If there is a debt buyer-of-last-resort â someone who can purchase unlimited amounts of debt â the suspicion will dissolve and investors are pleased to hold the ...
Università degli Studi di Trieste Corso di Laurea in “Scienze Politiche e Relazioni Internazionali” – L-36 Tesi di laurea
“Austerity: Economic Policies of the European Union” Laureando Lorenzo Navarini
Relatore Professoressa Grazia Graziosi
Anno accademico 2016/2017
Even if we act to erase material poverty, there is another greater task, it is to confront the poverty of satisfaction - purpose and dignity - that afflicts us all. Too much and for too long, we seemed to have surrendered personal excellence and community values in the mere accumulation of material things. Robert Fitzgerald Kennedy, University of Kansas, March 18, 1968
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ABSTRACT The dissertation, Austerity: Economic Policies of the European Union, discusses the political and theoretical origins, the reasons and the nature of austerity measures, as implemented in European countries after the economic crisis. In the first part, it is proposed a classification of the European countries, within and outside the Eurozone. It is outlined the process of convergence of Central and Eastern European Countries and the process of divergence between the Eurozone countries. Furthermore, it is presented the degree of imbalances between European countries and the economic and political issues. To sum up, the first part – Chapters 1, 2 and 3 – highlights the reasons why European governments would have needed to implement austerity measures. In the fourth chapter, it is discussed the role and the dynamics of the 2007-2008 economic crisis and the sovereign debt crisis. There is an assortment of the contributions of many economists’ ideas on the nature and the major features of these crises. In the fifth chapter, austerity is defined and classified as an economic policy. After the definition of fiscal contraction, it has been collected a considerable number of positions and ideas of economist on austerity as a successful or damaging measure. The classification is shaped by four characteristics. It is divided into fiscal consolidation and internal devaluation and it is contained the cases of Ireland and Latvia. Moreover, it is outlined the theoretical discussion about austerity, with contributions by many schools of thoughts. Indeed, it is presented the view of Keynesian and non-Keynesian economists on austerity and economic policies in times of crisis. In the last chapter, it is presented the main effects of austerity measures and a critical review of these policies. The economic issues and the consequent political issues are important to define the future of the European Union and its upcoming challenges.
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INDEX Abstract ................................................................................................................................ 3 Summary of the thesis in Italian .......................................................................................... 6 1
2
3
European Union and its structures ............................................................................... 8 1.1
European Union and its features ........................................................................... 8
1.2
Core and periphery of the European Union ......................................................... 12
1.3
Classification of the European countries .............................................................. 13
European Peripherical Countries outside Eurozone (EPC OE) ................................... 16 2.1
Central European and Eastern Countries and their economic structures ........... 17
2.2
Convergence or catch-up process ......................................................................... 19
2.3
Balassa-Samuelson effect in CEECs: tradable and non-tradable sectors. .......... 23
European Peripherical Countries within Eurozone (EPC WE) .................................. 26 3.1
Eurozone and interest rates: a process of convergence? ..................................... 29
3.2
Optimal Currency Area Theory ........................................................................... 32
3.3
A process of divergence ....................................................................................... 40
3.3.1
Productivity and competitiveness ................................................................. 41
3.3.2
Prices and wages........................................................................................... 42
3.3.3
Labour divergence and mobility................................................................... 44
3.4 4
5
Asymmetric crisis within Eurozone ..................................................................... 46
Financial Crisis in European Union ............................................................................ 48 4.1
Spreading the crisis in European Union: PIIGS .................................................. 53
4.2
From Private to Public: banking system and sovereign debt ...............................57
Austerity: economic policies of European Union. ...................................................... 60 5.1
Definition: Contractionary fiscal policy............................................................... 60
5.2
Classification........................................................................................................ 62
5.2.1
Business Cycle .............................................................................................. 63
5.2.2
Goals ............................................................................................................. 64
5.2.3
Tools ............................................................................................................. 66
5.2.4
Effects ........................................................................................................... 67
5.3
Definition: Austerity ............................................................................................ 67
5.4
Keynes vs. Hayek on Austerity ............................................................................ 73
5.5
Fiscal Consolidation ............................................................................................ 76
4
5.6
6
Internal Devaluation............................................................................................ 80
5.6.1
Internal devaluation with a fixed-exchange-rate regime: Latvia’s case ....... 87
5.6.2
Internal devaluation within a Monetary Union: Ireland’s case. ................... 91
5.7
Tax-based and spending-based Austerity ........................................................... 94
5.8
Keynesian views of Austerity ............................................................................... 97
5.9
Other views on Austerity (Non-Keynesian views) ............................................... 99
Evaluation of austerity .............................................................................................. 102 6.1
Data .................................................................................................................... 102
6.2
Unemployment .................................................................................................. 108
6.3
Slow growth ........................................................................................................ 112
6.4
Institutional development .................................................................................. 114
6.5
Economists’ views ............................................................................................... 116
6.6
Global Trumpism ................................................................................................ 124
Conclusions ....................................................................................................................... 126 Ringraziamenti ................................................................................................................. 130 Bibliography ...................................................................................................................... 131
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SUMMARY OF THE THESIS IN ITALIAN
N
ella prima parte della tesi di laurea è presentata un’introduzione all’Unione Europea, alla sua storia e alle sue caratteristiche generali. Il primo capitolo riguarda, principalmente, la definizione del concetto di
core e di periphery tra i paesi dell’Unione Europea e dell’Eurozona. Le differenze economiche e istituzionali dei paesi europei sono fondamentali per definire la portata della crisi e la necessità di sottoporre determinate politiche economiche. Sono perciò definiti i criteri di classificazione e sono classificati i diversi paesi in tre gruppi principali: paesi periferici esterni all’Eurozona, paesi periferici interni all’Eurozona e, infine, paesi centrali. Nel secondo capitolo vengono definiti quelli che sono i paesi periferici esterni all’eurozona. Particolarmente rilevante è il concetto di convergenza o di catch-up process, che è stato centrale nel definire la crescita vigorosa di questi paesi. Vengono inoltre definiti i problemi che il processo di convergenza ha determinato. Specificatamente, è argomentato come la distinzione di Balassa su beni tradable e non-tradable risulti particolarmente utile per definire gli squilibri presenti nelle economie di questi paesi. Il terzo capitolo tratta la classificazione dei paesi periferici interni all’Eurozona, chiamati altresì PIIGS o GIIPS. Nonostante sia stato completato il processo di convergenza dei tassi di interesse sul debito sovrano di questi paesi, richiesto per adottare la moneta unica, il processo di convergenza dei valori macroeconomici fondamentali e del funzionamento delle istituzioni non è avvenuto. Di fatto, si è compiuto un processo di divergenza su prezzi, salari e posizioni competitive. Sono perciò raccolte le posizioni di diversi economisti che dimostrano come questa divergenza abbia definito la necessità di adottare politiche di austerità quali: svalutazioni interne per restaurare la competitività dei paesi, interni all’Eurozona o aventi un regime di cambio fisso con l’euro, e consolidamento fiscale per attenuare i rischi relativi al debito sovrano elevato. Diverse posizioni raccolte dimostrano come l’architettura dell’Eurozona sia rimasta incompleta e altamente vulnerabile agli shock asimmetrici.
Inoltre,
le
differenti
strutture
6
economiche
e
la
mancata
sincronizzazione dei cicli economici hanno determinato lo scatenarsi di crisi asimmetriche, che definiscono uno dei problemi più profondi di un’unione monetaria incompleta. Il quarto capitolo definisce le dinamiche e la natura delle crisi finanziaria e del debito sovrano. Sono discusse le modalità di diffusione e le condizioni che si sono venute a creare a seguito della crisi. Il quinto capitolo è il cuore della tesi, definisce l’austerity a partire da quattro caratteristiche fondamentali di una politica di contrazione fiscale. come politica economica. Diversi dibattiti scientifici e teorici sulla validità di queste politiche sono riportati. Sono presentati due casi di svalutazione interna: l’Irlanda e la Lettonia. Infine, vengono presentati le visioni Keynesiane e non-Keynesiane sulle misure di austerità. Il sesto capitolo presenta dati e grafici utili a quantificare la portata delle svalutazioni interne e dei consolidamenti fiscali avvenuti all’interno dell’Eurozona e in diversi paesi europei e a misurare gli effetti che queste politiche hanno determinato sulle economie europee. La crescita dei tassi di disoccupazione, la crescita stagnante e il mancato sviluppo istituzionale dell’Eurozona, sono fondamentali per comprendere il rifiuto espresso da molti movimenti politici verso le misure di austerità. In questo capitolo, sono presenti le visioni di diversi economisti sugli effetti dell’austerity e la nozione di global Trumpism. Infine, il settimo capitolo conclude presentando i maggiori pericoli per il futuro dell’Unione Europea e come sono state definite le politiche economiche.
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1 EUROPEAN UNION AND ITS STRUCTURES 1.1
EUROPEAN UNION AND ITS FEATURES
European Union (EU) and its institutions are a vast and a remarkable political and economic experiment. As a political project, it has been an astonishing success (Blyth 2013). The European integration process has shaped the European Union and its structures: it began with six states, grew to fifteen in the 1990s, enlarged to include a further ten in 2004, and may eventually encompass another five or ten: totalizing twenty-eight member states nowadays (Hix e Høyland 2011).
EU
institutions – the Commission, the Council, the European Parliament and the Court of Justice – were established in the 1950s and, since then, they have gained foremost set of powers (Hix e Høyland 2011). From social policy to the environment, almost all aspects of government policy in Europe today are shaped by the EU in some way (Bickerton, Hodson e Puetter 2015). The establishment of EU and its common market have implied a huge effort by European countries and their leaders at the beginning of the European integration process. In facts, EU origins from the European Coal and Steel Community (ESCS) and European Economic Community (EEC).1 The Rome Treaty (1957)2 was established after the tremendous II World War (1939-1945), which has divided the continent and European citizens. After more than 70 million of deaths3, European leaders, such as Alcide de Gasperi, Robert Schuman and Konrad Adenauer 4, decided to create sound conditions for peace and spreading prosperity through the whole continent. Since then, European Union has incorporated the twenty-eight European States under a conformed legal system and a developing democracy.
“A Peaceful Europe: the beginning of cooperation”; The history of European Union: https://europa.eu/european-union/about-eu/history_en (European Union s.d.) 2 The founding treaty of European Economic Community (EEC), Rome, 1957. 3 Total Deaths of II World War https://www.census.gov/population/international/data/worldpop/table_history.php (Census s.d.) 4 Also known as the Founding Fathers of the European Union. 1
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As stated by Dinan: “Today’s European Union (EU) is singular among […] competing visions.5 Tempering the nationalist ethos that had become the ruling principle of European political development, the countries that formed the European Communities […] chose to limit (but not eliminate) their own sovereignty, the hallmark of a modern nation-state, in favour of collective peace, economic integration, and supranational governance.” (Dinan 2014) The push towards an “ever closer union” (European Council 1983) came from different and rival political thoughts. From Christian Democrats, as Helmut Kohl, to Communists, as Altiero Spinelli, the European Union and the European integration process has been set by them as the prospect to follow for future generations of Europe. Leaders of the greater European countries have succeeded to come together after a tragedy to build a better future from the ashes of the war. As Mario Draghi highlighted in one of his speech “In outlining the future shape of international relations, De Gasperi and his contemporaries concluded that only cooperation between European governments within a common organisation could ensure the joint security of their citizens”.6 Since 1999, Eurozone has welcomed nineteen EU-member States and it is negotiating with other European countries. Other countries have decided to peg their currency to euro or unilaterally accept the single currency.7 In fact, euro is the second largest reserve currency as well as the second most traded currency in the world after the United States dollar. 8 The constitution of a European Monetary
European interests and National interests: sometimes they are correlated, sometimes they are rival. 6 “Reviving the spirit of De Gasperi: working together for an effective and inclusive Union”; Speech by Mario Draghi, President of the ECB, at the presentation ceremony of the De Gasperi award, Trento, 13 September 2016 (https://www.ecb.europa.eu/press/key/date/2016/html/sp160913.en.html, 07/06/2017) (Draghi, Reviving the spirit of De Gasperi: working together for an effective and inclusive Union s.d.) 7 For example, Kosovo and Montenegro. 8 “Foreign exchange and derivatives market activity in 2007” BIS – Bank for International Settlements; http://www.bis.org/publ/rpfxf07t.pdf (Bank for International Settlements s.d.) 5
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Union (EMU) 9 , in 1999, was a large step forward towards a higher degree of integration of the European continent, after the institution of the Schengen area and the European Common Market. One Market, One Money, as emphasised by the European Commission. Although, after a profound crisis of European institutional framework and its legitimacy, United Kingdom decided to leave the European Union in 2016. 10 Furthermore, most of the popular movements and political parties are pushing towards a reform of the institutional framework of the EU: some of them wants a stronger integration11, some of them want to withdraw from the founding treaties of the European Union: the so-called populist and sovereigntist movements, as the Lega Nord in Italy or the Front Nacional in France. Rising unemployment, problems to manage an unprecedented immigration crisis, increasing number of terrorist attacks and a perceived lack of democracy are mining the trust of the citizens in the European institutions. Yet, covering 7.3% of the world population12, the European Union in 2016 produced a nominal gross domestic product (GDP) of 16.477 trillion US $, comprising approximately 22.2% of global nominal GDP and 16.9% when measured in terms of purchasing power parity (European Union s.d.) (International Monetary Fund s.d.). Implementing a common European market and a deeper political integration has fostered a vigorous economic growth and an unprecedented institutional development. From Germany to Greece, from Italy to Finland, European Union was
“Monetary union can consist of either a fixed exchange rate regime or a single currency. While both are possible, a single currency is found to offer a better benefit-cost result in economic terms, and so is the main focus of the analysis.” (Commission of the European Communities 1990) 10 “UK votes to leave EU after dramatic night divides nation”, Guardian, Anushka Asthana, Ben Quinn and Rowena Mason ( https://www.theguardian.com/politics/2016/jun/24/britain-votesfor-brexit-eu-referendum-david-cameron) (Asthana, Quinn e Mason s.d.) 11 Macron, with En Marche!, the ALDE Party, but even the Italian Partito Democratico ( http://www.politico.eu/article/emmanuel-macron-pledges-to-reform-the-eu/ ) This reformist or progressive want to make European Union more democratic and to support the European integration process. (Sheftalovich s.d.) 12 Data from http://www.populationeurope.org/ 9
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set to support a stronger political and economic cooperation within the European continent. Moreover, the eastern enlargement of European Union assisted a robust democracy building process in former socialist countries and a stout development of market, economic and financial institutions in these States, with growing living condition standards and developed civil and political rights. In 2015, Romania scored a 2.0 in both political and civil rights on Freedom Houses report. 13 The adaptation of National law to European standards and rules and the development of new wellfunctioning economic institutions have established better conditions for foreign direct investments (FDI) and financial markets, even for transition economies, like Romania or Hungary. These countries show more business-friendly regulations than advanced countries, like Italy or Belgium.14 However, the rapid expansion of credit and a deeper level of interdependence have generated vulnerabilities and disproportions between European economies. The financial crisis in 2008 and its effects on the international economy have been amplified in the European Union by a great degree of macroeconomic imbalances and a weak governance of its institutions. This produced a profound recession in many countries and unpopular15 political measures to be implemented. Sturdy economic growth was not followed by the development of sounder and stronger economic and financial institutions. As pointed out by Papaiounnou, “a burgeoning body of research on growth and political economy provides compelling
Freedom House Reports: Freedom in the world, ( https://freedomhouse.org/report/freedomworld/2015/romania ) This is a particularly important index for measuring democracy and basic freedoms in a country and it is used as a quantitative unit to understand how national institutions work. (Freedom House s.d.) 14 World Bank Data, Ease of doing business index ( http://data.worldbank.org/indicator/IC.BUS.EASE.XQ?end=2016&locations=ROBG&start=2015&view=map ) It is important to understand how these countries are different and how a market structure could enhance economic growth. (World Bank s.d.) 15 News and media refers usually to austerity as an unpopular measure, as highlighted by this BBC post. ( http://www.bbc.com/news/av/business-14803351/italian-austerity-measures-proveunpopular ) (BBC s.d.) 13
11
evidence that the focus should be on institutional reform” (Papaioannou 2015). Features of better economic and legal institutions for promoting growth should focus on investor protection, shareholders, and creditors’ rights, which are crucial for the development of efficient, deep, and liquid capital (Papaioannou 2015). Institutions building and development is a key feature to ensure a stronger and well-functioning free market.
1.2 CORE AND PERIPHERY OF THE EUROPEAN UNION The institutional and economic differences between core and peripherical countries are vital for devaluing European Union macroeconomic imbalances and political issues. At the very beginning, these differences have developed a vigorous economic catch-up process16, with large capital flows from European Core Countries (ECC) to the European Peripherical Countries (EPC). Philip Lane pointed out that “low policy rates adopted by advanced countries’ central banks, financial innovations (such as new types of securitisation) and shifting beliefs about risk levels and risk absorption capacity combined to foster an extraordinary boom in international capital flows.” (P. R. Lane 2012) However, institutional differences are a critical issue to carry on the process of European integration and to ensure a sustainable growth. For example, the constitution of a fiscal union needs functioning tax collecting institutions in every European country to prevent political conflict between citizens of the Union. Within the European Union, while Germany is 10th on a list of 176 countries based on the Corruption Perception index17, Italy is 60th and Bulgaria is 75th. Even if many
“In any period, the economies of countries that start off poor generally grow faster than the economies of countries that start off rich. As a result, the NATIONAL INCOME of poor countries usually catches up with the national income of rich countries. New technology may even allow DEVELOPING COUNTRIES to leap-frog over industrialised countries with older technology.” From The Economist dictionary, http://www.economist.com/economics-a-to-z/c#node-21529531 (The Economist s.d.) 17 This is the Transparency corruption perception index and it is particularly important to understand the level of corruption in a country. 16
12
European countries are facing deep renewal, as it happened in Romania 18 with massive protests against corruption, the problem of corruption is still important and pressing. These institutional differences could exacerbate a deep political conflict, as the Italian experience teaches. Differences between Northern Italy and Southern Italy have fostered the development and the affirmation of the Lega Nord, Northern League (NL). In facts, Lega Nord proposed a plan for fiscal federalism.19 1.3 CLASSIFICATION OF THE EUROPEAN COUNTRIES Figure 1 European Union countries' currency status. (2012)
https://www.transparency.org/news/feature/corruption_perceptions_index_2016 (Transparency International s.d.) 18 https://www.nytimes.com/2017/02/04/world/europe/romania-protests-corruption.html (The New York Times s.d.) 19 http://www.reuters.com/article/italy-berlusconi-federalism-idUSLDE71128E20110203 (Reuters s.d.)
13
Differences between ECC, EPC within Eurozone and EPC outside Eurozone were enormous: in 2000, while German (ECC) GDP-per-capita was equivalent to 23,718.75$, Spain (EPC Within European Union) had a GDP-per-capita of 14,787.76$ and Romanian (EPC Outside European Union) GDP-per-capita accounted for 1,668.16$. In 2008, Germany grew almost by 92% (In dollars, 45,699.2$), Spain grew by 140% (In dollars, 35,578.74$) and Romania raised its GDP-per-capita by a striking 507% (In dollars, 10,136.47$).20 In 1995, German GDP accounted for 2,841 trillion of euro (Current prices), Spanish GDP was about 940,995 billion of euro (Current prices) and Romanian GDP reached 111,404 billion of euro (Current prices). By 2000, German GDP grew by 9,96%, Spanish GDP increased by 7,86% and Romanian GDP decreased by 1,28%. Spain entered in Eurozone in 1999, while Romania was still external to the European Union. Romania has officially joined the European Union in 2007. Since then, its GDP increased by almost 41%. By 2016, German GDP grew by 48,04% from 2000, Spanish GDP increased by 72,81% from 2000 and, finally, Romanian GDP grew by 310,14% from 2000. 21 Different paths of convergence are due to the economic structure at the starting date of the process. Romania converged later than Spain, because of its market structures and its needs of economic and institutional reforms. These countries are indicative as examples of the structure of European Union. Most of the European countries have converged over this small period. Romania, Bulgaria and other Eastern European countries grew at a faster pace than 5% from 2000 to 200822.
Data from World Bank Database. http://data.worldbank.org/ (World Bank s.d.) Data from Eurostat Database. http://ec.europa.eu/eurostat/data/database (Eurostat s.d.) 22 Data from World Bank Database. (World Bank s.d.) 20 21
14
Table 1: GDP of Germany, Spain and Romania (1995-2015) in millions of dollars. 1995 2000 2005 2010 2015 Germany
2,841,000
3,124,000
3,214,000
3,417,000
3,697,000
Spain
940,995
1,015,000
1,385,000
1,432,000
1,415,000
Romania
111,404
109,983
145,503
167,998
189,016
Source: World Bank data European Core Countries (ECC)
23
have higher GDP-per-capita, developed
standards of living and a robust market structure. Most of them have a virtuous financial situation and stable fiscal balances. Denmark is an ECC outside Eurozone, even though its currency is pegged to euro. Therefore, European Core Countries comprise Germany, Austria, France, Belgium, Luxemburg, Netherlands, Denmark and the United Kingdom. Finland and Italy are difficult to classify. While Italy has more characteristics of EPC countries, Finland has a higher GDP-per-capita than Germany. Nonetheless, it shows imbalances and huge economic problems.24 EPC are countries with weaker economic institutions and higher imbalances. Moreover, EPC may be divided into two main groups: countries within Eurozone (WE Countries)25 and countries outside Eurozone (OE Countries)26. Furthermore, OE Countries should be divided into two main groups: V4, or the Visegràd Group, (Slovak Republic, Czech Republic, Poland and Hungary) and the so-called REBLL Alliance (Romania, Bulgaria, Lithuania, Latvia and Estonia) (Blyth 2013).
Netherlands, Germany, Belgium, Luxemburg, Austria, France, United Kingdom. For a deeper analysis on Finland: Permafrost, The Economist, ( http://www.economist.com/news/business-and-finance/21689751-nordic-laggard-can-forgeahead-reforms ) (The Economist s.d.) 25 Italy, Spain, Greece, Portugal, Ireland and Finland. 26 Poland, Slovakia, Hungary, Czech Republic, Lithuania, Latvia, Estonia, Romania and Bulgaria. 23
24
15
In general, WE Countries have benefitted from all-time low yields on Sovereign bonds (Baldwin e Giavazzi 2015) and OE Countries have even taken advantage of new economic institutions, foreign direct investments (FDI) and large capital outflows (Blyth 2013). Table 2: GDP-per-capita of European countries (Current US $). Country
1998
2003
2008
Germany (ECC)
27,340.673
30,359.952
45,699.198
France (ECC)
25,101.369
29,691.182
45,413.066
34,007.889
46,523.265
United
Kingdom 27,759.334
(ECC) Italy (EPC WE)
22,252.358
27,387.226
40,640.185
Spain (EPC WE)
15,340.332
21,495.707
35,578.736
Greece (EPC WE)
13,472.138
18,477.578
31,997.282
Poland (EPC OE)
4,510.413
5,693.254
14,001.447
Hungary (EPC OE)
4,739.817
8,396.253
15,669.259
Romania (EPC OE)
1,864.991
2,774.956
10,136.474
Bulgaria (EPC OE)
1,771.994
2,710.468
7,296.122
Source: World Bank Database (World Bank s.d.)
