"Confessions of a crass Keynesian
December 13, 2008
The German federal minister of finance, Peer Steinbrueck, does not like anything that increases government deficits. He does not like them, Sam-I-Am. I believe he is wrong - very wrong and dangerously wrong. In the interest of Anglo-German harmony and ever-closer cooperation, I have written this post.
It explains that there are bad deficits and good deficits. Or, in the words of Ecclesiastes: “To every thing there is a season, and a time to every purpose under the heaven:” a time to cut taxes and a time to raise taxes, a time to borrow and a time to refrain from borrowing.
Today is a time, even Ecclesiastes would agree, made for increased government borrowing, provided a few key conditions are satisfied.
Mum, the government are running a deficit again!
Government deficits have to be financed by selling assets, by borrowing from the domestic private sector, from the rest of the world or from the central bank. Asset sales by the government can be ignored as a financing option for the governments of the USA, the UK and the nations that constitute the Euro Area. Quite the opposite has been happening lately, with governments acquiring large stake in domestic banks and other financial institutions.
Borrowing from the central bank
Borrowing from the central bank (selling Treasury debt to the central bank) requires the central bank either to increase its monetary liabilities (currency or bank reserves held with the central bank), or to increase its non-monetary liabilities, or to run down its stock of official foreign exchange reserves or other central bank assets. The USA, the Euro Area and the UK all have floating exchange rates, and foreign exchange market intervention has not been a significant pastime for the monetary authorities of these countries. Under current economic circumstances, financing the acquisition of additional Treasury debt by running down central bank holdings of private securities would not make sense. True non-monetary liabilities of the central bank (Central Bank Bills or Central Bank Bonds) are common in developing countries and emerging markets but have not been a common sight on the balance sheets of the Fed, the ECB and the Bank of England - until recently.
The Federal Reserve System today holds a large amount (more than $400 bn) of Treasury deposits on its balance sheet , the result of the Treasury selling Treasury securities to the public and depositing the money with the Fed. The Fed has used these funds to acquire additional private securities. Instead of borrowing from the Treasury (through the Treasury’s deposits with the Federal Reserve System), the Fed is currently considering the possibility of issuing non-monetary, interest-bearing securities directly to the market. Assuming Treasury and Fed securities of the same maturity are perfect substitutes for private investors, this would give the Fed another, economically equivalent mechanism for expanding its balance sheet without increasing the monetary base. Why the Fed would want to increase the size of its balance sheet by issuing non-monetary liabilities rather than monetary liabilities is unclear to me. Liquidity preference remains unbounded from above. Further quantitative easing is not inflationary for as long as current economic conditions last.
Once the official policy rate is at its zero floor, quantitative and qualitative easing are the main instruments of monetary policy, which becomes inextricably intertwined with liquidity management. By acquiring longer-dated government securities and financing these purchases by expanding the base money stock, central banks can bring down the risk-free nominal rate of interest at longer maturities than overnight. Such purchases of longer-maturity government securities reinforce the expectations mechanism - long-term risk-free nominal yields are tied to current expectations of future overnight rates, give or take a term premium. By acquiring private securities, including illiquid private securities, whether through outright purchase or as collateral in repos or at the discount window, the central bank can influence a range of term spreads and liquidity spreads on these private securities.
For simplicity and to put the issue as sharply as possible, let’s assume that when the government (the Treasury) borrows from the central bank, the central bank monetises its acquisition of the Treasury securities, that is, it increases the sum of currency and banks’ deposits (reserves) with the central bank. In practice, the increase in base money is likely to take the form mainly of larger bank reserves with the central bank.
As long as the economy is in the doldrums, with a large (or even large and growing) amount of spare capacity and extreme risk-averse behaviour of banks, other financial institutions and individual investors, the increased quantity of central bank money will be absorbed willingly at the current price level and at the current (near zero) level of the short-run nominal interest rate. Fear and loathing in the financial markets have created a near unbounded liquidity preference - a willingness to hold a humongous quantity of real base money. Such injections of base money are therefore not inflationary.
When the economy recovers, as it will, and private investors recover their bottle, the demand for real base money normalises and the private sector finds itself with excessive real base money balances at the current official policy rate and price level. The private sector will try to reduce its holdings of real money base money balances partly by switching their portfolio allocation towards non-monetary assets and partly by spending them. In the aggregate, of course, the private sector cannot reduce the nominal stock of base money, unless the central bank plays ball and de-monetises the public debt it had monetised earlier. If it does not do so, monetary equilibrium will have to restored through a higher general price level.
