Evan Soltas
Apr 16, 2012

Euro Eulogy?

Fiscal and monetary policy mix in the Eurozone, and comments on Krugman

It should be obvious by now that the Eurozone's problems are beginning to worsen, after showing improvement from January to March. Spain's borrowing costs, most notably, are above 6 percent again as the Spanish economy continues to sour, making it harder for the government to cover its sovereign debt obligations, and raising interest rates as investors fear for the safety of their investments.

In late February, I wrote a post praising Mario Monti's fiscal consolidation program -- not because austerity was good per se, but that I thought it hit the right balance between increasing confidence without hurting the Italian economy too much, and that Monti was making very smart structural reforms. I thought that, pace Krugman, Italy might be spared, and that the Eurozone might just be alright after all.

Now, I have no problem admitting when I'm wrong, or at least when things are not improving as anticipated. (I don't think these are inherently easy events to understand or fix, given the huge costs presented by any option.) Italy's 10-year spread against Germany is rising now, although not nearly to the crisis levels (yet?). I still contend that governance, and confidence, matters in this sovereign debt crisis -- see this VoxEU article by Italian economist Tito Boeri, which estimates the size of this effect at 110 basis points. That's not a negligible confidence effect, but I grant now that it may not be enough to offset worsening macro conditions.

One other thing. It was striking to see Krugman compare the Euro to the gold standard:

Well, in the 1930s — an era that modern Europe is starting to replicate in ever more faithful detail — the essential condition for recovery was exit from the gold standard. The equivalent move now would be exit from the euro, and restoration of national currencies. You may say that this is inconceivable, and it would indeed be a hugely disruptive event both economically and politically. But continuing on the present course, imposing ever-harsher austerity on countries that are already suffering Depression-era unemployment, is what’s truly inconceivable.
Not that I'm claiming credit for the comparison, but I had actually said as much at the YUEA competition in early February, in question-and-answer from the judges. I agree strongly with Krugman that for Greece, Spain, Italy, Portugal, and Ireland, it would be prudent for them to begin planning exit strategies -- is there an economic version of "war gaming"? -- with the ECB. It's important to keep in mind we are far from the worst of the crisis a few months ago, judging from Intrade quotes, but also that the improvement in conditions can be reversed with a speed that will shock all of us.

At this point, the best thing we could (and should!) see from the Eurozone would be additional action by the ECB. Without a doubt, we'd want a rate cut of at least 50 basis points. Beyond that, I would think it reasonable for the ECB to make a two-fold promise -- to consider further rate cuts if macro and financial conditions warrant, and perhaps something like what the Fed has done, promising not to raise rates until a certain threshold (whether in terms of time or the price level) is hit. If things continue to worsen, then I think additional ECB purchases of sovereign debt will be required for conditions to calm.

By that point, the ECB might just as well commit to a program of financial repression, which is more or less where the ECB is heading with these debt purchases every time they are compelled by the market. This would probably be capping all Eurozone debt interest rates at 5 percent or something in that range. Now the odds that Germany will allow such a thing are next to nil, but hey, if the debtor nations can make a credible threat that Germany can pick between three options -- (1) financial repression, (2) default or very large write-downs, (3) outright Eurozone exit for such countries -- then I think they'll pick the first. I just think options 2 and 3 have unthinkable and nonlinear costs, that the Germans will realize it's just not worth the risk.

I see the 50 basis point cut as eminently plausible, and so do the economists at Citigroup, apparently. To explain, I created a Eurozone Taylor rule in the way that Greg Mankiw did -- using core inflation and the unemployment rate to estimate the federal funds rate. The EU equivalent, I figured, would be to weight the inflation and unemployment numbers by the size of the respective economies. And it recommends the 50 basis point rate cut -- interestingly, it too would have raised rates as the ECB did last year. (I've made my dataset available here so that nobody has to do this work twice. It took a long time to add up all of the inflation and unemployment rate data from FRED. I took a minor shortcut, not counting any Eurozone countries whose contribution to total output was < 1 percent.) I had to estimate Eurozone unemployment for January and February -- we don't have those numbers yet, but my guesses were 10.2 and 10.3 percent respectively, given that December was 10.16. Also, I'll note that I also simulated the policy based on inflation only, and the correlation between policy and inflation was much, much weaker than between policy and the Mankiw indicator (see above link), which considers unemployment. That's why I think it's in the cards that the ECB's single mandate for price stability could be revised, which I think Nicolas Sarkozy is a fool for not pushing for:

One Sarkozy aide, asking not to be quoted by name, said the president knew he would have "no chance" of getting the ECB's mandate changed to include provisions for supporting growth.
In other words, the data say that the ECB is already putting some weight -- although perhaps not an equal weight -- on unemployment. I don't see an NGDP target happening there, of course, but perhaps a refinement of their inflation target into something like the RBA's. (Reminder: the ECB targets the Harmonized Index of Consumer Prices at a 2 percent year-over-year -- although I would say that the data suggest their inflation target is much closer to 1.5 percent.)

I'm not as convinced as Krugman is by his net government saving and debt data that Spain was some paragon of fiscal responsibility, or at least as good as Germany. That's because the datapoint he uses -- 2007 -- represents very different points in the business cycle for Spain and Germany. For Spain, they were at the height of an economic boom, and unemployment was way below the natural rate (remember, it's a European country). For Germany, things weren't quite as hot; unemployment was higher then than it is today. So just looking at the budget balance at the time I don't find sufficient. If we look at structural budget balances, however, that it more helpful.Given that Spain's natural rate of unemployment is probably in the low teens, this would imply that they do have a structural budget deficit larger than a reasonable output growth rate. Now, I fear, Spain's fiscal position doesn't look as good as it did with that one data point.