2 EUROPEAN PERIPHERICAL COUNTRIES OUTSIDE EUROZONE (EPC OE) EPC outside Eurozone comprise diverse countries. EPC outside Eurozone are mainly Central and Eastern European Countries (CEECs). The term CEECs includes all the Eastern bloc countries west of the post-World War II border with the former Soviet Union, the independent states in former Yugoslavia and the three
16
Baltic states. EPC outside Eurozone is a classification of CEECs to define countries which, at the time of the financial crisis (2008), had not yet joined the Eurozone.27 EPC outside Eurozone, as defined in this dissertation, are: Poland, Hungary, Slovak Republic, Czech Republic, Estonia, Lithuania, Latvia, Romania and Bulgaria. Visegràd group comprise Hungary, Poland, Czech Republic and the Slovak Republic. The Visegràd Declaration 1991 states: “the cooperation of nations and civil communities of the three countries28 is essential for joint creation of conditions that will contribute in each of the countries to the development of a democratic social system based on respect for the fundamental human rights and freedoms, liberty of economic undertakings, rule of law, tolerance, spiritual and cultural traditions and respect for moral values.” (Visegrad Declaration 1991) Therefore, Visegràd group is a working international organization, which aspires to reach a deeper integration between these countries and the European Union. Instead, REBLL Alliance is not a formal institution. It is a term coined by Mark Blyth to define those countries who engage themselves in harsh fiscal consolidation and internal devaluation with tough austerity measures during the economic crisis, to restore competitiveness, while keeping their currency pegged to Euro. REBLL Alliance includes Romania, Bulgaria, Lithuania, Latvia and Estonia.
2.1 CENTRAL EUROPEAN
AND
EASTERN COUNTRIES
AND THEIR
ECONOMIC STRUCTURES
As pointed out by Schadler and others: “Evaluating the performance of the CEECs is complicated by three developments that are difficult to unravel: a recovery from the immediate post-central-planning drop in output; the emergence of policies and institutional conditions (including EU membership) that enhanced catch-up potential; and global economic developments favourable to investment and growth
27 28
Slovenia is formally a CEECs, but it has adopted euro in 2007. Then, V4, with the dissolution of Czechoslovakia.
17
in emerging market countries.” (Schadler, et al. 2006) The collapse of the Soviet Union and the end of planned economy has posed real challenges for these countries. They needed deep reforms to organize a stable democracy and a functioning open market. It is not an effortless process. As stated by Csaba, “path dependence and the nature of institutional change both require years, rather than months, if changes are to be meaningful and lasting.” (Csaba 2007) Since 1991, Central and Eastern European Countries have committed to ensuring civil and political rights, as well as economic freedom and institutional development. The prospect to join the European Union has shown the benefits from deeper institutional, trade, and financial integration with European Core Countries. These are evident in growing trade volumes, low-risk premia, and rising use of foreign savings in the CEECs; further changes in these directions are likely, especially for countries that commit to early euro adoption, as mention by Schadler (Schadler, et al. 2006). In 2004, Czech Republic, Poland, Hungary, Slovakia and Baltic Countries joined the European Union.29 Romania and Bulgaria followed them in 2007. Slovak Republic was the first EPC to adopt the Euro currency, in 2009. Estonia followed it in 2011, Lithuania in 2014 and, finally, Latvia in 2015. Baltic countries and the Slovak Republic did not have adopted the common currency yet at the starting of the financial crisis (2008), therefore they will be treated as EPC outside Eurozone. However, they kept their currency pegged to Euro, because of the convergence process and the prospects to join the European Monetary Union (EMU). This is particularly interesting to defining austerity measures. The deep reform of market structure in CEECs needed a huge amount of resources. “Generally, the immediate consequence of the transformation on rural performance was the drastic falls in agricultural production, in particular in 1992 and 1993. The Bulgaria's agriculture, for example, had the lowest production in 1993. For the period 1990-1994, the real output in agriculture decreased by 55%.” (Rangelova
Further Expansion, European Union ( https://europa.eu/european-union/abouteu/history/2000-2009_en ) (European Union s.d.) 29
18
1999) In facts, the industrial sector of CEECs was mainly inefficient, because of it was State-owned under the Socialist economic system. Therefore, CEECs economy needed a large amount of capital to reach a restructuring. OE European Peripherical Countries built their economic growth model on massive foreign investments, massive foreign borrowing and open and market-friendly economic institutions, as described it by Blyth (Blyth 2013). Huge capital flows and direct foreign investments in these countries should have led to a convergence process. This process is necessary and regular, and it should be followed by stronger and sounder economic institutions development (Papaioannou 2015).
2.2 CONVERGENCE OR CATCH-UP PROCESS Catch-up process or convergence is a progression where developing countries have the possibility to grow at a faster rate than advanced countries because fading returns are not as robust as in capital-rich countries.30 “There is a clear negative relation between the initial level of output per person and the growth rate since 1950: Countries that were behind in 1950 have typically grown faster.” (Blanchard, Macroeconomics 2017) As pointed out by Herrmann and Winkler, convergence is, usually, ran by a leader: leaders and followers form specific convergence clubs with a core (leader) and a periphery (converging countries) (Herrmann and Winkler 2008). Indeed, Baumol found out that convergence is driven by spill overs from the core to the periphery as converging economies engage in similar lines of production and develop extensive trade and financial linkages with the core (Baumol 1986). A clear example of the Baumol model are the so-called Asian tigers: in 1960, their average output per person was about 18% of the U.S.; by 2009, it had increased to 83% of U.S. output, as pointed out by Blanchard (Blanchard, Macroeconomics 2017). However, convergence is strongly related to institutional development. “The most important institutional developments for a transition economy are the emergence and legalization of the market economy, the establishment of secure 30
Investopedia vocaboulary, http://www.investopedia.com/terms/c/catch-up-effect.asp
19
property rights, the growth of a private sector, the development of financial sector institutions and markets, and the liberalization of political institutions.” (Hasan, Wachtel e Zhou 2006) In facts, these countries needed deep reforms to fight corruption and the black market. In facts, as stated by Papaioannou, “as countries develop, they need to shift their growth paradigm from capital investment towards technological innovation, research and development, entrepreneurship in skillintensive sectors, and high value-added activities” (Papaioannou 2015). This concept results in similar lines of production and further interdependence. These are pillars for supporting a stronger commercial integration. Furthermore, in Europe, commercial integration is needed to assure higher symmetry between European economies, from the European Commission’s point of view
31
(Commission of the European Communities 1990). As it is said before, convergence is strongly related to capital inflows and outflows, mainly because diminishing returns to capital are not as strong as in capital-rich countries.32 Therefore, strong credit growth is an essential element of the catching-up process, as it implies financial deepening in the household sector, as demonstrated by Barrell (Barrel 2009). As a matter of facts, catch-up growth is feasible and profitable when capital is relatively scarce, since in this case the return on investment is high, as stated by Papaioannou (Papaioannou 2015). However, as pointed out by Calvo, Leiderman and Reinhart, “a rapid expansion of bank credit to the private sector may affect macroeconomic stability by stimulating aggregate demand compared to potential output and creating overheating pressures, as bank lending fuels consumption and/or import demand, with subsequent effects on the external current account balance, inflation, and currency stability” (Calvo, Leiderman e Reinhart 1993). Strong credit growths could worsen the macroeconomic position of the country and its financial stability. Paul Krugman have opposed this view. In this dissertation, it is discussed both of the position presented by Krugman and the European Commission. For further readings, it is strongly encouraged the paper by Krugman on the Optimal Currency Area and the One Market, One Money report of the European Commission. 32 This is a definition from Wikipedia and others online encyclopaedias. 31
20
Figure 2: Growth episodes with high capital inflows in non-transition countries.33 As pointed out by Berglöf, “from the beginning of this decade until the first half of 2008, the economies of central and eastern Europe (CEECs) experienced large capital inflows from the West, a credit boom and rapid
expansions
in
both
consumption and investment. The counterpart to this boom was a sharp increase in private sector external indebtedness. In most countries, debt was denominated primarily
in
foreign
currency,
making corporate and household borrowers – and hence creditor banks
–
vulnerable
to
a
depreciation of the exchange rate.” (Berglöf, et al. 2009) Additionally, CEECs
banking
sector
became
between 80 percent and nearly 100 percent foreign owned in the early 2000s
(Blyth
2013).
This
is
important because bank credit was generated
mainly
by
foreign
borrowing and this makes an economy far more vulnerable to external shocks. In
33
For sources, see (European Bank for Reconstruction and Devlopment 2009)
21
facts, the sudden stop34 of capital inflows, due to the 2007-2008 financial crisis, generated a deep economic crisis. Parfield and Rosenberg described the situation of CEECs stating that “the key drivers of the credit boom were bank lending and a corresponding acceleration of domestic demand.35 Credit demand was fuelled by high permanent income expectations and very low real borrowing rates on euro denominated loans, which quickly became the predominant form of borrowing.” (Purfield e Rosenberg 2010) As a matter of fact, the convergence process in Europe has been accompanied by substantial current account deficits 36 , due to foreign borrowing and large capital inflows. As argued by Herrmann and Winkler, between 1994 and 2006, only seven countries recorded one or two years with current account surpluses, either in the mid-1990s or as part of an adjustment process after a period of financial turbulence (Herrmann and Winkler 2008). Estonia ran a current account deficit slighter than -4% from 1992 to 2008 (OECD Data), Latvia ran an average current account deficit of -14,26% from 2003 to 2008 (OECD Data) and Poland is still running a steady current account deficit since 2004. As pointed out by Herrmann and Winkler, “in EPC outside Eurozone, convergence and the associated current account deficits have been mainly driven by a rise in investment and only to a lesser extent by a decline in savings” (Herrmann and Winkler 2008). Relatively low domestic savings rates were supplemented by foreign savings, particularly in the three Baltic countries (Schadler, et al. 2006). As a matter of facts, as argued by Herrmann and Winkler, “underdeveloped domestic financial markets and weak economic institutions inhibit emerging markets’ ability to transform domestic savings into domestic investment” (Herrmann and Winkler 2008). Moreover, foreign investments were directed not to industry or infrastructure building, but to consumer credits and real estate (Blyth 2013). This is a major For further readings on the concept of sudden stop: Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops, by Calvo. 35 This is particularly important to understand the role of current account deficits and the correlation with Sovereign Debt yield spread with the German Bund, as highlighted by Daniel Gros and its graph. 36 Asia and NIC – Exports led economies have used capital inflows to build up an efficient manufacture sector to export and, thus, improving their trade balance position. 34
22
problem, because of the non-tradability of these goods. The thinking the 1980s, when financial integration was introduced before the euro, was that it would contribute to both catch-up process and macroeconomic stability37. Instead, capital flows tended to feed non-tradable sectors in the periphery of the Eurozone, as recalled by Baldwin and Giavazzi (Baldwin e Giavazzi 2015). Therefore, for example, as pointed out by Blyth, the transnational credit pump generated a remarkable construction bubble: Romania was the straggler with 11 percent yearly growths38, while Bulgaria busted the curve with a near 20-percent-a-year increase 39 (Blyth 2013).
2.3 BALASSA-SAMUELSON
EFFECT IN
CEECS:
TRADABLE AND NON-
TRADABLE SECTORS.
Inflation is a critical issue for developing countries, like CEECs. 40 High rates of inflation tend to worsen the position of creditors and capital, since it could generate huge losses (Blyth 2013). Otherwise, it is fundamental to address this issue to ensure a sustainable economic growth to these countries. As pointed out by Bernanke and Abel: The fall of communism in Eastern Europe and the breakup of the Soviet Union led to economic, political and social upheaval. All of these countries, to varying degrees, have introduced reforms intended to make their economies more market-oriented, and many (particularly the new countries formed from the breakup of the Soviet Union) have introduced new currencies. However, Russia and many of the Eastern European economies have continued to face serious problems, including very high rates of inflation. The main reason for the high For further readings: see Maastricht treaty and rules For house price growth see “House-gold debt and foreign currency borrowing in the new member states of the EU”. http://www.ephilipdavis.com/HH%20debt%20and%20foreign%20currency%20borrowing%20in %20NMS[1].pdf (Blyth 2013) 40 For further readings: https://blogs.wsj.com/economics/2014/02/07/inflation-is-expeciallypainful-in-developing-countries/ (Wall Street Journal s.d.) 37
38
23
inflation rates is the rapid rates of money growth in these countries. (Abel e Bernanke 2001) However, this is a demanding subject even because it is necessary to ensure the continuation of the process of European integration for these countries. Indeed, as argued by Breuss, the entrance criteria (convergence criteria) for the Eurozone are the same as those for the present EU member states. However, one out of the five convergence criteria is inflation (Breuss 2003). This could be a tough problem for the new European Union member countries, if the inflation and exchange rate criteria are impossible to achieve in the presence of the BS effect. As stated by Palic, “there would be a risk of sacrificing the real convergence for the nominal one, because a monetary tightening that might be necessary to bring inflation or exchange rate to Maastricht criteria could suppress real growth” (Palic 2011). The main intuition made by Balassa [1964] is the difference between tradable and non-tradable goods. More specifically, there is a significant difference between those goods which are exposed to international competition (tradable) and those which are not (non-tradable). The Balassa-Samuelson effect suggests that an increase in wages in the tradable goods sector of an emerging economy will also lead to higher wages in the non-tradable (service) sector of the economy. The accompanying increase in inflation makes inflation rates higher in faster growing economies than it is in slow growing, developed economies. 41 Ègert, Drine a Lommazatsch explained it more specifically: According to the Balassa-Samuelson effect (Balassa 1994, Samuelson 1964) [...] productivity growth in the open (tradable) sector usually exceeds that in the sheltered (non-tradable) sector. Given that wages are expected to be approximately the same across sectors, faster productivity growth in the open sector pushes up wages in all sectors, thus leading to an increase in the relative prices of non-tradable goods. Given that wages are expected to be approximately 41
For further information about this definition see Investopedia.com
24
the same across sectors, faster productivity growth in the open sector pushes up wages in all sectors, thus leading to an increase in the relative prices of nontradable goods. (Égert, Drine e Lommatzsch 2002) As argued by Ègert, Drine and Lommatzsch, “in facts, after the initial recession, these countries have experienced rapid productivity growth in particular in their industrial sectors going in tandem with a steady increase in the relative price of nontradable and a trend appreciation in the real exchange rate (Égert, Drine e Lommatzsch 2002)”. The Balassa Samuelson effect is, however, rather small and not sufficient to explain the observed inflation differentials between the CEEC8 and the EU11, as demonstrated by Wagner and Hlouskova (Wagner e Hlouskova 2004). But there is a necessary discussion to be made about tradable and non-tradable goods. Convergence process and large capital outflows had fuelled a boom of nontradable sector. While South East Asian Countries have concentrated a large amount of capital to develop highly competitive export sectors, Central European and Eastern countries have developed a less competitive model, feeding with foreign credit and borrowing the non-tradable sectors. More specifically, FDI in tradable sectors is associated with higher exports, while FDI in the non-tradable sector is associated with higher imports, as demonstrated by Kinoshita (Kinoshita 2011). Higher imports, therefore, could lead to a larger trade deficit and major current account imbalances. As confirmed by Kinoshita itself, the export to GDP ratio is the highest in the Slovak Republic, the Czech Republic and Hungary (Visegràd group or V4), countries with high stock of tradable Foreign Direct Investments. Instead, Bulgaria and Estonia (REBLL Alliance) have the highest stock of non-tradable Foreign Direct Investments and they also have a high import to GDP ratio (Kinoshita 2011). While EPC outside Eurozone cut their debt even before the crisis, their citizens and firms increased it exponentially in the form of non-productive assets, on the back of weak exports and current account deficits, using foreign sourced cheap credit, as showed by Blyth (Blyth 2013).
25
3 EUROPEAN PERIPHERICAL COUNTRIES WITHIN EUROZONE (EPC WE) European Peripherical Countries within Eurozone are mostly advanced economies. 42 EPC within Eurozone comprise different countries and they are usually called PIIGS or GIIPS. 43 Although they have developed good economic performance and high rates of growth, these countries were vulnerable because of their macroeconomic imbalances and their foreign credit exposures. PIIGS is usually referred “to the economies of Portugal, Ireland, Italy, Greece, and Spain, five EU member states that were unable (or close to being) to refinance their government debt or to bail out over-indebted banks on their own during the crisis”. 44 Nonetheless, Italy has not committed itself to an IMF plan of bail-out, while the other countries have discussed and approved financial plans with IMF, the European Commission and the European Central Bank. Bailouts from EU, ECB and the IMF, as well as bilateral loans, have accepted on the condition of implementing austerity packages (Blyth 2013). The common issues of these countries were similar and mostly known. For example, Greece has never run a budget surplus in fifty years (Blyth 2013). Spain, Portugal, Greece and Italy shared a higher rate of shadow economy than the European Core Countries.45 Moreover, Spain, Italy, Greece and Portugal have a higher tax evasion rate as a percentage of national GDP (Respectively, 19%, 22%, 19% and 25%).46 Institutions and National structures showed weaker performance than the Eurozone standard.
They are part of OECD, for examples. They are not to be considered as transition economies, because they are widely accepted as advanced economies, with a dynamic market structure and a competitive position. 43 Acronym for Portugal, Ireland, Italy, Greece and Spain. It is widely accepted the name GIIPS, since PIIGS could be referred to the animal. 44 From online encyclopaedias, as Wikipedia and other platforms. 45 For further information see https://www.washingtonpost.com/world/italys-tax-evasionculture/2011/11/24/gIQAvSletN_graphic.html?utm_term=.32cb4e9f2066 (Washington Post s.d.) 46 For further readings see A.T. Kerney, PhD Freiderich Shneider 42
26
Moreover, when they adopted the Euro, historically high borrowing cost for these countries fell, because the European Central Bank would have back all outstanding debt issue, as argued by Blyth (Blyth 2013). There has been a striking process of convergence of interest rates on Sovereign Bonds. This encouraged large capital flows. In facts, as demonstrated by Baldwin and Giavazzi, from the Euro’s launch and up until the crisis, there were big capital flows from Eurozone core nations like Germany, France, and the Netherland to Eurozone periphery nations like Ireland, Portugal, Spain and Greece (Baldwin e Giavazzi 2015). Cheaper credit and large capital inflows fostered a steady growth of consumption and investment. These capital inflows raised prices and wages, even if there has not been a process of productivity growth in these countries. 47 Indeed, this has determined worsening condition for competitiveness (rising wages and prices) and huge current account deficit. Large capital inflows, as said before, increase current account deficit, trough rising consumption and Foreign Direct Investments, as it has been shown in Figure 2. Therefore, they all shared the key problem of declining competitiveness relative to the European core, particularly Germany, and associated with that the problem of persistent current account deficits, as argued by Armingoen and Baccaro in 2012 (Armingoen e Baccaro 2012). Table 3 offers a valid insight of the competitive difference between European peripherical countries and European Core countries, which stands between the first places of the ranking, based on the Global Competitiveness Index created by the World Economic Forum. Germany ranks the 4th position, Spain is 33rd, while Greece is just 81st.
Further information and data available in this post on European Central Bank site: https://www.ecb.europa.eu/press/key/date/2016/html/sp161130_1.en.html (Draghi, The productivity challenge for Europe s.d.) 47
27
Table 3: Global Competitiveness Index, World Economic Forum Germany
5.5
4th
Netherlands
5.5
5th
Finland
5.5
8th
United Kingdom
5.4
10th
Denmark
5.3
12th
Belgium
5.2
19th
Luxemburg
5.2
20th
France
5.1
22nd
Austria
5.1
23rd
Ireland
5.1
24th
Spain
4.6
33rd
Portugal
4.5
38th
Italy
4.5
43rd
Malta
4.4
48th
Greece
4.0
81st
Source: World Economic Forum, http://reports.weforum.org/global-competitiveness-report-20152016/competitiveness-rankings/
Although these institutional and economic problems, these countries have adopted the euro currency. As Philip R. Lane wrote in 2012: By switching off the option for national currency devaluations, a traditional adjustment mechanism between national economies was eliminated. […] The monetary union was not accompanied by a significant degree of banking union or fiscal union. Rather it was deemed feasible to retain national responsibility for financial regulation and fiscal policy. (P. R. Lane 2012) As Corsetti pointed out, “at the birth of the euro, it was well understood that the fiscal, financial, and monetary institutions required for a sustainable currency union in Europe were not sufficiently developed” (Corsetti 2015).
28
3.1 EUROZONE AND INTEREST RATES: A PROCESS OF CONVERGENCE? Figure 3: Sovereign bond yields of the Eurozone countries
Source: Eurostat graph.
