Wednesday, February 22, 2012

Hope for Europe

A provocative Wall Street Journal OpEd by Donald Luskin and Lorcan Kelly gives me hope for Europe.

No, I'm not talking about Greece, and the latest bailout deal. That's more of the usual charade. But in the end Greece is small. Europe can bail Greece out if they feel like it; or let it default.Or let it rot, which seems where they are headed. 

Italy and Spain are where the real issue lies. Italy and Spain are too big to bail.

Growth is the only hope for paying back large government debts. "Growth" to an economist means long-run growth, growth that lasts decades. Even the most hard-bitten Keynesian, if honest,  has to admit that "stimulus" does not produce long-run "growth."   Growth comes from more people or more productivity. Period. Italy and Spain can only grow if they free up their markets, clean up their tax systems, put themselves quite a few notches higher on the list of good places to do business.

Growth  is also essential for solving the more immediate debt problems. Italy and Spain need to roll over debts. Markets can be quick to do that, and even lend more, if they see countries have good long-run growth prospects. Markets will stay away as long as they do not see a coherent plan for long-term growth. ("Growth" is distinct from "austerity." "Austerity" means high and distorting taxes, spending cuts but no liberalization of the economy. This quickly runs the economy into a death spiral as people and money leave.)

I had long thought that like the Greeks -- or, increasingly, like the Americans -- Italy, Spain and the rest of Europe (Belgium? France?) simply did not have the will to free their economies. If so, Europe seemed to me destined for a huge bout of inflation. The ECB is basically buying up the debt (via the banks); if the debt can't be bailed out, defaulted on, or repaid, it must end up with inflation.

But, as Luskin and Kelly point out, I may have for once been too Grumpy. Mario Monti, Italy's prime minister, is on a rampage of liberalization. They quote him, growth "will have to come from structural reforms or supply-side measures." Spain's prime minister Mariano Rajoy is headed in the same direction. Monti and Rajoy recognize that companies will only hire people if they can later fire them; that barriers to entry for all the professions ("from pharmacy and baking to taxi-driving") just drag down the economy, that state industries don't provide "jobs," but instead suck the lifeblood out of growth.

Will they get there? Will they reestablish growth soon enough to get the bond markets to roll over debt, or pay back the ECB before it needs to unwind its purchases to avoid inflation? It will be dicey. There is a lot of entrenched opposition to liberalization -- which is why obviously good ideas have such a hard time being implemented for decades. But, as my mayor once said, a crisis is a terrible thing to waste. Maybe Monti and Rajoy can achieve the needed "grand bargains."

What is remarkable -- what gives me hope --  is that they are even talking about "supply side" growth measures and liberalization at all!

The Conventional Wisdom makes no connection between stifling labor market regulations and a debt crisis. The debt crisis is about "confidence" and "contagion," to be met with bailout funds, "firewalls,"  financial engineering,  and ECB debt schemes.

For example, in her most recent speech, IMF Director Christiane Lagarde recommends that "stronger growth"  come first of all from "additional and timely monetary easing." Then, "raising [bank] capital levels" (Note the usual passive policy voice -- who does this raising and how? Translation: taxpayers give money to banks.) Then, "maintaining orderly funding conditions" whatever that means. (Watch your wallet.)

She warns that " On fiscal policy, resorting to.. budgetary cuts will only add to recessionary pressures...those with fiscal space should support the common effort by reconsidering the pace of adjustment planned for this year." Translation: Economies with stratospheric debt/GDP ratios need just a little more fiscal stimulus. As St. Augustine lamented,  Lord give me frugality, but not quite yet.

The bond market?  She wants a  "larger firewall.... Adding substantial real resources..folding the EFSF into the ESM, increasing the size of the ESM,.." Then, "Action by the ECB to provide the necessary liquidity support to stabilize bank funding and sovereign debt markets would also be essential." Translation: ECB to buy debt with printed Euros. 