This de-monetisation of the public debt (the reversal of the earlier monetisation) will be automatic if, when the economy recovers, the official policy rate rises again above its zero lower bound and quantitative easing comes to an end. When the official policy rate is set (pegged) above its lower bound, the demand for real base money balances becomes finite again. With the general price level pre-determined (given/sticky in the short run because the world is crass-Keynesian in the short run, that is, in real time), the nominal base money stock becomes endogenous. Given the central bank’s balance sheet, the counterpart of the endogenous (and lower) stock of base money is the endogenous (and lower) stock of Treasury securities held by the central bank.
When the economy normalises, the public debt issued by the Treasury to finance any deficits incurred during the slump leaves the central bank and comes back home to mama. Mama will have to convince the markets (the domestic private sector and/or the rest of the world) that it wants to hold this public debt. If the interest rates at which the markets are willing to hold that debt are high, or if there is no interest rate level, however high, at which the markets wish to hold the additional public debt spewed out of the central bank’s balance sheet, we have a problem. Either the government forces the central bank to hang on to the Treasury debt or the economy will have to live with very high interest rates or, in the most extreme case, with default on the public debt.
The first scenario - permanent monetisation of public debt issuance - means that, when the economy recovers, the central bank is forced to engage in whatever amount of monetary issuance may be required to finance the government deficit. The result will be inflation, when the economy recovers - quite possibly inflation in excess of the explicit or implicit inflation target of the central bank
While it is therefore true that the government can always, if it has the power to tell the central bank what to do, monetise the outstanding stock of government debt and any amount of new issuance of government debt, no matter how large, as long as the debt is denominated in domestic currency, there is a limit, for most base money demand functions, to the amount of real resources the government can extract though the inflation tax. This implies that there is a limit to the real value of the government deficit that can be financed through the inflation tax and also to the amount of index-linked government debt and foreign-currency-denominated government debt that can be monetized and inflated away.
The nastiest alternative is that the real value of the government deficit is larger than the real value of the additional issuance of money balances that the private sector is willing to absorb at any constant rate of inflation: the maximum long-run inflation tax at a constant rate of inflation is less than the real value of the government deficit. In that case hyperinflation will result.
It is a long way from the current threat of deflation (negative inflation) to hyperinflation, but it is never to soon to start worrying about the next crisis.
Borrowing from the market
Now consider the case where the government deficit is financed by borrowing from the markets rather than from the central bank. Like every other economic agent, the government is subject to an intertemporal budget constraint. A government is solvent if the value of its net stock of outstanding debt does not exceed the present discounted value of its current and future primary surpluses. The government’s primary surplus is its conventional financial surplus plus net interest paid on its outstanding stock of debt. Since the government here excludes the central bank, among the government revenues that are included in the government’s primary surplus are the taxes paid by the central bank to the Treasury. These contributions of the central bank to the government budget are not usually referred to as ‘taxes’.
Central bank operating profits (net interest income and other income minus the cost of running the show) are usually split between a contribution paid into the government budget and an addition to the central bank’s reserves. The contribution of the central bank to the government budget (called taxes on the central bank in the previous paragraph) increase one-for-one with any increase in interest paid by the government to the central bank on the central bank’s holdings of government securities. At the margin, therefore, borrowing from the central bank is free to the government.
As regards the solvency of the central bank, it makes no difference whether base money is non-interest-bearing (the case of currency) or interest bearing (often the case with banks’ reserves with the central bank). Ultimately, the central bank can settle any domestic-currency denominated claim on itself by paying in currency, which is both non-interest-bearing and irredeemable.
When the government violates its ex-ante intertemporal budget constraint or solvency constraint (its outstanding debt is larger than the present discounted value of its planned/expected primary surpluses) there are but three options for closing this ‘solvency gap’. (1) it cuts current and/or future public spending; (2) it raises current and/or future tax revenues; or (3) it defaults on part or all of the sovereign debt.