As pointed out by Baldwin and Giavazzi, in most of the Eurozone Countries, Financial Markets and investors have sought the institution of European Monetary Union (EMU) as a convergence process within the European Union, with its equalization of Sovereign bond yields (Baldwin e Giavazzi 2015). As said before, sovereign bond yields run through a process of convergence. Countries, like Italy or Greece, have sought a severe reduction of their usually very high Sovereign Bonds Yields. As stated by Blyth, “the introduction of ECB and its unending quest for antiinflationary credibility signalled to bond buyers that both foreign exchange risk and inflation risk were now things of the past” (Blyth, 2013). For example, Italy saw the nominal cost of borrowing fall from 13% to 3% in a decade (Baldwin, Giavazzi, 2015). In 1991, long-term government yields in Italy averaged 12.5%, while those in Germany averaged 8.5%. By the time of unification on January 1, 1999, long-term
29
yields in all four countries lay between 3.9% and 4.2%, a drop of over 8 percentage points for Italy and Spain.48 However, Codogno et al. (2003) found in a sample of nine EMU countries that for Italy and Spain the fluctuations in yield differentials can be attributed to domestic fiscal fundamentals. Nonetheless, Greece, Portugal, Spain, Ireland and to a lesser extent Italy experienced fast growth during the 1990s as monetary stability (pegging local currencies to the ECU) and the associated drop in inflation unleased the power of capital accumulation and led to an increase in investment, as argued by Papaioannou (Papaioannou 2015). Cheaper credit encouraged borrowing throughout the monetary union, some public, some private and some foreign. The inflows also tended to drive up wages and costs that resulted in competitiveness losses that validated the current account deficits, as argued before (Baldwin, Giavazzi, 2015). Competitiveness loss are a key point to understand the implementation of measures of internal devaluation during the crisis. Kelsen, Meunier and Jensen argued that “the single currency centralized monetary authority, ECB, provided only weak coordination of fiscal policy and no obvious mechanism to facilitate macroeconomic adjustment within the member state” (Kelsen, Meunier, Jensen, 2015). EPC should have walked a path of convergence towards sounder financial institutions and better opportunities to grow. However, for many economists, European Union institutions failed to see an imbalanced growth of the banking system, even if – or because of – they were focused on inflation rates, budget deficits and government debts. In facts, as Blyth call it “The Mother of All Moral Hazard”, European Banking system could have bought cheap periphery sovereign debt, with yield not reflecting the risk. This could have exposed banks to a systemic risk, covered by ECB or National Governments. As shown by Blyth, according to a sample of Eurozone For further information and data, see http://www.frbsf.org/economicresearch/publications/economic-letter/2008/november/long-term-bond-yields-euro/ (Swanson s.d.) 48
30
banks that underwent the stress test in July 2011, Greek banks hold 25 percent of Greek GDP in domestic bonds, and Spanish banks hold about 20 percent, and those bonds became increasingly national in terms of ownership through 2012.49 Simon Tilford and Philip Whyte wrote that the Eurozone crisis is “a tale of excess bank leverage and poor risk management in the core... [and] the epics misallocation of capital by excessively leveraged banks”. There was a process of convergence between interest rates, but it was not due to a real convergence of important economic factors. This suggests that the differentials of Sovereign Bond yields were primary not caused by the change of domestic factors. Real GDP per capita, productivity, current account balances and other crucial factors have not experienced a process of convergence. Though, there has been key event of divergence. As stated by Gough: The results suggest that while there was some convergence on inflation up 2007, there was no convergence on economic growth, total government debt, budget deficits, unemployment or GDP per capita. (Gough 2012) More specifically, as the European Central Bank itself described it: While there has been real convergence in the European Union (EU) as a whole since 1999 owing to the catching up of central and eastern European (CEE) economies, there has been no process of real convergence among the 12 countries that adopted the euro in 1999 and 2001. In fact, looking at the period as a whole, there is some evidence of divergence among the early adopters of the euro, given that over 15 years a number of relatively low-income countries have maintained (Spain and Portugal) or even increased (Greece) their income gaps with respect to the average. Moreover, Italy, initially a higher-income country, recorded the worst performance, suggesting substantial divergence from the high-income group. (European Central Bank 2015)
49
For further information, see Mark Blyth in Austerity (Blyth 2013)
31
This “catching up process” was rapidly reversed over the period 2008-13, when these economies underwent a severe recession. In the case of Portugal, there is limited evidence of even temporary convergence in the pre-crisis period. Among the high-income countries, Italy’s growth underperformed the euro area average over almost the whole period, leading to increased divergence. Furthermore, as argued by Papaioannou the drop-in interest rates and the stability of the single currency did not translate into an increased productivity in the south (Papaionnau, 2015). Finally, when the Eurozone was started, a fundamental stabilising force that existed at the level of the member-states was taken away from these countries. This is the lender of last resort function of the central bank50 (De Grauwe, 2015). To sum up, the constitution of the common currency has led to a process of convergence of interest rates. Though, this catch-up process has not led to real economic convergence. 51 Why? Has trade integration led to a major degree of synchronization of business cycle?
3.2 OPTIMAL CURRENCY AREA THEORY Optimal Currency Area theory is at the base of the European Monetary Union and the Eurozone. A functioning Optimal Currency Area is an area where business cycles are synchronized. For many economists, symmetry is generated by a higher degree of trade integration. Symmetry and trade integration are considered fundamental to determine a well-functioning Optimal Currency Area, as Paul de Grauwe wrote. Therefore, the convergence process within Eurozone should have been based on these factors, among others (De Grauwe, Economia dell'Unione Monetaria 2016). A, incomplete monetary union, such as the Eurozone, needs a development of labour mobility, trade integration and other policies to prevent the asymmetric Central bank of a country that has the authority and financial resources to act as the ultimate source of credit. http://www.businessdictionary.com/definition/lender-of-last-resort.html 51 http://blogs.lse.ac.uk/europpblog/2012/09/07/eurozone-convergence/ (Regan s.d.) 50
32
crisis, because of the lack of a fiscal union and the impossibility to transfer resources from a booming economy to a busted one. Symmetry is related to business cycles: more specifically, an existing correlation between the growth rate of product and employment (De Grauwe, Economia dell'Unione Monetaria 2016). Trade integration is fundamental to measure the openness of the economies within a monetary union. European Commission produced a paper, One Market, One Money, in which it was advocated that an Optimal Currency Area (OCA), like the Eurozone, would be less vulnerable because of the interdependence and the integration between its economies. Therefore, the institution of a common market and a common currency in Europe would tend to generate a process of convergence between European economies, leading to a major degree of interdependence (De Grauwe, 2016). Higher degree of interdependence and trade integration would lead to a higher symmetry of business cycles, therefore, lowering the risk of asymmetric shocks. In 2012, as reported by De Grauwe in his book, the countries with higher intraEuropean exports percentage per GDP were Slovak Republic (71,7%), Hungary (67,2%), Czech Republic (65,8%), Belgium/Luxemburg (62,5%) and Netherlands (61,4%). In brief, almost the whole Visegràd group and the so-called Benelux. On the bottom side of this ranking, there were Cyprus (5,1%) and Greece (6,0%), United Kingdom (10,8%) and, then, France, Spain, Italy and Finland. One of these countries, the Great Britain, has decided to leave the Union – the infamous Brexit – and Greece has been close to leave the Eurozone, provoking the so-called Grexit. Moreover, Italy, Spain and Finland show great imbalances, followed by France. For De Grauwe, benefits of a monetary union overcome costs when the economy reach a certain level of trade openness. More specifically, when a certain country has higher commercial exchange than a variable T*, where costs equal benefits. If commercial exchanges are under T*, the country will bear more costs by adopting a common currency (De Grauwe, Economia dell'Unione Monetaria 2016).
33
Figure 4: Costs and benefitys of a monetary union (% of GDP)
European Commission advocated that a common market would boost commercial exchanges and therefore, trade integration, leading to higher symmetry. This view was opposed by Paul Krugman. Krugman stressed the role of regional concentration of industrial activity, led by a higher trade integration. For example, United States market presented huge differences between car production areas (South West 66,3%, South 25,4%, West 5,1% and North East 3,2% 52) and it has a more integrated market than European Union (De Grauwe, Economia dell'Unione Monetaria 2016). These views were arguing about the correlation between symmetry and trade integration: European Commission thought it would be an upward sloping – higher symmetry leads to higher trade integration –, while Krugman argues for a downward sloping – higher symmetry leads to lower trade integration and a 52
For further information see Krugman, 1991 (Krugman, The austerity delusion 2015)
34
significant increase in regional concentration. This is a major issue to understand the problems of European Monetary Union. As Paul de Grauwe stated: The European monetary union lacked a mechanism that could stop divergent economic developments between countries. Some countries experienced a boom, others a recession. Some countries improved their competitiveness, others experienced a worsening. These divergent developments led to large imbalances, which were crystallised in the fact that some countries built up external deficits and other external surpluses (De Grauwe, Design failures of the Eurozone 2015). In facts, De Grauwe itself, in 2015, described Eurozone as not an Optimal Currency Area (De Grauwe, Design failures of the Eurozone 2015). Furthermore, De Grauwe pointed out that internal devaluation – this policy is described in the chapter 5.6 – , necessary to restore competitiveness within a monetary union, are “very costly in terms of growth and employment, leading to social and political upheavals” (De Grauwe, Design failures of the Eurozone 2015). The asymmetric crisis is deepened in 3.4 chapter. However, it is important to understand how the common market have influenced intra-European trade. In the following tables and graphs, it is showed the differentials between 1995 and 2015 in intra-European exports as a percentage of GDP. This data showed a vigorous growth in country like Czech Republic and Slovakia and, surprisingly, a major decline for country like Ireland and others.
35
Table 4: Intra-European export as a percentage of GDP (2000-2015) Country
1995
2000
2008
2012
2015
Change (2000-2015)
Belgium
45,5
60,7
69,7
62,73
62,6
+1,9%
Bulgaria
-
20,9
24,73
29,08
32,9
+12%
Czech
-
40,8
52,61
61,57
71
+30,2%
Germany
11,7
18,3
25,47
22,46
22,8
+4,5%
Estonia
-
48,6
35,72
46,28
42,9
-5,7%
Ireland
47,8
50,1
31,64
31,06
23,1
-27%
Greece
4,8
5,5
5,37
6,38
7,9
+2,1%
Spain
10,8
14,1
11,95
14,07
15,4
+1,3%
France
11,7
15,7
13,42
12,5
12,2
-3,5%
Italy
11,4
13
13,49
13,13
13,7
+0,7%
Cyprus
-
2,7
4,2
4,1
5,1
+2,4%
Latvia
-
18,6
19,29
31,73
31,2
+12,6%
Lithuania
-
23,2
29,66
41,68
37,5
+14,3%
Luxembourg
-
34,2
40,65
26,29
25
-9,2%
Hungary
-
50,2
54,62
62,97
65,8
+15,6%
Malta
-
20,5
16,31
18,16
10,8
-9,7%
Netherlands
31,9
45,8
53,64
59,89
57,5
+11,7%
Austria
15,7
26
31,03
28,63
28,4
+2,4%
Poland
-
15
24,71
28,25
33,1
+18,1%
Portugal
15,4
16,7
16,15
19,06
20,2
+3,5%
Romania
-
20,1
16,78
23,74
25,1
+5,1%
Slovenia
-
34,6
46,13
52,21
56,7
+22,1%
Slovakia
-
51,8
62,86
72,62
73,7
+21,9%
Finland
17,3
23,1
18,94
15,26
15,2
-7,9%
United
10,5
10,3
9,08
8,95
7,1
-3,2%
Republic
Kingdom
Source: Eurostat Database and European Commission AMECO.
36
Table 5: Intra-European export as a percentage of GDP in 2015 Country
2015
Slovakia
73,7
Czech Republic
71
Hungary
65,8
Belgium
62,6
Netherlands
57,5
Slovenia
56,7
Estonia
42,9
Lithuania
37,5
Poland
33,1
Bulgaria
32,9
Latvia
31,2
Austria
28,4
Romania
25,1
Ireland
23,1
Germany
22,8
Portugal
20,2
Spain
15,4
Finland
15,2
Italy
13,7
France
12,2
Malta
10,8
Greece
7,9
United Kingdom
7,1
Cyprus
5,1
Source: European Commission AMECO and Eurostat
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Figure 5: Internal Devaluation (2008-2012), percentage change of intra-European exports as percentage of GDP (2000-2015).
10,00%
Figure 6: Intra-European exports as percentage of GDP (2000-2015) Source: AMECO and Eurostat Database.
5,00%
The figures 5 and 6 identifies which country have converged over the common market in the last 15 years. Czech Republic, Slovenia and Slovakia showed the highest percent change of intra-European exports as a percentage of GDP. On the other side, countries like Ireland, Finland and France lowered their intra-European exports as a
0,00%
percentage of GDP.
-5,00%
-10,00%
-15,00%
-20,00%
Source: AMECO and Eurostat database
Figure 7: Process of convergence, percentage change (2000-2008): intra-European exports as percentage of GDP (2000-2015)
10,00%
5,00%
0,00%
-5,00%
-10,00%
-15,00%
-20,00% Percentage Change (2000-2007)
Source: AMECO Database and Eurostat
Percentage Change (2008-2012)
Percentage Change (2012-now)
Country with higher openness, like Slovak Republic, Belgium or Netherlands, have higher benefits in adopting a common currency. Country with lower intra-European exports, like Greece, United Kingdom and France, could have had more costs in adopting a common currency (De Grauwe, Economia dell'Unione Monetaria 2016). As Paul Krugman wrote: Before the creation of the euro, some statistical work on the limited number of country pairs sharing a currency suggested that the common European currency might produce an explosion in intra-European trade; that has not happened, but trade does seem to have risen modestly as a result of the single currency, and presumably that corresponds to an increase in mutually beneficial and hence productive exchanges (Krugman, Revenge of the Optimum Currency Area 2013). As argued by De Grauwe, the standard response – based on the theory of optimal currency area thinking – is that monetary union members should do structural reforms so as to make their labour and product markets more flexible. From an economic point of view, flexibility is the solution; from a social and political point of view, flexibility is the problem. It implies wage cuts, fewer unemployment benefits, lower minimum wages, and easier firing (De Grauwe, 2015).
3.3 A PROCESS OF DIVERGENCE European Commission was certain that a higher trade integration, reached through the common currency, would have led to a higher degree of symmetry of business cycles between countries of Eurozone and European Union. However, this has not happened (Krugman, Revenge of the Optimum Currency Area 2013). And it has not happened because of three main reasons: (i) the issues of labour mobility and wage flexibility, (ii) worsening external balances and current account deficits, and (iii) deteriorating productivity and competitiveness in peripherical countries, weakening the degree of synchronization of business cycles.
Table 6: Reasons and causes of a failed Optimal Currency Area. Issues of labour mobility and wage flexibility Worsening external balances and current account deficits Deteriorating productivity and competitiveness in peripherical countries
These three issues produced a process of divergence between Eurozone countries and this have fuelled growing divergence and unsynchronized business cycles. According to the Conference Board, a research group, between 2007 and 2016 real GDP per head at purchasing power parity rose 11 per cent in Germany, barely changed in France, and fell 8 per cent in Spain and 11 per cent in Italy. 53 As stated by Martin Wolf: “The painful truth is that the eurozone has not only suffered poor overall performance, but has also proved to be a machine for generating economic divergence among members rather than convergence.” 3.3.1 Productivity and competitiveness
The effort to ensure a higher trade integration, with the constitution of the common currency, has developed lowering degree of productivity and competitiveness. In facts, as demonstrated by Estrada, Galì and Lòpez-Salido, “a protracted period of rising unit labour costs, resulting from excessive wages increases or a poor productivity performance, could lead, in the absence of an exchange rate adjustment, to a real appreciation, a deterioration of the current account, and higher unemployment” (Estrada, Galí e López-Salido 2012). In facts, in the aftermath of monetary union, in the period 1999-2007, GDP growth, compared with a 15 per cent rise for Germany, reached 39 and 45 percentage points respectively in Spain and Greece, whereas inflation increase figures were 15, 32 and 33 per cent, in that order. At the same time trade competitiveness improved by 7
For further information, data and analysis, see https://www.ft.com/content/b8d5c83a-badf11e6-8b45-b8b81dd5d080?mhq5j=e1 (Wolf s.d.) 53
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for Germany and worsened by 14 and 13 per cent in the other two countries.54 This is clearly a process of divergence. Mario Draghi, governor of the European Central Bank, stated: The [second] condition for lasting stabilisation is the individual commitment of each government to maintain or restore in their own country the conditions of competitiveness that are at the source of balanced growth and employment.55 Competitiveness is mainly related to prices and wages. “Prices, costs and wages are crucial factors for firms to develop and maintain shares of the global market” 56, to cite the governor of the European Central Bank. 3.3.2 Prices and wages
Large capital inflows have led to higher prices and wages. On the same side, productivity has not followed the same growth of prices and wages. This divergence has led to major imbalances in the eurozone where EPC WE that have seen their competitive positions deteriorate have accumulated large current account deficits and thus external indebtedness, matched by current account surpluses of the countries that have improved their competitive positions (mainly Germany) (De Grauwe, In search of symmetry in the eurozone 2012). When private capital flows from the core to the periphery came to a sudden stop, leaving the peripheral economies with prices and unit labour costs that were well out of line with those in the core. Suddenly the euro faced a major adjustment problem (Krugman, Revenge of the Optimum Currency Area 2013). This adjustment problem could have been
For further explanations, see this ppt by Franco Parusello http://www.jeanmonnet.unige.it/materialedidattico/Asymmetric%20shocks%20and%20monetar y%20disintegration.pdf (Parusello s.d.) 55 For further readings, see https://www.ecb.europa.eu/press/key/date/2012/html/sp121130.en.html (Draghi, Competitiveness: the key to balanced growth in monetary union s.d.) 56 For further readings, see https://www.ecb.europa.eu/press/key/date/2012/html/sp121130.en.html (Draghi, Competitiveness: the key to balanced growth in monetary union s.d.) 54
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resolved with a currency depreciation. 57 However, this position is controversial, mainly, because of the so-called neutrality58 of money theory.59 Krugman described the PIIGS situation: When the capital stock has reached a new equilibrium, the economic boom runs out and, provided in the meanwhile labour productivity has not improved, growth subdues and a loss of competitiveness comes into view, which cannot be offset through the exchange rate depreciation. As a result, compared with core eurozone countries, such as Germany or France, peripheral countries record divergences in terms of growth rates and employment levels. Inflation and the Balassa-Samuelson effect is even significant. As stated by Estrada, Galì and Lòpez-Salido: Even slight differences in inflation rates, if persistent, can lead to sizable changes in relative price levels. Note that over the period 1999-2007, Greece, Spain, Ireland and Portugal experienced the highest inflation rates. Differentials have become more muted since 2007. (Estrada, Galí e López-Salido 2012) It is clear that, to a large extent, differences in inflation reflect a strong convergence process in price levels, especially for Greece, Spain, and Portugal (Estrada, Galí e López-Salido 2012). However, this process of price level “convergence” has involved a progressive reduction in the relative competitiveness of those countries with relatively low initial price levels. This convergence process has some connection with the observed patterns of employment: countries whose inflation rates
Even if it is not so clear and automatic. More on Blanchard, Macroeconomics. (Blanchard, Macroeconomics 2017) 59 “The neutrality of money, also called neutral money, says changes in the money supply only affect nominal variables and not real variables. In other words, an increase or decrease in the money supply can change the price level but not the output or structure of the economy. In modern versions of money neutrality theory, changes in the money supply might affect output or unemployment levels in the short run only, but neutrality is still assumed in the long run after money circulates throughout the economy.” http://www.investopedia.com/terms/n/neutrality_of_money.asp#ixzz4kS2KNwa6 57
58
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remained above the average euro area rate experienced stronger employment growth, as demonstrated by Estrada, Galì and Lòpez-Salido (Estrada, Galí e LópezSalido 2012). Furthermore, large capital inflows have fostered property boom, within nontradable sectors, generating higher inflation rates. The main difference between these goods is the international competition (De Grauwe, Economia dell'Unione Monetaria 2016). As explained in the previous chapters, if tradable goods are equal, because of international competition, non-tradable goods have different price levels. In 2007, the euro area periphery countries had a lower relative price of tradable goods and, yet, they experienced larger current account deficits (Estrada, Galí e López-Salido 2012). The main divergence has happened with wages and prices. Paul De Grauwe wrote that adjusting wages and prices, through internal devaluation, could be way more difficult than adjusting the exchange rate. 3.3.3 Labour divergence and mobility
As pointed out by The Economist in 2014: “the difficulty facing the 24-strong council is highlighted by the euro zone’s differing labour-market trajectories over the past decade (a period during which it expanded from 12 to 18 countries). Whereas joblessness has fallen in Germany, from 10.1% to 5.1%, it has soared in Spain, from 11.1% to 25.3%”.
60
A natural consequence of the different
unemployment rates would be for jobseekers to migrate from areas of high unemployment to places with low joblessness. Immigration to Germany from other eurozone states has jumped during the crisis, but from a relatively low level. However, “only 3-4 per cent of the eurozone working age population is employed outside their home country, according to Laszlo Andor, the European commissioner for employment. Language barriers and the many wrinkles in the EU’s attempts to For further readings and analysis, see this article properly called “One money, divergent economies” https://www.economist.com/news/finance-and-economics/21601878-one-currencydivergent-economies (The Economist s.d.) 60
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free up the movement of labour and capital mean the bloc is never likely to match a country like the US in labour mobility.” 61 To ensure a mechanism to restore an equilibrium within a monetary union, it is important a high degree of labour mobility. Mundell, whose classic 1961 paper argued that a single currency was more likely to be workable if the regions sharing that currency were characterized by high mutual labour mobility, as cited by Krugman (Krugman, Revenge of the Optimum Currency Area 2013). As Krugman explained: Well, suppose—to take a not at all hypothetical example—that the state of Massachusetts takes a major asymmetric hit to its economy that sharply reduces employment (which is, in fact, what happened at the end of the 1980s). If Massachusetts workers cannot or will not leave the state, the only way to restore full employment is to regain the lost jobs, which will probably require a large fall in relative wages to make the state more competitive; a fall in relative wages that is much more easily accomplished if you have your own currency to devalue. But if there is high labor mobility, full employment can instead be restored through emigration, which shrinks the labour force to the jobs available. And that is what actually happened. [Table 1] shows snapshots of the Massachusetts economy at three dates: 1986, the height of the “Massachusetts miracle” centered on minicomputers; 1991, after the shift to PCs and the bursting of a housing bubble had brought a severe local recession; and 1996. Notice that Massachusetts never regained the employment share it lost in the late 1980s bust. Nonetheless, by the mid- 1990s it once again had an unemployment rate below the national average, because workers moved elsewhere. (Krugman, Revenge of the Optimum Currency Area 2013)
For further analysis and readings, see https://www.ft.com/content/031b6238-f5f9-11e2-a55d00144feabdc0?mhq5j=e1 (Steen s.d.) 61
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Labour market, therefore, needs two factors to adopt successfully a common currency: flexibility of wages and labour mobility. If high degree of labour mobility is somehow difficult to reach in an area with 19 different languages, European labour markets needs supplementary flexibility of wages. This could be achieved through structural reforms, as highlighted by the European Central Bank paper of 2013 (European Central Bank 2013). However, this is a long path to the top. There is a significant difference between Labour Unions cross European Union: from Germany to United Kingdom. And Labour Unions are vital to define wages and prices, as showed by De Grauwe (De Grauwe, Economia dell'Unione Monetaria 2016). Furthermore, it is incredible costly from a political point of view. The protests against Jobs Act in Italy and Loi Travail in France62 have proven the vision of Paul De Grauwe: internal devaluation and labour flexibility could be good for economist, but evil for people. Or, at least, workers have a substantial negative view about the structural reforms.
3.4 ASYMMETRIC CRISIS WITHIN EUROZONE Symmetry, or the synchronization of business cycles, is central in a well-functioning monetary union (De Grauwe, Economia dell'Unione Monetaria 2016). Symmetry is fundamental to ensure similar business cycle for every country within a monetary union. If there is no synchronization, one country could experience a boom and one another could experience a bust. With a common monetary policy, it is almost impossible to answer in an efficient way, reducing the bad equilibrium and restoring competitiveness. According to the European Commission (1990), closer integration leads to less frequent asymmetric shocks and to more synchronized business cycles between countries (Babetskii 2005). Babetski [2005] endorsed the European Commission view, because higher trade integration means:
62
For further information, see http://www.bbc.com/news/world-europe-36609307 (BBC 2016)
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-
An increase in trade intensity leads to higher symmetry of demand shocks: the effect of integration on supply shock asymmetry varies from country to country
-
A decrease in exchange rate volatility has a positive effect on demand shock convergence (Babetskii 2005).
