Monday, April 1, 2013

Keynesian "Depression Economics" Does Not Apply to the Eurozone

. Monday, April 1, 2013

I'm swamped with real work, but I have more posts on austerity politics planned. Anyway, to keep the lights on around here I thought I'd ask a simple question with (I think) a simple answer. First the set-up, then a factual observation, then the question:

The standard Keynesian case appears to be that policy blunders around the world are the result of a mistaken belief in expansionary austerity. The eurozone crisis is often provided as the exemplary case, which it would have to be because the rest of the world economy is doing more or less okay. The Keynesian case against fiscal consolidation is that it is contractionary, not expansionary, when monetary policy is at the zero lower bound (meaning interest rates are zero). That's when you get the liquidity trap, paradox of thrift, and all the rest of it. If you're not at the zero lower bound then the whole case evaporates, and what drives macroeconomic outcomes is monetary policy, not fiscal policy. If you're not at the zero lower bound then fiscal consolidation is "appropriate" (neutral actually) since it can be offset by monetary policy, although there will be distributional consequences. 

But the European Central Bank is not at the zero lower bound. In nominal terms it literally is not. Interest rates are not at zero. In fact, the ECB raised rates as the euro crisis worsened, and have since then held them steady. Quantitative easing programs have been "sterilized" by the ECB, which has taken pride in so doing. (I quote them on it in a forthcoming paper, about which more later.) All of the evidence which supports being in a liquidity trap -- sovereign yield at zero or even negative real rates, etc. -- at best only asymmetrically applies to the eurozone.

None of this is news, but so much eurozone commentary doesn't start from the position that the story is monetary rather than fiscal. So all this commentary ignores the fact that the entire Keynesian "depression economics" structure, which takes as a precondition the presence of a liquidity trap, does not apply to the eurozone crisis. Not one bit. The entire problem is monetary rather than fiscal, according to Keynesian economics. Belief or non-belief in expansionary austerity is a total non-issue.

So here's the question: why aren't we all talking about the distributional monetary politics within the eurozone rather than debating this or that fiscal policy?


Vladimir said...

I won't presume to speak for other readers but at least Kindred and I are following different public commentators. Every major critic of austerity I can think of, has pointed out the failure of ECB to do enough to stabilize aggregate demand. If there is a focus on fiscal policy it is in my opinon because fiscal policy is something that political action can change in the short run via the democratic process. The ECB has the protection of its founding statue to hide behind. The people of Italy or Spain cannot in the short run expect to change the ECB's mandate or the daily operation of monetary policy. If the ECB is acting like it's at the zero bound i.e. interest rates can't go down , then as a practical matter the Keynesian framework is useful. A second point. When critics do discuss the redistributional effects of monetary policy they're discussing how it's manifested across countries: how the current policy may benefit Germany but hurt Italy. That is entirely different than focusing on how it affects segments of the population across the Eurozone. It would be interesting to see if there are complimentary benefits to particular socio-economic groups from the prevailing monetary and fiscal policies.

Kindred Winecoff said...

"If there is a focus on fiscal policy it is in my opinon because fiscal policy is something that political action can change in the short run via the democratic process."

My point is that in standard (non liquidity trap) economic models a change in fiscal policy should have little or not growth on macroeconomic aggregates. The central bank moves last. If a fiscal authority increases spending and then the central bank tightens, then the stimulative effect of the fiscal expenditure is offset by contractionary monetary policy. Everyone is saying that the ECB is pursuing tight monetary policy in order to keep inflation very low. Given that, the effect of fiscal expenditure should be more or less nil: the ECB will offset it. So I think this part is false as well:

"If the ECB is acting like it's at the zero bound i.e. interest rates can't go down , then as a practical matter the Keynesian framework is useful."

This presumes that the ECB is constrained by some *upper* bound. But it's not, and has tightened policy, to everyone's chagrin, on numerous occasions.

That's the whole importance of being in a liquidity trap. In a liquidity trap, fiscal policy is effective *because* monetary policy is not effective. If monetary policy is effective then fiscal policy is not.

The ECB is not in a liquidity trap. The ECB is fighting inflation. So attempts to stimulate the economy using fiscal policy will not be effective so long as the ECB offsets them by tightening monetary policy to fight inflation. This is true in Keynesian models, monetarist models, rational expectations models, all of them. (At least I think it is. If I'm wrong I'm sure someone will point it out.)

