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1 Europe, USA and Japan: Recent Macroeconomic Policy Errors and a Way Forward Richard Wood1 ABSTRACT This paper argues that a number of the central macroeconomic policies adopted by major economic blocks since the Global Financial Crisis have been inappropriate, largely ineffective, slow-­‐acting or counterproductive. These mistaken policies have proven very expensive. An alternative combination of monetary and fiscal policies is suggested as a way to combat high debt, credit traps, deflation tendencies and high unemployment. Introduction This paper is devoted to a review of monetary and fiscal policies adopted by Japan and the United States, and to the fiscal austerity and internal devaluation policies adopted by Eurozone periphery countries, during the global financial crisis and subsequently. The inquiry takes place at a high level of aggregation and abstraction. The central focus is on the monetary and fiscal policies adopted by economies experiencing similar economic problems; high public debt burdens, the deflation tendency, credit traps, loss of trade competitiveness, inadequate aggregate demand and high unemployment. This set of six problems is new to our generation, as is the required set of coordinated macroeconomic policy responses. It is argued below that policymakers anchored their strategic thinking in policy paradigms ̶ bond financing of budget deficits, austerity, asset purchases by central banks, reliance on market forces for internal devaluation, ultra-­‐low 1
School of Economics, University of Queensland. Email: [email protected] 2 longer term interest rates ̶ that were, or became, no longer appropriate or adequate to deal with this new set of macroeconomic problems. As a consequence, substantial errors have been made in the application of macroeconomic policies. Ball, 2014, estimates the loss of output will, for example, be 22.3 per cent of pre-­‐crisis trend GDP measured at 2015 for Spain, and over 30 per cent for Greece and Ireland. On present policies the situation in many afflicted countries is getting worse, not better. Interrelated Economic Problems and Causes Consider the list of economic problems identified above. In most cases, current high public debt burdens are due to four main forces; i)
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bond financed fiscal stimulus measures applied in response to the Global Financial Crisis (and the earlier crisis in Japan). These measures were adopted to compensate for demand contraction due to the bursting of private credit (debt) booms. In this way, the ‘private debt’ problem created a ‘public debt’ problem (Turner, 2013); lower revenues and higher welfare payments due to sluggish growth and higher unemployment, particularly in countries that adopted strong austerity measures in a crude attempt to address their ‘public debt’ problems; measures adopted to bail-­‐out banks; increased prices of government bonds due to bond purchases by central banks. The deflation tendency is approximately due to inadequate final demand. If demand was adequate, but supply was deficient, rising prices and inflation would by now be a major problem. The deficiency in demand may be due to unemployment, deleveraging, fiscal austerity, higher taxation burdens, declining workforces and populations in some countries, low business and consumer confidence, and insufficient consumer spending. The deflation in prices and inadequate consumer spending may also be partly due to depressed wage shares in national incomes, and to continued reductions in nominal and real wages in some countries (Eurozone periphery countries and Japan, in particular). 3 Credit traps could be defined as situations where lenders cannot find suitable borrowers to lend to, and/or where lenders have limited lending capacity. The credit trap, which originated in the form of a ‘credit crunch’ shock, has most likely evolved as the result of a combination of widespread bank and nonbank debt deleveraging; housing price crashes that reduce household wealth/purchasing power; net worth contractions and balance sheet repair; banking crises and financial sector fragmentation which truncate intermediation opportunities; increased capital requirements and higher liquidity ratios reducing lending capacity; fiscal austerity policies which reduce the demand for credit; high unemployment; inadequate general consumer and investment demand; and confidence effects. A credit trap may not arise predominantly as the result of a preference for ‘cash’ over the holding of ‘debt instruments’ at zero or close-­‐to-­‐zero interest rates (the Keynesian ‘liquidity trap’). Rather, a credit trap arises mainly from a sustained reduction in the demand for new loans, and/or from constraints on the supply of new loans. Endless injections of vast amounts of new money (via quantitative easing) into the financial system to artificially lower the price of longer-­‐term credit and increase bank lending potential is unlikely to be effective when the zero-­‐bound has already been reached (and interest costs are not excessive or effectively constraining); balance sheets are being