Furthermore, Jonung and Bergman studied the Scandinavian Currency Union and stated that “a number of recent studies demonstrate that the adoption of a single currency increases trade among members of a monetary union, in this way leading to increased business cycle synchronization within the union, we find that the degree of synchronization tended to increase during the currency union, thus supporting earlier empirical evidence” (Bergman e Jonung 2010). This was the position of the European Central Bank in his economic bulletin in 2013: Greater efforts and determined policy action are still needed in several euro area countries to complete the rebalancing process and ensure its sustainability, particularly
through
further
improvements
in
price
and
non-price
competitiveness. In addition, structural reforms aimed at greater flexibility in labour and product markets are essential in many euro area countries to facilitate external rebalancing within the euro area, now and in the future (European Central Bank 2013). However, Scerlenga and Shin demonstrated that: Applying the proposed approach to the dataset over 1960-2008 for 91 countrypairs of 14 EU countries, we find that the Euro impact on trade amounts to 3-4%, far less than those reported by earlier studies (Serlenga e Shin 2013) Furthermore, Gächter, Riedl and Ritzberger-Grünwald found that:
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“The results of our analysis show a pronounced desynchronization of business cycles during the crisis period, both with respect to dispersion and to the correlation of business cycles” (Gächter, Riedl e Ritzberger-Grünwald 2012). As it is showed in the Figure 5, the trade integration growth has not been homogenous. Moreover, European Monetary Union, as highlighted by Paul De Grauwe, lacking a fiscal union, have tremendous problems of solidity. Asymmetric crisis, triggered by diverse economies and dissimilar needed interest rates, are a main problem for economic stability of a monetary union (De Grauwe, Economia dell'Unione Monetaria 2016). As demonstrated by De Grauwe, after the great recession of 2008-2009, even though Germany and other 4 northern countries have overcome the recession, Netherlands, Finland and GIIPS have not grew enough to reach the pre-crisis level. This demonstrates the presence of large asymmetric shock in the Eurozone. Asymmetric shocks could put in jeopardy the survival of monetary union, since flexibility in the labour markets within member countries, above all in the form of labour mobility, could not be enough and trade integration for some of them could be too low in order to create sufficient benefits from the use of the single currency. 4
FINANCIAL CRISIS IN EUROPEAN UNION
The 2007-2008 Global Financial crisis has been the worst economic recession since the Great Depression of 1929.63 Triggered by a housing bubble in the United States, the crisis has spread throughout the financial markets. Since then, European Union has been hit by two different economic crises. The second one, the Sovereign Debt crisis, was undoubtedly significant to determine a deep recession. Greece lost
For further information see https://web.archive.org/web/20100212214538/http://www.reuters.com/article/pressRelease/id US193520+27-Feb-2009+BW20090227 (Reuters s.d.) 63
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almost 25% of its cumulative GDP growth from 2008 to 2015. 64 In 2013, The Economist wrote: The collapse of Lehman Brothers, a sprawling global bank, in September 2008 almost brought down the world’s financial system. It took huge taxpayerfinanced bail-outs to shore up the industry. Even so, the ensuing credit crunch turned what was already a nasty downturn into the worst recession in 80 years.65 In July and August 2007, the crisis in the US subprime mortgage sector erupted and quickly spilled over to securitised assets more generally, both in the United States and in Europe (Berglöf, et al. 2009). As Blanchard explained in his Macroeconomics: When housing prices declined, and some mortgages went bad, high leverage implied a sharp decline in the capital of banks. This in turn forced them to sell some of their assets. Because these assets were often hard to value, they had to sell them at fire sale prices. This, in turn, decreased the value of similar assets remaining on their balance sheet, or on the balance sheet of other banks, leading to a further decline in capital ratio and forcing further sales of assets and further declines in prices (Blanchard, Macroeconomics 2017). As summed up by The Economist, “it was the result of a range of problems that had built up over time: light regulation of banks, overly complex credit products, tighter cross-border linkages and irrational exuberance in the housing market.”66 As the extent of the economic crisis became clear, policy makers responded with financial, monetary, and fiscal measures: Central banks decreased the interest rates
For further readings see Paul de Grauwe, Economics of the Monetary Union. (De Grauwe, Economia dell'Unione Monetaria 2016) 65 For further information and analysis, see http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-beingfelt-five-years-article (The Economist s.d.) 66 For further explanations, see http://www.economist.com/blogs/economistexplains/2016/09/economist-explains-economics-2 (The Economist s.d.) 64
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under their control. Governments embarked on major fiscal expansions. It is likely that these policies avoided what would have been an even larger decline in output (Blanchard, Macroeconomics 2017). August 2007 marked the first phase of the global financial crisis, with the initiation of liquidity operations by the European Central Bank. The high exposure of major European banks to losses in the U.S. market in asset-backed securities has been well documented, since the dependence of these banks on U.S. money markets as a source of dollar finance (McGuire and von Peter 2009; Acharya and Schnabl 2010; Shin 2012). The Eurozone crisis started in early 2010. Once the crisis arrived in Europe, as Beck and Pedyrò [2015] pointed out that: •
Several Eurozone countries went through deep, persistent financial (and economic) crises, caused not only by bad crisis management policies, but mainly by a pre-crisis debt boom.
•
Sovereign public over-indebtedness (Greece);
•
Real estate private credit bubbles (Ireland and Spain); and
•
Current-account imbalances (Portugal, and also in Spain and Ireland, where the credit and real estate price bubbles were in great part financed by foreign liquidity). (Beck e Peydró, Five years of crisis (resolution) – some lessons 2015)
Low interest rates on Sovereign Bonds yields and large foreign capital inflows have favoured a huge expansion of credit. As Lane explained, this have fostered a large credit boom in European Union between 2003 and 2007 (Lane, 2012). This have created massive foreign borrowing episodes in the European periphery, as explained by Lane (P. R. Lane 2012) Indeed, credit boom and lending boom are two faces of the same medal. Lower interest rates and easier availability of credit stimulated consumption-related and property-related borrowing (Fagan, Gaspar, 2007).
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For example, Ireland experienced a striking increase of loans to private sectors from domestic banks and other credit institutions (Measured as a percent of GDP): in 1998, private credit accounted for 81.2%, in 2002, it reached 104.4% and, lastly, in 2007, it stretched to 185.3% 67 . Similar patterns were followed by Greece, Italy, Spain and Portugal, as it is described in Table 7. Table 7: Private Credit Dynamics. Loans to private sector from domestic banks and other credit institutions (percent of GDP). Country
1998
2002
2007
Greece
31.8
56.5
84.4
Ireland
81.2
104.4
184.3
Portugal
92.1
136.5
159.8
Spain
80.8
100.1
168.5
Italy
55.7
77.3
96.5
Germany
112.2
116.7
105.1
France
81.0
85.6
99.3
Source: World Bank Financial Database However, through the 2008 and 2009, there was relatively little concern about European sovereign debt (P. R. Lane 2012). As Feld pointed out “The loss of price competitiveness combined with the debt-financed increase in domestic demand and the associated imports resulted in high current account deficits”. Baldwin and Giavazzi wrote that “current account imbalances accelerated income convergence by reallocating resources from capital-abundant high-income countries to capitalscarce low-income countries, this would be a positive gain from monetary union” (Blanchard and Giavazzi 2002). This process is similar to the catch-up process experienced by Central and Eastern European Countries [Chapter 2.2]. Yet, as highlighted before, the 2007-2008 Financial crisis triggered an asymmetric shock on European economies: the process of adjustment disproportionally affects
67
For further data, see World Bank Financial Database (World Bank s.d.)
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countries with the greatest reliance on external funding (P. R. Lane 2012) [Chapter 3.3]. The cessation of the credit boom was especially troubling for Spain and Ireland, since their construction sector grew rapidly and the decline of it was a major shock to domestic economic activity, as demonstrated by Lane (P. R. Lane 2012). Sudden decline of large economic sectors has the effect of reducing the tax base. Moreover, rising unemployment implies higher public expenditures: for example, in unemployment subsidies. A big problem, as pointed out by Baldwin and Giavazzi, was that much of the investment headed towards non-tradable sectors [Chapter 2.3] like government consumption and housing (Baldwin, Giavazzi, 2015). This ‘sudden stop’ in investment financing raised concerns about the viability of banks and, in the case of Greece, even governments themselves. The close links between Eurozone banks and national governments provided the multiplier that made the crisis systemic (Baldwin, Giavazzi, 2015). Given the Eurozone design, governments who got in trouble had no lender of last resort (Baldwin, Giavazzi, 2015). As described by Lane, it provides a doom loop68. The ‘doom loop’ is closed by the fact that the banks – who view their national government as their lender-oflast resort – are also major lenders to the governments (Baldwin e Giavazzi 2015). Daniel Gros puts it succinctly: “The euro crisis started as a classic ‘sudden stop’ to cross border capital inflows. As boom turned into bust, government lost their tax base and had to assume private debt, thus creating a public debt crisis.” Stefano Micossi argued that the Greek decision to hide the real public deficit acted as detonator for the Sovereign Debt crisis. At that time Greece estimated its 2009 deficit would be 12.5 per cent of gross domestic product, far above 3.7 per cent predicted in April. It revised its 2008 deficit up to 7.7 per cent from 5 per cent.69 In facts, “The Greek fiscal crisis acted as a detonator in two ways,” write Stefano Micossi, “It alerted the authorities and public opinions in Germany and the other ‘core’ countries to the possibility of large (and hidden) violations of the common For more information, see (P. R. Lane 2012) and (Stratfor Worldview s.d.). For more information, see https://www.ft.com/content/33b0a48c-ff7e-11de-8f5300144feabdc0?mhq5j=e1 (Financial Times s.d.) 68 69
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fiscal rules; and it alerted financial markets to the risk of a sovereign default in a system where the provision of liquidity to ensure the orderly rollover of distressed sovereigns is not guaranteed.” 4.1
SPREADING THE CRISIS IN EUROPEAN UNION: PIIGS
Frankel identifies 3 main causes of the Eurozone crisis: -
Asymmetric shocks [Chapter 3.4].
-
Fiscal policy, “where the problem is the real and perceived moral hazard that the prospects for bailouts create for the incentive of member countries to exercise budget discipline”.
-
Banking, “where the problem is that responsibility for financial regulation was left at the national level while monetary policy was moved to the ECB”. (Frenkel 2015)
Asymmetric shocks were discussed in the previous chapters. Figure 8: GDP Growth in Selected EZ Countries, symmetry of business cycles.
Secondly, Fiscal Policy is crucial to understand the crisis. For Frenkel, “the Stability and Growth Pact had no teeth and no credibility. In other words, the moral hazard
53
problem, though correctly identified, had not been effectively addressed.” In facts, Blyth called it “The Mother of All Moral Hazard”. As Blyth described it: Imagine that you knew Greece was still Greece and Italy was still Italy and that prices quoted in the markets represented the bond-buying activities of banks pushing down yields rather than an estimate of the risk of the bond itself. You might realize that if you buy enough of them – if you become really big – and those assets lost value, you would become a danger to your National banking system and would pose a systemic risk to the whole European financial sector. Certainly, Blyth considers the banking system as malicious. However, Frenkel pointed out in his explanation of the crisis: Why did Mediterranean country spreads relative to Germany all but disappear? Private investors should bear some blame for having pushed the throttle all the way to ‘risk on’ during this period. They, however, would point to top ratings that the bonds received from the rating agencies. Rating agencies should bear some blame, but they would point to the readiness of the ECB to accept the periphery bonds as collateral. Recalling the chapter 3.4, there has been a convergence on Sovereign Bond yields, but the common currency has not developed a convergence of real economic factors, as Corsetti wrote: “the idea that financial integration would contribute to both convergence and macroeconomic stability proved rather naïve” (Corsetti 2015). At the end, banking sector was fundamental. To explain it, Baldwin and Giavazzi described it: A major problem is the so-called doom-loop – the potential for a vicious feedback cycle between banks and their government. Fear about the solvency of a nation’s government fans fears about the solvency the nation’s banks, which in turn weakens the economy, thus worsening the sustainability outlook for the nation. A deadly helix of rising risk premiums and deteriorating budget deficits can suck nations into a debt default vortex (Baldwin e Giavazzi 2015).
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As described by Stratfor Worldview a doom-loop was: Created by European banks' tendencies to hold their home government's debt, the vicious cycle, in theory, starts when markets lose faith in a government's ability to pay back its debt, precipitating a sell-off of its bonds. The resulting drop in bond prices would then hit the balance sheets of the banks that still hold those bonds, making them more likely to need a bailout from their governments. This, in turn, could further erode investor confidence, leading to additional sell-offs that damage the banks even more. Despite the danger that banks' practices pose, eurozone regulators have yet to find a way to sever the loop.70 Finally, deterioration of public finances places a ‘ceiling’ on the market evaluation of credibility for the national banks and consequently banks become hard-pressed for liquidity, as argued by Reinhart and Rogoff (Reinhart and Rogoff, 2010). And when investors become worried about repayment of the debt, they start asking for higher interest rates on government bonds, making it even harder for the government to repay the debt, as demonstrated by Blanchard (Blanchard, Macroeconomics 2017). In this context, banks must cut lending and thus debtors cannot refinance their debts. In facts, as De Grauwe wrote: “we found out that financial markets acquire great power in a monetary union” (De Grauwe, Design failures of the Eurozone 2015). As argued by De Grauwe itself, they can force countries into a bad equilibrium characterised by increasing interest rates that trigger excessive austerity measures, which in turn lead to a deflationary spiral that aggravates the fiscal crisis (De Grauwe, In search of symmetry in the eurozone 2012). As demonstrated by Phillip R. Lane, for Ireland and Spain, the government “In 2012, Europe's sovereign debt crisis exposed the "doom loop." Created by European banks' tendencies to hold their home government's debt, the vicious cycle, in theory, starts when markets lose faith in a government's ability to pay back its debt, precipitating a sell-off of its bonds. The resulting drop in bond prices would then hit the balance sheets of the banks that still hold those bonds, making them more likely to need a bailout from their governments. This, in turn, could further erode investor confidence, leading to additional sell-offs that damage the banks even more. Despite the danger that banks' practices pose, eurozone regulators have yet to find a way to sever the loop […]” as explained on Stratfor. [ For further readings https://www.stratfor.com/image/caneurozone-break-its-doom-loop] (Stratfor Worldview s.d.) 70
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was not a net borrower during 2003 –2007. Rather, households were the primary borrowers in Ireland and corporations in Spain, with the property boom fuelling debt accumulation in both countries. In Portugal and Greece, the government and corporations were both significant borrowers, but these negative flows were partly offset during this period by significant net accumulation of financial assets by the household sector in these countries (P. R. Lane 2012). These adverse developments were reflected in rising spreads on sovereign bonds. For example, the annual spread on ten-year sovereign bond yields between Germany and PIIGS was close to zero before the crisis, because of the convergence on sovereign bond yields (P. R. Lane 2012). However, as confirmed by Baldwin and Giavazzi, the nations with the highest debt ratios were not the ones hit; current account deficits were what mattered (Baldwin e Giavazzi 2015). As Baldwin and Giavazzi demonstrated, nations that relied on foreign capital to cover their savings-investment gap – Ireland, Portugal, Spain and Italy – all nations with substantial current account deficits were affected (Baldwin e Giavazzi 2015). The three countries hereto caught in the crisis were small and their debts were insignificant compared to the overall Eurozone output. Worries started to mount when markets started demanding higher rates for the government bonds of Belgium, Spain and Italy. As argued by Baldwin and Giavazzi, Italy in particular was a mortal threat to the Eurozone given the size of its economy and its massive debt (Baldwin e Giavazzi 2015). Figure 9: Foreign asset position and risk premia.
Baldwin and Giavazzi explained the Italian situation:
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As pointed out by Baldwin and Giavazzi, “when investors started to lose confidence in Italy – a trend which was not helped by its volatile political situation – they sold Italian government bonds in an effort to avoid future losses. These sales pushed interest rates up, making it harder for Italy to fund the rollover of its debt at reasonable rates” (Baldwin, Giavazzi, 2015). This was a self-fulfilling prophecy episode on Italian debt. Italy, in short, was coming down with the sudden-stop disease. As Guido Tabellini puts it: “When hit by a sudden stop, domestic fiscal policy has no option but to become more restrictive, and a credit squeeze cannot be avoided as domestic banks are forced to deleverage. To avoid a deep and prolonged recession, active aggregate demand management at the level of the Eurozone as a whole is required. But this did not happen.” Furthermore, this ‘sudden stop’ was a crisis rather than a problem since Eurozone members could not devalue and their central banks could not bail out the government (Baldwin, Giavazzi, 2015). 4.2
FROM PRIVATE TO PUBLIC: BANKING SYSTEM AND SOVEREIGN DEBT
As The Economist and Vox.EU explained, “the euro-area crisis was not a sovereigndebt crisis. If it had been, one would have expected Belgium and Italy, which entered the crisis with extraordinarily high debts, to have landed in serious trouble. As it turned out, they made it through without troika programmes, while Ireland and Spain, which entered the crisis with low levels of sovereign debt, needed bailouts. The problem, instead, was one of massive capital flows across borders, which encouraged high levels of private borrowing in the economies that eventually got into trouble.”71 As beautifully defined by Lane:
For further explanations and analysis, see http://www.economist.com/blogs/freeexchange/2015/11/disagreement-europe (The Economist s.d.) 71
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In late 2009, the European sovereign debt crisis entered a new phase. Late that year, a number of countries reported larger-than-expected increases in deficit/GDP ratios. For example, fiscal revenues in Ireland and Spain fell much more quickly than GDP, as a result of the high sensitivity of tax revenues to declines in construction activity and asset prices. In addition, the scale of the recession and rising estimates of prospective banking-sector losses on bad loans in a number of countries also had a negative indirect impact on sovereign bond values, since investors recognized that a deteriorating banking sector posed fiscal risks. Because of the gaps in European market structures and governance mechanisms, member state governments could not bail out their “national” banks without risking insolvency, as showed by Jensen, Kelsen and Meunier (Jensen, Kelsen, Meunier, 2015). This has been considered as a major problem: the lack of a lender of last resort in the Eurozone. Governments and Central Banks had to back the National banking system in providing liquidity. In 2007, Irish banks held debt equal to 700% of the entire countries GDP, as showed by Baldwin and Giavazzi. Basically, a banking crisis in Ireland could have brought down the whole nation (Baldwin e Giavazzi 2015). Irish banks got in trouble in 2010 and the Irish government bailed them out. In this way, private debt imbalances became a public debt imbalance (Baldwin e Giavazzi 2015). To stop this crisis, there was much needed something and it was a forceful intervention by European Central Bank Governor Mario Draghi in his famous July 2012 speech (Giavazzi, Baldwin, 2015). If there is a debt buyer-of-last-resort – someone who can purchase unlimited amounts of debt – the suspicion will dissolve and investors are pleased to hold the debt, as Mario Draghi instituted in this speech. So far it has worked. Paul de Grauwe elaborates on the dire consequences of divorcing authority and accountability: “when the Eurozone was started, a fundamental stabilising force that existed at the level of the member-states was
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taken away from these countries. This is the lender of last resort function of the central bank.” This created a fundamental fragility in the monetary union. Without a buyer-of-last-resort, shocks that provide re-funding difficulties in banks or nations can trigger self-fulfilling liquidity crises that degenerate into solvency problems, as pointed out by Baldwin and Giavazzi (Baldwin, Giavazzi, 2015). Daniel Gros writes “In Europe the banks and the sovereign are usually so closely linked that one cannot survive without the other. […] Insolvency of a government would also wipe out the capital of the banks and bankrupt them as well. But an insolvent government would no longer be able to save its banks”. In other words, a liquidity crisis triggered by lack of confidence could push into insolvency not only banks, but also sovereigns with high public debts and no access to the printing press (Baldwin, Giavazzi, 2015). For example, the funds lent by the European Stability Mechanism did not go directly to Spanish banks, increasing their capital. They were borrowed by the Spanish government, which in turned used them to increase bank capital. The outcome was a further increase in sovereign debt, as defined by Baldwin and Giavazzi (Baldwin, Giavazzi, 2015). Beck and Peydro stated: “European policy makers decided not to draw on the extensive crisis resolution experience in and outside Europe, a decision which has led to substantial number of policy mistakes.” The global economic crisis translated in a country specific way into the different economies included in the eurozone (Praussello s.d.). This crisis triggered asymmetric crisis between Eurozone countries and Eurozone was not prepared to address these problems. As pointed out by Beck, “the combination of the failure to address market inefficiencies – especially in labour markets and banking sectors – and fiscal austerity has not only failed to bring the Eurozone out of the crisis, but has made the crisis worse and significantly undermined support for the European integration
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project, which in turn has fuelled support for populist and anti-democratic parties” (Beck, Looking back at a lost decade; avoiding a second one 2017). 5
AUSTERITY: ECONOMIC POLICIES OF EUROPEAN UNION.
5.1 DEFINITION: CONTRACTIONARY FISCAL POLICY Contractionary fiscal policies could be easily clarified starting from Blanchard and his explanation: fiscal contraction (Contractionary fiscal policy) happens whatever the government decides to raise taxes (T) or cut public spending (G) (Blanchard, Macroeconomics 2017). Obviously, fiscal policy is strictly connected to political ideologies and political thoughts. More public spending and higher taxes are usually referred to leftists, lower taxes and less government spending are usually implemented by rightists. However, contractionary fiscal policy could help the government to reduce public deficit or an excessive public debt, but it should be even used to calm down an overheated economy. 72 Fiscal contraction could lead to rebalance an excessive employment level – and its effects on inflation – and to prevent recession and crisis, due to asset bubbles. Usually, Keynesian economists advocate for countercyclical policies. Instead, Hayek and other classical liberal economists supported a vision where government should not be involved in the economy. Therefore, fiscal contraction should be considered as a fundamental economic tool to fight macroeconomic imbalances. On the other hand, contractionary fiscal policies are usually considered as unpopular measures, because of their effects on citizens and firms: higher taxes (T) When a prolonged period of good economic growth and activity causes high levels of inflation (from increased consumer wealth) and inefficient supply allocations as producers overproduce and create excess production capacity in an attempt to capitalize on the high levels of wealth. Unfortunately, these inefficiencies and inflation will eventually hinder the economy's growth and cause a recession. (http://www.investopedia.com/terms/o/overheated_economy.asp#ixzz4k3dUbLtM ) 72
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leads to a lower disposable income (Yd=Y-T) and lesser government spending (G) leads to a decrease in output (Y). 73 Blanchard presents a model in his book “Macroeconomics” to explain this letter claim, where contractionary fiscal policies are based on two variables: •
Government spending (G)
•
Taxes (T)
The
effects
of
a
contractionary
fiscal
policies,
in
this
model,
are:
A fall in output, a fall in prices and a fall in interest rates in the short run. No change in output, but a lower price level and lower level of interest rates, in the medium run. Therefore, contractionary fiscal policy involves a decrease in government spending, an increase in taxes, or a combination of the two. It leads to a left-ward shift in the aggregate demand curve, as it has shown in Panel B of the Figure 10. Figure 10: Short run and long run effects of an expansionary fiscal policy and a fiscal contraction on price level and GDP.