When will the future spending cuts or tax increases have to be implemented? The solvency constraint and intertemporal budget constraint are silent on this matter. They only assert that the present discounted value of current and future spending cuts and tax increases has to be at least equal to the solvency gap. It does not tell you when this has to happen. So could we wait until the years 3125 before spending is cut or taxes are increased? Market realities imply the answer is no. Markets are doubting Thomases. To them seeing is believing. They want to put their fingers in the wounds. In practice, spending will have to be cut and/or taxes will have to be increased as soon as this is sensible from a conjectural or cyclical point of view. As soon as a tax increase or public spending cut would be counter-cyclical rather than pro-cyclical, it will have to be implemented. Failure to do so at the first opportunity would weaken the credibility of the government. Markets will entertain steadily stronger doubts about the sustainability of the fiscal-financial programme of the government. Default risk premia will be added to the interest rates at which the government borrows. As the perceived likelihood of a sovereign default increases, the default risk premia will rise and, ultimately, the government will be rationed out of the primary debt markets: it will become impossible to add to the government’s net indebtedness and even to roll over maturing debt.
So is Steinbrueck right in condemning proposals for deficit-financed fiscal stimuli in Europe and elsewhere to counteract the contraction of effective private demand? This question has two parts: (1) does a temporary tax cut or spending increase, followed by a future tax increase or spending cut that restores government solvency stimulated demand? Can governments credibly commit themselves to raise future taxes or cut future public spending by enough to maintain government solvency if they deliver an immediate tax cut or public spending increase?
Does a temporary tax cut boost consumer spending?
For the moment, let’s assume that the answer to the second question is ‘yes’ and let’s address the first. I will focus on a temporary tax cut. Will a temporary tax cut today resulting in a larger budget deficit and increased government borrowing stimulate demand, if future government taxes are raised again by the same amount, in present discounted value, as the current tax cut? Or, in other words, does postponing taxes, holding constant their present discounted value, boost demand?
I will focus on cuts in household taxes, like the personal income tax or VAT. The argument that deficit-financed tax cuts don’t boost consumption demand is known as Ricardian equivalence or debt neutrality. For it to be true, the aggregate consumption demand of consumers has to behave in the same way as would the consumption of a representative infinite-lived consumer with perfect foresight. This consumer knows, when his taxes are cut, that he will pay higher taxes in the future and that the present value of current and future taxes has not changed. His permanent income or wealth have not changed. He will not feel better off as the result of the tax cut. He will save all of the tax cut to pay the higher future taxes.
The demographics of the Ricardian equivalence model are not convincing. People are born, live for a while and die. While they are alive, they overlap with earlier generations (the old) and with generations born since their own generation arrived (the young). Postponing taxes will therefore shift the burden of paying the taxes from the older generations to the younger generations, and possibly even to the (as yet) unborn. The usual life-cycle arguments suggest that the old (who have fewer remaining years to live) will have a higher marginal propensity to consume out of a temporary tax cut than the young. The old certainly will have a higher marginal propensity to consume than the unborn. So cutting taxes today and raising them again in the future by the same amount in present discounted value raises aggregate consumption demand.
It is important that the current tax cut and the future tax increase don’t affect the same people equally in both periods. For the fiscal stimulus to work through a life-cycle mechanism, the current tax cut would primarily have to benefit today’s old and working generations. The future tax increase would be paid mainly by today’s young and working generations, or by those who today are still unborn (future generations). This will be the case if the tax is a tax on labour income or a capitation or head tax. It would not be true if the future tax increase were on the income from an asset that is already in existence and fully owned today (land or physical capital). In that case, both the current tax cut and the future tax increase will be reflected in the value of the assets, which will not change. Taxes on future labour income are not, however, capitalised in the value of any asset owned by anyone currently alive. This is because we have abolished hereditary slavery: the human capital of future generations is not owned by anyone currently alive today. Postponing labour income taxes therefore redistributes resources from the young and the unborn to the old. The life-cycle For life-cycle reasons, the old have a higher marginal propensity to consume than the old, and the unborn don’t consume at all.
If current generations care about their descendants, they may be planning to leave bequests for them. Should the government then try, by cutting taxes today and raising them in the future, to redistribute towards parents and grandparents and away from their children and their grand children, the parents and the grand parents would simply offset this involuntary intergenerational redistribution by the government with voluntary intergenerational redistribution towards their descendants. Lower taxes today would be saved and left as increased bequests. Since most people don’t leave bequests in the first place (most retirement wealth is annuitized), this ingenious argument in favour of Ricardian equivalence even in a world of overlapping generations with finite life spans, is a theoretical curiosum, not a useful empirical benchmark.