repaired, household demand for credit is weak; when credit intermediation channels are impaired; or when banks hold vast reserve accounts at the central bank. The loss of trade competitiveness is a problem evident in Eurozone periphery countries, reflecting the combination of a common currency and widely different cost, productivity and price trajectories across Eurozone countries. Eurozone countries that are at the lowest end of the competitiveness ranking are also those that have grown less after the crisis (Bin Smaghi, 2013). High unemployment is a major general economic problem. Unemployment is not due to excessive growth in real unit wage costs, as profitability has risen to record levels in many countries, and real wages are generally falling, not rising, in afflicted countries. This suggests that the unemployment problem is not of the ‘classical’ variety (excessive real wage costs), but predominantly of the ‘Keynesian demand deficiency’ variety. ‘Structural unemployment’ of various descriptions may be present in pockets here and there, but we will know little about it until the afflicted economies approach full employment. By that time 4 ,of course, market forces and regulatory adjustments (where the structural distortions can be identified) will have worked to reduce its relevance. Policy Successes and Policy Failures The initial large-­‐scale multilateral fiscal stimulus, the lowering of the policy (short-­‐term) interest rates and the regulatory responses to the banking crisis were unquestionably appropriate initial general policy responses to the collapse of financial markets. They countered the fall in demand, and they put a floor under the asset and liability positions of financial institutions: they were critically important policy successes. Identification and evaluation of policy mistakes, of course, are controversial. We will focus on four likely major policy mistakes. Financing the Fiscal Stimulus We begin by questioning the method used to finance budget deficits. Ever since the gross excesses in the use of the printing press and new money financing of deficits and debt during the Weimar German hyperinflation (under the authority of a private central bank disposed to encourage speculation in the currency), bond financing has become the preferred and recommended method of deficit financing. So when the global financial crisis hit it was natural, perhaps, for policymakers ̶ many schooled predominantly in the finer points of rational expectations, market efficiency, liberalisation, bond financing and the latest general equilibrium models ̶ to not even consider whether orthodox bond financing would continue to be appropriate. Policymakers at the time probably had little forewarning or understanding that a constellation of forces ̶ bond financed budget deficits, depression and deflation tendencies, bank bailouts, the public financing of the banking and financial sectors, and rising bond prices ̶ would lead shortly to a rapid and continuing escalation in public debt burdens. In periods of high inflation and low public debt, bond financing is likely to be preferred over new money financing of budget deficits. But the nature of macroeconomic problems changed dramatically in 2008. High public debt and deflation, not inflation, became major concerns. Had policymakers had sufficient understanding of what was about to happen to public debt burdens they may well have adopted a different policy approach 5 to deficit financing. This then raises the possibility that a large policy mistake was made when it was ‘subconsciously’ accepted by policymakers around the globe that the large fiscal stimulus ̶ needed to address collapsing demand ̶ would be funded by issuing new government bonds. The issuance of those government securities added directly and substantially to the size of the public debt (Wood, 2013). We will return to the issue of the methods of financing budget deficits later. Monetary Policy The development of monetary policy, particularly from late 2010 onwards, is highly controversial. Quantitative easing (asset and bond purchases by the central bank) directly increases ‘asset’ and ‘bond’ prices only. With asset and bond purchases, the ‘money base’ in directly increased but the ‘money supply’ may not be significantly impacted. The injection of massive volumes of new money into the financial sector via quantitative easing is not highly stimulatory of investment in plant and equipment, consumption or output, as many had claimed. There may, indeed, be few, if any, significant direct channels of causality by which quantitative easing could raise ‘consumer price’ inflation. Despite years of profligate money creation in Japan and the United States there has been no evidence of significant ‘demand-­‐pull’ or ‘cost-­‐push’ inflation. Occasional episodes of ‘imported inflation’ have occurred as exchange rates have moved around. Nevertheless, when one-­‐off events (including the tax hike and higher energy prices in Japan, and disease-­‐infected food prices in the United States) are taken into account, the deflation tendency largely remains. This tendency has been and continues to be disturbing and debilitating, particularly