If we consider a standard Keynesian economic model, because there are a significant number of different models which demonstrates other outcomes. 73
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5.2 CLASSIFICATION Contractionary fiscal policy is a general term and it needs to be specified with characteristics and a severer classification. The main discriminant between these policies and a main objective of the debate about it is when to apply a contractionary fiscal policy. This characteristic could be called business cycle. Precisely, the fiscal contraction could be implemented during different business cycle: the boom or the slump. “The boom, not the slump, is the right time for austerity." So, declared John Maynard Keynes 75 years ago (Krugman, Revenge of the Optimum Currency Area 2013). Others, like Alesina, Giavazzi and Pagano
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, have designed a different theory, which is called
“Expansionary Fiscal Consolidation”. This theory claims that a reduction of fiscal imbalances of a country with high public debt could lead to higher expectation and more investments. A concept known as Ricardian Equivalence. Therefore, a fiscal contraction – Bocconi Boys regularly call it fiscal consolidation – could bring growth and higher output. There are, indeed, a difference of goals. The implementation of contractionary fiscal policies could be focused to achieve a deflation, where a country cannot implement currency devaluation, because of a monetary union, a gold standard or others fixedexchange-rate regimes. Internal devaluation (i.e. deflation) is necessary to restore competitiveness. If a contractionary fiscal policy is meant to achieve this goal, it will be called internal devaluation (i.e. deflation). However, a government could implement a fiscal contraction to reduce its public debt or its excessive public deficit. If a contractionary fiscal policy is meant to achieve this goal, it will be called fiscal consolidation. Fiscal consolidation could be run even during a boom, internal devaluation is so hard75 to achieve which is highly improbable.
Usually, they are called Bocconi Boys, since all these authors are professor at the Italian institute or they have studied at this University. 75 De Grauwe, (De Grauwe, In search of symmetry in the eurozone 2012) 74
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Moreover, it has been found a difference between contractionary fiscal policy based on the tools adopted. There is a deep difference between tax-based fiscal contraction and spending-based fiscal contraction. Usually economists denote a spending-based fiscal contraction as a right austerity to be applied in advanced countries. Moreover, the main goal of this policies is to be referred to inefficient bureaucracy and ineffective public spending. Tax-based fiscal contractions are usually highly unpopular and they are considered as a wrong austerity. Indeed, the last characteristic is probably the most controversial: the effects of a contractionary fiscal policy. It could be, banally, contractionary or it could be expansionary, if – theoretically speaking – it is applied to advanced highlyindebted countries. Table 8: Summing up the main characteristic of contractionary fiscal policy. Business Cycle
Boom
Slump
Goals
Deflation
Consolidation
Tools
Tax-based
Spending-based
Effects
Contractionary
Expansionary
5.2.1 Business Cycle Probably, it is the most important characteristic to define what is an austerity policy. Macroeconomists use the term business cycle to describe short-run, but sometimes sharp, contractions and expansions in “economic activity” (Abel e Bernanke 2001). The definition of a business cycle will be taken by Burns and Mitchell: Business cycles are a type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises. A cycle consists of expansions occurring at about the same time in many economic activities, followed by similarly general recessions, contractions, and revivals
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which merge into the expansion phase of the next cycle; this sequence of changes is recurrent but not periodic; in duration business cycles vary from more than one year to ten or twelve years. (Burns e Mitchell 1946) The key features of business cycle are the definition of pro-cyclical and countercyclical policies. This is mostly related to Keynesian and classical theories. As Abel and Bernanke stated: In brief, classical economists view business cycles as generally representing the economy's best response to disturbances in production or spending. Thus, classical economists do not see much, if any, need for government action to counteract these fluctuations. In contrast, Keynesian economists argue that, because wages and prices adjust slowly, disturbances in production or spending may drive the economy away from its most desirable level of output and employment for extended periods of time. According to the Keynesian view, government should intervene to smooth business cycle fluctuations (Abel e Bernanke 2001). Therefore, we should recall the statement of John Maynard Keynes: “The boom, not the slump, is the right time for austerity”. Indeed, Keynesian economist think it is necessary to apply counter-cyclical policies: fiscal and monetary contraction during a boom, fiscal and monetary expansion during a slump. In facts, as written by Abel and Bernanke: “Keynesian economist, usually, advocated for a fiscal contraction during economic booms” (Abel e Bernanke 2001). Consequently, austerity is a pro-cyclical policy, because government decides to apply a contractionary fiscal policy during a period of slump or a recession. As a pro-cyclical policy should be considered as a non-Keynesian policy. 5.2.2 Goals Goals are truly important to define key features of an austerity policy. Goal defines why a government should implement an austerity policy, which is usually defined as unpopular measures. In facts, as highlighted before, raising taxes or cutting
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pensions, public servants’ wages, unemployment subsidies or public services could be extremely ostracised by citizens. In facts, austerity measures implemented in 2010-2011 were followed by protests and the birth of new social movements, like indignados in Spain. Contractionary fiscal policies are usually directed towards reducing fiscal deficit and public debt. In this case, the best term to describe such a policy is fiscal consolidation. Fiscal consolidation could be expansionary according to Alesina, Giavazzi, Pagano et al. Their theory about Expansionary Fiscal Consolidation states that a fiscal consolidation in a high indebted country could bring to more investments and a stronger economic growth (Alesina, Ardagna e Galí, Tales of Fiscal Adjustment 1998). Although there is widespread agreement that reducing debt has important longterm benefits, there is no consensus regarding the short-term effects of fiscal austerity (International Monetary Fund 2010). This is strongly related to effects of a contractionary fiscal policy. However, this is not the only goal of a fiscal contraction. When there is a financial bust, there are (mainly) four ways to adjust: inflate, deflate, devalue, or default (Blyth 2013). Blyth demonstrated that if a country is unable to use inflation, devaluation (of the National currency) or to default, the only way to restore competitiveness and re-establish a decent economic growth is to deflate. Deflation or internal devaluation is a policy aimed to lower price and wages, in order to restore the price competitiveness. This policy is usually implemented by countries who are unable to run a proper monetary policy, because of their membership in a monetary union or if their currency is pegged (Blyth 2013). Therefore, the definition of austerity implies a fiscal consolidation or a deflation (internal devaluation) during a recession. Austerity is achieved through a fiscal consolidation or an internal devaluation, as these policies are designed to reduce the public deficit or to restore competitiveness. Restoring competitiveness could be
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expressed as reducing the trade deficit. Austerity, therefore, is a set of policies directed to the reduction of public deficit or trade imbalances. Mainly, during the Eurozone crisis, austerity measures were implemented to achieve a deflation, to restore competitiveness with European core countries. Other countries have implemented a policy of fiscal consolidation during a recession, as the United States after the 1929 Wall Street crisis. 5.2.3 Tools The implementation of fiscal contraction requires the choice between raising taxes or reducing government spending. This is necessary to define, because it has significant political and economic implications and different desired-effects. For the OECD, “successful fiscal consolidations in the past have been largely driven by spending cuts due to political economy considerations and their positive impacts on efficiency and, when concentrated on transfers and other current spending, their perceived durability” (OECD 2012). For many economists, raising taxes would be counteractive in advanced countries. “Already reaching around 35% of GDP on average across the OECD (and up to around 50% of GDP in some countries), many tax regimes reduce GDP by blunting incentives to work, save and invest” (OECD 2012). Therefore, spending-based fiscal consolidation is considered as a better policy tool by many economists and economic institutions. As Alesina, Favero and Giavazzi demonstrated: An increase in taxation will […] have an unambiguous contractionary effect on output as the negative wealth effect on the demand side (both on consumption and on investment) is combined with the negative effect of increased distortions on the supply side. A reduction in government employment could instead be expansionary (Alesina, Favero e Giavazzi, The output effect of fiscal consolidation plans 2014).
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Moreover, a significant number of arguments and empirical studies suggest that spending restraint (notably with respect to government consumption and transfers) is more likely to generate lasting fiscal consolidation and better economic performance, as demonstrated by Guichard (Guichard, et al. 2007). Spendingbased fiscal consolidation are, therefore, a way to ensure a successful austerity. 5.2.4 Effects This is probably the most controversial characteristic of fiscal contraction. Some economists have theorized expansionary effects of a fiscal consolidation in high-indebted countries. These authors show that lower government spending may imply, through lower taxes on capital, higher investment and possibly higher output (Alesina, Favero e Giavazzi, The output effect of fiscal consolidation plans 2014). For Keynesian economists, fiscal contraction effects are always contractionary, as Paul Krugman stated, and it has any expansionary effect. 5.3 DEFINITION: AUSTERITY Therefore, there are four characteristics to define austerity. Consequently, the definition of austerity will be: Austerity measures are a specific type of contractionary fiscal policy or fiscal contraction. Specifically, austerity is a fiscal contraction applied during a slump or a recession. Austerity could be achieved through a deflation or a fiscal consolidation. Moreover, austerity could be tax-based or spending-based and it might display expansionary effects, even if, traditionally, it has contractionary effects. Austerity is a set of fiscal and economic policies implemented to ensure a fiscal consolidation or an internal devaluation: any attempt to reduce the government's deficit by cuts to public spending or higher taxes. Wren-Lewis, a British economist, is even more precise: not only the term austerity is related to an attempt to reduce the government’s deficits, but it is deeply related to a significant increase of
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involuntary unemployment rate (Wren-Lewis 2016). As Wren-Louis76 itself pointed out in his “A General theory on Austerity”: A more technical definition would be that austerity is fiscal consolidation that leads to a noticeably larger negative output gap. This definition implies that while austerity will always involve fiscal consolidation, fiscal consolidation could occur without austerity (Wren-Lewis 2016). However, as it is classified before, austerity run towards a deflation leads clearly to an increase in unemployment: this is the goal of the policy. Restoring competitiveness without the possibility to devalue the currency implies the necessity to implement an internal devaluation. Fiscal consolidation, as pointed out by Wren-Lewis, could occur without austerity, notably during a boom. Mark Blyth, professor of International Political Economy at Brown University, describe austerity as “a form of voluntary deflation in which the economy adjusts through the reduction of wages, prices, and public spending to restore competitiveness, which is supposedly best achieved by cutting the state’s budget, debts, and deficit. […] This will inspire “business confidence” since the government will neither be “crowding-out” the market for investment by sucking up all the available capital through the issuance of debt, nor adding to the nation’s already too big debt” (Blyth 2013). Paul Krugman was one of the most popular economist against austerity measures and in favour of a fiscal stimulus programme. He explained his position in a piece, published by The Guardian on the 29th April 2015: By late 2008 it was already clear in every major economy that conventional monetary policy, which involves pushing down the interest rate on short-term government debt, was going to be insufficient to fight the financial downdraft. Now what? The textbook answer was and is fiscal expansion: increase Simon Wren-Lewis is a British economist. He is a professor of economic policy at the Blavatnik School of Government at Oxford University and a Fellow of Merton College. 76
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government spending both to create jobs directly and to put money in consumers’ pockets; cut taxes to put more money in those pockets. But won’t this lead to budget deficits? Yes, and that’s actually a good thing. An economy that is depressed even with zero interest rates is, in effect, an economy in which the public is trying to save more than businesses are willing to invest. In such an economy, the government does everyone a service by running deficits and giving frustrated savers a chance to put their money to work. Nor does this borrowing compete with private investment. An economy where interest rates cannot go any lower is an economy awash in desired saving with no place to go, and deficit spending that expands the economy is, if anything, likely to lead to higher private investment than would otherwise materialise.77 To explain the means of austerity explained by a supporter of these policies, Blyth cites John Cochrane of the University of Chicago: “Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.” Cochrane tried to determine how useless is a fiscal stimulus as a proper policy to restore economic growth after a crisis. Cochrane describes the fallacies of the fiscal stimulus to help an economy in a recession: 1. If money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. This form of “crowding out” is just accounting, and doesn't rest on any perceptions or behavioural assumptions.
For further readings, see https://www.theguardian.com/business/nginteractive/2015/apr/29/the-austerity-delusion (Krugman, The austerity delusion 2015) 77
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2. Investment is “spending” every bit as much as is consumption. Keynesian fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather than save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift. 3. People must ignore the fact that the government will raise future taxes to pay back the debt. If you know your taxes will go up in the future, the right thing to do with a stimulus check is to buy government bonds so you can pay those higher taxes. Now the net effect of fiscal stimulus is exactly zero, except to raise future tax distortions. The classic arguments for fiscal stimulus presume that the government can systematically fool people. Cochrane identifies at least three problems of Keynesian fiscal stimulus. The first one is purely political. Cochrane sees redistribution of wealth, operated through higher government spending, as damaging for the economy. The second one is the backbone of the main controversy between Keynesian and non-Keynesian: the conflict between spending and investment. Finally, the third one is related to the fiscal consolidation concept. Sound public finances enhance growth and economic stability better than a fiscal stimulus. However, Cochrane itself identifies a wrong type of austerity. 78 In his blog, the Grumpy Economist, he rejects the term austerity and writes “But on one point I think we can agree.79 Steep tax increases, especially steep increases in marginal tax rates on people likely to work, save, invest, start new businesses, and hire others, are an especially bad idea right now. The only hope to pay back debt is growth, and
For further readings and information, see http://johnhcochrane.blogspot.it/2015/08/thewrong-austerity.html (John Cochrane s.d.) 79 With Krugman and others, who are supporting the implementation of a fiscal stimulus to rehabilitate the economy after a crisis. 78
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this sort of thing just kills growth.”80 To sum up, Cochrane identifies the wrong austerity as the tax-based fiscal consolidation. Veronica De Romanis, a Political Economy professor at Stranford University in Firenze and LUISS Roma, stated which the right austerity is to cut unproductive government spending and to implement structural reforms: spending review, privatizations and reforms.81 Therefore, right austerity should be considered as the spending-based fiscal consolidation, with more reforms to make more efficient the markets and to liberalize and free the market potential. In facts, in his blog, Cochrane identifies main problems of Greek economy: “the stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the “structural reform program” aimed at “deeply ingrained structural rigidities in labour, product, and service markets” got nowhere?”82 Finally, he concludes: ““Structural reform” is vital to restore growth now, not a vague idea for many years in the future when the stimulus has worked its magic. Europe learned that it’s also a lot harder politically than the breezy language suggests. “Reform” isn’t just “policy” handed down by technocrats like rules on the provenance of prosciutto; it involves taking away subsidies and interventions that For further readings, see http://johnhcochrane.blogspot.it/2015/08/the-wrong-austerity.html (John Cochrane s.d.) 81 For further information, see http://www.firstonline.info/News/2017/06/17/de-romanislausterita-non-e-uneresia-se-e-buona-fa-crescere-/MTdfMjAxNy0wNi0xN19GT0w (Locatelli s.d.) 82 For further readings, see http://johnhcochrane.blogspot.it/2012/03/austerity-stimulus-orgrowth-now.html (John Cochrane s.d.) 80
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entrenched interests have grown to love, and support politicians to protect. They will fight it tooth and nail.”83 Cochrane is surely influenced by the Ricardian Equivalence. “Simple analysis usually assumes that if government spending rises today and taxes are held constant, total demand will increase. The government buys more, and there is no reason for higher government demand to reduce private demand directly because taxes have not changed. According to Ricardian Equivalence, however, rational, forward-looking taxpayers will anticipate paying for government spending at some time in the future. If the government defers taxation, taxpayers will save enough of their current income to pay the higher taxes in the future necessary to meet the bond obligations. This higher saving causes private demand to decline when government demand rises, which reduces, if not totally eliminates, the demand stimulus created by higher government spending.”84 As summarized by Quah: “Standing for growth does not mean constant and unwavering support for always high government spending and expansionary monetary policy. By the same token, backing policies to lower debt and deficits does not mean wanting economic life to be wretched. Even when the final goal is the same — to have a healthy, prosperous, inclusive economy — depending on circumstances there is a time and place for different approaches to government policy”.85 For Cochrane, De Romanis and other economists, austerity 86 should work as a proper policy to reduce the State burden on the market economy. As Ronald Reagan
For further information, see http://johnhcochrane.blogspot.it/2012/03/austerity-stimulus-orgrowth-now.html (John Cochrane s.d.) 84 For further readings, see https://muddywatermacro.wustl.edu/fiscal-policy-intro/basiclogic/ricard-equiv (Muddy Water Marco s.d.) 85 For further readings, seehttp://blogs.lse.ac.uk/politicsandpolicy/uk-austerity-and-growthwinter-is-coming/ (Quah s.d.) 86 This term is rejected by pro-fiscal consolidation economist. 83
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stated, “government is not the solution to our problem; government is the problem”.87 Once again: austerity and its controversies are mainly political.
5.4 KEYNES VS. HAYEK ON AUSTERITY In 1932, John Maynard Keynes and Freidrich Hayek exposed their view on public spending and fiscal stimulus on the London Times. The confrontation between these two economists produced two different views on the implementation of these policies during a recession. Keynes and Hayek were notably arguing if austerity could have led a country out of a recession or could have determined a significant deterioration of the economic situation. In facts, Hayek was certain that: “These programs [Fiscal and monetary stimulus] would simply delay a day of reckoning. Instead, the economist argued that governments should instead reduce spending and taxes [Austerity] in order to make room for the free markets to determine the right course of action. While this could mean a deleveraging in the short-term, it would equate to a far healthier long-term economy.” Instead, Keynes argued that: “Governments should intervene to help put jobless back to work by implementing economic stimulus and other programs. If these people were employed, GDP growth would accelerate and debt as a percentage of GDP would be reduced. The prospects of a long-term growth rate would also making financing current projects much easier.” As wrote by Wapshott: Hayek failed to deliver a knock-out blow to Keynes, and although he returned to the fight in the London School of Economics learned journal Economica in the autumn of 1931, the argument about whether it is best to stimulate an economy 87
For further information, see http://www.presidency.ucsb.edu/ws/?pid=43130
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in the face of large scale unemployment or rather, let the market find its own solution, has been going on ever since. It continues to dominate not only the debate in Britain about whether growth or austerity should be the government’s guidelines in forming economic policy, but is at the heart of the presidential contest [2012] between Barack Obama (in favour of stimulus) and Mitt Romney (let the market fix the problem), as well as the extraordinary political and economic gavotte taking place in Europe to save the euro.88 Wapshott described beautifully the two positions which have designed modern economies: In brief, Keynes suggested that governments should keep the price of money cheap for a long time in order to deter savings and provide predictably affordable loans to entrepreneurs and businesses who would then take on workers; that taxation should be slashed so that people had cash to spend on goods that would create jobs; and that, in the last resort, governments should employ the jobless themselves to improve national infrastructure. If the government needed to borrow money to achieve these policies, never mind, he argued, the debt could easily be repaid as soon as everyone was back in work and could once again afford to pay tax. In his LSE lectures, Hayek, whose personal fear of inflation that had ravaged his homeland of Austria after the First World War was the well-spring of his thoughts, argued that while a Keynesian stimulus may well put some people to work, in the medium to long term the market would become so distorted that when the stimulus was removed employers would be left making goods that were no longer needed89.
For further readings, see http://blogs.lse.ac.uk/politicsandpolicy/keynes-hayek-nicholaswapshott/ (Washpott s.d.) 89 For further information, see http://blogs.lse.ac.uk/politicsandpolicy/keynes-hayek-nicholaswapshott/ (Washpott s.d.) 88
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As Jean Pisani-Ferry wrote in his 2012 piece “The Great Austerity Debate”, posted on Bruegel Institute site: Until the 1980s, it was routinely assumed that the so-called "multiplier" – the ratio of change in GDP to the change in government spending – was stable and larger than one. A dollar less of spending was believed to reduce GDP by more than one dollar, so that fiscal retrenchment was economically costly (while, conversely, stimulus was effective). Then came the counterrevolution, which advanced a long list of reasons why the multiplier was likely to be much lower. Cut spending, it was said, and inflation would fall. The central bank would lower interest rates, households would spend in anticipation of lower taxes, and business confidence would be boosted. In the end, there would be little, if any, damaging impact on output.90 In a slump, governments should increase, not reduce, their deficits to make up for the deficit in private spending. Any attempt by government to increase its saving (in other words, to balance its budget) would only worsen the slump. This was Keynes’ “paradox of thrift”.91 The debate on Austerity is still highly controversial. Therefore, austerity should be divided by its goals. Fiscal consolidation, through a fiscal contraction during a slump, and internal devaluation, if the country could not run a proper monetary policy.
For further readings, see http://bruegel.org/2012/11/the-great-austerity-debate/ (Pisani-Ferry, The Great Austerity Debate s.d.) 91 For further readings, see http://economistsview.typepad.com/economistsview/2010/06/paradox-of-thrift-versusconfidence-in-the-markets.html 90
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5.5 FISCAL CONSOLIDATION As it is said before, fiscal consolidation does not imply austerity. The majority part of times, fiscal consolidation is implemented during an economic boom, as a counter-cyclical policy. Austerity implies a procyclicality of fiscal consolidation. In the late 20th century, most advanced countries managed to pursue countercyclical fiscal policy on average: generally reining in spending or raising taxes during periods of economic expansion and enacting fiscal stimulus during recessions.92 As Jeremie Cohen-Setton pointed out, a country which implements fiscal consolidation during an economic boom could take advantage to run budget surpluses, pay down debt and build up reserves, which would allowed it the fiscal space to ease up and to operate a fiscal stimulus during probable future crisis. 93 On the contrary, procyclical fiscal policy could overheat the economy during a boom or depress even further an already bust economy. Jeremie Cohen-Setton described the damage of a procyclical policy: “they sought fiscal stimulus at times when the economy was already booming, thereby exaggerating the upswing, followed by fiscal austerity when the economy turns down, thereby exacerbating the recession”.94 Procyclicality was a main feature of Latin American countries before the 2000s. As a matter of facts, during the Sovereign Debt crisis in Eurozone, it has been implemented policies of fiscal consolidation during a recession. More specifically, Eurozone peripherical countries have enhanced procyclical policy to sustain public debt and to assure financial markets on their sovereign debts solvency. These policies were proposed enforced by the so-called Troika: European Commission, European Central Bank and International Monetary Fund.
