Download This PDF is a selection from a published volume from... Bureau of Economic Research Volume Title: NBER International Seminar on Macroeconomics

This PDF is a selection from a published volume from the National
Bureau of Economic Research
Volume Title: NBER International Seminar on Macroeconomics
2010
Volume Author/Editor: Richard Clarida and Francesco Giavazzi,
organizers
Volume Publisher: University of Chicago Press
Volume ISBN: 978-0-226-10736-3 (cloth); 0-226-10738-8 (paper)
Volume URL: http://www.nber.org/books/clar10-1
Conference Date: June 18-19, 2010
Publication Date: September 2011
Chapter Title: Comment on "Asymmetric Shocks in a Currency
Union with Monetary and Fiscal Handcuffs"
Chapter Authors: Hans-Helmut Kotz
Chapter URL: http://www.nber.org/chapters/c12215
Chapter pages in book: (p. 143 - 151)
Comment
Hans-Helmut Kotz, Albert-Ludwigs-University, Freiburg and Center for Financial
Studies, Goethe University, Frankfurt
Persons attempting to find a motive in this narrative will be prosecuted.
Mark Twain, epigraph to Huckleberry Finn
I.
European Monetary Union: Variety as a Problem?
The financial crisis hit European economies differentially. On impact,
the shock was mediated by the varying structural characteristics of
Euroland’s financial markets. While rules and regulations are the prerogative of the EU level, thus largely harmonized, financial systems still
show a significant variety, bearing distinctive national traits. The secondround impact was about repercussions in the real economy. Here, again,
the asymmetric response reflected substantial differences in the sectoral
composition of European Monetary Union (EMU) member economies.
Vulnerable in particular were those sectors that had, on the back of
low interest rates, generated capacities (especially in the construction sector), which were (ex post) seen as economically nonviable. In an older
vocabulary this would have been called “overaccumulation,” all of this
calling for a deep, structural adjustment process, having essentially to do
with the supply side.
This is, in a broad-brush way, the scenario on which Christopher Erceg
and Jesper Lindé want to shed light. Presenting a very well-written and
convincingly structured paper, which was definitely a pleasure to read,
they make at the same time a policy proposition that flies flatly in the face
of at least prevailing European perceptions. Namely, they suggest that
bigger countries with a more sustainable debt position should use their
“fiscal space” to give their peripheral brethren a helping hand via a
strongly discretionary budgetary impulse. In fact, this was an argument
also frequently referred to in the debates (and deliberations) in the Group
B 2011 by the National Bureau of Economic Research. All rights reserved.
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Kotz
of 20 context. There, in particular the United States called on the (currentaccount) surplus countries to boost their final domestic demand forcefully, thereby allowing for a less painful unwinding of global imbalances.
The paper thus also addresses a very pertinent international macro
issue—as it behooves this NBER conference. My remarks, being rather
al fresco, proceed in two steps. I will briefly outline the argument of
Erceg and Lindé, highlighting the overall approach and the results.
Then I will end with a few questions and comments, in particular,
why it is rather implausible that we will see their (and the U.S. government’s) policy propositions implemented in Euroland.
II.
The Argument
The argument of Erceg and Lindé relies on a meanwhile familiar setup.
Firms that produce the intermediate or domestic input good act in a
monopolistically competitive environment. They have to quote prices,
which are periodically reset. Their production processes are governed
by a constant elasticity of substitution technology. The domestic good is
home produced. It is costly to adjust the ratio of domestic and foreign
goods in the consumption bundle: real exchange rate movements come
with opportunity costs.
The economy has households of two types. Forward-looking ones,
with some consumption smoothing, maximize their quantity of utils subject to the constraints arising from current, period 1, budgets as well as
the need for capital accumulation to save for period 2. Labor markets do
not adjust instantaneously; they show some wage rigidity. This partial
recontracting at intervals leads to inertia and a structural persistence of
unemployment. Then there are liquidity-constrained households. They
cannot afford to optimize intertemporally but spend—hand-to-mouth—
what they get as after-tax, take-home income. Their wage behavior is,
however, similar to that of their forward-looking brethren.
The two macro handmaidens, as Arthur Okun liked to call them, show
postmodern (New Keynesian) traits. Monetary policy is set on a Taylor
rule path. In its conventional version, it becomes ineffective at the zero
nominal interest rate bound. This immediately poses two questions: Can,
could, monetary policy in particular in the European case be appropriately depicted as reacting to deviations from inflation and output from
target paths? The ECB strongly declines to interpret its policy in this light.
