The recent narrative regarding Greek debt sustainability has moved from the debt-to-GDP ratio towards the annual debt financing costs (interest payments + maturing debt). According to this analysis, Greece already enjoys very generous terms until 2020 and beyond and will only require small debt reprofiling measures in terms of interest rate payments and debt maturities after 2022. What is needed according to its creditors is for Greece to continue on the reform path, achieve economic growth and commit to credible fiscal measures that will allow it to maintain high primary surpluses close to 3.5% of GDP. Unfortunately that can only be achieved through tough measures on the pension front. «As long as Greece continues on this path, creditors will do their part» as the story goes.

In my view the above story is problematic, mainly because it relies on Greece achieving and maintaining a 3.5% GDP surplus target, a target which I believe is not credible in the long-run. In order to examine the subject from a theoretical point of view, I will use some well known concepts in economics, debt overhang and dynamic inconsistency.

Debt overhang is a concept usually used in corporate finance. It is based on the idea that, as long as the corporate balance sheet carries too much debt (which always takes precedence in payment over stock), stockholders do not have an incentive to contribute new funds in order to fund new investment projects if the proceeds are mainly used to improve the recovery rate of creditors. Balance can only be achieved if creditors ‘share the costs’ through a restructuring of the liability structure of the company balance sheet.

The same applies in the case of Greece. Its own ‘stakeholders’ do not have an incentive to contribute funds (in the form of high taxes or lower pensions/wages) if the increased surpluses will mainly be used to improve and ‘guarantee’ the recovery rate of foreign creditors. Given that Greece has a negative external balance (especially the cyclically-adjusted figure) it is an accounting fact that a primary surplus will involve a deterioration of the Greek private sector net financial assets position. Maintaining a 3.5% surplus target in the indefinite future involves a very large transfer of financial wealth from the Greek private sector to foreign official creditors with only a small part of the (possible) growth dividend staying in Greece. Most corporations would not accept such a bargain unless under threat, something which is more than evident in the Greek case where the Grexit threat has been thrown around for more than 5 years now.

Dynamic inconsistency on the other hand involves the idea that sometimes the solution to a dynamic optimization problem depends on the specific time when the problem is evaluated, which has the effect that a specific action time path is not credible.

A classical example is capital taxes. A fiscal authority might want to commit to low capital taxes in order to achieve large investment and growth. Yet at time t=1 investment has already been made and the temptation is high to increase capital taxes in order to enlarge fiscal revenue.

In a way, the same applies in Greece. In order to achieve debt sustainability, the fiscal authority must commit to a path of large primary surpluses. Yet, given the fact that such surpluses deteriorate the private sector position and the possibility of a negative shock hitting the economy, it is highly likely that Greece will have to lower its surplus (or even run a deficit) at some point in time. When the time of a negative shock comes, the optimal solution for the sovereign is to try and smooth the effects of the shock on the economy, not maintain a target that will only make matters worse.

As a result, especially given the need to maintain the surpluses for a very long time (in order to achieve debt sustainability), such a path is not credible. The fiscal authority will deviate ‘at the first sign of trouble’.

Combining the debt overhang with the dynamic inconsistency argument leads to a clearly unstable equilibrium. Both the sovereign and the Greek private sector (Greek stakeholders) do not have the incentive to commit on a high surplus strategy. Under completely rational behavior they have every reason to not damage their financial position and maintain the best possible growth rate. Any commitment on the high surplus strategy will not be credible but only a ‘temporary deviation’ in order to avoid short-term negative outcomes since the Grexit threat is still considered credible.

In my view, only a path of low future surpluses (accompanied by a large upfront debt restructuring) is a long-term credible strategy. Otherwise, we ‘ll keep on observing the current ‘stop and go’ path, with the Greek government implementing the least possible measures and its creditors using Grexit as stick and the (insufficient) future debt reprofiling as carrot in a repeated game with a non-optimal outcome.

 

 

Bank of Greece recently released its balance sheet statement and profit & loss account for the year 2015. One important observation is the significant increase in its profits which totaled €1.16bn compared to €654mn during 2014. I have already commented on this profit flow in my post on the November balance sheet. Assuming a spread of 150bps over the MRO (which is paid to the Eurosystem by BoG) on ELA financing the cumulative profit flow during 2015 was €1073mn, a figure quite close to the total profit for that year.

In terms of bank lending, total bank loans and ELA outstanding are now back to March 2014 levels at €107.5bn and €68.9bn respectively. Nevertheless, this level of financing is supported by a much higher figure for collateral which stands at €189.15bn instead of €177.59bn in March, a fact which signifies the quick deterioration in quality of Greek bank assets (total collateral for December are only €16bn lower than their peak during 2015). This figure is close to 2/3 of their total primary assets (debt securities and credit claims) or more than 85% of credit claims (before provisions). Given the large non-performing exposure of Greek banks it is clear that most of their assets are already encumbered as collateral towards BoG.