For further readings, see http://bruegel.org/2016/05/the-abandonment-of-counter-cyclicalfiscal-policy/ (Cohene-Setton s.d.) 93 For further readings, seehttp://bruegel.org/2016/05/the-abandonment-of-counter-cyclicalfiscal-policy/ (Cohene-Setton s.d.) 94 For further readings, see http://bruegel.org/2016/05/the-abandonment-of-counter-cyclicalfiscal-policy/ (Cohene-Setton s.d.) 92
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Typically, these measures were necessary to restore competitiveness and reducing the public deficit. These measures were implemented with the decision to bail-out and concede a huge amount of financial assistance to certain European countries, like Spain and Ireland. For instance, in 2011, Portugal received a bailout that was tied to a series of spending cuts and other reforms.95 The OECD describes fiscal consolidation as a policy aimed at reducing government deficits and debt accumulation. As a matter of facts, apart from the risk of sovereign default, excessive public debt might also have a negative impact on financial stability. Bruegel’s database developed by Merler and Pisani-Ferry (2012) with later updates shows that commercial banks in some euro-area countries (Portugal, Italy, Greece, Spain, Germany, and Ireland) have high exposures to marketable sovereign debt.
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The connection between the banking sector and sovereign debt is
dramatically fundamental, as it has been demonstrated by Blyth and many others regarding the Spanish and Greek banking sectors. As written by Alesina and others: “Many European economies did not enter the financial crisis with a clean fiscal slate. Before the crisis, debts and deficits were already high in many countries. One reason was the low interest rates of the first decade of the Euro, which had facilitated large debt build-ups in several countries, especially in the European periphery. The country with the largest debt was Italy, with a ratio to GDP of 1.06 in 2008. Among the other, Greece had a ratio of 1. But even countries with apparently better fiscal positions (such as Spain and Ireland) still had budget deficits, notwithstanding an exceptional (and as it turned out unsustainable) level of revenues accruing from a booming construction sector and real estate market. Concerns about fiscal sustainability were not limited to the European
For further analysis, see http://blogs.lse.ac.uk/europpblog/2017/05/23/portugal-leadersexploited-bailout-to-pass-measures-they-already-supported/ (Moury e Standring s.d.) 96 For further information, see http://bruegel.org/2016/12/challenges-to-debt-sustainability-inadvanced-economies/ (Dabrowski s.d.) 95
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periphery. Many countries faced the challenge posed by the rapid aging of their populations: social expenditure had increased from an average of 18% of GDP in 1980 to 25% and 2009, with a rise of 5 percentage points of GDP in just the last 10 years. Moreover, total government spending, even if reduced at the end of the 90s to meet the Maastricht criteria, was still high in 2007 (43 percent in 2007 in the EU average). The average share of public spending over GDP had increased from 34% in 1970 to 43% in 2007 in the OECD economies”. (Alesina, Barbiero, et al. 2014) Therefore, fiscal consolidation was unavoidable. However, as written by Simon Wren-Lewis (Wren-Lewis 2016), there was no good macroeconomic reason for austerity – fiscal consolidation – at the global level over the last five years (2015), and austerity seen in periphery Eurozone countries could most probably have been significantly milder. As austerity could have been so easily avoided by delaying global fiscal consolidation by only a few years, a critical question becomes why this knowledge was not applied.97 However, if we consider the importance of engaging these countries in policies of internal devaluation, to restore price competitiveness and to seek a balanced position, fiscal consolidation could have been avoided, but internal devaluation should have been implemented anyway. This is probably the so-called TINA, There Is No Alternative, argument, but it is considerably important. Moreover, there was an urgent problem of credibility on financial markets. However, as highlighted by Bruegel Institute in his post “Challenges to Debt Sustainability in Advanced Countries”, “our debt sustainability simulations for those advanced economies whose gross public debt-to-GDP ratio exceeded 80 percent in 2015, suggest that the current record-low interest rates and post-crisis growth recovery should be used for fiscal consolidation now”.98
For further information, see http://bruegel.org/2016/05/the-abandonment-of-counter-cyclicalfiscal-policy/ (Pisani-Ferry, The Great Austerity Debate s.d.) 98 For further analysis, see http://bruegel.org/2016/12/challenges-to-debt-sustainability-inadvanced-economies/ 97
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Alesina and Ardagna defined two diverse ways to reduce large debt/GDP ratios: -
Sustained economic growth.
-
A period of controlled and moderate inflation.
If the first one is not credible in these times, the second one is defined as “medicine worse than the disease” (Alesina e Ardagna, Large Changes in Fiscal Policy: Taxes versus Spending 2010). Neither inflation, nor growth was possible by the point of view of these authors. Therefore, fiscal consolidation has been considered as unavoidable. Another critical issue is to define the foreign asset position of the country, as highlighted by Daniel Gros. Many economists noted that it was not a sovereign debt crisis, because the high-indebted countries, as Belgium, did not get involved in these dynamics. In facts, Gros demonstrates that Belgium was in a better condition on foreign assets than Mediterranean countries. Overall, Gros found out a correlation between foreign assets position and spreads against German bund, as it is shown in Figure 9. Anyway, if growth alone cannot do it and inflating away the debt carries substantial risks, we are left with the accumulation of budget surpluses to rein in the debt in the next several years in the post-crisis era (Alesina e Ardagna, Large Changes in Fiscal Policy: Taxes versus Spending 2010). Figure 11: Extent of Pro-cyclical policies in Advanced Economies during and after the financial crisis.
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Alesina and Ardagna identifies a few effects of fiscal consolidation: -
Consumers anticipate a permanent increase in their lifetime disposable income, and this may induce an increase in current private consumption and in aggregate demand. This effect is strongly related to the so-called Ricardian Equivalence.
-
If agents believe that the stabilization is credible and avoids a default on government debt, they can ask for a lower premium on government bonds.
-
Expansionary effects of fiscal adjustments work via the labour market and via the effect that tax increases and/or spending cuts have on the individual labour supply.
The last two effects are particularly interesting for defining the Eurozone crisis. With skyrocketing Sovereign Bonds yields of peripherical countries, a fiscal consolidation could have helped these countries to lower their borrowing costs. Furthermore, a fiscal consolidation could restore competitiveness, through an internal devaluation, as pointed out by the third effect of a fiscal consolidation. It is important to notice which fiscal consolidation could have two different natures, based on the business cycles when it is implemented.
5.6 INTERNAL DEVALUATION Figure 12: Restoring competitiveness, average nominal wages as % of Germany
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The concept of internal devaluation is probably more important to better understand and to gain a deeper insight of the Eurozone and European crisis. Internal devaluation or deflation is a policy aimed to reduce wages and prices, in order to restore competitiveness without using a currency devaluation. Restoring competitiveness is necessary to improve exports performance of a country, thus expanding the aggregate demand. As explained by Armingoen and Baccaro, its goal is to reduce prices relative to other countries by cutting employment and wages and by introducing structural policies (especially labour market and welfare state liberalization) aimed to increase wage and price flexibility. (Armingoen e Baccaro 2012) Of course, an internal devaluation could have been implemented together with a fiscal consolidation. However, internal devaluation is indistinguishably connected to monetary union, hard-pegged currencies and other fixed-exchange-rate regimes. In facts, internal devaluations are applied as a way to avoid operating a currency devaluation. This could preserve the peg or the participation in a monetary union. Paul Krugman affirmed that the implementation of internal devaluation has proved extremely hard. (Krugman, Revenge of the Optimum Currency Area 2013) As pointed out by the International Monetary Fund itself, internal devaluations are almost inevitably associated with deep and drawn-out recessions, because fixed exchange rate regimes put the brunt of the adjustment burden on growth, income, and employment. However, this view was opposed by many economists. For instance, Anders Åslund, a Swedish economist, argued that internal devaluations are advantageous99. Åslund pointed out three examples of successful internal devaluations: Denmark pegged its krone to the Deutschmark in 1982 to achieve more structural reform and cost control, what we now call internal devaluation, and it For further information, see https://piie.com/blogs/realtime-economic-issues-watch/whyinternal-devaluation-advantageous (Åslund, Why Internal Devaluation Is Advantageous s.d.) 99
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succeeded. In 1987–89, Holland did the same with similar success. So did Germany in the early 2000s, and all three Baltic countries as well as Bulgaria did so in 2008–10. Thus, contrary to the unverified IMF statement, internal devaluation has probably been the most successful reform strategy in Northern Europe. It is a different matter that severe crises are always difficult to resolve. When big adjustments are necessary, the social cost becomes substantial regardless of the solution.100 However, the International Monetary Fund stated: The experience of Argentina in 1998–2002 shows that an economy can get trapped in a downward spiral in which adjustment through internal devaluation eventually proves impossible, and the only way to an eventual recovery remains default and the abandoning of the exchange rate peg.101 Åslund ends his paper affirming: On the contrary, if a country maintains a fixed exchange rate, it is forced to undertake more structural reform, and is more likely to do so. Fixed exchange rates prompted the greatest fiscal and structural adjustments in Central and Eastern Europe.102 Therefore, internal devaluation could support structural reforms and restore the competitiveness of the economy. Although, it is probably more precise if it is considered which internal devaluation is necessary to maintain the value of the currency, because when a country has adopted a fixed exchange rate regime (for example, a currency board or a hard peg, as in the Baltic states) or has joined a monetary union, then internal devaluation – For further readings, see https://piie.com/blogs/realtime-economic-issues-watch/whyinternal-devaluation-advantageous (Åslund, Why Internal Devaluation Is Advantageous s.d.) 101 For further data and analysis, see https://www.imf.org/external/pubs/ft/scr/2012/cr1257.pdf (Fund s.d.) 102 For further information, see https://piie.com/blogs/realtime-economic-issues-watch/whyinternal-devaluation-advantageous (Åslund, Why Internal Devaluation Is Advantageous 2012) 100
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that is, a relative downward adjustment in production costs, notably nominal wages, and prices – is the only way to adjust the real exchange rate in the short run, as argued by Myant, Thodoropoulou and Piasna (Myant, Theodoropoulou e Piasna, Unemployment, internal devaluation and labour market deregulation in Europe 2016). However, as more precisely pointed out by Piton and Bara: In practice, however, governments have no influence on overall prices and must rely on the propagation of a substantial cut in civil servants’ wages to the private sector’s salaries, and eventually to producer prices. The process should lead to a shift in investment from the non-tradable towards the tradable sector. Structural reforms should allow for increased productivity (Piton e Bara 2012). In Europe, internal devaluation was first adopted in the Baltic states which, even though they did not belong to the euro zone, chose to maintain currency pegs/boards, while pursuing adjustment policies against their balance of payments crises (Myant, Theodoropoulou e Piasna, Unemployment, internal devaluation and labour market deregulation in Europe 2016). Latvia cut public servants wages by 13.2% in 2009 and 8.1% in 2010 and reduced public service payroll by 19% between 2008 and 2010 (Piton e Bara 2012). Ireland engaged itself in similar economic policies. The country made substantial cuts to public servants’ wages: by 4.4% in 2010. Consequently, consumer prices fell by only 2.1% in Ireland between 2008 and 2011 (Piton e Bara 2012). Piton and Bara conclude their paper stating: Overall, internal devaluation produced in these countries limited results at the cost of widespread social hardship and long-standing strains on domestic demand. Real exchange rate misalignments were wider in Portugal and Greece in 2011 than they were in Ireland and Latvia in 2008. Deflationary policies seem likely to fail in these countries and in any case, will not be enough to efficiently curb existing disequilibria. Moreover, deflation could weigh the debt burden
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down, pushing already high public debt further on an unsustainable trajectory (Piton e Bara 2012). Though, as demonstrated by Åslund, Latvia, and the other Baltic countries, on the contrary, have seen a stunning expansion of exports and manufacturing after the crisis that not even the greatest optimists predicted. Estonia and Lithuania experienced a peak annualized export growth of 45 percent in the first quarter of 2011 (Åslund, Why Internal Devaluation Is Advantageous 2012). Myant does not agree with him. In a post on the London School of Economics and Political Science blog, she states: There are many grounds for criticising internal devaluation. It has not led recovery in any part of the European Union. Nor was the crisis caused by issues of cost competitiveness. It was caused by failures in the finance system which led to high spending, and hence current account deficits, in a number of countries. Nevertheless, improving competitiveness and increasing exports in those countries would seem highly desirable. The trouble is that internal devaluation is not the way to achieve this because the policy is based on a flawed conception of competitiveness (Myant, Why internal devaluation fails 2016). Moreover, as argued by Myant, Theodoropoulou and Piasna, a less painful approach would have been if member states with current account surpluses (for example, Germany and other European core countries) had also take action to produce an internal revaluation of their real exchange rate by increasing demand and investments in their economy. More expansionary fiscal or monetary policies could have helped in that direction. However, fiscal policies have been constrained by the European Union fiscal rules, whereas until 2013 the ECB was fairly reticent in its responses to recession in the area. (Myant, Theodoropoulou e Piasna, Unemployment, internal devaluation and labour market deregulation in Europe 2016)
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Paul De Grauwe seems to agree with Myant. He states in a 2012 paper called “In search of symmetry in the Eurozone”: One can conclude that the burden of the adjustments to the imbalances in the eurozone between the surplus and the deficit countries is borne almost exclusively by the deficit countries in the periphery. Surely some symmetry in the adjustment mechanism would alleviate the pain in the deficit countries. The surplus countries, however, do not seem to be willing to make life easier for the deficit countries and to take their part of responsibilities in correcting external imbalances. […] The asymmetry in the adjustment mechanism in the eurozone is reminiscent of similar asymmetries in the fixed exchange rate regimes of the Bretton Woods and the European Monetary System. In both these exchange rate regimes, the burden of adjustment to external disequilibria was borne mostly by the deficit countries. (De Grauwe, In search of symmetry in the eurozone 2012) When discussing the effects of internal devaluation in the euro zone it is, therefore, important to distinguish between internal exchange rate adjustment (devaluation or revaluation) as a means of adapting to asymmetric shocks and internal devaluation as a strategy for improving economic performance. The current account imbalances that emerged in the euro zone reflect divergent domestic demand developments rather than export performance (European Commission 2009, 27) and thus some realignment of relative prices is required across the eurozone member states. Ideally, that should take place in both deficit and surplus countries, with devaluations and revaluations. However, in several instances the policy recommendations imposed on member states that received financial support made unilateral relative price adjustment the main driver for improving macroeconomic performance. It is in this context that labour market reforms have been advocated in order to push wages down further, but also – more broadly – to promote labour market flexibility.
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In favour of this view of revaluation of surplus countries, Ben Bernanke criticized the German trade surplus and its refusal to operate needed investments and to support internal demand103. Figure 13: PIIGS Real Unit labour costs: total economy (Ratio of compensation per empolyee to nominal GDP per person employed)
PIIGS Real unit labour costs: total economy (Ratio of compensation per employee to nominal GDP per person employed.) (QLCD) 110
105
100
95
90
85
80
75
70
Ireland
Greece
Spain
Italy
Portugal
Source: AMECO
For further information, see https://www.brookings.edu/blog/benbernanke/2015/04/03/germanys-trade-surplus-is-a-problem/ (B. Bernanke s.d.) 103
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5.6.1 Internal devaluation with a fixed-exchange-rate regime: Latvia’s case
As described by Piton and Bara, one of the main examples of internal devaluation were the policies implemented by Latvian government. Weisbrot and Ray produced a paper to analyse the real costs of this internal devaluation. Latvia’s experience has been similar to that of Argentina from 1999-2002, which also suffered a deep recession as it tried unsuccessfully to adjust its economy under a fixed exchange rate regime. (Weisbrot e Ray 2010) Usually, an economy that must adjust to external shocks, or has been spending internationally beyond its means, or has an overvalued currency, or some combination of all of these – as in the case of Latvia – will often accomplish this at least partly through a fall in the value of its currency. (Weisbrot e Ray 2010) Latvia was invested, as other European countries, by large capital inflows. As discussed before, Latvia presented an unstable situation, not due to its public debt, but because of its external imbalances. Moreover, as showed by Blyth, “REBLL banking sectors became between 80 percent and nearly 100 percent foreign owned in short order” (Blyth 2013). Baltic states were particularly vulnerable to external shocks. After the 2007-2008 financial crisis, foreign banks operated large capital outflows from these economies. As told by Blyth, Latvia and the other countries engaged themselves with harsh austerity measures, because of the Vienna Agreement. “In Vienna in 2009, an agreement was signed between the Western banks, the troika, and Romania, Hungary and Latvia that committed Western European banks to keeping their fund in their Eastern European banks if these governments committed to austerity to stabilize local banks’ balance sheets” (Blyth 2013). As described by De Haas, Korniyenko, Loukoianova, and Pivovarsky: “In response to this institutional vacuum, the Austrian government and a number of multinational banks with high exposures to the Central and Eastern European region started to engage in informal discussions towards the end of 2008. The goal of this ‘Vienna Initiative’ (VI) was to avoid collective action problems and to guarantee macroeconomic stability in Central and Eastern
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Europe. Soon the VI meetings also included the main International Financial Institutions (IFIs), Ministries of Finance, central banks and bank regulators from the host and home countries of the main multinational banks, as well as the European Union and the European Central Bank.” (Haas, et al. 2012) As argued by Weisbrot and Ray, there were even some good points in favour of an internal devaluation and thus against a currency depreciation. For instance, there were also balance sheet effects: firms and households (as well as the government) that borrowed in foreign currency will have an increased debt burden as a result of the fall in the exchange rate. In the case of Latvia, where 89 percent of private debt is in foreign currency, the Central Bank has argued rationally that a currency devaluation would be contractionary because of these balance sheet effects and related impact on the economy (Weisbrot e Ray 2010). However, the paper of Weisbrot and Ray argues that the depth of the recession and the difficulty of recovery are attributable in large part to the decision to maintain the country’s overvalued fixed exchange rate. With the nominal exchange rate fixed, the adjustment in the real exchange rate takes place through pushing down prices and wages: the internal devaluation (Weisbrot e Ray 2010). In 2011, Sommers and Hudson argued on The Guardian that: The reality in Latvia is that after experiencing the world's greatest economic contraction from the 2008 crisis, it has now observed a modest bounce of the dead cat after its freefall finally ended with it hitting the pavement. The modest uptick in growth is primarily a consequence of Swedish demand for Latvian timber. Long-term economic prospects in the country, however, remain grim.104 In facts, The Guardian quoted Edward Hugh, who affirmed that:
For further information, see https://www.theguardian.com/commentisfree/cifamerica/2011/sep/16/latvia-anders-aslundausterity (Sommers e Hudson s.d.) 104
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Only 10% of Latvia's economy is from manufacturing, as opposed to roughly 40% for an industrialised economy like Germany's.105 Even though the debate is controversial, The Economist has noted that “Latvia did achieve a hefty internal devaluation remarkably swiftly, but the improvement in unit labour costs came mostly through unexpectedly big productivity gains rather than a more unpalatable fall in private-sector wages.”106 Overall, “there is a danger of reading too much into the experience of any one economy. Precisely because it is so small, Latvia had more scope than larger countries to adjust through emigration: its population has shrunk by almost a tenth since 2007. The fall in output, which took away only a portion of the catch-up growth after it had won independence in 1991, may have been easier to endure for a citizenry hardened by a harsher existence under Soviet rule.”107 Blanchard itself affirmed that austerity has inflicted more damage on European economies than expected.108 Figure 14: Latvia's Gross Domestic Product at 2010 Reference Levels (MRD Euro)
Latvia's Gross Domestic Product at 2010 Reference Levels (MRD Euro) 25 20 15 10 5 0
For further information, see https://www.theguardian.com/commentisfree/cifamerica/2011/sep/16/latvia-anders-aslundausterity (Sommers e Hudson s.d.) 106 For further readings, see http://www.economist.com/news/finance-and-economics/21586603new-study-asks-whether-latvia-exception-or-exemplar-extreme-economics (The Economist s.d.) 107 For further readings, see http://www.economist.com/news/finance-and-economics/21586603new-study-asks-whether-latvia-exception-or-exemplar-extreme-economics (The Economist s.d.) 108 For further readings, see http://www.economist.com/news/finance-and-economics/21586603new-study-asks-whether-latvia-exception-or-exemplar-extreme-economics (The Economist s.d.) 105
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Source: AMECO Anti-austerity economists argued that the growth was not imputable to internal devaluation. Frances Coppola, endorsed by Paul Krugman, considered the role of Swedish banking system for enhancing the economic growth: The Swedish bank bailout in 1992 has been widely admired as a model of how to deal with a banking crisis. Depositors and bondholders were protected, shareholders were diluted or wiped and banks were forcibly restructured, in some cases through nationalisation. Perhaps because of this swift and effective action by Swedish authorities, Swedish banks did not build up the dangerous leverage of other global banks. The market freeze in 2008 forced them to stop lending, and the falling value of Baltic real estate assets after the crisis damaged their balance sheets, but they recovered quickly and were soon able to commence lending again.109 Blanchard drew 7 lessons from the internal devaluation of Latvia. In his piece Lessons from Latvia, posted on the IMF Blog, he explains: 1. The adjustment was preceded by an unusually strong boom, so there was wide acceptance on the part of people that part of the downward adjustment was a return to normal. 2. There was political support for fiscal consolidation, and the acceptance of pain. 3. Wages were flexible, at least relative to the generic European labour market. 4. There was substantial room for productivity increases. Latvia has income per capita of half the European Union average. 5. Latvia is a small, open economy---although less so than its Baltic neighbours. With exports around 50% of GDP, improvements in competitiveness can have large effects on both imports and exports, and in turn on GDP. For further information, see http://www.coppolacomment.com/2015/05/how-do-you-saydead-cat-in-latvian.html (Coppola s.d.) 109
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6. Public debt was very low to start, less than 10% of GDP. Even today, public debt remains around 40% of GDP. 7. The Latvian financial system was largely composed of relatively friendly foreign banks—better than unfriendly foreign banks, or friendly but weak domestic banks. For the most part, the Swedish banks recapitalized their banks and maintained their credit lines to the Latvian subsidiaries, reducing the intensity of the sudden stop and of the credit squeeze. 110 Therefore, Blanchard argues that it is almost impossible to apply these seven conditions to the Mediterranean country, such as Spain or Italy. 5.6.2 Internal devaluation within a Monetary Union: Ireland’s case.