And, given the dysfunctional behavior of short-term money markets
(as captured in the dramatic widening of the spread between unsecured
vs. secured interbank loans; see fig. 1), how can one appropriately
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Comment
145
Fig. 1.
Spreads in interbank money markets
acknowledge or account for the indeed massive liquidity provision of
central banks?
In fact, this policy was explicitly about substituting for the ineffectiveness of the standard or conventional policy instrument, that is, interest rates (see fig. 2). Fiscal policy is purely nonexhaustive. It is irrelevant
with regard to households’ utility or the capacities of firms to produce
output. Budgetary gaps are funded through debt issuance. To steer the
debt over GDP ratio toward a sustainable path, a distortionary tax on labor
income is imposed. As concerns the cross-border dimension, the evolution
of the current account obeys the intertemporal budget constraint—which
Fig. 2.
Fed and ECB balance sheets
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Kotz
in reality it apparently does not, and which, in the EMU case, implied
substantial tensions, with consequences for the market ’s assessment of
what is now called peripheral sovereign debt.
In other words, this is very much a typical model as it is used in most
central banks (see Galí and Gertler 2007). What is remarkable, however,
is that the zero lower bound arises out of the model’s behavior, is endogenous. In solving the model, structural parameters are chosen that
appear to be basically plausible. The European Central Bank’s (ECB)
policy target—note the singular!—namely, “close to two but below
two,” is preserved. Half of all households are (except for the habit persistence aspect) rational. Incidentally, this was also a conclusion to
which Alan Blinder was led by his empirical work some two decades
ago. The trade-off between unemployment and wage inflation is rather
flat. This picks up a protracted response of prices as well as the duration
of wage contracts. Government expenditures amount to 20% of GDP.
Against this backdrop, which should characterize EMU, a Great Recession is simulated. This starts with a negative preference shock, being
substantial and long lasting. GDP falls relative to its potential by 6 percentage points, a third of this output fall being the upshot of the ineffectiveness
of monetary policy under liquidity trap conditions. This liquidity trap lasts
2 years and generates a fall of the price level for a sustained period of time.
Countries are faced with two shocks: a fiscal and a financial one, the
latter implying difficulties in access to funds, in particular also with the
rolling over of maturing debt (quantity rationing).
Erceg and Lindé simulate a front-loaded contraction in government
spending. They subject the economy to a taste plus a government expenditure shock. This leads to (for the nomenclature of cases, see table 1)
1. a highly persistent effect (impact multiplier unity), a protracted recession (very slow, very gradual fall of real exchange rate); case 5 is essentially similar (negligible effect on real rate in monetary union);
2. with flexible rates, a rapid fall of real exchange rate, a faster output
rebound, and a rapid decline in debt ratio; case 6 is essentially similar;
3. monetary policy responds to concerted fiscal contraction, engineers a
gradual depreciation of real exchange rate (more protracted than in case 4);
Table 1
Normal
Small periphery
Large periphery
EMU 1
3
Non-EMU 2
4
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Liquidity Trap
5
7
6
8
Comment
147
GDP in Core EMU countries (CORE) rises (stimulative effect of lower rates
vs. fall in exports to periphery);
4. zero lower bound (case 7): protracted contraction, constrained monetary policy, real rates rise and stay higher for longer; CORE GDP also
contracts (rise in real interest rates);
5. response of CORE and peripheral EMU countries (PER) GDP is nonlinear (impact increasing at the margin)—fiscal contraction extends
liquidity trap.
All in all, this leads to strong conclusions. It is difficult for fiscal consolidation to control/reduce the debt ratio. As a consequence, it would be
welfare improving if discretionary fiscal expansion in CORE, strong fiscal activism, would offset PER’s contraction. Balanced budget rules are,
as depicted in this world, literally counterproductive: They in fact extend
the period of debt accumulation, making debt potentially unsustainable.
III.
Questions
Persons attempting to find a plot in it will be shot.
Mark Twain, epigraph to Huckleberry Finn
First of all, it should be stressed, given a number of assumptions, that
nominal exchange rate flexibility might be advantageous in the case of
an asymmetric and temporary shock. (For small, open economies, which
nicely fall into the PER category, however, even that is not self-evident.)
Otherwise, there is ultimately (after some period of buying time) simply
no way around a real adjustment. Moreover, quite obviously, there are
substitutes, mechanisms that help coping with a shock. Whereas fiscal
transfers as well as migration are either implausible (actually, given the
no-bailout presumption, forbidden, at least under the then-prevailing institutional setup) or not available on the required scale, the adjustment of
relative wages (uncompetitive unit labor costs, internal devaluation) of
course is.
