Download It is a great honor for me to address you and I want to

 It is a great honor for me to address you and I want to thank the German organizers, and in particular Mr Shauble for his invitation. I was asked to speak about questions of fiscal policy and growth. The critical issue on this topic today is the question which was the title of one of this morning sessions: In order to grow more, do we need less public debt or more aggregate demand? 1 This is a tough one. Rudi Dornbusch used to say: “in economics every difficult question has a simple answer, too bad it is always wrong” In fact, the answer is not easy: we need both, less public debt and more aggregate demand. Why is this so? I do not have to review with this audience the perils of high debt and debt overhang. This is the reason why the first simple answer -­‐-­‐ forget the debts and increase government spending -­‐-­‐ is deeply flawed. On the other hand the major economies, in different degrees, have found it hard to emerge smoothly from the Great Recession. Unemployment is still high in several 2 countries in Europe. As President Mario Draghi pointed out last fall in Jackson Hole, it is not all structural. In the US, unemployment is low, but so is participation in the labor force. Japan finds it difficult to emerge form a prolonged period of stagnation even though the very latest data are encouraging. Sustained private demand, namely consumption, investment and exports are needed in these economies. This is why the second simple answer: frontally attack the high debt by raising government revenues immediately -­‐-­‐ is also flawed. 3 So, how do we achieve these two seemingly contradictory goals of less debt and more aggregate demand? We need to move aggregate demand from the public sector to the private sector. How to do so successfully depends upon the specific circumstances of different countries. In order to illustrate the point let me use a climbing analogy since I like mountaineering. I’ve been quite addicted to it over the years actually. When you climb, before making a difficult move, you follow this rule: move one limb at a time. Make sure that you are well anchored with your hand and feet so that if the move does not work out, you are less 4 likely to fall. You should not make aggressive moves starting from a precarious position because if you fall you go down a lot and get hurt. So, using this analogy, how are today’s climbers doing? Let’s begin with the Euro area. We have two types of climbers: some are still in a precarious situation some are not. Those at risk are the countries, which recently experienced a near fall due to a debt crisis. Italy, Portugal and Ireland have an average of approximately 130 percent debt over GDP ratio. Spain has a lower debt ratio, but had a crisis due to public finances 5 deeply shocked by the real estate crisis a private debt is high. A vast body of recent empirical evidence suggests that, especially for high tax countries such as those in Europe, the tax multiplier is larger than the spending multiplier. This implies that tax cuts stimulate consumers’ demand more than the decline in aggregate demand generated by spending cuts. In addition, by reducing labor costs, labor tax cuts increase competitiveness, profits, confidence of firms and private investment. Thus equally sized spending cuts and tax cuts are expansionary. 6 Once again, going back to our climbing analogy, in Europe we also have climbers like Germany whose position is safe – all arms and legs are in strong positions. Germany has a decreasing debt over GDP ratio and a primary surplus. Therefore, they could be aggressive in stimulating the economy with tax cuts, even without spending cuts. One may argue that Germany is at full employment so it does not need stimulus. True, but inflation is zero, so well below the 2 percent target of the ECB. Thus, inflation risk is minimal, and a stimulus in Germany may help rebalance current accounts within the Euro area. In fact, well designed tax cuts would increase German domestic demand. Clearly, the 7 larger burden of the adjustments of the Current Account imbalances will have to come from increases in productivity in Southern Europe. However, German stimulus of domestic demand seems warranted, and not too costly for this country. France, in my view, is a climber that in the current day is not at a risk for a fall. France did not have a debt crisis, but with a government size of 56 percent of GDP, this country can afford cuts in taxes and spending. Of course the next question is: what to cut? Obviously, every country has its own specificity, but I think two issues are 8 generally important. One issue is spending on pensions due to population aging. In some cases, we are reaching extremes in which youngsters are not finding employment because labor taxes are very high in order to pay the pensions of their parents, who then support the unemployed children. In my home country of origin Italy it is shocking how common this situation is. I see it commonly amongst my friends. This has to stop. The second issue is the fact that many publicly provided services such as health and university education, are not means tested. We use taxpayers money to finance free services for the rich. The distortions are obvious. 9 Are spending cuts political suicide for candidates running for office? The evidence suggests that this is not the case as the recent British elections confirm. In many other cases, voters have understood the need for spending adjustments. This is especially the case when they are well explained, announced in advanced and implemented fairly. A G7 example is Canada in the mid nineties. A European example is Sweden -­‐-­‐ also in the mid nineties. Both of these countries followed austerity policies much more draconian than those recently introduced in Britain. And the governments in both Canada and Sweden were reappointed. 10 The other policy areas which can help growth are structural reforms. These include deregulation of the labor market and creating more competition in the service sector -­‐-­‐ both within countries and across Europe. For example, Italy has recently implemented an excellent labor market reform. Other countries like France seem much less willing. Recent studies with the econometric model EAGLE at the ECB suggest that the benefits of these reforms are substantial in the medium run, but also positive in the short run. What can Europe do to create incentives for countries that are slow in implementing these reforms? Here we enter into delicate issues of the relationship between national 11 and super national institutions. One may think about incentives, like temporary departures from Stability and Growth Pact in exchange for aggressive reforms. Or, one can think about a more direct intervention of European institutions. This is an important political issue which needs to be dealt with as soon as possible. It is clear that simple and repeated appeals for reforms do not seem to be enough. The QE policies followed by the ECB have been successful in reducing interest rate spreads and should continue until inflation is back where it should be, around 2 per cent. These QE policies will also facilitate the necessary fiscal and structural reforms in Europe. 12 The climber United States is in a safe position for now. The risk of falling from the cliff of debt in the short run is non-­‐