in the Eurozone, and even still in Japan, and (possibly) to a diminishing degree in the United States. Enterprises, particularly in the United States, were highly profitable in late 2010, and commercial banks already had massive financial resources in reserve accounts. They did not need further quantitative easing. Those players in the real economy that most needed financial support, the unemployed, low income households and the disadvantaged (all with high marginal propensities to consume) were not recipients of the new money 6 provided under the asset purchase program: that new money never reached the ‘real economy’ in significant volumes. And, households and retirees, reliant on low risk interest incomes, were denied a safe source of revenue. The emergence of the credit trap should have provided a flashing red light to policymakers. Policymakers should have given greater attention to resolving, or by-­‐passing, the credit trap with new economic policies. The failure of governments and central banks to by-­‐pass, and to adequately compensate for, the effects of the credit trap, by injecting sufficient additional purchasing power directly into the ‘real economy’ by increasing household incomes directly, stands out as a major blunder (see later). When the zero-­‐bound was reached, and when it became apparent that the credit (lending) channel was becoming dysfunctional, or was seizing-­‐up, then an alternative channel should have been used to inject purchasing power into the economy in a manner that did not increase already excessive public and private debt levels in the process. Those who did receive new money under continued quantitative easing were commercial banks, traders, speculators, financial investors, high wealth individuals and hedge funds. The lending banks could find few borrowers; and those banks and the other beneficiaries of the new money have a low marginal propensity to consume ordinary goods and services, and so output multipliers and impacts on investment and on consumer prices were relatively small on that account. The ‘trickle-­‐down’ route to substantially higher aggregate demand was not triggered. The attempted flattening of the yield curve was equally concerning as it caused risk-­‐taking to become distorted throughout the economy. Ordinary citizens, businesses and banks have been forced to invest in more risky assets and encouraged to take on excessive debt. Time-­‐and-­‐interest-­‐rate-­‐dependent purchasing, investment, leverage, production and savings decisions are all being distorted. In the wake of: i)
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massive injections of new money (quantitative easing) through financial institutions into substantially deregulated global financial markets; contrived shortage of safe assets; and with interest rates ultra-­‐low; 7 it is not surprising that risk-­‐taking and price bubbles are being encouraged and emerging in the stock-­‐market (the Dow Jones Industrial Average, and more generally), property (USA, UK, Germany, Australia, Canada, Switzerland and New Zealand), commodities (gold), bonds (including 10-­‐year US Treasury Notes and Eurozone government bonds) and in selected exchange rates. Collateralised debt obligations are again booming and levels of private debt are rising strongly. Arguably, asset prices have already moved far beyond what the real economic fundamentals would suggest is reasonable. When interest rates are finally increased, to ‘prick’ a bubble, the fallout could be widespread and of unpredictable magnitude, and the inappropriate risk, resource and investment allocation decisions, encouraged by sustained ultra-­‐low interest rates, will then, in time, become increasingly apparent, and adversely affect the real economy. The calculation of the full costs and benefits of quantitative easing must include the likely fallout from the normalisation of interest rates when it occurs. What is being suggested here is that the continued application of quantitative easing beyond 2010 in the United States, but also in Japan, has arguably represented an additional policy miscalculation. The key practical issue for consideration in this regard is whether the design of monetary policy could have been changed and made more effective in terms of generating higher consumption, investment, a stronger general expansion and inducing a higher rate of inflation? Could monetary policy have achieved these outcomes earlier and without distorting the pricing of risk, creating new asset price bubbles and forcing investors to take on higher risk? Was it sensible, or appropriate, to use new money creation to provide finance only to the commercial banks and other lending institutions (few, if any, of which could find borrowers) and, indirectly, to speculators? Was it sensible to rely on portfolio rebalancing and its untested effects? Could monetary policy have changed tack, and been applied in a manner that could have allowed the new money to navigate around, and by-­‐pass, the credit trap, in order to reach the household sector and to directly increase aggregate demand? We will return to these important policy questions later in this paper. Fiscal