A second point should be stressed at the outset: both constraints—
“handcuffs”—are not a defining feature of the EMU. They are endogenous. In other words, also outside of the ECB’s remit, countries subject to
such a shock would have to ponder the options briefly outlined. EMU is
therefore orthogonal to the issue.
I would like to highlight the following five points summarily: Given
the importance of the questions addressed in policy formulation, more
sensitivity analysis would be very useful. Policy makers are simply
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Kotz
confronted with a wide range of assessments of fiscal policy effectiveness, often arising from exactly the same modeling approach (Wieland
2008). This translates into a low confidence in policy proposals. That is,
quite clearly, an important point in politics, that is, in reasoning approaches in the public agora—and these places, again, bear in Euroland’s
case quite distinctive national traits. Apparently, much of the argument
rests on the ratio of optimizing households to liquidity-constrained consumers, which, again, could be quite different in the respective countries.
In Germany, for example, given the long-lasting public drumbeat claiming that the pension system as well as public finances are in dire straits,
angstsparen possibly makes for a higher share of “Ricardians.” Along
these lines, second, a practically important characteristic of Euroland is
its regional diversity. PER and CORE are, however, structurally identical
in Erceg and Lindé’s modeling. This raises at least two questions: How,
being isomorphic, did they get into such divergent situations to begin
with? More practically, are we entitled to practically build policy advice
from such obviously counterfactual descriptions?
This leads to my more policy-oriented remarks: Most evidently, monetary policy responded, third, with unconventional measures (see again
fig. 2), initially with credit easing (collateral requirements etc.), then with
quantitative easing—allowing the balance sheet of central banks to grow
very substantially. In the ECB’s case, in fact, the first intervention—very
much at the beginning; hence, when things were still not called “the
crisis,” that is, on August 9, 2007—was indeed unconventional—full
allotment at a fixed rate.1 Unconventional or nonstandard also since
the underlying diagnosis (a run of banks on themselves) was not at all
received wisdom at the time. It became a conventional diagnosis only
after Northern Rock’s demise, which was publicly exposed only after
having run into insurmountable difficulties in wholesale funding markets long before (Shin 2009).
Then, fourth, reiterating a point just alluded to, adjustment, given an
asymmetric and nontransitory shock, largely has to rely on real exchange
rate movements, the relative price of home to foreign (or, in EMU’s case,
extraregional) goods. But, quite obviously, while the nominal exchange
rate with a Europeanized monetary policy is gone, by definition this real
adjustment option evidently still exists. It is at the same time true that
adjustment will be painful and the political economics of pursuing it will
be difficult indeed, without the “social mollifier” (Martin Bronfenbrenner)
of some additional inflation. However, looking for example at the case of
Greece, I do not wonder at all whether structural reforms on this scale
would have been possible with an independent monetary policy. They
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Comment
149
would not have been. Handcuffs apparently have been useful. In Erceg
and Lindé’s argument, non-EMU would, however, have been preferable
for PER. That is a very strong point, which EMU member countries simply do not only not share but act forcefully against markets that at times
appear to push them in that direction.
Fifth, coming to issues of politics, it would be interesting to understand, if we could assume that Erceg and Lindé’s arguments are correct,
why European politics is oriented in exactly the opposite direction. In
fact, Europeans, rather unanimously have embarked on a rule-oriented,
quasi-automatic institutional setup to rein in unsustainable deficits and
debt. This, to be sure, very much reflects the prevailing antifiscal activism
consensus, which, in my eyes, was never completely convincing (see in
particular Solow [2002] and Friedman [2007]). Germany, borrowing from
an existing procedure in Switzerland, has introduced a so-called debt
brake. That is, the country with arguably the most fiscal room for maneuvering is not at all prepared to use it, more correctly, even by force
of a constitutional clause not any more able to use it. In the European
debate, reference was consistently made to the confidence-building effects of rigorous expenditure cuts; the emphasis was thus not on shortterm dampening cyclical fluctuations about a trend but the long-term
sustainability of public finances (Alesina and Perotti 2010). Therefore,
initial suggestions to counteract in the cyclic dimension were greeted
in the German debate with all the well-known standards about inherent
operational flaws of budgetary stabilization efforts, at best allowing for
futile Strohfeuereffekte (“straw-fire” or flash-in-the-pan effects). To be fair
to policy makers, European economies were affected only with some
delay, and then very abruptly, somehow almost out of the blue sky. In
the fall of 2008, the prevailing diagnosis was “decoupling.” Indeed, in
November 2008 the German Council of Economic Experts still predicted
a growth rate of GDP in 2009 of 0.0%, with dynamics picking up again
from the second quarter onward (Council of Economic Experts 2008, 32).