One important development that seems to have gone unnoticed is the large increase in securities held for monetary purposes by BoG (as part of ECB’s QE) which have risen from €5.8bn in December 2014 to €20.7bn, although ‘Other Securities’ registered a drop of €6.2bn from €25.27bn to €19.05bn. As a result total ‘ Securities of euro area residents denominated in euro’ increased €8.7bn. Nevertheless, securities held by Greek MFIs did not move much during 2015 which means that any BoG purchases were performed abroad and (all else equal) should lead to a rise in Target2 liabilities. This is confirmed by the fact that ‘liabilities towards the Eurosystem – Bank Lending Operations’ reached a figure of €6.5bn in December while it was in negative territory until January 2015.

Bank of Greece Balance Sheet items during 2015.jpg

 

Given that securities purchases will continue during 2015 we can expect to observe a further change in BoG balance sheet mix with a larger part of Eurosystem liabilities being financed by securities rather than bank loans, something which will obviously change its net income flows significantly. Whether these purchases will lead to an increase of Target2 liabilities or not will depend on broader developments within the economy and private capital flows.

It is more than usual to read articles examining the Euro boom years which tend to suggest that capital inflows from the core funded the credit expansion in the periphery. Although that line of reasoning is not wrong when examining capital flows between countries, I do not think it is entirely correct in the case of a monetary union such as the Eurozone.

The main reason is the fact that the Eurosystem is structured in such as way that it is accommodating of capital flows between Eurozone members through overdrafts at the NCBs and unlimited Target2 credit. Banks as suppliers of credit and creators of deposits do not need a pre-existing stock of funds, nor to they need to pre-finance any outflows to other Euro members.

More specifically imagine the following example depicting the normal flow of credit and cross-border flows:

  1. A bank customer in Greece applies to a Greek bank for a loan to fund a new investment project (which will require German manufactured capital goods).
  2. The bank extends the loan and credits the corresponding customer’s bank account. No actual funds are needed by the bank apart from the 2% reserve requirements (which is elastically provided by the ECB).
  3. The customer pays for the capital good by transferring funds to a German bank. For the transaction to take place, the  Greek bank debits its reserve account at the Bank of Greece with the corresponding amount and BoG increases its Target2 net liability position. In case the Greek bank is short of reserves (compared to average reserve requirements) it can source funds at the BoG marginal lending facility, at the weekly MRO or at the interbank (repo) market.
  4. Since the interbank repo rate is quite favorable compared to the marginal facility rate, the Greek bank will use high quality bonds from its bond portfolio (mainly Greek government bonds) to source funds from the European interbank repo market using the bonds as collateral. It is clear at this point that the new bank loan remains on the Greek bank books and is never transferred outside its balance sheet, nor does it play any significant role in the cross-border flows.
  5. Apart from the increase in bank liabilities to RoW (described in (4)), periphery countries also saw a large increase in the amount of government bonds held by the foreign sector. As a result, instead of (4), Greek banks could just use the flow of funds from abroad (which were used to acquire Greek government bonds) to repay their (extra) liabilities towards the BoG and maintain a stable amount of interbank funding. It should be noted at this point that any inflows of funds either from the interbank market or from foreigners for the purpose of buying government bonds will lower the net liability position of BoG to the rest of the Eurosystem (a position that actually remained quite small until the start of the 2008 crisis).

What is clear from the above is that cross border flows are accommodating (in the sense that central bank financing is always available to cover them) and that the reason of incoming flows has almost nothing to do with the original loans and transactions (in our case a bank loan to pay for an investment project ends up in a cross border liability of the government or the banking system).

Financing of cross border flows was always provided by the Eurosystem. Inflows of funds to buy government bonds and interbank loans were merely used by the banking system as a cheaper source of funds instead of large liability positions towards the corresponding NCB. Capital inflows did not ‘fund investment in the periphery’ but were the result of foreign portfolio preferences and mostly changed the composition of the net liability position in the periphery away from Target2 liabilities which were replaced by higher liabilities of the government and banking sector.

BoG published its November 2015 balance sheet data which makes it a good opportunity to look into recent developments.

BoG - Balance Sheet - Jan - Noc 2015

Compared to the peak during June, liabilities towards the Eurosystem (Target2 + extra banknotes) have decreased substantially from €130.5bn (more than 70% of Greek GDP) to €117.8bn which is still a very high number. Almost all of the fall was driven by the €10.5bn reduction in Target2 liabilities.