Eventually, yes, "some countries still have much to do to boost their competitiveness and growth potential." Some? What, most of Europe is right on its "growth potential? And finally, at the very end, "..structural reforms are critical, however medium or long-term their impact might be. ... fiscal sustainability depends, ultimately, on generating long-term growth." Four or five years down the line, maybe, meekly approach Italy's unions and government-run industries with a request for "structural reforms." Sure, that's going to work. 

I don't mean to pick on Lagarde. Her speech is just a good example of global bien-pensant policy Conventional Wisdom. I'm sure everyone murmurs this sort of thing at Davos.  Grumpy's favorite columnist, Paul Krugman is, believe it or not, arguing for more spending and stimulus across Europe. I'm not exactly clear how he wants Italy, Spain, Portugal or Greece to borrow more money to spend it. Budget constraints are never the forte of Keynesian economics. He seems to saying that  multipliers are so large that spending is self-financing:  "Because spending cuts have deeply depressed their economies, undermining their tax bases to such an extent that the ratio of debt to G.D.P." It's either that or the Easter bunny: I don't see bond markets ponying up more stimulus. But "growth," tackling absurd regulations, unions, labor market rigidity denying employment to a generation of Italians and Spaniards... that' s not even on his agenda.

In this noxious intellectual environment, it is remarkable and praiseworthy that Monti and Rajoy are putting "supply side growth" on the front burner at all; that they make a connection between a debt crisis and sclerotic microeconomics. This is a Reagan / Thatcher moment, when courageous politicians may seize the moment of crisis to jump to the long run; let their economies grow and pay off a mountain of debt, ignoring the Conventional Wisdom. It could happen. Or not, but at least there finally is hope.  

In bocca al lupo ("good luck" in Italian -- and, literally, "into the mouth of the wolf," an unusually apt expression) Signor Monti!


  1. One of the best pieces I've read on this blog so far.

  2. John,
    I wish, as an Italian citizen, I could be half as optimistic as you are on Monti's job. If we separate facts from intentions (i.e. words) so far we have seen mostly austerity in the form of tax increases (with admittedly a long due reform of the pension system).
    It's true, there is a lot of talks about cutting the tax rates and increasing the revenues by a tougher enforcement against tax evasion. This is great! But so far it is just words. The government, in the meanwhile was much quicker in acting when it came to raise IVA (the value added tax) form 20 to 22%.
    Again, I am all for enforcement against evasion, however you also need to set up a system where it is actually possible to pay taxes both in terms of rates and in terms of ease to comply. The Italian system seems to be designed so that the Guardia di Finanza (the "Fiscal Police", yes I am not making this up, in Italy there is such a thing) can play gotcha with the tax payer.
    Few interesting points in this report, just take a look at the time required to file and at the overall rates; Italy ranks 170th for rates and 127th in Time to Comply:

    Liberalizing is great but if it does not come with a significant shrinkage of Italy's pachydermic bureaucracy, it won't do much. Do we really think that Italy's last fifteen years of zero or negative growth come from horrible taxi, pharmacy and lawyer markets?

    The Labor laws are certainly a significant factor and I am glad that this issue is back on the table. But again, we have Sweden's tax rates and Ireland's welfare... not a good deal.

    1. You nation can survive high tax rates, but the real killer is barriers to hiring. If your new government can actually reduce the regulatory burden then you might have a significant improvement in growth. My only doubt is that, if that happens, can it be sustained? The bureaucrats will certainly fight back and the pendulum will swing again.

  3. Gio: Thanks for writing. I didn't mean all is great yet. Just a glimmer of possibility that Italy seems to be starting to talk about the right things. Yes, low marginal rates, simple, and collectable taxes are a crucial part of a "growth" policy agenda. "Pachydermic bureacracy" -- I'll have to remember that one.