Austerity 8 Opposition to fiscal stimulus is entrenched, and widespread in Eurozone countries. There is no uniform fiscal policy in Europe. In Germany ̶ a possible fiscal locomotive country ̶ a Constitutional budget rule limits structural budget deficits to a mere 0.35 per cent of GDP. The IMF database reports that the net borrowing requirement in Germany was zero in 2013. Elsewhere in the Eurozone, the Stability and Growth Pact and the Fiscal Compact are designed to maintain fiscal discipline, and preclude a substantial fiscal stimulus. Blanchard and Leigh, 2013, and De Grauwe and Ji, 2013, have reasonably demonstrated that fiscal austerity policies have been counter-­‐productive. These policies ̶ cutting government expenditure or raising taxes ̶ contribute to deeper recessions and higher public debt. This result has been more recently confirmed by Riera-­‐Crichton, Vegh and Valentin, 2014. The difference between the recovery in the United States and the continued stagnation in many European countries provides a further pointer. Fiscal austerity ̶ by cutting public expenditures when the economy is already depressed, and lowering tax revenues without cutting tax rates ̶ lowers aggregate demand, creates unemployment and ‘unhealthy’ budget deficits, and works to raise the public debt burden. In 2013, the IMF raised its estimates of the multiplier magnitudes during the crisis to well above 1. Riera-­‐Crichton et al. demonstrated that the magnitude of the multiplier are greater in bad times when public expenditure is falling than when it is rising. They estimate the relevant multiplier at around 1.7. When a fiscal multiplier is greater than 1 the debt burden is increased by austerity as GDP contracts. As is well known, despite years of applying fiscal austerity, budget deficits are still substantial and public debt burdens have continued to rise. The EU Fiscal Compact requires that public debt to GDP ratios fall to 60 per cent by 2030. The IMF, 2013 estimates that to achieve this objective the average primary fiscal surplus in the decade 2020 to 2030 has to reach 7.2 % for Greece, 6.5 % for Italy, 5.9 % for Portugal, 5.6% for Ireland and 4.0 % for Spain. They are very large primary surpluses to maintain, and seem improbable based on economic history. According to De Grauwe, 2014, if Spain, for example, wishes to stabilise its debt-­‐to-­‐GDP ratio in 2014 it would have to institute an additional austerity effort of 4.6 % of GDP: a practical impossibility now, but with disastrous 9 implications for GDP had it been attempted. If the above multipliers are any guide, not only would GDP fall substantially but the debt to GDP ratio would also increase. We suggest, therefore, that the adoption of fiscal austerity policies represents yet another policy mistake. We later suggest how fiscal stimulus can be delivered without increasing public debt Internal Devaluation According to the European internal devaluation philosophy, austerity reduces aggregate demand and pushes up unemployment. In turn, the higher unemployment is expected to moderate wage claims, and lead to reductions in the growth of nominal wages. The growth in prices is then expected to fall down in line with the reduction in the growth of wages. The intended result is that national price levels decline in trade deficit countries (relative to those in surplus countries) and competitiveness in the deficit countries is improved. The reality is that, for many reasons ̶ including weak competition policies, market segmentation and different institutional arrangements across national borders, rigidities in product and labour markets, etc ̶ nominal wages (wages growth in some countries) have fallen in many periphery countries by more than prices (growth in prices): hence real wages have declined. This fall in real wages has likely contributed to weakening demand and general stagnation. In the meantime, strict wage and price restraint policies in Germany have generally maintained German competitiveness at a high level relative to many periphery countries. Consequently there has been no significant adjustment to relative competitiveness among the Eurozone countries, based on export price developments (Wood, 2014). Because of German intransigence, the adjustments now needed to restore competitiveness in periphery countries would necessitate further reduction in wages in the South, which would push these economies further away from internal balance. So austerity, reliance on market forces and internal devaluation have been largely ineffective (see Chart 1 below), and arguably represent yet another policy mistake. An alternative approach to internal devaluation is suggested later. 10 Chart 1: Export Price-­‐Based Competitiveness Indicator 150
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The Case for an Alternative Set of Macroeconomic Policies We are now in a position to draw out some general policy principles for counties that experience simultaneously high public debt, inadequate demand, high unemployment and the deflation tendency. We have argued that: i)