This improvement of BoG’s net liability position was reflected on bank borrowing which fell from €126.2bn to €113.4bn. Most of the change is attributed to lower ELA which is down €9.3bn but still stands at May levels.

An interesting side effect of large ELA bank borrowing is the fact that BoG earns around €100mn monthly from the (assumed) 150bps spread over the MRO rate. As a result it has already accumulated profits probably close to €1bn from these operations. These profits will clearly prove quite helpful for the 2016 budget execution although they represent a ‘windfall flow of income’.

Lower loans from the BoG mean that banks can free up a part of the collateral they have been posting to the central bank with total collateral being almost €14bn lower than its peak during the summer. Given the fact that Greek banks already have €10bn less assets than during January while NPLs are still on an upward path this development is more than welcome. Especially since the total of debt securities and credit claims (before provisions) on their balance sheet is only a total of €288bn. Taking into account NPLs it is evident that Greek banks were already very thin in available collateral during the heated summer standoff between Greece and its creditors.

Lastly, one other positive news item is the fact that the government account at the BoG now holds more than €5bn. Since for the next months the remaining Greek debt obligations are quite contained it stands clear that the Greek government has some leeway to not try and conclude the first quarter negotiations (which contain some of the most difficult parts of the package such as pension reforms) without giving a fight. Specifically, it has to pay €1.2bn to the IMF in December and €1.4bn during the first quarter.

Based mostly on this article on Japan. What is important when looking at dependency ratios is not the ratio of old persons to the working age population but rather the ratio of non-working citizens to working ones. And this includes people (usually) younger than 24, especially in developed countries (where most people attend some type of college).

Greece Germany Dependency ratios

When examined under this perspective the relevant picture is quite different: Non-working dependency ratios were extremely high during capitalism’s ‘Golden Age’ (1950 – 1970). Greece will hit ratios last seen in 1975 at.. 2040 (with the dependency ratio being much higher in the ’50s) while Germany will only get into trouble after 2025-2030.

As long as pensions are not a ‘defined benefits’ but rather a ‘defined contributions’ scheme and remain flexible, population aging will not lead to the ‘dooms day’ scenarios that some people fear about. We managed to take care of baby boomers just fine during capitalism’s finest hour.

Something which I think goes overlooked from time to time is the fact that what is actually available as (taxable) income within a country is not GDP but GNP (which is GDP plus net income from RoW). As a result, calculations involving maximum tax income potential and debt sustainability should take into account any income lost from GDP as income of foreigners.

This is especially true for Greece where an examination of the available data actually shows that somewhere close to its Euro entry the country moved from a positive net income balance to an increasingly negative one, both nominally and as a percentage of GDP:

Greece - Net Primary Income to RoW - Chart 1995 - 2014

At its peak (2008), Greece lost more than 3% of its GDP as income returned to RoW with dynamics that were quickly becoming unsustainable. Ever since the 2009 crisis and especially after 2012 (and the PSI exercise) that lost income was significantly reduced (and even reversed at least during 2012). Nevertheless, it seems that funds lost to the RoW are slowly increasing again with the relative balance (as %GDP) moving from -0.6% in 2012 to 0.4% during 2014:

Greece - Net Primary Income to RoW - 2007 - 2014

Although the figures are still almost an order of magnitude less than during the second half of the previous decade their long-run dynamics should be modeled in any debt sustainability exercise, especially since Greece will depend on FDI for a large part of its future economic growth (which will create large flows of income for the RoW).

The same dynamics (with a peak again during 2008) are actually present in the rest of Europe as well with the periphery increasing its lost income during the Euro’s first decade and EU center (Germany, France, Netherlands) moving from a roughly balanced figure to positive net income of close to 2% GDP (which obviously increases their taxable income):

Net Primary Income from RoW - EU Center and Periphery - PIIGS

BoG recently released the Greek balance of payments for July 2015 (which is actually the first release where the data are based on ELSTAT rather than bank transactions). The release is the first after the imposition of capital controls (following the announcement of the Greek referendum) and includes some quite interesting developments.

Compared to July of 2014 the balance of payments increased to €4.25bn (from €1.27bn), an increase of close to €3bn. The major movements in specific categories are as follows:

  • The fuel balance dropped from -€726mn to -€227mn mostly due to a large fall in fuel imports of €731mn (although exports also fell €241mn). A large part of the drop is probably due to much lower oil prices compared to a year ago.
  • Purchases of ships were nil compared to €114mn last year.
  • Other goods imports fell strongly by €730mn to a little more than €2bn (while the average figure during the first 7 months of 2015 was around €2.6bn).
  • Apart from travel receipts all categories of the services balance dropped significantly, especially payments abroad (-€690mn) and transport receipts (-€700mn).
  • Secondary income receipts (basically government receipts from the EU) increased substantially by €1.75bn.

