This will bias economies to accepting higher than necessary unemployment rates. This sort of bias is endemic in the European Commission’s reasoning associated with excessive deficits in the SGP.

What we can conclude is the various ‘official’ estimates of the full employment are biased towards accepting a higher unemployment rate benchmark that is in fact true and thus the whole analysis of whether the government intent is to stimulate or contract is biased towards concluding there is more stimulus in the system than is the actual case.

[subheading]Structural deficits and the SGP rules[/subheading]

This discussion about ‘structural’ deficits is central to the way we understand the flaws in the SGP and why the fiscal rules bias the Eurozone towards higher unemployment and slower growth than is necessary. The Maastricht outcome was based on the neo-liberal assumption that the ‘structural’ balance should be always close to zero or in surplus. It was then assumed that even the worst ‘cyclical’ impacts would, on average, keep the reported deficits below the 3 per cent threshold. In other words, the fiscal rules were deemed to be a reflection of reasonable fiscal policy practice.

The question that arises is why should a preferred ‘structural’ balance be small or in deficit or even below 3 per cent? Is it possible that a responsible fiscal position for a government to take would deliver a ‘structural’ balance in excess of 3 per cent?

The aim of fiscal policy – that is, discretionary government spending and tax decisions – is to achieve the government’s macroeconomic policy goals, which include full employment. The responsible goal of fiscal policy is not to achieve some dictated fiscal ratio. Once you reflect on the previous discussion, which showed how the private sector spending decisions ultimately determine the reported fiscal outcome anyway the idea that it is reasonable to pursue some given number (such as a deficit of 3 per cent of GDP) becomes nonsensical.

Fiscal policy positions can only be reasonably assessed in the context of the macroeconomic policy goals. Attempting to assess the fiscal outcome strictly in terms of some prior fiscal rule (such as a deficit of 3 per cent of GDP) independent of the actual economic context is likely to lead to flawed policy choices. The ‘structural’ budget balance thus has to be sufficient to ensure there is full employment. The only sensible reason for accepting the authority of a national government and ceding currency control to such an entity is that it can work on our behalf to advance our welfare. The achievement of full employment is an important part of this pursuit of public purpose.

As we noted previously, total economic activity (output and employment) is determined by how much spending there is in the economy. Firms produce output and pay incomes to workers and others according to their sales volumes. One person’s spending is another person’s income. There will be a particular level of national output at any point in time, which we would consider to be sufficient to generate enough jobs that will satisfy the preferences of workers for work. In other words, there will be a particular level of total sales (total spending) that will justify the firms producing this level of output and offering sufficient jobs to exhaust the supply of labour.

Once the private sector has made its spending (and saving decisions) in any particular period, the national government has a choice. It can use its fiscal capacity to ensure that total spending in the economy is equal to the full employment level. It will typically be the case that the total private spending is below that necessary to support the full employment output level. Economists call this discrepancy a ‘spending gap’. Thus the responsible role of government fiscal policy is to eliminate any ‘spending gap’ by allowing its deficit to rise accordingly. It is unlikely that the automatic stabilisers will be sufficient to provide that level of required public spending support to the economy. In other words, the government has to take discretionary decisions to expand its spending and/or cut its tax rates to ensure the ‘structural’ deficit rises. How much should it rise? The responsible action is to allow it to rise to the level that is sufficient to close the spending gap left by the private spending choices.

Thus there is no predisposition towards a ‘small’ structural deficit or a surplus. The ‘structural’ balance should be whatever is required to maintain full employment over time and is conditional on what the private sector spending choices are.

The alternative choice the government can make it to maintain some slack in the economy with persistently high unemployment and underemployment in an effort to maintain a lower fiscal deficit than would be associated with maintaining full employment. Economists call this strategy one of ‘fiscal drag’ which refers to the policy choice dragging the economy below its full employment output level. This type of fiscal stance ultimately undermines the confidence of the private sector and cause firms to reduce production and income. The automatic stabilisers then drive the fiscal outcome towards increasing deficits and stagnation sets in.

