Monday, September 8, 2014

Facing Reality in the Eurozone

by Adair Turner

LONDON – European Central Bank President Mario Draghi’s recent speech at the annual gathering of central bankers in Jackson Hole, Wyoming, has excited great interest, but the implication of his remarks is even more startling than many initially recognized. If a eurozone breakup is to be avoided, escaping from continued recession will require increased fiscal deficits financed with ECB money. The only question is how openly that reality will be admitted.

The latest economic data have forced eurozone policymakers to face the severe deflationary risks that have been apparent for at least two years. Inflation is stuck far below the ECB’s 2% annual target, and GDP growth has ground to a halt. Without strong policy action, the eurozone, like Japan since the 1990s, faces a lost decade or two of painfully slow growth.

Until last month, growing concern provoked unconvincing policy proposals. Jens Weidmann provided the novel spectacle of a Bundesbank president calling for higher wages. But wage growth will not occur without policy stimulus.

Draghi sought to talk down the euro exchange rate to improve competitiveness. But Japan and China also want competitive exchange rates to spur export growth, and the eurozone already runs a current-account surplus. The German model of export-led growth cannot work for the eurozone as a whole. Structural reform is certainly needed in some countries to increase long-term growth potential; but the impact of structural reform on short-term growth is often negative.

The eurozone needs higher domestic demand to escape the debt overhang left behind by pre-crisis excess. In countries such as Spain and Ireland, private debts grew to unsustainable levels. In others, such as Greece and Italy, public debt also was too high. Household consumption, business investment, and public expenditure have all been cut in an attempt to pay down debt.

But simultaneous public and private deleveraging is bound to depress demand and growth. Faced with private deleveraging in the 1990s, Japan avoided an even deeper depression only by running large public deficits.

That is why eurozone fiscal austerity has become self-defeating. The more aggressively the Italian government, for example, cuts expenditure or increases taxation, the more its public-debt burden – already above 130% of GDP – will likely grow to unsustainable levels.

Until two weeks ago, eurozone policymakers denied this reality. On August 22, at Jackson Hole, Draghi admitted it. Without higher aggregate demand, he argued, structural reform could be ineffective; and higher demand requires fiscal stimulus alongside expansionary monetary policy.

The Italian economists Francesco Giavazzi and Guido Tabellini have spelled out what coordinated fiscal and monetary policy could mean. They propose tax cuts equal to 5% of GDP for 3-4 years in all eurozone countries, financed by very long-term public debt, all of which the ECB should buy. They argue that ECB quantitative easing alone, with no fiscal relaxation, would be ineffective.

Giavazzi and Tabellini’s proposals may entail too large a stimulus. But they also highlight a crucial question: How does quantitative easing stimulate an economy? The Bank of England has presented QE as a purely monetary policy tool that sustains economic growth in the face of necessary and desirable fiscal consolidation. It works, the BoE has argued, by reducing medium-term interest rates, increasing asset prices, and inducing shifts in investor preferences that indirectly stimulate investment and thus demand.

The US Federal Reserve’s position has been more ambiguous. Fed Vice-Chairman Stanley Fischer, like former Chairman Ben Bernanke, has stressed that premature fiscal consolidation can hold back post-crisis recovery. Thus, the Fed has implicitly viewed QE in part as a tool to ensure that rising bond yields do not offset the beneficial impact of large deficits.

The Fed’s position is more persuasive. Fiscal stimulus has a direct and powerful impact on demand. In Milton Friedman’s words, it enters directly into “the current income stream.” Monetary stimulus alone is less direct, takes longer, and risks causing adverse side effects. Continued low interest rates allow unsuccessful companies to struggle on, slowing productivity growth; asset-price rises exacerbate inequality; and monetary stimulus works only by reigniting the private credit growth that generated the debt overhang in the first place.

But if fiscal stimulus must be facilitated by central bank bond purchases to prevent yield increases and to assuage fears about debt sustainability, doesn’t that amount to monetary financing of fiscal deficits?

The answer depends on whether the purchases prove permanent. In Japan, where the central bank now owns government bonds worth 35% of GDP (a level that is rising fast), they undoubtedly will. There is no credible scenario in which Japan can generate fiscal surpluses large enough to repay its accumulated debt: a significant proportion will remain permanently on the Bank of Japan’s balance sheet. Likewise, if Giavazzi and Tabellini’s proposal were adopted, the result would almost certainly be some permanent increase in the ECB’s balance sheet.

Should we admit that possibility explicitly in advance? The argument in favor is that failure to do so would raise fears about how increased public debt would ever be repaid, or about how the ECB would “exit” from a swollen balance sheet, in turn undermining the stimulative impact of fiscal and monetary coordination. The argument against is moral hazard: If we admit that modest ECB-financed deficits are possible and appropriate now, what will prevent politicians and electorates from demanding large and inflationary ECB-financed deficits on other occasions?

The political risks are certainly great. Optimal policy may therefore require a non-transparent fudge; monetary and fiscal “coordination” might mean, after the fact, permanent monetary finance, but without ever openly admitting that possibility. But, fudge or not, Draghi has moved the debate forward dramatically. Without a greater role for fiscal policy, the eurozone will face either continued slow growth or an eventual breakup.

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