You are currently browsing the category archive for the ‘macro’ category.

So it is more than clear that European creditors of Greece are continuing to demand long-term primary surpluses around 3.5% of GDP. One has to ask: What’s so special about this number? Why can’t it be lowered a bit and give Greece more breathing space?

The answer is quite simple:

2% interest rate x 180% debt to GDP = 3.5% of GDP/year

The 3.5% primary surplus target is the one consistent with maintaining the debt-to-GDP ratio stable when the nominal GDP growth rate is zero. This means that Greece can  withstand shocks to its nominal growth rate (negative real GDP growth or a deflationary shock) and still manage to keep its debt ratio stable. Obviously, as long as it manages to achieve positive nominal growth its debt ratio will decline each year while privatization receipts will lower debt even quicker.

From a slightly different point of view, the 3.5% target provides insurance to European creditors that any short-term failures of the Greek program will not lead to an increase of the debt ratio, only to a flatter decline path. The risk of the Greek program not achieving its ambitious targets is pushed on the back of Greece while its creditors can keep the upside of any positive shocks that will improve debt sustainability.

Yet again one observes that the Greek issue is mostly a political rather than an economic issue. It relates to the question of who provides insurance regarding the program targets. Since European creditors appear unwilling to provide such insurance my feeling is that agreeing on a lower target will prove substantially difficult, especially in the current political climate across Europe.

So the IMF decided to publish its views on the size and path of Greek budget surpluses. In a nutshell, it still thinks that only a 1.5% primary surplus target is credible in the long-run and even that target must be accompanied by «growth-enhancing» budget reforms, including a lower tax-free income threshold and a reduction in pensions in order to lower state transfers to the public pension system.

Yet if Europeans and the Greek government «agree» on a higher surplus target (the 3.5% target agreed by the recent Eurogroup meeting) then the latter has to legislate measures upfront in order to make that commitment credible.

My first comment is to state the obvious fact that there really doesn’t exist any sort of «agreement» between the Greek government and its European partners. Rather, European countries would like to avoid any actual debt relief and thus will demand higher surplus targets than those that are reasonable from an economic standpoint. It is quite obvious that the Greek government is the weak side of this bargain and, as long as the IMF thinks that any target above 1.5% does not make economic sense, it should pressure the Europeans (who are the strong side in this debate) into accepting deeper debt relief, instead of standing ready to work with any surplus target they demand from the Greek side.

The IMF cannot claim to be a neutral technocratic institution and yet sign-off budget balance targets which it clearly believes to be unrealistic from a technical point of view only because they seem to be the only ones «politically acceptable».

Turning to the specific details of the IMF analysis, there are a couple of points to be made.

The IMF believes that the tax-free income threshold is quite high in the Greek case, which results in more than half of the wage earners to be exempt from income taxes (while the Eurozone average is close to 8%):

tax-free-income-threshold-in-euro-area

Its proposal is to lower that threshold significantly in order to be able to reduce the «high marginal tax rates». My objections are two-fold: First, the IMF does not insist on such a reduction in order to strengthen the revenues of the social safety net and lower the tax rates of middle-income wage earners. Rather, it would like to see the additional revenue being used in reducing the tax rates of high-income earners (which stand at more than 50% if the solidarity tax is taken into account). Thus it is actually proposing a post-tax income redistribution from the low-income earners to the top. In the IMF view such a redistribution will be «growth-enhancing» although I personally fail to understand how its effects will be anything else but contractionary, at least in the short-term, since it will by definition redistribute income from persons with a low saving rate to individuals with a higher saving rate.

Moreover, Greece displays one of the highest «risk of poverty» rates in the Eurozone which is close to 36% (and is actually even higher for people 16-54 years old) as well as a significantly high Gini index. As a result, a reduction of the income threshold, especially if it is not used to strengthen the social safety net significantly, will result in a rise of the post-tax poverty rate and income inequality with ambiguous medium/long-term growth effects.

The second point of the IMF is that Greece makes budgetary transfers to the pension system that are many times higher than the rest of Europe, at 11% of GDP compared to 2¼ for the Eurozone.

Greece - State Transfers to Pension System.jpg

Although it is difficult to deny that the Greek pension system is expensive, unequal and in need of reform, it is still true that the above analysis does not take the state of the economy into account. According to the latest Eurostat figures, Greece still posts an output gap of -10.5% compared to only -1% for the whole of the Euro area. As a result, a large part of the budget transfers to the pension system are not structural but cyclical, due to the high unemployment level (close to 25%) and the significant incidence of part-time, low-paying jobs for the individuals who are actually employed.

Based on the latest statistics for wage earners (March 2016), the part-time employment share is 29% (532 thousand persons) with an average salary of 405€ while the full-time average is 1220€ (1300 thousand persons). At the same time, the average old age monthly pension is close to 800€. It is obvious that no pension system would be able to survive without significant state transfers given the level of unemployment and under-employment present in the Greek economy.