"It would be interesting to see if there are complimentary benefits to particular socio-economic groups from the prevailing monetary and fiscal policies."

I agree. It's not just Germany vs Spain.

Aidan said...

Two points:

1. I think you're using "Keynesian 'depression economics'" in an imprecise way - if you look at Krugman's "The Return of Depression Economics," for example, he clearly doesn't believe that fiscal policy is the correct response in every depression scenario. So the zero lower bound scenario might not be applicable, but that doesn't mean we have to throw the Keynesian baby out with the bath water.

2. I think you make solid points in this post, but I just have to quibble a little bit. My understanding of the Keynesian case is that a) under most circumstances, fiscal austerity can and will be offset by expansionary monetary policy, b) there are conditions where the central bank is unable to FULLY offset fiscal contraction, and c) there are scenarios where central banks have the ability to offset (or further offset) fiscal contraction (or expansion) but don't. Yesterday Krugman argued that Europe's "obtuseness on fiscal policy is derived in part from the broader European obtuseness on monetary policy" - that because the ECB lacks a dual mandate, is unwilling to tolerate higher inflations, prematurely raised rates in 2011 and refuses to lower them, etc., fiscal austerity is harming European economies because the ECB won't offset its effects.

I know there can be some inconsistencies in the way Keynesians discuss these issues, but I think that most Keynesian discourse I've read has placed the majority of the blame in Europe on the ECB and on the folly of having a monetary union without a fiscal union. I don't think there's an inconsistency in thinking that Europe's problems are mostly monetary but that the the bulk of the damage is being caused by tight fiscal policy in the absence of monetary accomodation, or even that fiscal policy is too tight but expansionary fiscal policy won't work.

Kindred Winecoff said...

1. may be correct. If I read him right, Krugman (and those who think similarly to him) use the term "Depression economics" to mean that during depressions "normal" economics doesn't work, so policy needs to be open to other policies. Among them, at least sometimes, are fiscal mechanisms. "Depression economics" is defined, in part, by the inability of monetary authorities to stabilize aggregate demand -- the liquidity trap. The implication is that during non-depression periods fiscal policy is irrelevant since the central bank moves last.

All I'm doing is extending that same basic framework to the current situation, while noting that the ECB is still moving last, and has a revealed preference for things other than stabilizing aggregate demand. Therefore, fiscal stimulus is unlikely to work even if it was tried.

It is true that the eurozone is far from full employment, so fiscal policy *could* work. But not if the ECB cuts its legs out from under it, which it seems likely to do.

2. This point -- with which I agree -- is really the conversation I want to have. I have two basic audiences in mind with these posts: left-liberal economists, and comparative politics folks. The former believe that policy is misguided because the ECB has a single mandate. The latter think that same policy is (or was at any rate) necessary for the furtherance of the European project. You can't have one without the other.

So I'd like the debate to be about the *function* of the ECB, which is central to the entire European project; probably the most central element of it in its 21st century manifestation. So the left-leaning economists are maximizing the wrong optimization problem: it's not full employment and high aggregate demand that is the goal, it's political union.

If the crisis is understood that way the Keynesian playbook goes out the window. It's irrelevant. It doesn't have the right dependent variable.

So this makes little sense: "most Keynesian discourse I've read has placed the majority of the blame in Europe on the ECB and on the folly of having a monetary union without a fiscal union."

I agree that that's what they're saying, but it's wrong. It's not the ECB's fault... they're just doing what they're told. It's not "Europe's" fault, and it's not folly either; these are the conditions under which political union is possible, and political union is the goal.

What I'd like the comparativists to think about is whether political union is really desirable (or stable) under these conditions. I think some of them are starting to ask those questions, but this requires a fundamental re-think of the past 50 years of European integration efforts, so it's no small ask.

Aidan said...