In addition to life-cycle reasons for current tax cuts boosting aggregate consumption, there are liquidity reasons. If some consumers are liquidity-constrained (unable to borrow more or sell assets) a cut in current taxes will relax a binding liquidity constraint on current spending, even if the consumer were to be fully aware that he would have to pay higher taxes in the future. Of course, not all households can be liquidity-constrained, otherwise there would be no-one to purchase the securities the government is issuing to finance the increased government deficit.
In the current liquidity crunch there is bound to be a significant increase in the number of liquidity-constrained households. If they could be targeted through the tax cuts, the consumption effects would be strengthened. Liquidity constraints are especially likely among those with large debts, no liquid assets and no collateralisable assets who suffer a temporary interruption in their labour income, due to unemployment, say. They are also likely to affect those with rising age-earnings profiles who have few liquid and collateralisable assets. This would include yuppies and other upwardly mobile groups.
It is hard to believe that, provided a government has the fiscal-financial credibility to be able to commit itself to future tax increases or public spending cuts when it implements immediate tax cuts or public spending increases, that this would fail to stimulate aggregate demand through the usual life-cycle effects and liquidity constraint effects.
The VAT cut rubbished so emphatically by the German minister of finance is in fact quite a clever tax cut, precisely because it is temporary. By cutting the price to the consumer today and raising it again tomorrow, there is an incentive to shift the timing of consumption of non-durables and services, and the timing of the purchases of consumer durables, toward the present, when consumer prices are temporarily low. The neo-classical substitution effect reinforces the Keynesian current disposable income effects.
Mr. Steinbrueck is not impressed and provides variations on the ‘who would cross the road for a 2.5 percent VAT cut when there are 20 percent to 50 percent discounted sales on everywhere’ argument. I think Mr. Steinbrueck underestimates the German and British shopper. But even if he were right and the substitution effect of the temporary VAT cut is negligible, there still is the income effect.
Would the income effect have been stronger if, instead of a VAT cut worth, say £14 bn, the same amount of money had been sent directly to British households in the form of a cheque with the same amount of money for each tax-paying or benefit-receiving adult? This is not at all obvious to me. Assume households spend the same amount following the VAT cut as they did before. If prices come down by the full 2.5 percent cut in the VAT rate, they will buy a larger amount of real commodities with the same amount of income. This stimulates the demand for real goods and services. If prices were to come down by less than the cut in VAT, after-tax profits would increase for the sellers, which could boost the consumption demand of their owners or the demand for investment or working capital inputs by the enterprises themselves.
If none of this sounds convincing to the German minister of finance, he could always implement a temporary investment credit or a similar temporary subsidy to or tax cut on investment on fixed assets. Precisely because it is temporary, it would shift the timing of investment spending toward the present.
So Mr. Steinbrueck’s outburst appears to be rooted in faulty logic and sloppy thinking.
Who can afford even a temporary tax cut or spending increase?
Until further notice, I will assume in what follows that the central banks in the countries or monetary union I am discussing stick to their price stability or dual price stability and full employment mandates. That means that they will monetise government debt and deficits only up to the point where they perceive such actions to undermine the effective pursuit of price stability.
Not all nations in the north Atlantic region are equally well positioned to implement a fiscal stimulus that would result in a significant increase in the government deficit. The decision of the EU to call on all EU member states to implement a 1.5 percent of GDP stimulus to GDP therefore appears to be ill-advised. The magnitude of the stimulus should be modulated (a) according to the needs of the country (how deep is the recession, how open is the economy) and (b) according to the fiscal-financial sustainability of the government and the credibility of the government, that is, the likelihood that it will act in a determined counter-cyclical manner during the next economic upswing, raising taxes and/or cutting public spending.
Italy’s fiscal-financial sustainability and the credibility of its government were it to announce a pleasure today - pain tomorrow temporary fiscal stimulus are close to zero. The UK’s fiscal-financial sustainability is poor and the credibility of its government is severely impaired after years of pro-cyclical fiscal policy during the age of excess that preceded the current bust. The UK government, by de facto or de jure underwriting the liabilities of the UK banking system has assumed debts worth over 400 percent of GDP. Of course there are assets on the other side of the banks’ balance sheets, but the liabilities are firm and clear, while the assets are dodgy and of uncertain value. The same applies to the United States of America, where the Federal government is not only up to its neck in actual and contingent liabilities through its underwriting of the banking system, GSEs like Fannie Mae and Freddie Mac, insurance companies like AIG and non-specific partly financial enterprises like GE, but is about to have the water rise even higher as it bails out the three domestic automobile manufacturers.
