October 2014 newsletter – QE alone plus supply side reforms will not save the Eurozone

Francesco Giavazzi and Guido Tabellini* argue for fiscal expansion as part of a package to reanimate the Eurozone.

At the end of 2013 private consumption in the Eurozone was 2 per cent below its 2007 level; private investment was 20 per cent below the 2007 level. Since then producers’ prices have been decreasing for over a year. In the US, by contrast, GDP and private consumption are 6-7 per cent above where they were six years ago, and investment too is above its pre-crisis level. Looking at unemployment (labor force survey data) it was around 10 per cent in 2010 in both the US and the core of the Euro area (17 countries): by the end of 2013 it had fallen to 7.4 per cent in the US, while in the euro area it had increased to 12 per cent. The only bright spot in the euro area is exports: in Germany for instance extra-EU exports have increased from 14.5 to 18 per cent of GDP since 2007; in Italy from 9 to 12 per cent. Clearly, the Euro area suffers from an aggregate demand problem. Supply side reforms are in the long run interest of many Euro area countries, but they will not do much to restore growth in the near future.

The mantra is that once again it is up to the ECB to revamp aggregate demand and save the Eurozone. Quantitative easing is the last policy tool available to jumpstart the Eurozone economy. The longer the ECB waits before starting to buy government bonds, the further away will the recovery be. This analysis, however, over-estimates the power of monetary policy. Quantitative easing should take place, but together with coordinated fiscal easing.

If lack of demand is the problem, then the solution can only be found at the European level. Macroeconomic policy in the Euro area is no longer a national prerogative. Fiscal policy is bound by the Stability Pact, and monetary policy is in the hands of the ECB. Moreover, spillover effects between member states make a coordinated effort to revive aggregate demand much more effective than isolated, country-specific actions.

What can be done to increase aggregate demand in the Euro area? From a technical point of view, the answer is simple and has few disadvantages. All countries should enact a large tax cut, say corresponding to 4 per cent of GDP. They should be given several years (say three or four), to reduce the budget deficit created by this tax cut, through a combination of higher growth and lower expenditures. To finance the additional deficits, member states should issue long term public debt with a maturity of say 30 years. This extra debt should all be bought by the ECB, without any corresponding sterilization, and the interest on the debt should be returned to the ECB shareholders as seigniorage.

Combining a monetary and a fiscal expansion is key to the success of aggregate demand management, as shown by the recent experience of other advanced countries. QE by itself would not do much to revive bank lending and private spending, because credit demand is absent, and credit supply in Europe flows mostly via banks whose balance sheets are saddled with bad debt, particularly in Southern Europe. And fiscal expansion without monetary easing would be almost impossible, because public debt in circulation is already too high in many countries. Indeed, as shown by Willem Buiter, one reason why QE works is because it relaxes the government budget constraints; but if governments don’t take advantage of this opportunity, this benefit is lost.1 The combined monetary and fiscal expansion would stimulate aggregate demand both directly and indirectly through a devalued exchange rate. The resulting temporarily higher inflation would be welcome, as it would reduce the debt overhang problem and it would facilitate achieving the ECB’s price stability goal.

The outcomes in the US and the UK 
The policies enacted in the US and in the UK during the great recession (as shown in the tables below) provide evidence in favor of the need for a money-cum fiscal expansion. The US let its budget deficit expand by almost 7 per cent of GDP in a single year, through a combination of higher spending and lower revenues. Less than half of this change was due to the effect of fiscal stabilizers, the rest reflected deliberate policy decisions. The changes on both sides of the budget were later reversed. In part because the increase in the deficit due to the actions taken to bail out financial institutions were one-off; in part automatically, as the economy recovered; and in part through deliberate shifts in fiscal stance, such as the 2013 Sequester. Net of the effect of automatic stabilizers, federal outlays were reduced by more than 2.5 per cent of GDP between the trough of the business cycle and now, while federal revenues net of automatic stabilizers increased by about 3 per cent of GDP during the same period (source: Congressional Budget Office).

In the UK the budget deficit expanded almost as much as in the US (+ 6,4 per cent of GDP in a single year), also through a combination of higher spending and lower revenues. Two thirds of this fiscal expansion was due to deliberate policy decisions. The fiscal expansion was entirely reversed during 2010-13 with about one half (56 per cent) of the contraction due to deliberate policy actions, almost entirely on the spending side.

In the Euro area the fiscal expansion in 2008-09 was smaller, as the area-wide budgets worsened by 4.2 per cent of GDP, about two-thirds the size of the fiscal expansion in the US and the UK. Half of this expansion was policy-induced. As in the UK, the fiscal expansion was subsequently entirely reversed, but with two significant differences. Discretionary contractionary measures were twice as large as the expansionary measures which had accompanied the expansion (a contraction of 4 per cent of GDP over 2010-14, compared with a policy-induced expansion of 2 per cent in 2008-09). And, most importantly, the fiscal policy impulse was pro-cyclical, as it was enacted in the middle of the sovereign debt crisis that squeezed credit and raised economic uncertainty in Southern Europe. Moreover, in most countries it mainly took form of tax hikes. The result was a 2-year long recession that erased some of the budgetary improvement.

There is almost unanimous agreement amongst economists that the counter-cyclical policies enacted in the US and the UK, together with the exceptional monetary easing, contributed to stabilize output fluctuations and explain the much more rapid recovery of these economies compared to the Euro area, despite the fact that the heart of the financial crisis was in the Anglo-Saxon countries and not in continental Europe.