The effects of capital controls were very strong on most elements of the goods and services balances. It is helpful that exports of other goods did not seem to be affected and actually increased by €50mn. It will be interesting to observe August figures (when they do get released) to determine to what extent the drop in goods and services imports was permanent or just postdated.

The improvement of the goods and services balance was €1.24bn in a single month. As long as this improvement is permanent I think it is reason enough to not expect a large fall in Greek GDP during 2015Q3. Even a nominal drop of 6% during the third quarter (which is consistent with a fall of 5% in real GDP if the VAT increases are taken into consideration) is equal to roughly €2.9bn. In other words, the improvement of the July balance of goods and services is close to 40% of that drop. As long as the August external balance figures are also positive news it is very hard for Greek internal demand to negate the positive impact of the external sector. Third quarter GDP might actually prove to be quite resilient.

Despite the large economic losses in the Eurozone since 2008 one will hear the same constant argument: Most countries (especially those in the periphery) lived ‘beyond their means’ and the correction that followed was inevitable. Austerity might cause short-term pain but the subsequent economic recovery (however weak and thin) vindicates its use and merits.

In this short post I will take a rather simplistic approach. Since the ECB inflation target is 2% while the usual assumption about long-run growth in per capita real output is also 2% we can compare the path of NGDP per capita in European countries to a 4% trend:

Euro Countries NGDP per head

What we see is quite significant. It is true that before 2008 Greece and Spain had a NGDP path that constantly diverged from the 4% long-run trend (this pattern is especially strong in the Greek case). France, Italy and Portugal roughly followed the long-run trend while Germany quickly suffered significant losses due to its stagnant domestic demand environment and low inflation.

What is especially interesting is the path of NGDP/capita since the Great Recession. All countries seem to have suffered significant and permanent losses with their expected expansion path moving to a new and lower level. This is even more visible in the case of Greece and Italy where their projected 2016 NGDP per capita level will only be 70% of the long-term trend. Interestingly, Spain seems to be the country that has suffered the least losses compared to the trend line while France, Germany and Portugal are quite far from the 4% growth path (France at 74% while Germany and Portugal are close to 78%) with France actually growing only by 1.5% since 2012.

Yes, the path of Greece and Spain up to 2008 seems to have been unsustainable (in the context of a monetary union). Yet their correction entailed significant and permanent losses while the whole of the Eurozone is now on a new growth path at least 20-25% lower than the long-term 4% trend. Austerity and tight monetary conditions result in large output losses that are lost forever. Adding a few years of income 20-25% lower than trend implies a permanent loss of more than a year’s worth of income which in the context of a person’s lifespan is more than important.

Olivier Blanchard, the IMF’s Chief Economist who is stepping down from that position at the end of September gave an interesting interview on his term at the IMF which focused, among other things, on the issue of fiscal multipliers as one of the main topics where the IMF had to update its beliefs and change its assumptions on the relationship between fiscal consolidation and growth. Given this opportunity I would like to use this space as a small reference on the existing literature on the topic.

Up until the crisis, fiscal multipliers were calculated usually through an SVAR system IRFs based on a methodology pioneered by Blanchard himself (Blanchard and Perotti 2002) . Based on that research, fiscal multipliers were considered to be rather small with estimates ranging between 0.3 and 0.6 for tax multipliers and 0.3 and 1 for spending multipliers. The large (and persistent) output gaps since the crisis, the presence of the ZLB which limited monetary accommodation as well as the inability to devalue at least in the Eurozone countries changed the focus of the research away from a roughly balanced growth path where fiscal effects are only temporary (and Ricardian equivalence holds) and towards a methodology focused on regime-switching models, usually implemented through Smooth-Transition VARs. Early and significant contributions to this literature were made by Auerbach and Gorodnichenko whose work is still the primary reference on the subject.

Under this kind of framework, fiscal multipliers are different in downturns and upturns measured by a state variable such as the output gap. Moreover, in order to avoid bias problems, fiscal shocks were not specified using the cyclically adjusted primary balance approach (as originally used by Alesina in his ‘expansionary austerity’ papers) but rather using either the ‘narrative approach’ where fiscal shocks are determined based on the examination of policy documents to identify episodes of exogenous fiscal measures or where shocks are identified as forecast errors based on professional forecasts of fiscal policy.