Germany’s Maastricht gross general government debt as a percentage of annual GDP was about 20 percentage points higher than that of the UK at the end of 2007. However, the cyclically adjusted budget deficit in Germany is far smaller than that of the UK. In addition, the exposure of the German government to its banking sector, while non-trivial, is much smaller than that of the UK government to its over-developed banking sector. Most important, the German authorities have demonstrated both the willingness and the capacity to engage in countercyclical fiscal policy during the most recent boom period.
This means that reasons of national self-interest and as a constructive member of the global community, Germany can and should engage in a significantly larger fiscal stimulus (relative to the size of its economy) than the US and the UK. Spain and France also should deliver an above-average fiscal stimulus, while Italy cannot afford much of a stimulus at all.
Sovereign default versus inflation levies
For the first time since the German default of 1948, a number of countries in the north Atlantic region (North America and Western Europe) face a non-negligible risk of sovereign default. The main driver is their governments’ de facto or de jure underwriting of the balance sheets of their banking sectors and, in some cases, of a range of non-bank financial and non-financial institutions deemed too big to fail. Unfortunately, in a number of cases, the aggregate of the institutions deemed too large, too interconnected or too politically connected to fail may also be too large to save. The solvency gap of the private institutions the authorities wish to save exceeds the fiscal spare capacity of the sovereign.
The clearest example of the ‘too large to save’ problem is Iceland. Iceland’s government did not have the fiscal resources to bail out their largest three internationally active banks. The outcome was that all banks went into insolvency. The government then nationalised some key domestic parts of the three banks out of the insolvency regime, decided (under massive pressure from the British, Dutch and German governments) to honour Iceland’s deposit guarantees and left the rest of the unsecured debt to be resolved through the insolvency process.
Other countries face the problem of the inconsistent quartet ((1) a small open economy; (2) a large internationally exposed banking sector; (3) a national currency that is not a major international reserve currency; and (4) limited fiscal capacity). They include Switzerland, Sweden, Denmark and the UK. Ireland, the Netherlands, Belgium and Luxembourg have all but the third of these characteristics.
There can be little doubt that, faced with the choice between sovereign default and an unexpected burst of inflation to reduce the real value of the government’s domestic-currency-denominated debt, the US government would choose inflation. It would simply instruct the Fed to produce the required burst of inflation. The Fed is the least independent of the leading central banks. The Fed regained a measure of operational independence in the conduct of monetary policy in 1951 through the US Treasury Federal Reserve Accord. This accord does not have the force of law, and can be revoked at any time by the Treasury.
In the UK too, I believe that, given the choice between sovereign default and a burst of unanticipated inflation, the UK Treasury would choose inflation. The Treasury could repatriate the rate setting powers of the Monetary Policy Committee of the Bank of England under the Reserve Powers clause of the Bank of England Act 1998.
Things are different in the Euro Area. The independence of the ECB is embedded in the Treaties. A unanimous decision by all member states is required to change the Treaty. Given this operational independence ‘on steroids’ of the ECB, it is unlikely that any Euro Area national government or coalition of governments could bully the ECB into engaging in a burst of public-debt-busting unanticipated inflation. Perhaps Mr Peer Steinbrueck’s intemperate expostulations about the horrors of increased public debt are due to his recognition that he, unlike his fellow ministers of finance in the UK and the US, does not have the option of inflating away the public debt, unless Germany were to decide to leave the Euro Area.
If instead we accept as an axiom that every German finance minister worth his salt would emulate the stance taken by Ludwig Erhard in 1948 and would therefore never choose the inflation option, even if the only alternative would be government default, then Peer Steinbrueck’s eruption is hard to rationalise. Perhaps it cannot be rationalised because it was an emotional outburst rather than a thought-through argument. Surely not…."