Together with Latvia, Ireland was one of the European countries which have embarked itself in a serious policy of internal devaluation. As pointed out by McDonnell and O’Farrell, Ireland have been cited as an example of successful internal devaluations in the context of the period since the 2007–2008 economic crash. Both countries [With Latvia, precedentially analysed] have been praised by the European Commission for pursuing internal devaluation strategies to reverse perceived macroeconomic imbalances (McDonnell e O’Farrell 2015). Ireland pushed harsh measures to obtain an internal devaluation. As a matter of facts, since 2008, Ireland’s current account has moved from deficit to surplus, reflecting improved cost competitiveness, allied to reduced consumer demand for imported goods (McDonnell e O’Farrell 2015). However, Ireland has, by European standards, an unusually open economy. Much of its trade is with non-eurozone countries. To some extent, then, Irish economic growth has benefited from the euro’s decline against major currencies. 111 In facts, Ireland has increased by almost 20% the exports towards the United States. By contrast, it has reduced exportations towards European Union, even if it is within the common market. As it is showed in Figures For further information, analysis and readings, see https://blogs.imf.org/2012/06/11/lessonsfrom-latvia/ (Blanchard, Lessons from Latvia s.d.) 111 For further information, see https://www.ft.com/content/328ce524-cb48-11e5-a8efea66e967dd44 (Financial Times s.d.) 110
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5 and 6, trade integration with European countries has diminished since the start of the financial crisis. In facts, citing the Financial Times, “as Aidan Regan of University College Dublin pointed out, Ireland’s export-led revival has had little to do with “internal devaluation”. Many companies that led the recovery in the biotechnology, pharmaceuticals, finance and computer services sectors did not reduce, but increased, their labour costs in Ireland’s bailout years. But the success of high-tech companies in Ireland — often US multinationals such as Amazon, Google and Oracle — depends more on technological prowess, entrepreneurial skills, low corporate taxes, flexible labour markets and well-educated workers”.112 McDonnell and O’Farrell concludes in 2015 their paper arguing that: Overall, there is no clear causal link between an internal devaluation in Ireland and the substantial movements in employment after 2008. Irish wages are now relatively lower than in other EU countries (compared with 2008). However, this is not due to a coordinated policy, but to a weak Irish economy and a collapsed construction sector, and in large part to the policies of ‘austerity’ which served to increase unemployment and push down wages. The decline in nominal unit labour costs is almost entirely due to a shift away from the labour-intensive construction sector. (McDonnell e O’Farrell 2015) Moreover, as written by Blyth: [This anomaly] also explains the high rate of exports from Ireland, which went from 80 percent of GDP in 2007 to 101 percent of GDP in 2010, which is also held up as evidence of the boom after the bust. The revenue of multinationals operating out of Ireland is booked as an export of Irish services – even if there is no real economic activity going on. Given this, exports of services have grown five times faster than the export of goods. (Blyth 2013)
For further readings, see https://www.ft.com/content/328ce524-cb48-11e5-a8efea66e967dd44?mhq5j=e1 (Financial Times s.d.) 112
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McDonnel and O’Farrell supported the view of symmetrical revaluation of surplus country. The alternative way to restore lost competitiveness in the euro area periphery, while simultaneously supporting demand, would have been for the more competitive ‘core’ to engage in a process of internal revaluation (increasing domestic wages and prices) (McDonnell e O’Farrell 2015). De Grauwe observed that the Irish internal devaluation of 23.5% is substantial. However, the internal devaluations of Greece and Spain (11.4% and 8.9%) are lower but significant. Finally, the internal devaluations of Portugal and Italy are much less impressive. (De Grauwe, In search of symmetry in the eurozone 2012) Figure 15: Internal Devaluation of PIIGS Country
Figure 16: Internal devaluation of core countries.
Source: (De Grauwe, In search of symmetry in the eurozone 2012)
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5.7 TAX-BASED AND SPENDING-BASED AUSTERITY While internal devaluation needs spending cuts and public servants’ wages restructure to work, fiscal consolidation could be achieved through tax-based and spending-based fiscal contraction measures. For many economists, this is considerably important to determine the possible output of these policies. A key conclusion of these studies […] is that fiscal adjustments tend to be expansionary when they rely primarily on spending cuts, as pointed out by the IMF (International Monetary Fund 2010). Alesina, Favero, Giavazzi and others advocated for the importance of the composition of fiscal consolidation plans. In facts, these economists have pursued the view that a tax-based fiscal consolidation is usually wrong and it implies large losses of output (Alesina, Ardagna e Galí, Tales of Fiscal Adjustment 1998). If it is recalled the chapter 5.5, tax-based and spending-based fiscal consolidation identifies respectively wrong and right austerity measures. Figure 17: Fiscal consolidation in Europe
Source: The Economist and OECD
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As written by Alesina and Ardegna, “are fiscal consolidations always contractionary? The answer is no: several adjustments have been associated with expansions even in the short run” (Alesina, Ardagna e Galí, Tales of Fiscal Adjustment 1998). However, this policy implies some conditions as Alesina and Ardegna themselves affirmed: It must combine spending cuts in transfers, welfare programmes and the government wage bill, some forms of wage agreement with unions to ensure wage moderation, and a devaluation immediately before the fiscal tightening (Alesina, Ardagna e Galí, Tales of Fiscal Adjustment 1998). In 1998, they have demonstrated how Denmark and Ireland managed to successfully recover thanks to an expansionary fiscal consolidation plan. However, this plan implied a currency depreciation113 to support exports. As affirmed by The Economist, “most importantly, episodes of expansionary austerity are clearly associated with two dynamics: large declines in interest rates and big currency depreciations”. 114 Although, as Alesina, Giavazzi and Favero determined: “an increase in taxation will have an unambiguous contractionary effect on output as the negative wealth effect on the demand side (both on consumption and on investment) is combined with the negative effect of increased distortions on the supply side. Instead, a reduction in government employment could instead be expansionary” (Alesina, Favero e Giavazzi, The output effect of fiscal consolidation plans 2014). As it is clear from the Figure 17, Italy and United States were the only country to implement a tax-based fiscal consolidation. Italy’s tax-based austerity was summarized by the Dipartimento del Tesoro:
Denmark embrace itself in a fiscal devaluation without devaluing its currency. For further information, see http://www.economist.com/blogs/freeexchange/2012/07/expansionary-austerity (The Economist s.d.) 113
114
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In 2012, on the revenue side, key measures include an increase in cadastral values and a new tax on real estate (IMU); a VAT increase; a municipal tax on waste and services; introduction of a tax on ‘tax shielded’ assets and measures to increase transparency and widen tax bases; higher excise duties on polluting fuels and increased taxation of luxury goods; measures to favour greater emersion of the tax base; fight against tax evasion; increased fiscal transparency.115 Moreover, in April 2012, the Italian Parliament approved a Constitutional amendment that introduces a balanced budget provision on pressures from European institutions, as imposed by the so-called Fiscal compact.116 The Monti cabinet, a technocratic government issued by Giorgio Napolitano at the end of 2011, has implemented such fiscal consolidation and further reforms to assure the markets. Monti affirmed "There will be a strong element of continuity as regards Italy's fiscal consolidation efforts. But there will be more attention paid to growth”.117 However, as highlighted by Kenneth Kang: In Italy, fiscal adjustment is taking place mainly on the revenue side. Shifting the composition of adjustment to cutting government expenditure and lowering taxes would help spur growth.118 Moreover, he affirms that: At the IMF, we have looked at the impact of fiscal devaluation on growth. In the case of Italy, a 2 percent of GDP shift from social security contributions toward For further readings, this is a document from the Italian Dipartimento del Tesoro, http://www.dt.tesoro.it/export/sites/sitodt/modules/documenti_en/analisi_progammazione/ana lisi_programmazione_economico/Government_measures_xNHS_Master_25_09_2012.pdf 116 A mandatory balanced budget rule: The signatory Member States commit themselves to implement in their legislation a fiscal rule which requires that the general government budget be balanced or in surplus. (For further readings: https://www.ecb.europa.eu/pub/pdf/other/mb201203_focus12.en.pdf) (European Union s.d.) 117 For further readings, see http://www.reuters.com/article/italy-eu-montiidUSB5E7MG00Q20111122 (Reuters s.d.) 118 For further analysis, see https://www.imf.org/en/News/Articles/2015/09/28/04/53/socar071012a (Kang s.d.) 115
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value-added tax could lift the level of GDP and employment by about 1 percent over the long run. In addition, the cut in social security contributions could be targeted at lower wage levels to reduce the cost of the measure, but also to benefit low earners, women, and young workers. There are a number of reasons why fiscal devaluation might work well in Italy: its high labour-tax wedge, wage rigidity, and the fact that the fixed exchange rate covers a large proportion of trade. Fiscal devaluation would facilitate the wage and price adjustments needed to restore Italy’s external competitiveness in the absence of an exchange-rate adjustment.119 Nonetheless, the Monti government tried to operate an internal devaluation on public sectors, such as health and education, as argued by Kenneth Kang. Indeed, it has been decided to abolish the pensions based exclusively on years of work irrespective of age and imposed the contribution-based method of calculating benefits for all workers (Figari e Fiorio 2015). This last measure has provoked harsh protests, enchanneled by diverse parties. Other measures were issued to operate a deflation of prices and wages.
5.8 KEYNESIAN VIEWS OF AUSTERITY As Keynes’ biographer Lord Skiedelsky put it in a book celebrating 2009 rediscover of Keynes, he had witnessed the Return of the Master (Blyth 2013). After the 20072008 Financial Crisis country like Spain or United States committed themselves in huge fiscal stimulus packages. However, this has last until 2010. In chapter 5.4 it is discussed the debate among John Maynard Keynes and Frierich von Hayek about the necessity of an active countercyclical policy to recover an economy from a financial crisis. Keynes provided compelling evidence against austerity. He discovered, at least, two fallacies of the austerity theory:
For further information, see https://www.imf.org/en/News/Articles/2015/09/28/04/53/socar071012a (Kang s.d.) 119
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-
Although any worker can accept a wage cut to price himself into employment (lower wages), if all workers did this, it would in the aggregate lower consumption and prices (C and P), and thus increase real wage (the wageminus-price effects).
-
Under condition of uncertainty about the future, it is irrational for any investor to invest rather than sit on cash. (This is the main point about Expansionary Fiscal Consolidation). Of course, saving does not lead necessarily to investment (dead-hand effect).
The job of the State was, then, to alter the investors’ investment expectations by raising prices so that profits could be made, thereby making it rational to begin hiring workers again and, by doing so, to get out of the slump (Blyth 2013). Furthermore, Keynes designed the so-called paradox of thrift. If the whole citizens save money, they shrink the demand and, thus, make the recession worse. The economy needs a proper policy to restore the conditions for economic growth and investments. Savings, consumption and investment are indissolubly related. However, as Keynes affirmed “Consumption is the sole end and object of economic activity”.
120
This is about the great debate on austerity. For pro-austerity
economists, it fosters savings and thus it creates a better environment for investments. Although, it could drive an economy in a deflationary vortex. Paul Krugman describes the Paradox of Thrift as: The story behind the paradox of thrift goes like this. Suppose a large group of people decides to save more. You might think that this would necessarily mean a rise in national savings. But if falling consumption causes the economy to fall into a recession, incomes will fall, and so will savings, other things equal. This induced fall in savings can largely or completely offset the initial rise.121
For further readings, see Keynes, General Theory. (Keynes 1953) For further information, see https://krugman.blogs.nytimes.com/2009/07/07/the-paradox-ofthrift-for-real/ (Krugman, The paradox of thrift — for real s.d.) 120 121
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Therefore, the role of the State is crucial to support the recovery of a busted economy. As Krugman argued, the textbook answer to an economic crisis was and is fiscal expansion: increase government spending both to create jobs directly and to put money in consumers’ pockets; cut taxes to put more money in those pockets (Krugman, The austerity delusion 2015). For instance, as pointed out by Blanchard, “when the size of the adverse shock became clear, the U.S. government turned to fiscal policy, using a combination of reductions in taxes and increases in spending. When the Obama administration assumed office in 2009, its first priority was to design a fiscal program that would increase demand and reduce the size of the recession. Such a fiscal program, called the American Recovery and Reinvestment Act, was passed in February 2009” (Blanchard, Macroeconomics 2017). Figure 18: Correlation between Harsher Austerity and Rate of GDP Growth.
Source: (Krugman, The austerity delusion 2015)
5.9 OTHER VIEWS ON AUSTERITY (NON-KEYNESIAN VIEWS) Otherwise, many economists challenged the idea of Keynes. The main theory, adopted by the major part of European countries at the dawn of the sovereign debt crisis, was the so-called expansionary fiscal consolidation. Fiscal contraction could be expansionary, if it is based on certain assumptions. The basic floor for this theory
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was the high debt and huge macroeconomic imbalances of the European countries. As pointed out by Sunderland, “at moderate levels of debt, fiscal policy has the traditional Keynesian effects. Current generations of consumers discount future taxes because they may not be alive when taxes are raised (or there will be a larger population available to pay the taxes). But when debt reaches extreme values, current generations of consumers know there is a high probability that they will have to pay extra taxes. A fiscal deficit can have a contractionary effect in these situations” (Sutherland 1997). The standard Keynesian effect is that, for a given monetary policy, a fiscal contraction creates a downturn or recession, at least in the short run (Alesina, Ardagna e Galí, Tales of Fiscal Adjustment 1998). In facts, high fiscal expenditures could generate an excessive public debt. “Public debt is a basic instrument for optimally distributing public policies over time” (Costa s.d.). Although, as pointed out by De Grauwe, a country needs a large commercial surplus to sustain a high debt (De Grauwe, Economia dell'Unione Monetaria 2016). A fiscal stimulus, as prescribed by Keynesianism, could exacerbate the public deficit and could lead to threatening debt dynamics. However, the International Monetary Fund found that fiscal consolidation typically reduces output and raises unemployment in the short term. At the same time, interest rate cuts, a fall in the value of the currency, and a rise in net exports usually soften the contractionary impact (International Monetary Fund 2010). However, as demonstrated by Gujardo, Leigh and Pescatori, by raising households’ expected future disposable income and by increasing the confidence of investors, fiscal consolidation can thus stimulate private consumption and investment even in the short term, a phenomenon known as “expansionary fiscal contraction” or “expansionary austerity” (Guajardo, Leigh e Pescatori 2011). This effect is commonly known as the Ricardian Equivalence. Mark Blyth critically reviewed the non-Keynesian theories about austerity and he considered Walter Eucken and the German ordo liberalism, Einaudi and the so-called Bocconi Boys122, Schumpeter, Hayek and the Austrian
122
Alesina, Giavazzi, Pagano…the so-called Bocconi Boys, as Blyth and others defined them.
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School of Economics and the British Treasury view. For instance, Ordoliberals viewed Keynesian policies as intrinsically inflationary. Inflation was probably the main fear of Austrians and Germans economists, after the disastrous 1920s hyperinflation. Germany adopted a slightly different model of liberalism, designed by Walter Eucken and others – the so-called Freiburger Schule -, which has insisted on the crucial role of competition as an engine for growth. As pointed out by Blyth, “by attacking concentration and cartels while keeping prices stable, ordoliberals hoped to generate growth by enhancing the competitiveness of German firms and the attractiveness of their products” (Blyth 2013). Moreover, the basic idea was that the cartels led Hitler to the power. As legal theorist David Gerber notes, the notion of Gesamtentscheidung123 “turned the core idea of classical liberalism…on its head by arguing that the effectiveness of the economy depended on its relationship to the political and legal system”. Therefore, Christian Democrats, influenced by the Freiburger
Schule,
have
implemented
the
social
market
economy,
Sozialmarktwirtshcaft. Moreover, the Bundesbank itself and consequently the European Central Bank was designed following this theory. As Eucken itself pointed out “a strong central bank [would be] the guardian against any misuse of power by the political authorities” (Blyth 2013). Blyth summarized the German beliefs as erst sparen, dann kaufen and he affirmed that this “leaves no room for the profligate except austerity, and it allows no room for compensation apart from policies that speed the adjustment of the market” (Blyth 2013). And this is considerably important to define the role of European institutions during the crisis. Furthermore, the role of monetarists and the Austrian school of economics in defines business cycles and economic crisis is interestingly fundamental. As Blyth wrote: Writing in the 1920s, Hayek and Mises drew attention to the rather obvious fact that banks make money from the extension of credit. And while each bank may wish to be prudential, each has an incentive to expand credit beyond its base (at 123
In German, “Total Decision” as the fundamental, existential choice for market economy.
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that time, gold) reserves to stay in business against more aggressive banks and/or capture market share. Moreover, banks are encouraged to do so by the presence of a central bank that backstops the financial system with liquidity. Both these forces produce an expansion of credit beyond what real savings would allow and lower interest rates on loans (Blyth 2013). Further credit expansion fosters the creation of new firms and the undertaking of new project by entrepreneurs. This, in turn, leads to higher prices and wages. The underlying economy, however, has not changed. Therefore, this results in simply inflation: more money chasing fewer goods. The credit bubble grows until it reaches a tipping point. As Mises puts it, “once the flight into real values begin”, people realize that “the crisis and the ensuing period of depression are the culmination of the period of unjustified investment brought about by an expansion of credit” (Blyth 2013). Therefore, the process of recovery from a financial crisis is austerity, because banks should restore a sound financial situation and it has to control further extensions of credit. If the government gets involved, as advocated by Keynes, it will prolong the adjustment towards the real values of prices, assets and wages. Therefore, it will prolong the recession. At the end, Blyth recalls the importance of Einaudi and his idea of government spending. Einaudi advocated for a constitutional rule banning fiscal deficits and to take “away the possibility to face public works by groaning the press of banknotes from member states, and forces them to cover these expenditures with taxes and with voluntary loans” (Blyth 2013). Indeed, austerity is deeply related to the management of public debt and the role of the State.
6 EVALUATION OF AUSTERITY 6.1 DATA In this section, there are available tables of data chosen from AMECO Database, Eurostat and other sources.
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Figure 19: Public balance and general government debt, 2013–2016 (% of GDP)
Table 10: Taxes on production and income (% of GDP)
Country
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Germany
10.3
10.3
10.7
10.7
11.2
10.8
10.9
10.9
10.8
10.8
10.8
France
15.2
15.1
14.9
14.7
14.9
14.7
15.1
15.3
15.5
15.7
15.8
Italy
13.9
14.5
14.4
13.6
13.4
14.0
14.1
15.3
14.9
15.3
15.2
Spain
12.2
12.3
11.5
9.7
8.5
10.2
10.0
10.4
11.2
11.5
11.9
Czech Republic
10.8
10.3
10.6
10.4
10.8
11.1
11.9
12.4
12.7
11.8
12.3
Estonia
12.6
13.3
13.3
12.1
14.5
13.7
13.4
13.8
13.4
13.9
14.5
Romania
12.8
12.7
12.4
11.6
10.7
11.8
13.0
13.1
12.7
12.7
13.3
Bulgaria
16.2
16.8
16.0
16.7
14.3
14.1
13.7
14.8
15.3
14.8
15.3
Table 9: Current taxes on income and wealth (% of GDP)
Country
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Germany
10.5
11.3
11.7
12.0
11.2
10.6
11.1
11.6
12.0
12.1
12.3
France
11.1
11.7
11.6
11.7
10.5
11.0
11.6
12.3
12.7
12.6
12.5
Italy
12.8
13.8
14.5
14.7
14.1
14.1
13.9
14.9
15.0
14.7
14.8
Spain
10.8
11.6
12.7
10.4
9.4
9.3
9.5
10.2
10.3
10.2
10.1
Czech Republic
8.4
8.4
8.6
7.6
6.9
6.6
7.0
6.9
7.2
7.3
7.3
Estonia
6.9
7.0
7.4
7.7
7.4
6.6
6.3
6.6
7.2
7.5
7.9
Romania
5.3
6.0
6.7
6.6
6.2
5.7
6.0
5.8
5.9
6.2
6.6
Bulgaria
4.5
4.6
7.2
5.8
5.3
4.8
4.6
4.7
5.1
5.4
5.4
Source of Table 8 and Table 9: Eurostat
Table 11: Social benefits (other than social transfers in kind) paid by general government (% of GDP)
Country
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Germany
17.9
17.1
16.0
15.8
17.3
16.7
15.7
15.6
15.6
15.5
15.5
France
17.5
17.5
17.4
17.6
19.2
19.2
19.1
19.6
19.9
20.0
19.8
Italy
16.3
16.3
16.4
17.0
18.5
18.6
18.6
19.3
19.9
20.2
20.2
Spain
11.5
11.3
11.5
12.3
14.4
15.1
15.3
16.2
16.6
16.5
15.8
Czech Republic
11.5
11.6
11.9
11.8
13.0
13.1
13.1
13.1
13.3
12.9
12.5
Estonia
8.9
8.6
8.4
10.4
13.8
12.7
11.2
10.7
10.7
10.8
11.6
Romania
9.0
8.7
9.2
10.2
12.5
12.7
11.8
11.2
10.7
10.5
10.6
Bulgaria
10.3
9.9
9.1
9.6
11.3
11.8
11.1
11.1
11.8
12.2
12.0
Source: Eurostat
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Figure 20 and Figure 21: Spending-based and tax-based fiscal consolidation
Spending-based Fiscal : Spending-based fiscal consolidation
Consolidation (Final consumption expenditure of general government at 2010 prices (OCTG)) [2008=100]
105
100
95
90
85
80
75 2008
2009
2010
2011 Greece
2012 Italy
2013 Spain
106
2014 Portugal
2015 Ireland
2016
2017
2018
Fiscal consolidation Tax-based Current taxes on income and wealth: households and NPISH (UTYH) (2008=100) 144 134 124 114 104 94 84 74 2008
2009
2010
2011 Ireland
2012 Greece
2013 Spain
Source for Figures 18 and 19: AMECO Database European Commission Figure 22: Revenue composition of European countries
2014 Italy
2015 Portugal
2016
2017
2018
6.2 UNEMPLOYMENT Unemployment has been one of the most serious issues for the European economies. Essentially, unemployment is one of the most fundamental issues for many European societies. The increasing unemployment rates in Mediterranean countries, especially between young people (16-25 years), has posed a significant threat to a sustainable development of public finance and economic growth. Figure 23: Unemployment rates in Europe
Moreover, economic policies have not reduced meaningfully the unemployment rate in a decade, despite all the efforts. The rise of unemployment rates in the Eurozone was dramatic. As shown by the Figure 23, Greece experienced a 27.5% unemployment rate in 2013, Spain peaked at 26.1% in 2013 and Ireland experienced a 14.7% all-time high in 2011.
As pointed out by Matsaganis on Greece: In 2008q2, the total employment rate (population aged 15-64) was 62.2%. Six years later, it had fallen to 49.4%. The unemployment rate had fluctuated around the 10% mark in 2000-05. It then began to fall until May 2008, when it reached its lowest level for over a decade (6.7% of the labour force). Thereafter it started to rise again, gathering pace as the recession deepened. Unemployment peaked at 28.7% in November 2013, and fell back somewhat to 26.8% in 2014q2, or 2.3 times as high as in the Eurozone as a whole (while five years earlier, it had been exactly equal to the Eurozone average) (Matsaganis 2015). Matsaganis itself drew out the implications of internal devaluation: Labour market policy under austerity relied on ‘internal devaluation’ as a means to boost competitiveness, revive the economy and reverse the rise in unemployment. The strategy had two main features. On the one hand, in February 2012 there was a drastic cut in the minimum wage – by 32% in nominal terms for young workers, and by 22% for those aged over 25. Unemployment insurance benefit was also cut, from €454 to €360 a month (i.e. by 22%), for all workers irrespective of age. On the other hand, there was a sweeping deregulation of labour market institutions, from employment protection legislation and collective bargaining to working-time regulations and non-wage costs (Matsaganis 2015). Table 12: Table on internal devaluation measures taken by the Greek government. Minimum wage
-32%
Minimum wage over 25
-22%
Unemployment insurance benefit
-22%
Source: Matsaganis on Vox.EU Matsaganis concludes that internal devaluation has not worked as predicted:
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Otherwise, in terms of a boost to export-led growth, internal devaluation has clearly not worked as intended: as the IMF (2014) has acknowledged, exports of goods and services excluding oil and tourism actually fell in 2012-14. As explained in another IMF report (IMF 2013), while “competitiveness improved somewhat on the back of falling wages, structural reforms stalled, [and] productivity gains proved elusive”. (Matsaganis 2015) Yet, increasing unemployment has been dramatic even in Baltic countries and in other PIIGS countries.