Of course, GDP shrank by 5%, on average. Moreover, when crisis undeniably hit and governments finally gave in to calls for counteracting
measures, European policy makers correctly pointed out that automatic
stabilizers were substantially more powerful, given the significantly
larger share of their public sectors as well as their much more progressive
tax systems.
The “plot” of course is that two conflicting views about how to cope
with the fallout from the Great North Atlantic crisis (a notion due to
Willem Buiter) exist. In one line of reasoning, in order to get back as
soon as possible to the precrisis potential output trend, a forceful fiscal
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impulse is called for. This entails the acceptance of higher budget deficits,
in particular in those countries (regions) with a current-account surplus.2
Such a policy should also allow for some demand switching in order to
reduce global imbalances. This is, quite obviously, a plot not very much in
favor in Euroland, at least not in the northern surplus regions (Germany,
the Netherlands, etc.). If, however, the diagnosis of a credit bubble was
correct, then there must also have been—to use again old-fashioned
vocabulary—as a logical corollary a quite significant amount of overinvestment and a substantial misallocation of resources. Therefore, one
obviously would not want to sustain these economically nonviable production facilities, in fact, in this reading of the situation, even augment
social opportunity costs.
This ultimately boils down to two perennial questions: What is trend
output or, implicitly, the output gap? Moreover, how can one smooth the
inevitable structural adjustment process or, in the same vein, are there
reliable, effective macro instruments to engineer this? In Erceg and
Lindé’s model the answer is palpable. And I should admit that, policywise, I largely share their position. However, I am not completely convinced that their model underpins this position, in particular, since from
the same suite of models, with not too much different parameters, one
can derive just the opposite type of suggestions (see, very concisely,
Wieland [2008]). This is one reason that might have made European policy makers rather reluctant to buy into likewise policy propositions. At
the same time, precisely models of this type did not really give any early
warnings (Clarida 2009). Until very recently they had simply not had
much interest in finance or intermediation. (Implicitly, this is now admittedly acknowledged.) To the contrary, they were used to buttress a certain European mode of denial—to give credence to what one might see,
ex post, as a too little, too late approach. Therefore, while Erceg and
Lindé’s modeling work is instructive and very useful—though possibly
in a more deconstructive way—policy making has to be eclectic and
judgmental. In particular, under such unprecedented circumstances as
in the fall of 2008,with substantial uncertainty, confidence is in very short
supply and consequently the option to delay becomes very attractive. It
was thus helpful indeed that actual policy making made use of complementary perspectives in reading what was going on (Romer 2009).
Endnotes
1. For a comprehensive explanation of the ECB’s policies, see ECB Monthly Bulletin
(2009). I do not go into nuances here, which are of course important: why the ECB talks
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Comment
151
of enhanced credit support (instead of quantitative easing) or why it justifies its policy in
light of the dysfunctional markets.
2. The assumed underlying strict correlation between balances on current account and
the public sector is for sure a bit too simple. As concerns (northern) European trade surplus
regions, their purported imbalances reflect to a large degree the behavior of companies,
exposed to competition, i.e., companies’ endogenous response to a changing environment.
Governments have not much leeway to intervene here — which is possibly not that bad.
References
Alesina, Alberto, and Roberto Perotti. 2010. “Germany Spending Is Not the
Cure.” Vox, June 17.
Council of Economic Experts. 2008. Die Finanzkrise meistern, Wachstumskräfte
stärken. Wiesbaden: Statistisches Bundesamt.
Clarida, Richard. 2009. “The Dog That Didn’t Bark and the One That Did.”
PIMCO Global Perspectives, July.
ECB Monthly Bulletin. 2009. “The Implementation of Monetary Policy since
August 2007.” July, pp. 75–88.
Friedman, Benjamin. 2007. “What We Still Don’t Know about Monetary and
Fiscal Policy.” Brookings Papers on Economic Activity, no. 2:49–71.
Galí, Jordi, and Mark Gertler. 2007. “Macroeconomic Modeling for Monetary
Policy Evaluation.” Journal of Economic Perspectives 21, no. 4:25–45.
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