Now Wolfgang Munchau in the FT:
"Over the past three years, I have closely followed the German finance minister with a growing sense of disbelief. Peer Steinbrück’s lack of diplomacy is remarkable only insofar as that it has now become known to a wider audience. He has been talking like this forever. His bashing of the “Anglo-Saxons” goes down very well in Germany for now. But at the time of the general elections in September 2009, Germany and the rest of the eurozone will be in the middle of an economic depression. Then people will be asking why their chancellor and their finance minister have been so extraordinarily complacent.
Given the extreme economic deterioration in the past few weeks, I actually expected they would have done something by now. But they are digging in. Angela Merkel, the chancellor, held a domestic summit in Berlin to discuss the economic situation. I suspect another stimulus package will come eventually, sometime next year. But I doubt it will come in time to help the economy in 2009. Whatever is eventually decided will have no economic effect until well after the elections. Germany is thus entering 2009 with a total stimulus of 0.5 per cent of gross domestic product, in other words, with essentially no fiscal support. Since monetary policy has little traction when credit markets are dysfunctional, there is hardly any support at all.
Two weeks ago, I forecast that the German economy would contract between 2 and 4 per cent in 2009. What looked to some like an eccentric forecast has now become mainstream. Last week, two of Germany’s large economic institutes forecast a decline in growth for 2009 of 2 and 2.2 per cent respectively. Norbert Walter, chief economist of Deutsche Bank, said a contraction of 4 per cent in 2009 was possible. The Ifo institute predicts that the contraction will continue in 2010.
Expect all those forecasts to get progressively worse throughout the winter, especially if global trade continues to contract at current rates. Germany ran a current account surplus of 7.6 per cent of gross domestic product in 2007. This means that a global trade crisis will hit Germany disproportionately hard. Last week’s most shocking economic news was the 2.2 per cent year-on-year fall in Chinese exports in November, which is a bellwether of global trade volumes. To make matters even worse, the real effective exchange rate of the euro is beginning to rise again.
What about Germany’s domestic consumption? The optimists say this is providing some support. This is true for now, since total unemployment is low. But consumption is sensitive to changes in unemployment. By next spring, exports, investment, employment and consumption will all be falling. And with Germany, the rest of the eurozone will also go down.
What about the €200bn European Union stimulus package that was agreed in a watered-down form by EU leaders on Friday? Unfortunately, it is a public relations exercise first and foremost, designed to dupe people into believing that the EU is finally doing something. The headline figure of 1.5 per cent includes some new money, but mostly expenditures that were already committed before the crisis, as well as guarantees.
Ms Merkel now claims that the German stimulus is not a meagre €12bn, but an impressive €32bn ($47.8bn, £28.6bn). Italy provides an even more comic example of fiscal stimulus accounting. Tito Boeri, professor of economics at Bocconi University in Milan, has noted* that the Italian stimulus programme has a negative cost. It includes more taxes than expenditures.
The recently announced €26bn French stimulus is a useful package of structural expenditures, which might even raise the country’s potential growth in the long run. But unfortunately, it is not a stimulus. European politicians simply cannot get it into their head that the sole purpose of stimulus should be to stop a dangerous, self-fulfilling economic slump. This is not about bridges and canals, or structural reforms.
Last week, at a debate in Brussels organised by the Financial Times and Friends of Europe, a think-tank, André Sapir, professor of economics at Université Libre de Bruxelles, made an astute observation. He said we should not try to avoid 1929. We have already failed. The best we can do now is to avoid 1930, 1931 and 1932. It will depend on the quality of our policy response whether we succeed.
At the present rate, I fear, the effort is not going well. The electoral timetable in the US has delayed an effective policy response and I fear that the new economics team of President-elect Barack Obama will be too much focused on domestic stimulus and not enough on global co-ordination. The Europeans and Asians, meanwhile, are unbelievably complacent. Even a US stimulus at 10 per cent of GDP will not miraculously pull the world economy out of recession. It will most likely focus on domestic infrastructure investment rather than private consumption. US households, meanwhile, will continue to adjust their balance sheets, which will take some time.
So our financial crisis is on the brink of turning into a policy crisis. People will blame not only bankers, but increasingly politicians as well. I would expect that Mr Steinbrück will be one of those politicians. He seems to be enjoying his crisis so far. But just wait a few months."
