The European Union (EU) has negotiated a deal for a new Treaty of the willing. We're not yet in the possession of all the details, we're relying on the early Associated Press version of events, what's clear is that the new Treaty commits the signing countries to much stricter fiscal policies:
Participating governments will need to have balanced budgets — which is calculated as a structural deficit no greater than 0.5 percent of gross domestic product — and will have to amend their constitutions to include such a requirement. An unspecified "automatic correction mechanism" will punish countries that break the rules.
In addition, countries that run deficits larger than 3 percent will face sanctions.
To prevent such deficits, countries will have to submit their national budgets to the European Commission, which will have the authority to request that they be revised. Countries will also have to report in advance how much they plan to borrow.
By the looks of it, this could more or less abolish Keynesianism (except for the working of some automatic stabilizers). In fact, it looks like re-creating some form of the Gold Standard in which most, if not all, adjustment falls on deficit countries. This is in danger of creating a terrible deflationary bias in the whole euro zone.
This isn't actually so new, it enshrines in a Treaty what the euro zone has done in practice in its efforts to solve the crisis. Or at least what it tried to do. That might provide some indication of how successful it's going to be already. Here are a few of the consequences:
End of Keynesianism?
Keynesian policies are needed when economies are faced with a demand shock. A demand shock happens when aggregate demand, for some reason, falls below the production capacity of the economy. For instance, due to normal variations in the business cycle.
There are, believe it or not, economists who argue that such demand shocks aren't possible. They explain business cycles as forms of supply shocks, a literature known as 'The Real Business Cycle literature.' They also believe that the economy would instantly operate to correct them and policy to deal with them would either not be necessary or even counterproductive.
We think there is a wealth of evidence that contradicts this view and belief that these economists are informed by rather esoteric general equilibrium models, rather than by reality. However, the essence of Keynesianism is that there are circumstances when counter-cyclical policy is necessary, and those circumstances are when the economy suffers a demand shock.
The new rules can be seen in a number of different ways. One could, with some fantasy, argue that they merely enshrine Keynesianism because they oblige countries to balance their budgets over the business cycle. Indeed, an often forgotten part of Keynesianism is that policy is supposed to be counter-cyclical. That includes running budget surpluses during boom years.
The new rules leave little room for discretionary reflationary ('Keynesian') policies by individual countries. In a way, this is not necessarily a disaster. Monetary policy can be quite effective in smoothing the business cycle, even Milton Friedman agreed with that.
Three problems ensue though:
- How wedded is the ECB to counter-cyclical policies?
- What happens if the demand shocks are country specific?
- Most important, what happens when monetary policy isn't effective?
How 'Keynesian' is the ECB?
Since the new Treaty limits the scope of fiscal policy, more has to be done with monetary policy. Basically most of demand management is 'outsourced' to the ECB.
Whether the ECB is up for that task remains to be seen, but the omens are not very good. Although Jürgen Stark has resigned from the ECB, he recently talked about "Keynesian romanticism," and his views are born out by ECB actions and the ECB's single mandate (price stability).
This year, in the aftermath of one, and in the face of another rather unprecedented financial crisis, the ECB actually increased interest rates (a move which the new ECB president has hastily undone). So the question is whether automatic fiscal stabilizers and perhaps some mild counter-cyclical monetary policy from the ECB are enough to smooth out the business cycle remains to be seen. But this is not where the main problems lie.
Monetary policy and country specific shocks
What about if one, or a few countries are hit by a demand shock, but the rest of the euro zone isn't? These are so called asymmetric, or country specific, shocks in the economic literature. Monetary policy in the euro zone is one-size-fits-all, so monetary policy falls away as an instrument of dealing with those.
Well, perhaps not totally. If the countries experiencing the shock constitute a significant part of the euro zone, the ECB would be more prone to act. But the shock would be less country specific, so it's not what we're talking about.
So, we could very well have a situation where a country is hit by a shock while it is unable to offset the shock by either monetary stimulus or devaluing the currency. All adjustment has to come from fiscal policy. Now, a positive reading of the new Treaty might give some reason for optimism.
The 0.5 structural budget deficit does give some leeway when demand shocks hit economies. A structural budget deficit is one not caused by such a demand shock, so there is indeed some room for automatic stabilizers as the budget deficit can increase. In this way, it's a more sensible measure than limiting countries to the 3% budget deficit enshrined in the Stability and Growth Pact.