As stated above, not all of these swings in the US and UK fiscal outcomes were achieved through a mix of discretionary policy changes. They also reflect cyclical fluctuations in output and prices. But this is precisely the point, and the same would be true in the Euro area. A main purpose of engaging now in a fiscal expansion in the Euro area would be to abandon the pro-cyclical fiscal stance that has inflicted unnecessary pain, and engage instead in counter-cyclical policies. In the Euro area between 2009 and 2013, after the output gap had moved from +3.2 per cent to -3 per cent, the area-wide cyclically adjusted budget balance tightened by almost 4 percentage point of GDP. In some countries the pro-cyclical tightening happened mostly via spending cuts (Spain and the UK in particular) and was more benign. Elsewhere, such as in Italy, it was almost entirely based on tax hikes and induced large and lasting recessions. Some of the tax cuts that we advocate would thus simply undo the pro-cyclical tax increases that were enacted in those countries during the peak of the sovereign debt crisis. As income and prices start growing again, at least some of the budgetary expansion would, as in the UK and the US, automatically be reduced without any policy intervention, since receipts as a fraction of GDP are pro-cyclical, while spending as a fraction of GDP is countercyclical. If the elasticity of the budget to the cycle were symmetric (which need not be the case) and using the numbers from the budget deterioration experienced in the Euro area between 2007 and 2009 (a 2 per cent of GDP cyclical worsening of the budget , that is net of policy measures, for a 6.6 per cent worsening of the output gap) a return of the output gap to balance, from the current level (-3.8 per cent at the end of 2013) would automatically improve the deficit by 1.2 per cent of GDP, not a big number but not zero either.

Moral hazard and the credibility of future spending cuts
A common counter-argument is that more lax monetary and fiscal policies would create moral hazard, particularly in the countries of Southern Europe. There is no doubt that the governments of Italy and France seem to lack the political will, or the political majorities in Parliament, to carry through the major structural reforms that would be in the long run interest of these countries. But it is not at all clear that prolonging the depression is a recipe for more willingness to reform. The contrary is more likely to be true, for two reasons. First, a longer stagnation and higher unemployment can only reinforce the more radical and populist political parties in Europe. The recent surge of the Five Star movement in Italy and of the anti-Euro sentiment in France did not happen by chance, they are the byproduct of the economic failures of the European project. Second, political opposition to spending cuts and structural reforms tends to be stronger when the economy is depressed, because voters perceive such measures as likely to further dampen aggregate demand and increase layoffs.

The correct sequence, from both an economic and a political point of view, is an inter-temporal substitution: expansionary tax cuts now to restore some growth, and spending cuts on the way up as the economy recovers. To give credibility to the future painful measures, the spending cuts can be legislated immediately, but with a delayed implementation, and with a legislative commitment to raise taxes by a corresponding amount if the spending cuts were to be abandoned.

Is there an alternative strategy?
Contemporaneous incremental steps to reduce government spending and taxation at the same time, would avoid the moral hazard problem and may work during normal times. But it is politically too difficult in the current circumstances. Moreover, and more important, it completely misses the point that now we need a major coordinated effort to jumpstart the Euro area economy. Leaving this task to the ECB alone is bound to fail.

A different suggestion has come from Jean-Claude Junker, the new President of the European Commission, who has proposed to increase public investment by a cumulative Euro 300 billion over the next several years. But the plan is much too timid. First, the monetary expansion part is missing, which makes financing problematic and reduces the effectiveness of the stimulus. Second, higher public investment has several disadvantages compared to tax cuts, as the experience of Japan has shown. Above all, it would take much longer to be implemented, and action is needed now, not in two years. Moreover, in some countries it is likely to lead to corruption and misallocation of resources. Some investment in European infrastructures is welcome and should be financed by the European Investment Bank, but not on the scale that is needed to overcome the aggregate demand failure that is sinking the Euro area.

Political obstacles
The main objection to the combined monetary and fiscal stimulus described is not economic, but political. It would be opposed by Germany, and perhaps a few other member states, because it runs counter to the principle of monetary and fiscal policy separation that is enshrined in the Treaty, and because the idea that taxes are too high in Europe does not go down well with the principles of a Sozialmerketeconomie. If political concerns were to prevent a coordinated action to revive aggregate demand, as now seems likely, in a few months the ECB will be forced to engage in QE anyway, to try and fight deflation. But this will not work. And the Euro area will remain depressed, fuelling anti-European sentiment among its citizens.

Mario Draghi’s speech in Jackson Hole, his recognition that growth in the Euro area is demand-constrained, that the appropriate policy to relieve the constraint is a coordinated effort by both fiscal and monetary policy, and that monetary policy can play an accompanying role but can hardly be the driver of growth, has changed the policy landscape. If Euro area governments miss this opportunity and keep muddling through they will go down in history as the politicians responsible for having destroyed a 60-year long effort by Europeans to build a more peaceful continent. Unfortunately they seem determined to do just that.


* Università Bocconi and CEPR

1. Buiter, W H (2014), ‘The Simple Analytics of Helicopter Money: Why It Works — Always’, Economics: The Open-Access, Open-Assessment E-Journal, 8(2014-28): 1-51. See also Gali, J. (2014), ‘The Effects of a Money-Financed Fiscal Stimulus’, CREI working paper.