Now, Paul Krugman in the NY Times:
"European macro algebra (wonkish)I’ve been on the warpath over Germany’s refusal to play a constructive role in European fiscal stimulus. But what does the math look like? Here’s a simple analysis — well, simple by economists’ standards — of the reason coordination is so important for the EU.
We start from the proposition that Europe is, or soon will be, in a position where interest rates are up against the zero lower bound. This means both that fiscal policy is the only game in town, and that we can use ordinary multiplier analysis.
Let m be the share of a marginal euro spent on imports — either for an individual county, or for the EU as a whole (I’ll explain in a minute). I’ll assume that m is the same for government spending and for domestic demand. Let c be the marginal propensity to consume. And let t be the share of an increase in GDP that accrues to the government in increased taxes or reduced transfers.
Consider the effects of an increase in government purchases dG. This will raise GDP directly, to the extent that it falls on domestic goods and services, and indirectly, as the rise in GDP induces a rise in consumer spending. We have:
dY = (1-m)dG + (1-m)(1-t)c dY
or dY/dG = (1-m)/[1 - (1-m)(1-t)c]
Since governments are worried about debt, it’s also important to ask how much the budget deficit is increased by an increase in government spending. It’s not one-for-one, because higher spending leads to higher GDP and hence higher tax revenue. We have
dD = dG - tdY
A crucial number is “bang for euro”: the ratio of the increase in GDP to the increase in the deficit. After a bit of grinding, it can be shown to be
dY/dD = (1-m)/[1 - (1-t)(1-m)c - t(1-m)]
OK, some numbers. The average EU country spends about 40 percent of GDP on imports, and collects about 40 percent of GDP in taxes. Let me cut corners and assume that the marginal rates are the same as the average, and also assume that the marginal propensity to consume is 0.5. That is, for an average EU country, m = 0.4, t= 0.4, c = 0.5.
We can represent a coordinated fiscal policy by looking at the numbers for the EU as a whole. The only difference is that m falls to 0.13, because two-thirds of the imports of EU members are from other EU members.
And we get the following results:
UNILATERAL FISCAL EXPANSION
Multiplier = 0.73
Bang per euro = 1.03
COORDINATED EXPANSION
Multiplier = 1.18
Bang per euro = 2.23
The bang per euro is what matters: the tradeoff between increased debt and effective stimulus is MUCH better for the EU as a whole than it is for any one country.
You can play with these numbers, but I don’t think that conclusion is very sensitive to the details as long as you keep the large intra-EU trade effects in there. The lesson of this algebra is that there are very large intra-EU externalities in fiscal policy, making coordination really important. And that’s why German obstructionism is such a problem."
"It has become a cliché in political Berlin that of all the ministers in chancellor Angela Merkel’s cabinet, the one she gets along with best is Peer Steinbrück, holder of the finance portfolio and, as a Social Democrat, a political rival to the chancellor.
Yet as they have joined forces to rebut mounting criticism of their economic policy abroad, a subtle division of labour has developed between the two, with Mr Steinbrück, it seems, all too happy to play bad cop to the more soft-spoken Ms Merkel.
This was obvious in Mr Steinbrück’s assertion, in an interview with Newsweek this week, that Gordon Brown, the British premier, was pursuing “crass” Keynesian policies and “tossing around billions” by cutting value-added tax in a move that would burden British taxpayers for generations.
This was tougher stuff than anything Ms Merkel has said. Though the chancellor expressed “serious concern” recently about attempts to tackle the crisis by injecting cheap money into the economy – a comment aimed mainly at US fiscal and monetary policies – officials say she sees the VAT cut as a valid decision for the UK, albeit one that would not work in Germany.
This is not the first time Mr Steinbrück has breached the rules of diplomacy. In a speech in the Bundestag held in the immediate aftermath of the Lehman Brothers collapse, he proclaimed “the end of the US as a finance superpower.”
In a more recent, deeply sarcastic interview, he accused other European leaders of acting like “lemmings” – a species of rodents with an undeserved reputation for committing mass suicide - by following the UK in raising their deficits to battle the crisis.
That the German finance minister does not take outside advice graciously is a gross understatement. Indeed, European counterparts have long grown wary of his lengthy lectures at European meetings about the alleged superiority of German economic management and its three-pillar banking system.
And although the tandem with Ms Merkel has worked well so far, even the chancellery has become slightly uncomfortable with the minister’s verbal outbursts.