  4. Wow, Prof Cochrane, quoting St. Augustine, do they teach this thing at Chicago Econ or at Booth? Just kidding.
    I read the Luskin piece last week. And yes it is encouraging.
    But I think I have a slightly different take on how this "supply side" came about. Maybe I am wrong, but it seemed to me that Luskin and Kelly made it seem that European suddenly got a "Damascus conversion" (since we are using Biblical comparisons all over...) and suddenly they fell in love with Arthur Laffer and supply side econ.
    No, I do not think it was like that.
    It seems to me that supply side econ was forced upon them by the fact that monetary policy is no longer available to them. Individual countries cannot inflate/reflate their economies any more. And honestly, I do not think that politicians from Italy, Spain, Portugal, understood this at the time (in 1999). They thought they could continue borrowing galore, la dolce vita with inflation and reflation.
    The *only* ones who understood this were the Germans. Which is why they implemented the reforms early on, as mentioned in the Luskin piece (the so-called "Hartz reforms I, II, III and IV", named after Peter Hartz, personnel director at VW). The Germans understood that they needed to become more competitive, and without monetary policy, fiscal policy and labor market policy would HAVE to be the way.
    Which is why other experiments, like Argentina in the 90s, failed.
    Politicians were simply not willing and able to undertake the reforms needed to make the model work.
    But, at the end it does not matter why the Europeans do it. The fact remains that they do it, and as such it is encouraging.

  5. Dear John, I am newcomer to your blog. Being spanish and a LSE economist, I have long foreseen much of the mess we are in. The situation is the sum of wrong decisions taken by both government, business and citizens. Many of us warned tiredlessly about the fragile jobs in the building sector, the ponsi scheme of pensions, the lack of productivity gains, and still the economy raged, creating jobs and a huge wealth effect. So I do not share you analisis. Once you brake the plates, blaming the porcelain they were made off is short sited. And making stronger plates will not stop in the future, than another dumb generation feel they are "on top of the world" and smash them to pieces. When we find a way to rid economies of Business Cycles, then we may get on our high "economist" ground and lecture. As to the future of spanish growth, we need the construction sector, but the excess stock of houses is in the hands of banks, too afraid to sell them at market prices and write off their losses. As "true" liberal I despise the attitude of shifting the problem from the state to the private sector, without addressing the social norms that also aply withing business. You think you are grumpy... you havent met me :-)

    1. I just read an article relating how many Young, educated Spanish are immigrating to South America, especially Chile, because they simply cannot find jobs. This is a bad drain of human capital that will have long term effects.

  6. Dear Prof. Cochrane,
    Crepi! (Litterally, "let the wolf die!", kind of "thank you, and let's hope for the best")!
    Well, I'm also Italian, and not that optimistic too on how's going to end up with Mr. Monti's reforms. Some risk of dramatic social consequences holds too... But this is not my point.
    On the one hand, you claim, clearly there is no space for a fiscal stimulus which, in any case, couldn't solve our problems in the long run. Fine. Yet, on the other hand, it looks like the EU & ECB are forcing quick debt reduction via, de facto, tight austerity. In Greece, this seems to make the deficit/GDP getting worse and worse. Something similar is going to occur in Italy. There's great debate in Italy about Germans and "la signora Merkel" being too tight. What's your opinion on this? OK, no Keynesian stimulus, but is fast debt recovery more urgent that re-starting to grow?

    1. Well, It's Signora Merkel's money, so she can be tight if she wants!

      I agree I was painting a rosy picture of the possibilities for a huge deregulation more than a forecast.

      I think a lot of the decline does not have to do with Keynesian multipliers -- much of Italian and Greek government spending is simply wasted and could easily be cut without economic or true social harm. Rather, people are fleeing against the prospect of wealth expropriation. If you were in Greece, you'd be getting your money, business, and human capital out as fast as possible, because the austerity hounds are sure to try to tax it or grab it as soon as they can. I gather Italy is also instituting lots of new taxes, including taxes on property.

      This all goes in the opposite direction of "growth." The disincentives of ruinous taxation or expropriation can happen before the taxes, when people see them coming! That view argues for even more spending cuts, along with tax reform and lowering tax rates.

      Hmm. A topic for a new blog post... Greek decline, a multiplier or fear of expropriation?

  7. All this talk on the blogs about targeting NGDP, or stimulus spending tends to drive me nuts. Could we paper over some problems? Perhaps. But where do we get real growth going forward, how do we deal with the growth of government spending.