One way to compare Greece with the rest of Europe in a cyclically-adjusted manner is to calculate old age pension expenditure as a percentage of potential product. This is exactly what I have done in the following table (nominal potential product is equal to potential output multiplied with the actual GDP deflator):

old-age-pension-expenditure-potential-product

We can see that pension expenditure actually compares quite favourably with other European countries such as France, Italy and Portugal.It is thus probable that a large part of the state transfers are the result of the large economic slack present in the Greek economy. That suggests that Greece primarily needs cyclical relief (through lower surplus targets for instance) rather than an upfront deep structural reform.

So it seems that Europe and the IMF have found a way to guarantee the presence of the latter in the Greek economic program. The SMP and ANFA profits of the Greek bonds held by the Eurosystem (which are no longer returned by European governments to Greece) will be used as a guarantee for the IMF loan repayments.

These profits amount to more than €10bn in total up to 2020 while the total amount currently due to the IMF is 11.3bn in SDRs (about €14.3bn at current exchange rates).

amounts-to-be-transferred-by-european-central-banks-eurosystem-from-anfa-and-smp-profits

Since the IMF insists that only a 1.5% of GDP primary surplus is reasonable in the long-run (for Greece), my assumption is that this amount (which currently stands at €2.7bn annually) will be added to the SMP/ANFA profits and provide a guarantee for the IMF (in effect the IMF will have a senior claim on these financial resources). The IMF needs to be able to guarantee its repayment (either through such measures or by maintaining the the Greek debt is sustainable with high probability) in order to stay in the Greek adjustment program.

That way the Europeans will be able to include the IMF in the Greek program without having to satisfy its recommendations for a long-run primary surplus of 1.5% GDP and a larger debt restructuring. This is made easier by the IMF itself who insists that only a 1.5% surplus target is realistic (politically) but if Europe wanted to avoid it then it would have to impose further consolidation measures on the Greek budget. These include more cuts on pension expenditures, a reduction of the exemption on income tax and lower public wages (a total of €4.5bn in additional cuts).

The end result will be that Europe will avoid having to perform any serious debt restructuring in the short-term, include the IMF in the Greek program and face the 2017 election cycle without serious concessions to the Greek side. It will insist on maintaining the 3.5% surplus target for the foreseeable future and place (again) all the adjustment burden on Greek shoulders regardless of the fact that such a target makes no economic sense.

The IMF view that Greek debt was unsustainable, the surplus targets unrealistic and serious debt restructuring necessary did briefly open a window for the return of economic logic in Europe. My feeling is that this window is quickly being closed by Europe which will insist on maintaining the current unrealistic course just because the alternative is difficult politically.

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.

 

 

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.

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

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.

A few days ago, this article would have started with the statement that Grexit is closer than ever. Today it seems that Grexit has been postponed for a few months. Yet I fail to understand the underlying strategy of the Greek government since the proposed austerity measures (along with capital controls and low confidence) are destined to push the economy in a deep recession. This recession will make achieving the primary surplus targets even harder and government debt clearly unsustainable (even based on the IMF’s quite optimistic projections). The current program will fail in 2016 and Grexit will come back on the table with a Greek government that enjoys a much more fragile domestic political support and an even weaker economy with a higher output gap.

Probably the biggest problem of returning to the drachma is the fact that there are certain (probable) scenarios where the economy almost collapses and others where we observe the usual path of a large devaluation following an unsustainable currency peg: A short-lived large fall in output followed by a long path of economic growth. Usually people will just choose the scenario that fits their story and ideology and not consider (or even imagine) any other possible paths. The ‘ugly scenario’ basically includes official creditors accelerating Greek debt in the form of EFSF loans and the Greek Loan Facility. That will push Greece in a permanent default state and most probably not make it able to accumulate any foreign reserves (since they would be claimed by creditors). EU structural funds will most likely be lost and Europe will not support the newly created currency exchange rate in any way. Greece will have to function in a ‘semi-pariah’ state with strict and permanent capital controls and an economy that will slowly lose most of its human capital and internationally oriented sectors (such as shipping).

In this blog post I will not analyze the above scenario any further but rather take a closer look at a controlled exit from the Eurozone which will include the help of the other Euro member countries (if not for anything else but to enhance the recovery of their official loans).

First of all let me remind people that currency movements happen mostly because of large gross capital flows and not due to the underlying real trade flows (this paper from BIS Claudio Borio is quite informative). Capital flows, at least in the short-term, will happen for only a few reasons:

  • RoW liquidating domestic claims in order to transform them in foreign currency (think of other Euro banks not rolling over repos with Greek banks or equity investors exiting the Greek stock exchange).
  • Domestic firms and households trying to exchange their liquid assets (mostly deposits) for foreign currency.
  • Institutional players taking large currency positions. This requires being able to borrow large amounts of the currency that will be shorted at favorable terms.