Fiscal multipliers in the G-7

One of the earliest research notes on the subject was during 2012 by the IMF (which was also presented in the Fiscal Monitor of that year) on the fiscal multipliers in G-7 countries. The paper used a TVAR methodology to calculate spending and tax multipliers for six G7 countries.The results showed that multipliers are significantly different between regimes with spending shocks having a substantially higher effect on output:

Fiscal Multipliers in G-7 Economies

Growth forecast errors and multipliers

Following the strong Greek disappointment the IMF and its Chief Economist published significant research on its WEO 2012 and as a separate paper on the fiscal multipliers during the fiscal consolidation period. The idea was actually rather simple and elegant:

regress forecast error for real GDP growth on forecasts of fiscal consolidation. Under rational expectations, and assuming that forecasters used the correct model for forecasting, the coefficient on the fiscal consolidation forecast should be zero. If, on the other hand, forecasters underestimated fiscal multipliers, there should be a negative relation between fiscal consolidation forecasts and subsequent growth forecast errors

The results indicated that forecasters had significantly underestimated the impact of fiscal consolidation on economic growth and especially on consumption and investment (in other words, on internal demand):

Our forecast data come from the spring 2010 IMF World Economic Outlook (IMF, 2010c), which includes forecasts of growth and fiscal consolidation—measured by the change in the structural fiscal balance—for 26 European economies. We find that a 1 percentage point of GDP rise in the fiscal consolidation forecast for 2010-11 was associated with a real GDP loss during 2010-11 of about 1 percent, relative to forecast. Figure 1 illustrates this result using a scatter plot. A natural interpretation of this finding is that multipliers implicit in the forecasts were, on average, too low by about 1.

Table 1 reports our baseline estimation results. We find a significant negative relation between fiscal consolidation forecasts made in 2010 and subsequent growth forecast errors. In the baseline specification, the estimate of β, the coefficient on the forecast of fiscal consolidation, is –1.095 (t-statistic = –4.294), implying that, for every additional percentage point of GDP of fiscal consolidation, GDP was about 1 percent lower than forecast. Figure 1 illustrates this result using a scatter plot. The coefficient is statistically significant at the 1% level, and the R² is 0.496.

As Table 1 reports, when we remove the two largest policy changes (those for Germany and Greece), the estimate of β declines to –0.776 (t-statistic = –2.249) but remains statistically significant at the 5 percent level.

As Table 6 reports, when we decompose the effect on GDP in this way, we find that planned fiscal consolidation is associated with significantly lower-than-expected consumption and investment growth. The coefficient for investment growth (–2.681) is about three times larger than that for private consumption growth (–0.816), which is consistent with research showing that investment varies relatively strongly in response to overall economic conditions.

Overall, we find that, for the baseline sample, forecasters significantly underestimated the increase in unemployment and the decline in domestic demand associated with fiscal consolidation.

Expansionary austerity? Not so fast

Another important piece of research by the IMF is a paper which focused on the ‘expansionary austerity’ narrative championed mainly by Alesina. The paper argued that using the cyclically adjusted primary balance (CAPB) suffered from serious bias problems and using instead a narrative approach (focusing on historical data of discretionary fiscal consolidation measures) changed the impact on growth significantly, especially compared to the CAPB estimation:

The conventional approach is to identify discretionary changes in fiscal policy using a statistical concept such as the change in the cyclically-adjusted primary balance (CAPB). As this paper explains, changes in cyclically-adjusted fiscal variables often include non-policy changes correlated with other developments affecting economic activity. For example, a boom in the stock market improves the CAPB by increasing capital gains and cyclically-adjusted tax revenues. It is also likely to reflect developments that will raise private consumption and investment. Such measurement error is thus likely to bias the analysis towards downplaying contractionary effects of deliberate fiscal consolidation. Moreover, a rise in the CAPB may reflect a government’s decision to raise taxes or cut spending to restrain domestic demand and reduce the risk of overheating. In this case, using the rise in the CAPB to measure the effect of fiscal consolidation on economic activity would suffer from reverse causality and bias the analysis towards supporting the expansionary fiscal contractions hypothesis.

To address these possible shortcomings, we examine the behavior of economic activity following discretionary changes in fiscal policy that historical sources suggest are not correlated with the short-term domestic economic outlook. In particular, we consult a wide range of contemporaneous policy documents to identify cases of fiscal consolidation motivated not by a desire to restrain domestic demand in an overheated economy, but instead by a desire to reduce the budget deficit.

A comparison of our measure of fiscal consolidation with the change in the CAPB reveals large differences between the two series, and suggests that, in these cases, the CAPB based approach tends to misidentify deficit-driven fiscal consolidations.