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on current policy settings the path ahead will be unstable, and that the risks of asset price crashes and new debt crises are rising; quantitative easing since 2010 has been misguided and largely a waste of a precious resource (new money); deleveraging and balance sheet repair, not high interest costs, held back credit growth; it is questionable whether central banks needed to go on pouring excessive volumes of new money down into credit traps in order to lower longer term interest rates: in the process increasing surplus, unusable and un-­‐loanable reserves of commercial banks, distorting central bank balance sheets and the pricing of risk, and creating asset price bubbles; with interest rates at or near zero, fiscal policy stimulus is necessary to lift aggregate demand, but fiscal deficits should not be permitted to push-­‐up public debt, as it is already excessive; 11 vi)
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in an environment where private and public debts are still excessive, new money creation should be used to avoid the unhealthy building-­‐
up of new additional debt burdens, to by-­‐pass credit traps, and to provide purchasing power directly to households, rather than to lending institutions; monetary policy should not be used to distort risk-­‐taking; fiscal austerity is counterproductive; austerity and market forces cannot be relied upon to achieve adequate internal devaluation in the Eurozone. New monetary and fiscal policy coordination From a fiscal policy perspective, when monetary interest rates are at or near zero bound, countries suffering from inadequate aggregate demand require strong fiscal stimulus. But where such countries have high public debt levels there is no further room for conventional bond financed fiscal stimulus, particularly where countries do not have their own currencies. From a monetary policy perspective, where interest rates are at, or close to, zero bounds, and credit traps are widespread and constraining lending and economic expansion, one might conclude, in line with modern textbook accounts of monetary policy, that all monetary policy options have also been exhausted. The implication usually drawn from the above two paragraphs is that both monetary and fiscal policies have reached their limits. Fortunately, this is definitely not the case. However, a different paradigm involving greater monetary and fiscal policy coordination is required to reinvigorate aggregate demand in countries with high public debt, credit traps, the deflation tendency and high unemployment. The new plan involves the creation of new money. That new money could be created by a central bank or by the Treasury/Ministry of Finance. As the new monetary policy is adopted the old monetary policy can be withdrawn, subject to banks retaining sufficient liquidity. The new money creates no liability to the issuer (Buiter, 2003) and should be used to finance a large stimulatory budget deficit and directly boost household incomes. The new money requirement could be capped by legislation, or central banks could be required to introduce it without breaching inflation targets or increasing public debt. 12 The principal purpose of the new money injection is to increase the money supply and to provide for the first round of increased public expenditure or tax cuts. Beyond that, and when multiplier effects take hold, the equivalent of the new money injection could be withdrawn, provided liquidity in the economy and in the banking sector is judged adequate to meet the needs of stronger economic growth. By channelling new money to the household sector, rather than into the financial sector and down credit traps, there is a much greater probability that consumption ̶ the main component of aggregate demand ̶ will increase. The credit trap will be bypassed: fruitless new money injections into banking sectors already bloated by previous new money injections, and with constrained lending opportunities, will be stopped. Beyond some point, the rise in consumption expenditures, induced by the fiscal stimulus, will call forth price increases for consumer goods and services: investment, employment and wages will tend to increase in turn. In this way the tendency toward deflation will be addressed, and unemployment reduced. This new combination of fiscal and monetary policies ̶ fiscal stimulus and the new money financing of it ̶ is called Overt Money Financing2. Overt Money Financing: i)
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is not, as is often claimed, equivalent to bond financing and quantitative easing (Wood, 2013). Overt Money Financing represents the most powerful monetary and fiscal policy combination, and requires strong coordination between fiscal and monetary authorities; does not increase either interest rates, government borrowing requirements or public debt, does not withdraw funds from the economy (as does bond financing), does not involve crowding-­‐out 2
