Thursday, April 28, 2011

The Politics of Hard Keynesianism in the E.U., Part Two

. Thursday, April 28, 2011

I posted yesterday on how I see the short-run political dynamics of the EU political economy, and why specifically why a holding pattern until 2013 makes some sense for EU leaders. At some point the EU will likely need to decide whether to contract membership or expand its political reach, but that decision doesn't have to be made immediately, and won't be due to local political pressures in member states.

This was all in response to an article by Henry Farrell and John Quiggin in Foreign Affairs that proposed a "Hard Keynesian" legal-institutional overhaul to the eurozone Stability and Growth Pact, that forces a build-up of surpluses during expansions so that states have necessary fiscal flexibility during downturns. That, in turn, should prevent the huge debt pressures that now threaten the integrity of the monetary union. (Note: As usual at Crooked Timber, the comments are well worth reading. Daniel Davies corrects some misconceptions I had about the Irish banking sector, and others responded with some points about the Irish economy that I'm drawing from here.)

What I didn't get around to yesterday was discussing the political feasibility of the Farrell/Quiggin proposal itself. It's certainly an attractive technocratic solution, at least in some ways, but that doesn't necessarily mean that the necessary commitment from member states is credible, which means that a first-best technocratic solution may not be feasible. The Stability and Growth Pact, which intended to serve much the same purpose, certainly wasn't. Farrell and Quiggin admit that monitoring and enforcement capabilities will be necessary, but they're light on specifics. But before getting into the necessary institutional design, I think it's worth asking what is meant by Hard Keynesianism.

As I understand it, Hard Keynesianism (aka "Keynesianism") argues that states should build up "rainy day funds" that can be drawn down when economies are stressed. Essentially, this requires a counter-cyclical fiscal policy to match a counter-cyclical monetary policy. This is similar to the budget requirements of U.S. states, many of which have constitutional mandates to maintain balanced budgets. Since maintaining a balanced budget is very painful during recessions, states often try to build surpluses during expansions. For national governments, this will often mean paying down debt during expansions, and expanding debt during recessions.

The graphic at the top of this post shows the Irish debt-to-GDP ratio, as reported by Ireland's National Treasury. From 1993-2007, Ireland slashed its debt as a percentage of GDP by 70 percentage points. From 1999, when Ireland joined the euro, to 2007 Ireland's debt-to-GDP ratio nearly halved. That's a huge reduction in a short period of time, and any EU "Hard Keynesian" rule would surely consider a debt-to-GDP ratio of 25% to be acceptable. (And if it didn't, of the EU27 only Bulgaria, Estonia, and Luxembourg would be in compliance as of the most recent EU data.) Moreover, this report (linked to by Quiggin in comments at CT) indicates that as of 2007, Ireland ran government surpluses in 10 of the previous 11 years. Quiggin argues that this Keynesianism isn't hard enough, but then what would be? Until the bust, Ireland was the shining example of fiscal rectitude in the EU. How could Ireland's leaders have persuaded voters in 2005 that following all that debt reduction, what was really needed for economic health was to raise taxes and cut spending? Especially considering that much of Ireland's debt reduction came from high growth rates, which were attributed at the time to supply-side factors, not Keynesian counter-cyclical policies.

Also in comments at CT, Farrell linked to this discussion of former Irish Finance Minister Charlie McGreevey's famous maxim: "When I have it I spend it, and when I don't, I don't". The conclusion of the article is that this "negligence" and "madness" was embedded into the culture of Ireland during the Celtic Tiger days:

In the space of a generation the Irish had gone from a people that saved before they bought, questioned any extravagance, and were wary of debt, to a nation only too happy to blow their paycheque on nights out, put the bills on the credit card, and become sodden in debt to buy their dream home and all the trimmings in one go. For a long time the Irish had been a people who simply didn’t have it to spend. Now that we had it, by god we were going to spend it.