Based on our new dataset, Section III estimates the short-term effect of fiscal consolidation on economic activity. Our estimates imply that a 1 percent of GDP fiscal consolidation reduces real private consumption over the next two years by 0.75 percent, while real GDP declines by 0.62 percent. In contrast, repeating the analysis using the change in the CAPB to measure discretionary policy changes provides evidence consistent with the expansionary austerity hypothesis. On average, a rise in the CAPB-to-GDP ratio is associated with a mild expansion in private consumption and GDP. The large difference in these estimates also arises for a subset of large fiscal adjustments––those greater or equal to 1.5 percent of GDP. These results suggest that the biases associated with using cyclically-adjusted data may be substantial.

Meta-Regression: Effects on Eurozone and Greece

Apart from presenting the results of specific papers it is also interesting to note the conclusions of a large meta-regression on the available literature on the topic. This research was also used in order to determine the actual effects of fiscal consolidation within Europe and in Greece. Its main results are:

The meta-analysis finds that the fiscal multiplier estimates are significantly higher during economic downturns than in average economic circumstances or in booms.

For example, the multiplier of unspecific government expenditures on goods and services robustly rises by an average of 0.6 to 0.8 units during a downturn. And for some specific instruments, for instance fiscal transfers, the multiplier increases by much more, turning transfers from the second least effective expenditure instrument into the most effective one. Part of the strong increase of the transfer multiplier might be explained by an increase in the share of liquidity constrained private households in downturns.

Importantly, and by contrast, there does not appear to be any such regime dependence in the impacts of tax changes. In fact, the spending multipliers exceed tax multipliers by about 0.3 units across the board in normal times and even more so in recession periods. Furthermore, during average economic times and in boom periods, the fiscal multipliers are not only lower than in downturns but also tend to vary less across different fiscal instruments.

Gechert and Rannenberg (2014) find that for all expenditure categories other than increases in unspecified government spending, the cumulative multipliers robustly exceed one in the downturn regime.

Spending multipliers tend to be larger than tax multipliers,

More open economies have significantly lower multipliers than more closed economies, and

The multipliers generally vary significantly across spending and tax categories, so that studies which look at the strength of general fiscal multipliers (or deficit multipliers) on average can produce very misleading results.

Looking into the effects of Euro wide fiscal consolidation the authors find that:

the fiscal consolidation in the Eurozone reduced GDP by 4.3% relative to a no-consolidation baseline in 2011, with the deviation from the baseline increasing to 7.7% in 2013. Thus, the austerity measures came at a big cost. By far the biggest contribution to this GDP decline comes from transfer cuts

estimated effects of EU fiscal consolidation

This is especially evident in Greece where austerity can explain more or less the full extent of the loss of output since 2009, as well as the return to growth during 2014 (since that was the time when fiscal consolidation was largely put on hold) :

We estimate that austerity almost entirely explains the collapse of Greek GDP after 2009. This result suggests that ceteris paribus in the absence of austerity, the Greek economy would have entered a prolonged period of stagnation, rather than a depression.

We find that the fiscal consolidation in Greece reduced GDP by more than 10% in 2010, with the cumulative GDP decline increasing to 28% in 2013, after which it decreases to about 26% in 2014, as – according to our estimates – fiscal austerity was relaxed somewhat on the expenditure side in 2014.

consolidation measures expenditures revenues - impact on GDP based on multipliers

Fiscal multipliers: Monetary accommodation and medium-term effects

I will end this post with a look at two more papers on the subject that do not attempt to just re-estimate fiscal multipliers for specific countries but rather to answer some important policy questions. Mainly whether monetary accommodation plays a role on the impact of fiscal consolidation (economic theory and common logic suggests it does) and how fiscal consolidation affects economic growth in the medium-term (which can have negative effects on potential output through lower growth of the capital stock and hysteresis effects on the labour market).

The first paper finds that fiscal policy is much more effective when monetary policy is accommodative. This also answers the crowding-in/out question of government spending since controlling for the stance of monetary policy can determine to a large extent the effects of fiscal measures.

Clearly, the response of output is conditional on the state of monetary policy: output increases to a large extent following a federal spending shock when monetary policy accommodates, while it falls, albeit not significantly, when monetary policy does not accommodate. This result holds over time and is consistent with the findings in Auerbach and Gorodnichenko (2012). The authors find that government spending tend to be slightly recessionary during expansions when expectations are controlled for.

Estimation results suggest that output increases by 2.5 dollars within a year for a dollar increase in federal spending when monetary policy is accommodative and decreases by 1.6 dollars when monetary policy is non-accommodative. The peak multiplier when the accommodative state prevails is equal 5.5 and only equals 2.8 under non-accommodative monetary policy.

GDP cumulative and peak multiplier

The second paper tries to study the effects of fiscal consolidation on output and employment over a 5-year period for a sample of OECD countries during periods of deep recession defined as economic contractions lasting at least two consecutive years. It  Fiscal shocks are identified using the narrative approach while separate expenditure and tax multipliers are calculated. An important contribution of this paper is the fact that it also tries to estimate employment and unemployment multipliers.