In the Greek case we know that a Grexit will happen under strict capital controls (which are already present), while the terms and price (interest rate) under which the RoW will access the drachma will be determined exclusively by Bank of Greece. Since drachma does not exist in any way, a Eurodollar market is not present and cannot help anyone to circumvent capital controls. Private players outside Greece have already liquidated most of their claims (either equity or interbank loans) while the bulk of Greek liabilities are long-term official loans by other Eurozone member countries. The same is true to a large extent for Greeks themselves who have moved large amounts of liquidity outside Greece. This is the main reason why BoG has more than €120bn in liabilities towards the Eurosystem (Target2 and extra banknotes combined).

As a result, coupled with the presence of capital controls and the fact that Greece already has a strong current account surplus (on a yearly basis) there is actually small scope for strong pressure on the exchange rate of a newly introduced drachma. It is probably one of the few times that capital controls can truly be used as a policy tool and not to trap large funds looking for a way out (as was the case in Iceland). As long as outstanding Greek debt to the ECB (in the form of SMP bonds) and the IMF is rescheduled in the form of a long-term loan by the ESM, the GLF spread over Euribor is lowered to  5bps and interest payments postponed until 2020 (as has already happened with the EFSF loan) Greece will have truly minimal refinancing needs (in terms of foreign currency obligations) for the rest of the decade and be able to slowly accumulate FX reserves through its current account surpluses.

The main subject where a host of different opinions exist is what will happen with ELA financing by BoG and the corresponding liabilities towards the Eurosystem. The story usually goes that BoG will have to default on these liabilities and the Eurosystem having to perform a large capital injection. In my view any such claim is most probably false, at least in the favorable scenario. EU already has an exchange rate mechanism for EU members that do not participate in the Euro area but wish to maintain a controlled exchange rate relationship, called ERM II. This mechanism defines a ‘central exchange rate’ with the Euro, with a fluctuation band of +/- 15%. Intervention at the margins is automatic and unlimited while a short-term financing facility exists with a maturity of 3 months (which can be renewed at least once):

for the currency of each participating non-euro area Member State (hereinafter ‘participating non-euro area currency’) a central rate against the euro is defined;

there is one standard fluctuation band of ± 15 % around the central rates;

intervention at the margins is in principle automatic and unlimited, with very short-term financing available.

For the purpose of intervention in euro and in the participating non-euro area currencies, the ECB and each participating non-euro area NCB shall open for each other very short-term credit facilities. The initial maturity for a very short-term financing operation shall be three months.

The financing operations under these facilities shall take the form of spot sales and purchases of participating currencies giving rise to corresponding claims and liabilities, denominated in the creditor’s currency, between the ECB and the participating non-euro area NCBs. The value date of the financing operations shall be identical to the value date of the intervention in the market. The ECB shall keep a record of all transactions conducted in the context of these facilities.

The very short-term financing facility is in principle automatically available and unlimited in amount for the purpose of financing intervention in participating currencies at the margins.

For the purpose of intramarginal intervention, the very short-term financing facility may, with the agreement of the central bank issuing the intervention currency, be made available subject to the following conditions: (a) the cumulative amount of such financing made available to the debtor central bank shall not exceed the latter’s ceiling as laid down in Annex II; (b) the debtor central bank shall make appropriate use of its foreign reserve holdings prior to drawing on the facility.

Outstanding very short-term financing balances shall be remunerated at the representative domestic three-month money market rate of the creditor’s currency prevailing on the trade date of the initial financing operation or, in the event of a renewal pursuant to Articles 10 and 11 of this Agreement, the three-month money market rate of the creditor’s currency prevailing two business days before the date on which the initial financing operation to be renewed falls due.

My view is that in the case of a Grexit current BoG liabilities towards the Eurosystem will be transformed into a long-term financing facility, capped somewhere close to their current level. BoG will have to pay interest to the Eurosystem, either the 3-month rate applicable to ERM II financing facility or the MRO (as it happens today for Target2 liabilities) with the clear agreement that BoG will use its FX reserves in order to slowly pay back the facility (through annual current account surpluses). This will obviously mean that BoG financing towards Greek banks will remain significant, absent a domestic QE program. Short-term financing by the Eurosystem will be provided in order to facilitate temporary FX needs (the Greek current account is actually in deficit during the first months of a year) and to allow the smooth payment of government liabilities denominated in Euros. Obviously this financing facility will be capped for intramarginal interventions.

As long as the central rate is reasonable and both sides are determined to defend it through monetary policy (interest rates), capital controls and automatic interventions, confidence on the drachma will quickly be strengthened and domestic players will have little reason to try to convert their assets into foreign currency.

Obviously one important problem is the fact that creating the actual physical currency will take time. Electronic payments as well as the over €50bn in Euro banknotes circulating in Greece right now (for a GDP of less than €179bn) will help minimize the short-term impact.

Although I hope the above will remain only a scenario exercise, it is my view that, given the political climate inside Europe and the short-term economic reality, Grexit will emerge again during 2016, especially if the current package is not accompanied by serious debt restructuring.