One factor in Mr Steinbrück’s boldness, however, is the perception within Germany that he has indeed been largely successful in managing a financial crisis that originated in the US and has affected the UK in a more graphic way than it has the rest of Europe.
A passionate chess player – he spends idle moments confronting his Mephisto chess computer and once played, and lost, against world champion Vladimir Kramnik – Mr Steinbrück is not as impulsive and short-sighted as his public comments may suggest.
The first test of his strategic skills was the near-collapse of Sachsen-LB and West-LB, two state-owned regional banks, just after the outbreak of the subprime crisis last year, followed by the rescue of IKB a Düsseldorf-based lender, and its eventual sale.
He then engineered the state-sponsored €50bn bailout of Hypo Real Estate, a property and public sector lender, wrapped up over two weekends of intensive talks.
For all his love of chess, his behaviour throughout these talks was more akin to that of a poker player. By insisting that the government would not deploy a UK-modelled rescue package for the financial sector and would never resort to nationalisations, he persuaded the country’s assembled top bankers to foot a large part of the bill for the HRE rescue.
Only once this rescue was sealed, did the government launch a €500bn rescue fund for Germany’s banks and insurance companies, exposing Mr Steinbrück’s bluff.
Many of the reforms of the world financial system members of the G20 agreed to in Washington last month were championed by Mr Steinbrück as far back as 2007, when Germany, then holder of the G8 presidency, tried and failed to rein in the under-regulated sector.
Despite the high regard he enjoys at home, the minister has had little ground to rejoice lately. Politically, he looks likely to get few rewards from his performance in the crisis since opinion polls show at least a third of respondents do not know he is a Social Democrat – a legacy of his image as a moderate right-winger in a centre-left party.
And the economic crisis has robbed him of what would have been the crowning achievement of his career as minister, namely his goal to balance the federal budget by 2011."
"Germany will wait to launch its next fiscal stimulus until it has a clearer view of the economic plan of Barack Obama, who is to be sworn in as US president on January 20, say German officials.
Michael Glos, economy minister, said – after a meeting of government officials and business leaders on Sunday night – the government would decide late next month whether to adopt more measures to stimulate the economy, Reuters reported.
That would mean Berlin would not top up its €12bn ($16bn, £10.7bn) growth-boosting package at an extraordinary meeting of leaders of the governing coalition on January 5, as many economists and international leaders had hoped.
“We will probably know what Obama is going to sign before January 20 but I would be surprised if any decision were made on January 5,” said an official before the meeting.
European Union leaders agreed on co-ordinated fiscal action worth 1.5 per cent of the region’s gross domestic product on Friday and urged Mr Obama to join them in a “transatlantic economic recovery plan”.
The German chancellor and several ministers met on Sunday night with 32 economists and trade union, business and bank leaders summoned to the chancellery.
Germany has come under pressure from experts and other governments to beef up its steps to combat the threatening slump.
Angela Merkel, the chancellor, has long acknowledged that more muscular measures would be required but she insisted more time was needed to measure the scale of the downturn and draft an appropriate plan.
She is sceptical of strategies aimed primarily at boosting consumption, given Germany’s high savings rate and low unemployment.
“We will assume our responsibility and we will keep working on stabilising the situation,” said Ms Merkel in an interview in Bild am Sonntag on Sunday. “We will work hard on a co-ordinated approach over the next few weeks.”
Sunday night’s meeting was “less about policies than about trying to get some clarity about the economic picture”, the official said beforehand, pointing to the wide range of estimates for growth next year.
The German economy will shrink 0.8-2.2 per cent in 2009 while unemployment shoots up, according to economists, most of whom see the government’s prognosis of 0.2 per cent growth as hopelessly outdated.
Berlin may soon be forced to modify its €500bn bank rescue package, adopted in October, which has failed to revive the interbank lending market and prevent lending to companies drying up.
“We designed the fund so that its rules could be modified by decree,” the official said. “This means we can change them very quickly if we have to, though I am not saying we have to.”
Politicians led by Ms Merkel and Peer Steinbrück, finance minister, have lambasted the banks for parking their cash with the European Central Bank at very low interest rates instead of lending it to each other or to companies for higher fees".I can't help feeling that Germany is committed to a larger stimulus but is bluffing its way towards some unstated goals. Maybe these bluffs are directed at the German People in order to prepare them for a stimulus. Just a hunch.
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