Its findings suggest that multipliers are indeed significantly larger during prolonged recessions while the asymmetry between long and ‘normal’ recessions exists mainly for expenditure based adjustments:

Our empirical findings suggest that the medium-term fiscal multiplier on output is significantly larger during PRs. Specifically, the medium-term multiplier is approximately -2 at a five-year horizon during PRs, compared to -0.6 during normal times. This means that during PR episodes a cumulative increase in the primary surplus of 1 dollar leads to a cumulative decrease in output of 2 dollars over a five-year horizon. We also find that the employment ratio persistently declines after a fiscal consolidation during periods of PR, resulting in a medium-term employment multiplier above -3 compared to -0.5 on average. The unemployment rate also persistently increases with an estimated medium-term multiplier of around 1.5, indicating that a cumulative increase in the primary surplus of 1 percent of GDP leads to a cumulative rise in the unemployment rate by 1.5 percentage points at a five-year horizon.

Our empirical results show that the asymmetry in the size of multipliers between PR and non-PR only exist for expenditure-based (EB) adjustments for which medium-term multipliers on output, employment or unemployment, are significantly higher during PR episodes compared to the average response in non-PR periods. Our results for tax-based (TB) consolidations are in line with previous literature, which finds large and symmetric effects of TB consolidations on output (Romer and Romer, 2010). These results are robust to several alternative specifications, including different definitions of the cycle, credit growth, and exclusion of countries with financial crises or with constrained monetary policy.

cumulative multiplier per variable

It is also highly significant that protracted recessions appear to have a serious impact on variables such as the capital stock, the NAIRU and (as a direct result) on potential output. Consumption, investment and private-sector employment are also seriously affected.

fiscal impulse response per variable table

Conclusions

Overall I think it is quite clear that fiscal multipliers (especially expenditure multipliers) are high and significant during times of recession and negative output gap. They are able to explain the largest part of the output losses and stagnation in the Eurozone since 2010. The ‘confidence fairy’ does not seem to exist while continued consolidation during a deep and prolonged recession can have very serious effects not only on current output but also on potential output and future growth due to its impact on structural unemployment and the capital stock. Monetary policy accommodation (which is even more important in times when the ZLB has been hit or inside the Eurozone) determined to a large extent whether fiscal policy will have expansionary results or not and answers the crowding-in/out question.

Recently I have been going through the excellent blog of Dietz Vollrath (which is mainly focused on long-term economic growth and its drivers) and have found a number of points on long-term growth which are highly related to the Greek case. As the IMF debt sustainability analysis made clear, Greek long-term growth expectations of 2% annually were based on Greece achieving a steady TFP growth rate equal to the best Euro performer (Ireland). These expectations have already proven way too optimistic and economic growth projections have been lowered to 1.5% yearly. Yet, as the DSA states, if Greece were to achieve a labor force participation rate close to the highest of the Euro area, unemployment fell to German levels and TFP growth reached the average in the euro area since 1980, real GDP growth would average 0.8 percent of GDP. As a result, any long-term growth projection higher than 1% per year seems highly optimistic and conditional on extremely favorable TFP growth rates. In this blog post I would like to explore a few of the headwinds that are likely to put a serious break on Greek long-term growth and how the structural reforms blue pill will not be able to help.

Structural Reforms long-term impacts

Before looking into specific issues let me remind people that the IMF’s own research indicates that most of the proposed reforms in the Greek case (labor and product markets) have low impact on long-term TFP growth rates. The reforms that do impact technical change and productivity in a positive and permanent manner are those that involve actually investing large sums of funds on R&D, ICT capital and infrastructure. Labor market reforms on the other hand have negative effects in the short-term and no impact on long-terms horizons yet they remain high on the reform agenda, even after Greece has already implemented a whole set of measures that have reduced labor bargaining power, minimum wages and allowed for much more flexible working conditions (something which is evident in the very large share of non-permanent work contracts in new hires):

Short and medium term impact of structural reforms on total factor productivity

Sectoral Composition and Growth

Dietz Vollrath also makes a very valid point when analyzing the services sector. He highlights the fact that when someone buys a service what he is ultimately purchasing is time, not a thing. When you buy a massage you are buying 60 minutes of a professional’s time. Increasing productivity in services is not even very difficult, it is also not desirable. We could increase productivity in schools by enlarging the number of children in each class but no parent would be overly fond of such an idea. Ultimately, what the services sector can achieve is either to increase its mark-ups by offering higher quality services (ie in restaurants and tourism) or provide massive, high productivity services (think large retail stores like Zara or large super-markets) which require closing down most SMEs and lowering labor inputs (since much less labor will be required to provide these services). In any case, both avenues require real investment and restructuring of the economy and not just having the state ‘reform and get out of the way’. Obviously taking the second route can increase productivity but at the expense of employment, markups, competition and most probably quality.