    I hate that so many want to argue that the choice is goosing the economy or austerity. What about structural changes?

    Thank you.

  8. It gives me the creeps when anybody mentions Reagan/Thatcher in the same conceptual basis as Rajoy/Monti.

    These are European-conservatives which are equivalent to a moderate-Democrat in the US. Rajoy in Spain has concentrated on reducing spending, which is all fine, but he has also increased taxation, to "balance the books", and has not proposed in Parliament yet, much less pass, a single supply side policy. Same goes for Monti.

    Their labor reform is restricted to allow the firing of employees with lower compensation, but compensation, nevertheless, that would shock an American company. Both, Italy and Spain, have entitlement fortresses with moats around them. But even more difficult than these bastions of invincibility is the mentality of the people. They have grown to expect all their goodies as "rights", not as privileges. Try taking it away from them, and you will be running for your life before you say "supply side".

    1. As Italian, I totally agree with the post above. The real problem here is mentality, at basically all levels of society.
      Beside this, Monti's "supply-side" plan is all but decent. It really doesn't tackle any crucial matters, neither for services nor for professions.
      It doesn't deal with state-run companies privatization such as ENI, Enel or Finmeccanica, just to name the most important.

      We just hope he will be doing good with labour market reforms, even if that is the toughest ground. You cannot understand from there how powerful are unions here. They are so strong to claim the right to discuss with any elected goverment about EVERY aspect of the economic life of the country. They are a metastasis for Italy's economy and industrial relations.

  9. "let it rot". Strong words, condescending and cruel. Not appreciated even by your Greeks fans!

  10. All economists agree that structural impediments, taxes and regulations on business should be a scant as possible. Pompous pettifogging on these points adds little to debates.

    Sure reform, I want reform, you want reform, we all want reform. (Except not my pension or tax break or protected industry).

    That said, if you starve an economy for money you will get deflation and contraction, no matter what. See Japan.

    Monetary policy must be growth oriented. Greece has a real problem in that they need structural reforms and a very bullish monetary policy---but they are no longer a sovereign nation. They do not control their money supply.

    Hard to see a way out for them. They will have to take the "pain but no gain" path. Ouch.

  11. Right. What do you suggest for Ireland, why don't we have growth? It's important to me as it's where I live.

    Ireland is seen as one of the most liberalized countries in the world and it is very easy to hire and fire workers. Ireland also has an already extremely high productivity per capita. As far as I know Ireland is the poster child of supply-side measures, yet somehow it's not really working out.

  12. On Bad Ideas and Hope

    John Cochrane probably understands just as well as I do that "bad ideas" aren't the cause of the European crisis, they are just means used in a political struggle by those who do not want to "waste the crisis" in their pursuit of more "political, regulatory, bureaucratic, and fiscal integration" (his own words in a WSJ op-ed).

    As the sovereign debt problems in the periphery of the Eurozone didn't come about overnight, and as they moreover corresponded exactly to the risks of which the sceptics of monetary union had always warned, I wondered why we hadn't heard of these problems building up during the time when they were building up. After searching a bit I found this:

    "Experience with government bond markets suggest that the disciplining role of financial markets may become less effective in EMU as investors have lost their most effective mechanisms for pricing default risk, namely the exchange rate premium. In particular, there is a possibility that country risk premia might respond in a non-linear way (i.e. responding sharply but late) to possible insolvency problems in a Member State."

    [From the European Commission's 2006/Q4 report on the euro area containing the focus on widening current account differences within the euro area, which very officially acknowledged the build-up since the beginning of EMU of imbalances in the periphery.]

    So it isn't as if they (ecofin ministers) hadn't seen it coming. They also knew that if something cannot go on forever, it has to stop one day. But they simply waited three more years for this day to come. And then started 'rescueing the euro' and blaming markets. (It is impressive in a way.)

  13. Olivier Blanchard also had written on Portugal in 2006, I found out during my search. (I'm sorry, I don't have the link ready.)


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