The author, Cian O’Callaghan, attributes this shift in mentality to some sort of neoliberal voodoo, but I imagine the Irish citizens didn't need a lot of persuading. After all, other countries went through the same thing. The U.S. shifted from decades of budget deficits to a brief moment of surplus after following a classic counter-cyclical Keynesian policy in the 1990s. It raised taxes on the rich, cut some welfare programs and defense spending, and didn't reinvest the tax proceeds that came from robust growth. It was the height of center-left technocratic management, in the U.S. at least, and it wasn't very popular. Those that were created those policies were first impeached, and then voted out of office in 2000, in favor of the candidate who promised to blow through that surplus by cutting taxes. Arguably this was the proper Keynesian choice too, considering the US was in recession, but the move back to balance (much less surplus) never happened.

I don't think this has much to do with neoliberalism per se. To the contrary, neoliberals have generally been perjoratively accused of forcing balanced budgets (or at least reduced deficits) on others, through the IMF or otherwise. I think it has more to do with the fact that the politics of surpluses is very bad for the technocrats. There is no constituency built around "surpluses in good times". There are plenty of constituencies built around "lower taxes" or "more generous pensions" or "smaller class sizes" or "more funding for alternative energies" or "more aid to the developing world" or ______________.

Viewed in a certain way, we can think of the maintenance of a budget as a common pool resource: we'd be collectively better off in the long run if everyone could commit to maintaining balance (or surplus) in good times as insurance, but we're all individually better off in the short run by defecting. In democracies, the incentives for legislators will always be to appease their constituents via tax cuts or spending increases. So this could be viewed as a collective action problem of sorts*.

Of course it's possible that a major crisis could shake that political equilibrium long enough to erect legal and institutional reforms that lock in the technocratic solution. Perhaps the debt crisis is such an event. If ever there was one this would probably be it. The Germans want to ensure they won't always be on the hook for bailouts in the periphery. The indebted in the periphery need funds to such a great extent that they may accept significant restraints on their future sovereignty in exchange. It's not clear that the Germans want such a Hard Keynesian rule, much less that they'd have much leverage over the EMU17 legislatures that *aren't* in need of bailout, but let's just pretend that interests are sufficiently aligned for this to happen.

Obviously such a rule needs an enforcement mechanism that doesn't require collective action, or else we're right back where we started. This was the problem with the Stability and Growth Pact. But what sort of mechanism would that be? The power to sanction? To levy tariffs? Fines? The best bet would seemingly be the withholding of Structural/Cohesion funds, but those apply to the whole EU27, not just the EMU17. And why would the legislators in periphery states not receiving EFSF funds agree to this? That could have worked

There is one final issue I wanted to cover, and that is that this particular crisis was so severe that no prior Hard Keynesian arrangement could possibly have contained it, so any technocratic mechanism runs the risk of being anachronistic: observed when it's not needed, and neglected when it is. But this is already too long, so I'll have to save that for another day.

*I tend to not like this sort of framing of distributional issues, but I'm trying to present a technocratic objection to a situation that was mostly presented as a technocratic problem.


John Quiggin said...

On the political point, Australia has managed to do a bit better than Ireland in terms of fiscal surpluses, despite not having such a spectacular boom. And, having introduced a large stimulus in 2009, we are now headed back to surplus in a year or two. So, I don't see hard Keynesianism as unsustainable.

And even in the US, it's arguable that a win for Gore in 2000 would have produced sustained surpluses, enough to produce a much better response to a financial crisis like the one that actually happened.

Kindred Winecoff said...

I agree that under a different constellation -- say, Gore defeats Bush -- things might've been different. But in order for this to work you can't have it in some places some of the time. You need it in the whole union all of the time. To get that you unanimity during the creation of the rule, then need a credible enforcement mechanism to govern it after. This was the problem with SGP. That requires a level of political consensus that I just don't see right now.

Ie, I believe you when you say that something like this has worked in Australia. But what's the mechanism driving that result? How well does it map onto the EU periphery? Those are the important questions.

And I still don't think it would've saved Ireland or Greece. The former because this shock was just too big to have been mitigated by any feasible Keynesian rule. The latter because they wouldn't've been in compliance with it in the first place.

The Politics of Hard Keynesianism in the E.U., Part Two




Add to Technorati Favorites