However, structural budget deficit is a fungible concept, and perhaps that's a good thing, as it could provide some leeway. On the other hand, it also could be very limiting. If a country experiences a demand shock it's budget deficit automatically rises, and this could well make the overseeing authority in the Commission nervous, especially if it lasts. Since the country cannot avail itself of either lower interest rates or a lower exchange rate, this could very well be the case.
So the devil is in the details here, and how they are interpreted. This could be problematic, or perhaps not. We think if present experience is anything to go by, there isn't a whole lot of room for optimism. The whole history of monetary integration in the European Union is one of adjustment falling on deficit countries, and there is little reason to assume that 'this time will be different.'
If adjustment falls on deficit countries, like it has always done in the European Monetary System (EMS, the precursor of the European Monetary Union, EMU) and EMU, this creates a deflationary bias in the whole system. Something which we believe is one of the main problems of the crisis today, and a situation not unlike that of the Gold Standard in the 1930s. But it gets worse.
Financial shocks
What happens when the euro zone is hit by a financial shock, like the one in 2008? These are shocks where credit infused asset bubbles form, and then implode, leaving balance sheets of the private sector (households like in the US after 2008, or corporations like in Japan in the 1990s) and banks (saddled with bad debts) in a terrible state.
These then reduce borrowing and spending in order to repair the damage to their balance sheets. This is exactly why monetary policy is ineffective in a balance sheet recession. Most of monetary policy effectiveness is predicated on the private sector expanding credit demand. But if the private sector doesn't want to borrow to repair balance sheets and if banks don't want to lend for the same reason, monetary policy loses much of its effectiveness.
There could very well be no (positive) interest rates which induce credit to resume, the dreaded liquidity trap. We've set out these thoughts in greater detail here.
Japan suffered from such a balance sheet recession, a terrible one in fact. Three years worth of GDP wealth was destroyed by falling asset prices, that's a financial shock that was three times as big as the one that hit the US in the 1930s. Yet Japan escaped a Great Depression remarkably well, on closer inspection. How did they do that? Here is Richard Koo:
Had there been no fiscal stimulus, the Japanese economy today would have contracted by 40-50%, if the U.S. experience during the 1930s is any guide. [Richard Koo]
Yes, we realize that Japan has run up a formidable public sector debt (and we'll deal with that in more detail in another post), but one could make a case that this is preferable to suffering a Great Depression, one that destroys millions of lives.
One could also argue that at 1% interest rate (the yield on Japanese 10 year bonds), there might be at least some public sector investments generating bigger returns. Not necessarily all Japanese bridges are the proverbial bridges to nowhere.
So the new Treaty leaves the euro zone almost completely defenseless against such a balance sheet recession. In fact, if present practice is anything to go by, it could very well be that policy becomes terribly pro-cyclical, reinforcing the downward draft coming from falling asset prices and the private sector reducing spending to repair balance sheets.
Here is how that can work out:
Greece has been subjected to the greatest fiscal squeeze ever attempted in a modern industrial state, without any offsetting monetary stimulus or devaluation. The economy has so far collapsed by 14pc to 16pc since the peak – depending who you ask – and is spiralling downwards at a vertiginous pace. [The Telegraph]
Our only hope is that the new Treaty provides some cover for the European Central Bank (ECB) to finally act as lender of the last resort. They have done so for euro zone banks, but only very haphazardly for euro zone sovereigns. Which is odd, as banks are subject to every bit of moral hazard risks as sovereign states are, and banks are in trouble mostly because they have so much sovereign debt on their books.
These hopes for the ECB to put a line in the sand (as we keep saying, just like the Swiss central bank did when stemming the rise of the Swiss frank), are just that, hopes. We don't know. The noises out of the ECB provide no reason for optimism, but they might, just might, be part of a poker game.
Avoiding financial crisis
If the ECB doesn't play ball, the only, we repeat, only, way to deal with financial crisis is to prevent them in the first place. That invariably means not letting private debt run up. We always wondered, where were all those people who are now so worried about public debt when private debt was escalating??
Preventing private debt from escalating involves either some rather discretionary policies by financial authorities and/or new, much tougher regulation. But you guessed it, those very same economists who adhere to those esoteric general equilibrium models are not only dead set against discretionary fiscal policy, they're also dead set against any discretionary policy, and especially against stricter regulation. Some of them even blame the whole crisis on that.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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