I still think you're partially mistaken on point 1, or at least you're operating under a simplistic view of Keynesian depression economics. Look at some of the biggest proponents of the liquidity trap view: Krugman, Simon Wren-Lewis, etc. None of them argue that the ECB is out of ammo fiscal stimulus is the only option. They blame the ECB for raising rates in 2011 and not lowering them now or allowing higher inflation. You can argue that neither of those is consistent with the ECB's mandate so they can't be blamed, but I'd still blame a police officer with a hose for allowing a house to burn down even if it's technically someone else's responsibility. I see Keynesians and market monetarists as having basically identical criticisms of the ECB, and both argue that the ECB isn't doing everything it can to stabilize NGDP growth.

I do think you're correct that the success or failure of fiscal policy largely has to do with the discretion of monetary authorities. I've argued several times with Scott Sumner on this point, but I think monetary offset in the United States is much less likely because Bernanke and Yellen have repeatedly argued for expansionary fiscal policy to Congress and because it wouldn't be consistent with the Fed's dual mandate. It's far likelier in Eurozone because of the ECB's single mandate (more on that later, and I don't think they should be let off the hook as easily as you do). However, I think this is basically the least of Europe's worries as long as the central bank has proven itself indifferent to terrible unemployment and growth. If the Keynesian playbook for Europe was simply fiscal stimulus, your critique would be entirely on point, but that just isn’t correct.

Point #2 is an interesting discussion. I would say that a political union that is only compatible with continually underperforming economies is not a sustainable model. I don't think I’ve heard the argument that a unified Europe is entirely dependent on a central bank only concerned with price stability at the expense of stable NGDP growth and functioning labor markets. I’d like to see an explanation of the comparative politics people's reasoning on that point. What is the incentive for peripheral countries to remain in the Euro if it means unending economic disaster? How do political leaders convince their constituents that a political union that requires their unemployment is a mutually beneficial union for all members? What happens when that unity inevitably breaks down?

Aidan said...

I had to break this up into two parts for character count purposes...

Why I don't think the ECB should be left off easily: they aren't even hitting their supposed inflation target. If undershooting their mandate is acceptable, then why isn't overshooting it a bit if it would be helpful to the economy? And this hasn't been unique to the ECB. One of my big problems with single price stability mandates is that central banks are perfectly willing to allow too-low inflation even if hurts the economy and then use the sanctity of the mandate as an excuse for inaction.

I do think that central bank mandates is the biggest issue here. To my eyes, the biggest lesson in comparing the performances of the United States and Europe in the past few years is that a single price stability mandate is disastrous in depression conditions. It drives me absolutely nuts that there are plenty of people, including elected politicians, who want to force that single mandate on the Fed. If people don't like the idea of a price + unemployment dual mandate, I think the single NGDP mandate is a good idea. If your central bank has plenty of tools at its disposal to alleviate mass human suffering and fight a depression and likely lost decade and then argues that that isn't its responsibility, then there is something badly wrong.

Kindred Winecoff said...

I might be wrong about #1. But I don't think so. Krugman keeps talking about how Europe is in a liquidity trap. He also talks about how the ECB should be doing more. This makes no sense. Either "liquidity trap" means something or it does not.

I don't know if I'm saying the ECB should be let off the hook. I'm saying they are responding to the political dynamics in the EU. The ECB is no longer an independent central bank. In fact, they never were. The ECB is highly politicized, so their actions should be understood in that light. They are not just a central bank now; they are an extension of German/French bargaining in negotiations with all the Southern economies.

Given that, it makes little sense to keep ranting about suboptimal policy choices. That's missing the point. So, for me, this does not compute:

"If undershooting their mandate is acceptable, then why isn't overshooting it a bit if it would be helpful to the economy?"

The ECB has always erred on the side of undershooting, as did the Bundesbank before it. This is not a surprise.

Kindred Winecoff said...

Also see my most recent post, which was inspired in some ways by your comment. I think this is probably the best way to think about this.

Aidan said...

Final point about liquidity traps - whether or not Europe is in one, it's not inconsistent to argue that central banks can do more in a liquidity trap. Indeed, people who believe in the liquidity trap and people who don't have pretty much the same idea about what to do in Europe right now. But I don't think that's the big issue to focus on with Europe right now. I probably agree with you on this point. I'm basically nitpicking on this.

I also completely agree with everything in your latest post. I guess the argument we've been having seems kind of irrelevant in light of this.

Keynesian "Depression Economics" Does Not Apply to the Eurozone




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