Fiscal sustainability is thus about governments ensuring there are no ‘spending gaps’ so that the levels of economic activity is consistent with full employment. Fiscal sustainability cannot be defined independently of full employment. Once the link between full employment and the conduct of fiscal policy is abandoned, we are effectively admitting that we do not want government to take responsibility of full employment (and the equity advantages that accompany that end). That is the position that the Eurozone took on once it accepted the SGP as its guiding framework.

[subheading]The SGP and ‘pro-cyclical’ policy choices[/subheading]

Eichengreen (1997: 34) concluded that the fiscal rules defined by the SGP “raises the danger that fiscal policy will become increasingly procyclical, as governments are forced to raise taxes and cut spending in downturns to satisfy these restrictions. With neither fiscal nor monetary flexibility, Europe will be helpless in the face of business cycle disturbances.” The anathema of sound fiscal policy practice is to create a bias towards what economists call ‘pro-cyclical’ policy changes. The terminology is straightforward. The economic cycle (that is, movements in GDP) goes up and down according to the growth in real GDP (output). The economy cycles between booms (strong growth) and busts (weak growth or recession). If something follows the economic cycle up and down it is said to be ‘pro-cyclical’, whereas, if some variable moves in the opposite direction to the economic cycle it is said to be ‘counter-cyclical’.

Discretionary fiscal policy changes should be ‘counter-cyclical’ because the role of government is to ensure economic activity remains at levels consistent with full employment. So when the private sector spending growth slows, which would push the economy into a slump with lower output growth and falling employment, the correct response of government is to introduce a fiscal stimulus – to inject spending into the economy to make up for the deficiency caused by the slowdown in private spending. That is, the deficit should rise as the private economic cycle falls (a ‘counter-cyclical’ policy response).

The worst thing a government can do as private spending falls off and the economy moves towards or into recession is to cut its own spending and/or increase taxes in an attempt to reduce its deficit. The withdrawal of the public spending contribution to total sales would only make the recession worse and further undermine the confidence of the private sector. This sort of response is called a ‘pro-cyclical’ policy change and clearly is not consistent with responsible policy practice.

The fiscal rules defined by the SGP thus bias nations to making ‘pro-cyclical’ policy decisions as we have seen in the recent crisis. As private sector spending collapsed, the deficits rose purely through the workings of the automatic stabilisers as the available tax base shrunk as unemployment increased. For many nations, as we will see later, this ‘cyclical’ impact was sufficient to breach the upper threshold of 3 per cent and warrant an excessive deficit procedure being implemented by the European Commission against the nation. The pressure was then imposed on the nation to make discretionary cuts to their spending and/or raise taxes in an effort to offset the automatic stabilisers and maintain the overall fiscal balance below the three per cent threshold.

This was madness. As the recent experience has so emphatically demonstrated, imposing fiscal austerity on a nation in recession is self-defeating because the attempts to cut the discretionary or ‘structural’ component of the deficit, further undermines the tax base and drives the automatic stabilisers into further deficit as economic growth deteriorates. An unemployed person pays no taxes!

The very fact that the automatic stabilisers are pushing the fiscal deficit up indicates that the government should increase the ‘structural’ deficit to stimulate growth. The SGP is neither a source of stability nor growth.

[subheading]Further flaws in the SGP rules[/subheading]

[END OF INSERT – NEXT PARAGRAPH IS FROM YESTERDAY AS A GUIDE]

In the period after Maastricht, the European Commission published several research papers which aimed to show that sufficient stabilisation could occur at the national level to avoid crisis. The research papers that were summarised in the One Money, One Market publication (European Economy, 1993) used various ‘Neo-Keynesian’ economic models to compare the role of central budgets in the US and Canada, for example against what occurred in say France and Germany. The simulations were deeply flawed.

[THEN MATERIAL FROM YESTERDAY]

[NEXT – FINISH OFF THE STABILITY AND GROWTH PACT BY EXAMINING THE ASSUMED OUTPUTS COMPARED TO THE REALITY]

[TO BE CONTINUED]

Additional references

This list will be progressively compiled.