The case for Overt Money Financing of fiscal deficits dates back to Abba Lerner, ’Functional Finance and the Federal Debt’, Social Research 1943; Milton Friedman ‘A Monetary and Fiscal Framework for Economic Stability’, June 1948; and Ben Bernanke, Remarks before the National Press Club 2002. Overt Money Financing was revisited and proposed in 2012 as a means to address high public debt and deflation by Richard Wood, ‘Delivering Economic Stimulus, Addressing Rising Public Debt and Avoiding Inflation’, Journal of Financial Economic Policy, April 2012. Subsequently Biagio Bassone, Willem Buiter and E Rahbari, McCulley and Pozar have advocated the case for Overt Money Financing. A deep review of the proposal can also be found in Lord Adair Turner, ‘Debt, Money and Mephistopheles: how to get out of this mess’, Cass Business School Lecture, 6 February 2013. 13 iii)
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and nor are there any Ricardian Equivalence effects to be concerned about. Overt money financing is, therefore, especially suitable to situations where public debt is already excessive, interest rates are at zero bound and when liquidity or credit traps are present; can be applied if there is or is not an independent central bank, and it could be implemented by the Treasury/Ministry of Finance acting alone; can be applied if Eurozone countries remain inside the Zone or leave it. Is not precluded by Article 123 of the Lisbon Treaty as the use of new money created by the European Central Bank can be transferred to individual governments in the Eurozone using non-­‐debt financial instruments (Bassone and Wood, 2013); does not promote risk-­‐taking or create asset price bubbles; does not create a consumer price inflation threat because if and when inflation did begin to rise above target levels excess liquidity can be removed. In the near-­‐term, however, the new money will be needed to finance the higher rate of economic expansion. does not pour money down into the credit trap, but does successfully inject new money and purchasing power to households and into the real economy. A new approach to internal devaluation in the Eurozone Finally, as internal devaluation has been ineffective in reducing competitiveness imbalances in the Eurozone, consideration there could also be given, on a case-­‐by-­‐case basis, to the adoption of centralised wage and price policies, or incomes policies, to bring about the appropriate price and wage levels in individual Eurozone countries, including wage and prices increases in highly competitive surplus countries. This new country-­‐specific centralised approach would eschew wage austerity and the reliance on very slow-­‐acting market forces. The new approach would aim to achieve appropriate levels of nominal wages, prices and real wages for each country. In this way competitiveness differences can be addressed without adding further to unemployment, and the 18 country convey can then reform the line and try to steam faster ahead in closer alignment. 14 For some of the most distressed periphery countries to be able to form the line and steam ahead, they also need debt relief, or debt forgiveness. Concluding Comment Going forward, the macroeconomic policy challenges remain enormous. Looking back, and while the reader may not agree fully with the economic logic adopted in this paper, the profession has a responsibility to better understand where policy mistakes were made, and why. The profession must establish whether an alternative policy paradigm could have led to better outcomes in terms of earlier and stronger recoveries from the Global Financial Crisis. At the centre of the inquiry, we need to establish greater agreement about how to combat high debt, credit traps, deflation and unemployment. We also need to ensure that we become more vigilant; be prepared to use all the instruments at our command; not allow orthodoxies established in the past and in different circumstances to get in our way when the nature of economic problems change fundamentally; and not allow history to repeat itself. References BALL L, ‘The Great Recession’s long-­‐term damage’, VoxEU, 1 July 2014. BASSONE B, and WOOD R, ‘Overt Money Financing: Navigating Article 123 of the Lisbon Treaty’, Roubini Global Economics EconoMonitor, 22 July 2013. BIN SMAGHI L, ‘Austerity and Stupidity’, VoxEU, 6 November 2013. BLANCHARD O, and LEIGH D, ‘Growth Forecast Errors and Fiscal Multipliers’, IMF Working Paper, WP/13/2013. BUITER W, ‘Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap’, NBER Working Paper, No. 10163, December 2003. DE GRAUWE P, and JI Y, ‘Panic-­‐Driven Austerity in the Eurozone and Its Consequences’, VoxEU, 21 February 2013. DE GRAUWE P, ‘Revisiting the pain in Spain’, VoxEU, 7 July 2014. IMF, Fiscal Monitor, 2013. 15 RIERA-­‐CRICHT0N D, VEGH C, and VULETIN G, ‘Fiscal multipliers in recessions and expansions: Does it matter whether government spending in increasing or decreasing?’ Preliminary Draft, March 31, 2014. TURNER A, ‘Debt, Money and Mephistopheles: How do we get out of this mess?’ Cass Business School Lecture, 6 February 2013. WOOD R, ‘Helicopter Money Debate: Lord Turner and professor Woodford’, EconoMonitor, May 22, 2013. WOOD R, ‘Overt Money Financing and Public Debt’, Roubini Global Economics EconoMonitor, 3 September 2013. WOOD R, ‘Eurozone Macroeconomic Framework: Reducing Internal and External Imbalances’, Roubini Global Economics EconoMonitor, 4 February 2014.