existent. Thanks to the acceleration of growth, the deficit is now below 3 per cent. The debt has grown from about 40 to about an apparently manageable 75 per cent of GDP with the crisis. However if this climber, the United States, looked up the cliff he would see very difficult moves in front of him. The climbing will get tougher. According to projections of the Congressional Budget Office, the medium and long term state of US budget is not rosy. These projections are made under the scenario of no policy change. In the baseline scenario, the debt over GDP ratio 13 will never fall below the current level. In fact, it may actually increase to more than 100 per cent of GDP in the next couple of decades. In addition, projections of the social security administration have been called into question for being too optimistic. This potential debt dynamics requires some interventions in order to avoid an excessive debt burden when interest rates will inevitably rise. The room for more public investment in infrastructure in the US, a topic that I will revisit shortly, must be consistent with fixing the growth of entitlements. Returning to the climbing analogy, more public investment are a necessary move, but which needs 14 anchoring of the other limbs of the budget -­‐
-­‐ the entitlements -­‐-­‐ to avoid dangerous falls. Regarding the climber Japan, there are two different narratives in play. The first one is a dangerous scenario. The enormous level of public debt (well above 200 per cent of GDP) requires immediate attention with tax increase. The Japanese economist Taka Ito argued for a doubling of the value added tax. The second very different story is the following. This climber is in less danger than it appears. Public debt held by the public (net of that held by other public entities) is much lower close to 140 per cent of GDP, 15 and it is almost completely domestic. Thus, any kind of debt restructuring would have mostly domestic consequences, and imply redistribution amongst Japanese citizens, bond holders and tax payers. For these reasons and given the current “soft” state of the Japanese economy, further tax increases should be announced for the future, but not implemented immediately. I tend to agree with this second approach and that Japan is in a less dangerous situation than it appears. I would add in the spirit of my previous observation, that even Japan, despite its much smaller size of government relative to Europe, should look 16 into possible savings on the expenditure side. For instance, additional public investment spending seems unwarranted. Also structural reforms a are lacking. Overall of the three arrows of Abenomics only monetary policy has been used very aggressively Let me now turn to some issues regarding long run growth. Some have argued that potential output in many advanced economies, and perhaps especially in the US, is destined to grow at a lower rate in the future, than in the past. The culprit for this pessimistic forecast are two-­‐fold: first, reduction in labor force 17 participation due amongst other things to the retirement of the baby boomers and second, a reduction in the rate of growth of productivity. The first point is undeniable. However, immigration policies may be used to mitigate its effect. The US has had decades of experience in regulation and dealing with the costs and benefits of immigration. Europe is far behind. I predict that dealing with immigration in ways which are beneficial for Europe will be one of the very big challenges for the next several decades. I believe that Europe is still divided and unprepared. 18 The second argument about productivity is more debatable. Productivity depends upon physical capital, human capital accumulation, and technological progress. And yet, technological progress is very hard to predict. When will another group of youngsters in a garage revolutionize our lives with their computers? Will companies like the secretive Trai Alpha in California, produce revolutionary breakthroughs in the area of cold fusion -­‐-­‐ all financed by private money by the way. Rich countries like those of the G7, are at the technological frontier and grow because of innovation. Those who argue that in order to facilitate growth, we need more public infrastructures like trains, airport, 19 and wider roads, in my view, need to be very specific. If I had to list the main problems for the richest countries in Europe, lack of physical infrastructure, would not rank amongst the top five. With various emphases in different countries, my top five problems would include labor market regulation, excessive regulation of services, high taxes, excessive bureaucracy, and high costs of doing business. These five would rank well above the need for additional fast trains and wider roads. In some areas of the US, instead, crumbling infrastructures definitely need work. With relatively low long-­‐term interest rates, it 20 may be a good idea to spend on these projects. But, as I mentioned earlier, if this is done, the growth of entitlements needs to be addressed energetically. As for Japan, again lack of infrastructure is not the problem. If anything, this country may have overinvested in them. On the other hand pension spending in this country needs attention due to aging of the population. Rich countries grow by means of innovation, human capital and human creativity. Private investment in research and development are the engine of growth. Government should provide the best possible environment for these innovations 21 to flourish. Don’t pick winners, but favor competition. Create a good university system. In Europe, this often means not more public money, but more meritocracy and more private donations. Make good schooling accessible for everybody. This will guarantee equal opportunities, a goal which is still elusive in the US. But let’s assume that indeed potential output growth slows down in rich countries. This is another reason why government spending has to follow in this decline. Otherwise, spending over GDP and taxes over GDP would go up making the decline in growth even larger. 22 To conclude, the last seven years have been difficult. The climb remains challenging, but a fall into the abyss has been avoided. As for the longer run, creativity and ingenuity, not government spending will keep us progressing on the rock wall. Thank you. 23