Andrews, E.L. (1997) ‘German’s Slick Bookkeeping to Meet Euro Goal Is Scrapped’, New York Times, June 4, 1997. http://www.nytimes.com/1997/06/04/world/germans-slick-bookkeeping-to-meet-euro-goal-is-scrapped.html

Böll, S., Reiermann, C., Sauga, M. and Wiegrefe, K. (2012) ‘Operation Self-Deceit: New Documents Shine Light on Euro Birth Defects’, Der Spiegel, May 8, 2012. http://www.spiegel.de/international/europe/euro-struggles-can-be-traced-to-origins-of-common-currency-a-831842.html

Buiter, W. (2009) ‘The unfortunate uselessness of most ‘state of the art’ academic monetary economics’, Financial Times, March 3, 2009. http://blogs.ft.com/maverecon/2009/03/the-unfortunate-uselessness-of-most-state-of-the-art-academic-monetary-economics/

Buti, M., Franco, D., and Ongena, H. (1997) ‘Budgetary Policies during Recessions – Retrospective Application of the “Stability and Growth Pact” to the Post-War Period’, Economic Papers, 121, 1-33. http://ec.europa.eu/economy_finance/publications/publication11240_en.pdf

Deutsche Bundesbank (1998) ‘Stellungnahme des Zentralbankrates zur Konvergenzlage in der Europäischen Union im Hinblick auf die dritte Stufe der Wirtschafts- und Währungsunion’, April 1998. http://www.bundesbank.de/Redaktion/DE/Downloads/Veroeffentlichungen/Monatsberichtsaufsaetze/1998/1998_04_konvergenzlage.pdf?__blob=publicationFile

Dunbar, N. and Martinuzzi, E. (2012) ‘Goldman Secret Greece Loan Shows Two Sinners as Client Unravels’, Bloomberg News, March 6, 2012. http://www.bloomberg.com/news/2012-03-06/goldman-secret-greece-loan-shows-two-sinners-as-client-unravels.html

Eichengreen, B.J. (1997) ‘Saving Europe’s automatic stabilisers’, National Institute Economic Review, 159(1), 92-98.

Eichengreen, B.J. and Wyplosz, C. (1998) ‘The stability pact: more than a minor nuisance?’, Economic Policy, 26. 65-114.

European Central Bank (1998) ‘Joint communiqué on the determination of the irrevocable conversion rates for the euro’, May 2, 1998. http://www.ecb.europa.eu/press/pr/date/1998/html/pr980502.en.html

European Monetary Institute (1998) ‘Convergence Report’, March 1998. http://www.ecb.europa.eu/pub/pdf/conrep/cr1998en.pdf

EurActiv (2010) Theo Waigel: Greek crisis exposed EU weaknesses’, September 13, 2010. http://www.euractiv.com/euro/waigel-stability-pact-not-flawed-all-countries-must-play-rules-news-497698

European Council (1997a) ‘Presidency Conclusions’, Amsterdam, June 16-17, 1997.
http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/032a0006.htm

European Council (1997b) ‘Resolution of the European Council on the Stability and Growth Pact Amsterdam, 17 June 1997’, Official Journal C 236, 02/08/1997 P. 0001 – 0002. http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31997Y0802%2801%29:EN:HTML

European Council (1998) ‘Presidency Conclusions’, Vienna, December 11-12, 1998. http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/00300-R1.EN8.htm

European Monetary Institute (1998) ‘Convergence Report’, March 1998. http://www.ecb.europa.eu/pub/pdf/conrep/cr1998en.pdf

Italianer, A. and Pisani-Ferry, J. (1992) ‘Systèmes budgétaires et amortissement des chocs régionaux : implications pour l’union économique et monétaire’, Economie prospective internationale, 51, 49-69. http://www.cepii.fr/IE/PDF/EI_51-4.pdf

Mitchell, W.F., Muysken, J. and Van Veen, T. (2006) Growth and Cohesion in the European Union, Cheltenham: Edward Elgar Publishing.

Pisani-Ferry, J., Italianer, A. and Lescure, R. (1993) ‘Stabilizatoin properties of budgetary systems: A simmulation approach’, in The Economics of Community Public Finance, European Economy, Reports and Studies, 5.

Pisani-Ferry, J., Vihriälä, E. and Wolff, G. (2012) ‘Options for a Euro-Area Fiscal Capacity’, Bruegel Policy Contribution, Issue 2013/01, January. http://www.bruegel.org/download/parent/765-options-for-a-euro-area-fiscal-capacity/file/1636-options-for-a-euro-area-fiscal-capacity/

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.