In any case, what the above highlights is that one cannot expect that economies with very different sectoral composition between services and industry can achieve comparable TFP/productivity gains without a long and painful process of economic restructuring. This is especially true in the case of Greece when compared to Ireland and Germany:

Sectoral Value Added Shares Germany Ireland Greece

* Source: OECD STAN archives

Economic Restructuring and the financial sector

Closely related to the argument above is the fact that economic restructuring (which means moving resources from low-productivity firms and sectors to high-productivity ones) requires a working financial sector. As long as banks carry a large pool of NPLs on their balance sheets they will mainly attempt to ‘postpone the day of reckoning’ and not help in moving capital towards high-growth/efficient sectors. This phenomenon is highlighted in recent research by BoE on the impaired capital reallocation mechanism in the UK. The high increase in the standard deviation of firm rates of return since the crisis is a significant indicator of such ‘distortions’:

figure 4 - SD of firm rates of return relative to change in capital stock

Obviously Japan is also another example of how NPLs can become a long-term bottleneck for economic restructuring and a drag on new bank lending and economic growth. As long as Greek banks are not properly recapitalized and cleared of their NPLs (which will probably reach €100bn) they will remain a barrier for restructuring the Greek economy and increasing long-term growth.

This is even more important for Greece because of the relative dominance of SMEs in the economy since SMEs are much more reliant on bank financing for their continued operation and growth:

Source of SME financing

Poverty and risk-aversion

Another point emphasized by Dietz Vollrath is the fact that there is a close (and probably non-linear) relationship between poverty and risk-aversion. High growth is usually closely related to high risk and opening an enterprise in a high growth/export oriented sector requires, apart from capital, risk taking individuals. As long as people face the risk of poverty and social exclusion (over 37% of Greek nationals aged 18-64 faced that risk during 2014) and are in trouble of securing their most basic needs such as food and shelter they are bound to be extremely risk averse and not willing to take business risks. You cannot have almost 40% of the population risk poverty and still expect strong productivity growth based on implementing risky and cutting-edge entrepreneurial ideas.

Sectoral Balances

Furthermore, whatever our projections about economic growth, the economy should be able to achieve it without creating (or worse, increasing) economic imbalances. One of the most basic tools to guarantee consistency on this front is to use the sectoral balances which involves the basic macroeconomic accounting identity that the sum of savings in an economy should balance to zero. In the Greek case this revolves around the fact that ‘debt sustainability’ requires a long-term fiscal primary balance of 3.5% from 2018 onwards. This large fiscal surplus requires a corresponding balance for the private domestic and external sector. Either the current account surplus will have to reach and remain at close to 3.5% of GDP or the private domestic sector will face a constant deficit of its net accumulation of financial assets.

Given the fact that Greece has achieved a current account surplus of less than 1.5% GDP and an output gap that is probably close to 10% its cyclically adjusted external position is still close to deficit. A quick way to determine that is to assume an import-to-GDP ratio of 25% and a low correlation between the output gap and exports (since the latter depend on external demand). As a result, closing the output gap and bringing the Greek economy back to potential will mean a deterioration of the current account balance by 2-2.5% of GDP which will bring it back to deficit. Consequently, achieving the 3.5% long-term fiscal primary surplus target implies a domestic private sector deficit of close to 4% GDP. Basing long-term growth on the accumulation of large imbalances is obviously not the way to make credible projections.

Fiscal financing of growth

One last thing that is related with the long-run target of a 3.5% primary surplus has to do with the simple fact that achieving high growth cannot be decoupled from the availability of public financing. An economy cannot grow without a strong and high quality public capital stock, nor without heavy investment in public education and R&D (especially since Greek growth will depend mainly on moving resources between non-tradable/tradable and low/high growth sectors). Nor can a country achieve high employment in the context of an aging population without finding ways to increase participation rates of women and people close to retirement which require financing of things such as (re-)educational initiatives and childcare (see the IMF on the related German case).

Conclusion

Overall, the point of this post is not to make any long-term projections for TFP/economic growth (a task which is clearly very hard) but rather to highlight the fact that achieving the IMF ambitious targets does not (mainly) rely on structural reforms but rather on actual investment (which requires large fund injections), financial sector restructuring, NPL clearance and reduction of poverty all while respecting sectoral balances which most probably requires an upfront debt restructuring and much more realistic fiscal surplus targets.