Youth unemployment is especially threatening and
worrying, for its social costs. In Italy, the youth unemployment rate doubled between 2008 and 2013 from 20% to 40%, one of the highest rates in Europe (lower only than Greece, Portugal and Spain) (Leonardi e Pica 2015). For every threepeople aged 15 to 24 who are active in the Portuguese labour market, one is unemployed; that is three times the usual youth unemployment rate observed in the 1990s (Novo 2015). As posted on Bruegel Institute: “Peter Coy writes in a special Business Week report that the youth unemployment bomb is global. In Tunisia, there called the hittistes—FrenchArabic slang for those who lean against the wall. Their counterparts in Egypt are the shabab atileen, unemployed youths. -In Britain, they are NEETs—"not in education, employment, or training." In Japan, they are freeters: an amalgam of the English word freelance and the German word Arbeiter, or worker. Spaniards call them mileuristas, meaning they earn no more than 1,000 euros a month. In the U.S., they’re "boomerang" kids who move back home after college because they can’t find work.”124 Unemployment and youth unemployment tend to aggravate the labour market and to raise immigration and emigration rates. On one hand, as stated by Peter Coy, the global youth unemployment crisis has driven many young people of poor countries
For further information, see http://bruegel.org/2012/07/blogs-review-the-youthunemployment-crisis/ (Cohen-Setton s.d.) 124
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to flee towards advanced country. This have fostered a sense of antagonism against these foreign workers in many cities and countries. On the other hand, regions which have experienced large emigration episodes, now suffer from the so-called brain drain: the shortage of skilled and graduate workers. This is particularly dangerous for the economy, because it cuts the perspectives of growth. The South of Italy has experienced one of the worst brain drain episodes during the crisis within advanced economies. Though, Alessandro Turrini found out that fiscal consolidations do produce a significant impact on cyclical unemployment, but effects are mostly transitory.125 Therefore, fiscal consolidation could have been less harmful to employment than expected. In 2014, Mark Blyth defined the unemployment level of European Union – at that time it was at a 11.5% rate – “not just politically unacceptable but economically impossible” (Blyth 2013). Eurozone is now – in April 2017 – at a 9.3% rate. Yet, unemployment rate is recovering – in April 2016 it was stuck at 10.2% -, however, the process is taking a lot of time, despite the efforts. Figure 24: Unemployment rate in 2017; Source: Eurostat
For further information, see http://blogs.lse.ac.uk/europpblog/2013/08/21/europes-austeritypolicies-appear-to-have-created-less-unemployment-in-countries-with-liberalised-labourmarkets/ (Turrini s.d.) 125
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6.3 SLOW GROWTH Eurozone and its countries experienced a decade of slow growth and, for many peripherical countries, even recession. Countries like Greece suffers from an economic crisis similar to the American Great Depression. As pointed out by Matsaganis on the Greek situation: “In 2007-13, the Greek economy contracted by 23.6% in real terms. The loss in output was far greater than in other southern European economies (-6.8% in Portugal, -5.7% in Spain and -8.7% in Italy) and Ireland (-7.6%) over the same period (Matsaganis 2015). Furthermore, according to Bank of Greece estimates (2014), household disposable incomes fell by over 30% in 2009-13 (Matsaganis 2015). Moreover, slow growth or recession and austerity measures tend to worsen the debt/GDP ratio, since, as explained by Paul De Grauwe, austerity measures depress the GDP (De Grauwe, Economia dell'Unione Monetaria 2016). De Grauwe explains the situation of Ireland, Portugal and Greece. These countries needed to restore the competitiveness through an internal devaluation, as argued before. However, these policies tended to generate a recession and, therefore, through the action of automatic stabilizers – a worsening condition of public deficit. This, in the De Grauwe’s point of view, could lead to a crisis of liquidity and, consequently, a crisis of solvency. In other terms: a sovereign debt crisis. This could lead to popular protests and democratic instability, as it has been happened in Greece or in Spain. Moreover, the countries could experience a credit crunch and growing numbers of NPLs. This could lead to banking crisis and zombie banks. As argued on Bruegel, Europe emerged from the recession with too many zombie banks, wounded households, and struggling companies. In Germany, the private economy was fit enough to recover, but this was less true in southern Europe or even France.126
For further readings, see http://bruegel.org/2012/11/should-europe-emulate-the-us/ (PisaniFerry, Should Europe Emulate the US? s.d.) 126
112
Some problems with the banking sector is still viewable in Italy and in Spain. Italy has recovered important banks, as Monte Paschi di Siena (MPS), and it is yet engage in solving other banking problems – like Veneto Banca and Banca Popolare di Vicenza. This could worsen the economic condition and cause a credit crunch, as argued previously. From a macroeconomic point of view, it should be considered the role of Philips curve. Figure 25: Aggregate Demand and Aggregate Supply
In this model, an internal devaluation would mean to move along the Philips Curve from B to A, with an increase of unemployment rate and lower inflation. This internal devaluation could bring down the price level and the GDP, determining a restore of competitiveness and a slower growth. Internal devaluation, therefore, are achieved through firing public servants and increasing labour flexibility, to assure the power to fire more workers from firms. In the classic Philips Curve, this would mean lower inflation rate.
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A fiscal consolidation could be achieved the same objectives through a reduction of public expenditures and, therefore, a reduction of the aggregate demand.
6.4 INSTITUTIONAL DEVELOPMENT Nowadays, European integration process is fixed at a crossroad. Of course, some institutional measures have been found to survive to the crisis and its effects. However, European integration process seems not to have make any step further. Paul De Grauwe indistinctly said: “If there is no willingness to step into a fiscal union – which can only exist in a political union –, the euro has no future” (De Grauwe, 2015). However, a fiscal union requires well-functioning institutions – for example, taxcollecting agencies or an efficient buerocracy – and, of course, it requires an effective democratic organization. It is important to recall a motto: no taxation, without representation. 127 This would be particularly threatening to the core countries, since monetary transfers are necessary to assure the synchronization of business cycles. “Most Eurozone countries are not prepared to step into a political union because they do not want to create a system of automatic assistance. Their mutual distrust is too large to do this” (De Grauwe, 2015). As it has happened in Italy, with the raise of the Northern League, monetary transfers could exacerbate a political conflict between Northern Europe and Southern Europe. To be more precise, the conflict is already happening, especially with the Quantitative Easing of Mario Draghi’s European Central Bank, which is outraged by mostly German savers – pensioners and others – and German newspapers. Moreover, as Papaionnau pointed out:
[a phrase, generally attributed to James Otis about 1761, that reflected the resentment of American colonists at being taxed by a British Parliament to which they elected no representatives and became an anti-British slogan before the American Revolution; in full, “Taxation without representation is tyranny.”.] 127
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There are significant differences across Eurozone countries on both aspects of state capacity. Tax evasion is rampant in Greece and also widespread in Italy and other parts of the south, where the size of the shadow and unofficial economy are considerable (Papaionnau, 2015). Papaioannou identifies 4 main problems and issues with institutional development: (i) the focus for ensuring growth should be on institutional reform, (ii) court efficiency and the quality of contract enforcement affect economic performance and total-factor-productivity, (iii) formalistic product market regulations and associated red tape constitute a significant impediment to firm creation, innovation, and entrepreneurship in many countries in Europe, (iv) State capacity on enforcing contracts and tax collection has also been linked to development and prosperity. These are mostly needed to ensure an institutional convergence between European countries and to pose the foundation for a well-functioning fiscal union. Institutional development has grown at a faster pace during the Sovereign Debt crisis. However, for example, the Fiscal Compact introduction [2013] has been accompanied by several critics. Philip Lane pointed out on Fiscal Compact that: 1. A fiscal framework based on structural budget faces tricky measurement problems because it requires macroeconomic forecasters to differentiate between cyclical fluctuations and trend fluctuations in output almost in real time. 2. The primary source of fiscal discipline is national. 3. The fiscal compact is accompanied by new European regulations that go beyond narrow fiscal governance in monitoring excessive imbalances. A wide range of risk indicators will be tracked, including credit growth, house price indices, and external imbalances. (P. R. Lane 2012)
115
Other criticism implied the role of fiscal policy during a recession and other problems correlated. Mark Blyth expressed his ideas on institutional development in 2014 post-scriptum of his book: In short, Europe is not and still cannot be made into a single economy. It is constituted by different varieties of capitalism that work on orthogonal principles. The current path of recovery via structural reforms and new treaty commitments ignores this fact, trying to make very different sets of national institutional complementarities into one set of complimentary trans-national institutions. Economies are historically specific complexes of institutions and ideas. The current attempt to turn the whole of Europe into a net exporter in the German image cannot work once one recognizes this (Blyth 2013).
6.5 ECONOMISTS’ VIEWS Economists argued about the size, the nature and the effects of these fiscal consolidations and internal devaluations. Alesina, during a conference in Zurich 128, showed how Italy implemented a taxbased fiscal adjustment in 2011, therefore, worsening its recession. Alesina and Giavazzi criticized the Monti cabinet to have implemented tax-based fiscal adjustment, however the extraordinary conditions of the economic situation tended to generate a sense of urgency.129 Other countries, like Spain or Ireland, which have implemented draconian austerity measures, have not grew as predicted by the
Alberto Alesina: Austerity and Fiscal Stability in Europe; Forum for Economic Dialogue Zurich, 17 November 2014 Zurich Lecture of Economics in Society: Austerity and Fiscal Stability in Europe [https://www.youtube.com/watch?v=_uIYrCHmhzg] (Alesina, Austerity and Fiscal Stability in Europe s.d.) 129 For further readings, see in Italian http://www.corriere.it/editoriali/11_dicembre_04/alesina_giavazzi-presidente-cosi-nonva_0205d1da-1e50-11e1-b26c-4b15387dad1c.shtml (Alberto Alesina 2011) 128
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models of Alesina. Portugal started a very aggressive fiscal consolidation plan in 2010, under financial pressure on government bonds and liquidity concerns. Alesina itself, recognizing it, said that it would be probably caused by the exceptional factors of this crisis. At the end of this conference, he advocated for a tax-based fiscal stimulus, which is a countercyclical policy, as a spending-based fiscal stimulus. In his idea, a tax-based fiscal adjustment, with the plan to cut spending after a certain period, would be beneficial to the economy, even though he considered it highly improbable, because of the European rules. However, as argued by N. Gregory Mankiw, then economic adviser of the Bush administration, “the Reagan and Bush tax cuts combined the logic of supply-side economics and of Keynesian stimulus. Supply-siders argue that lower marginal tax rates give people more incentive to work and invest. Keynesians argue that leaving more money in people’s pockets, rather than in government coffers, increases spending and that greater demand for goods and services expands employment. When the government enacts deficit-financed tax cuts, the two channels can work simultaneously”.130 Moreover, Alesina considers fundamental the role of banking sector and the credit crunch to determine the worsening economic conditions of European countries. Indeed, it is crucial to determine the role of the banking sector in an economy and in relation to this crisis. According to (Tsakalotos, 1991, quoted in Gibson and Tsakalotos, 1992), in Greece, decisions on extending bank credit were frequently made on the basis of non-banking criteria such as ‘‘personal contacts and social pressure’’ which lead to inefficiency as regards risk management and to problems with NPLs. Italy suffers from similar issues. This is a situation described as clientelist capitalism. Southern European countries shared this problems at a very similar level. Credit was mismanaged and the incredible growth of credit lines was not followed by a stricter regulation or major reforms on banking regulators. For further readings, see https://www.nytimes.com/2017/06/02/upshot/a-tax-cut-might-benice-but-remember-the-deficit.html (Mankiw s.d.) 130
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Moreover, this has caused an exceptional level of NPLs, which are still threatening the banking sector.131 Furthermore, this is worsening the credit crunch. As Presbitero, Udell and Zazzaro pointed out “a number of studies of the effect of the global financial crisis on European small and medium enterprises confirm the presence of a credit crunch in Europe after Lehman’s collapse. The evidence also suggests that younger firms, smaller firms, and more opaque firms may have been more severely affected” (Presbitero, Udell e Zazzaro 2012). As The Economist pointed out: Because small firms do not issue bonds or sell equity in public markets, they rely on banks for borrowing. And since small firms are so vital, one of the measures of economic health in the euro area is how cleanly the interest rates set by the European Central Bank (ECB) feed through to the rates that firms pay. By that measure, the first eight years of the single currency were pleasant. If the ECB rate was 2%, firms would pay 4%. The difference between the two was small and it was stable. It made policy decisions easy: if the ECB thought the economy was overheating, it could raise its rates, confident that the rates firms would pay would rise by the same amount. But that system has broken down. The stable wedge between ECB rates and firms’ borrowing costs has been replaced by an unstable gap that varies by country. In Germany and France things are still close to how they were in the good years. The ECB rate has been 0.75%; firms have been paying around 3.5% to borrow. But in Italy and Spain the wedge has almost tripled in size, in part because banks there are paying more to borrow. When fears rise, most recently in response to the mess in Cyprus, funding costs to banks spike and are then passed on to firms. So, SMEs in Spain and Italy must pay over
131
See the last news on Italian banks [06/07/2017].
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6% to borrow; money is tighter there than it was in 2005, even though the ECB’s rate is far lower.132 The market structure is fundamental to understand the role of the banking sector in the crisis. Therefore, fiscal policy has many limits to deliver a full-bright restore of economic growth. Furthermore, large expanse on banking sector could undermine the financial stability of European countries, as it has happened in Eastern European countries. In 2016, Alesina stated that: Now, it exists a large body of literature that demonstrate incontrovertibility how the tax-based fiscal adjustments are costly and tend to worsen the economic recessions. Spending-based fiscal adjustments are, indeed, less costly. With other structural reforms, spending-based fiscal adjustments could be expansionary. It does not exist austerity, but it exists diverse forms of fiscal consolidation.133 However, as stated by Iyanatul Islam and Anis Chowdhury on Vox.EU: Our point is that, contrary to what is popularly reported, Alesina merely demonstrates that, in some cases, one cannot detect a contractionary impact of fiscal austerity. As Alesina he notes: “…sometimes, not always, some fiscal adjustments based upon spending cuts are not associated with economic downturns”. It is unfortunate that such a modest proclamation made by the author has been overlooked by the cheerleaders of fiscal consolidation and, at times, even by the critics. For example, Romer writes that the much-cited study “...finds that output tended on average to rise after (fiscal) consolidations,
For further readings, see http://www.economist.com/news/leaders/21577068-woes-smallbusinesses-italy-and-spain-threaten-be-next-twist-euro (The Economist s.d.) 133 For further readings, see in Italian http://www.ilfoglio.it/economia/2016/09/22/news/qualeausterita-parla-alesina-104361/ (Capone 2016) 132
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particularly those focused on reductions in government spending”. This statement exaggerates Alesina’s own summary of his findings. 134 Moreover, these authors identify, at least, 4 more factors supporting a successful fiscal consolidation: There are often complementary factors at work that might be more important than fiscal actions. They include: (1) the influence of the global and regional business cycle, (2) monetary policy, (3) exchange rate policy and (4) structural reforms.135 Islam and Chowdhury conclude their article trying to answer to why Alesina and coauthor’s papers have been used as a justification for austerity measures: One plausible answer lies in collective and wilful ignorance driven by an ideological aversion to counter-cyclical fiscal policy because fiscal interventions are seen as an enlargement and encroachment of the state on the functioning of the private sector.136 On the other hand, Alesina and Giavazzi argued that a further increase of taxes in Europe could lead to relative low increases in tax revenues and could be very recessionary, through the usual supply- and demand-side channels. 137 However, post-Keynesian economist Steve Keen described austerity measures as naïve. Indeed, he explains how less spending and higher taxes could lower the disposable income and, thus, improving banking borrowing for maintaining the previous standards.
For further readings, see http://voxeu.org/debates/commentaries/revisiting-evidenceexpansionary-fiscal-austerity-alesina-s-hour (Vox.EU s.d.) 135 For further readings, see http://voxeu.org/debates/commentaries/revisiting-evidenceexpansionary-fiscal-austerity-alesina-s-hour (Vox.EU s.d.) 136 For further readings, see http://voxeu.org/debates/commentaries/revisiting-evidenceexpansionary-fiscal-austerity-alesina-s-hour (Vox.EU s.d.) 137 For further readings, see http://voxeu.org/article/austerity-question-how-important-howmuch (Vox.EU s.d.) 134
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Keynesian economist advocated vehemently for a fiscal stimulus. For example, Yanis Varoufakis, former Finance Minister of Greece, said that European Union should embrace itself in a fiscal stimulus programme on developing green economy infrastructures.138 Others, as Bernanke, believes that Germany should use its trade surplus to raise its internal demand and to invest in public infrastructure.139 Corsetti, furthermore, pointed out to address the problem of unemployment: A key point here is the recognition that much of the advanced world is currently in an unemployment and underemployment crisis. Destruction of jobs and firms today may be expected to have persistent effects on potential output in the future. These effects in turn translate into a fall in permanent income, and hence demand, today.140 As Corsetti itself demonstrated: When sovereign risk is high, the negative effect on demand of a given contraction in government spending is offset to some extent by its positive impact on the sovereign-risk premium. Moreover, a prospective increase in spending in a recession may feed confidence crises by amplifying the anticipated deterioration of the budget associated with output contractions. Corsetti concluded its article saying: In light of these considerations, it is perhaps useful to move beyond the headlines of ‘expansionary contractions’ and ‘self-defeating fiscal austerity’. As a matter of fact, most governments face specific questions on how to reform their spending and taxation, rather than a general question of ‘how much’. Not only the intensity, but also and especially the content of upfront budget cuts currently
For further information, see https://www.project-syndicate.org/commentary/europeanintegration-based-on-simulated-federation-by-yanis-varoufakis-2017-06 139 For further readings, see https://www.brookings.edu/blog/benbernanke/2015/04/03/germanys-trade-surplus-is-a-problem/ (B. Bernanke s.d.) 140 For further analysis, see http://voxeu.org/article/has-austerity-gone-too-far-new-vox-debate 138
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contemplated in countries may be expected to have a first-order impact on the current recession.141 Moreover, Corsetti found out that: Strongly capitalised banks are a key element here. The ongoing efforts, coordinated by the European Banking Authority, to create extra capital buffers in European banks correspond to this logic.142 The government and European Union must find new measures to prevent a credit crunch and to restore economic growth, even in the future. Furthermore, as pointed out by Daveri, “with Europe in recession, voters rewarded those who oppose budget cuts”. To paraphrase Blyth, you cannot run a gold standard in a democracy. This is particularly important, because internal devaluations and fiscal adjustments have massive social costs. Lower disposable income, lower consumption and less – or highly inefficient and costly – public services could lead to a deterioration of the conditions of the citizens. The so-called revolt of the middle class is extremely important to understand the importance of just fiscal policies. This problem will be addressed in the chapter 6.6 on global Trumpism. Daveri, in one of his paper posted on Vox.EU, supposed that: All these parties [Critics of European Union policies] are driven by the electorate’s aversion to restrictive fiscal policies that are necessary to keep them inside the monetary union. These policies, however, are increasingly identified as the eventual reason of the persistence of the crisis and not as an umbrella of protection against it In facts, these policies are taken as Bruxelles measures. This have fostered a vigorous anti-EU sentiment in many European countries. From 1997, when the 141 142
For further readings, see http://voxeu.org/article/has-austerity-gone-too-far-new-vox-debate For further readings, see http://voxeu.org/article/has-austerity-gone-too-far-new-vox-debate
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trust in European Union was at 73%, now only a minor percentage (34%) 143 of Italians believe in the European Union as a successful project. In Italy, the Northern League and Movement 5 Stars, both of them critics to European Union policies, accounts for 41% of Italian voters. Austerity could exacerbate a conflict with citizens and workers. Furthermore, internal devaluations, as adopted within European Union, are unequivocally costly. It is a process which takes a lot of time and it is undoubtedly painful. Internal devaluation is to force families to cut their disposable income and to save more. Is it sustainable politically? As Giancarlo Corsetti writes; “Instability grew out of a disruptive deadlock between national governments forced to address and correct fundamental weaknesses in their national economies on their own, and the EZ-level policymaking, which could have created the conditions for successful implementation of national policies, but did too little, too late (at best).” Figure 26: Satisfaction running low...while political instability is increasing.
For more analysis, see http://www.termometropolitico.it/1249953_sondaggi-34-italianifiducia-unione-europea.html 143
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6.6 GLOBAL TRUMPISM If there is a definition about the political response to these major economic issues and policies, it should be the concept of global Trumpism, as defined by Mark Blyth in one of his lessons.144 The role of Trump, Brexit, Corbyn, Podemos, SYRIZA and Movement 5 Stars, in developing innovative – or a renewal of old – ideas on economics and politics, is undoubtedly revolutionary. Nowadays, we are assisting to a deep reinstitution of old political parties and institutions, as the trade unions. Table 13: Where we were and where we are now: macroeconomic regimes. Where we were
Where we are now
Inflation: The Debtor’s Paradise of Deflation: The Creditor’s Paradise of the 1970s
today
Sustained inflation
Secular disinflation
Labour’s share of national income at all Capital’s share of national income at all time high
time high
Corporate profits at all time low
Wage share at all time low
Unions strong
Unions weak
Low inequality
Inequality high
National Markets
Globalized Markets
Finance weak
Finance strong
Central Banks weak
Central banks strong
Parliament strong
Parliament weak
Source: Mark Blyth slides at the Watson Institute Student Seminar Series
This is a macroeconomic regime analysis, presented by Mark Blyth at the Brown University, which is useful to identify the differences between the 1970s and today. Blyth argues that this model has generated winners and losers. Losers, notably the
Mark Blyth ─ Global Trumpism, Watson Institute Student Seminar Series - American Democracy: The Dangers and Opportunities of Right Here and Right Now, 2016 [https://www.youtube.com/watch?v=Bkm2Vfj42FY&t=4580s] 144
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debtors, are increasingly voting for extreme and populist parties, typically antiausterity. Parties, which embrace a vision of anti-austerity and national control of the economy, are gaining power and rising its members. Therefore, the role of fiscal policy and macroeconomic policies is necessary to understand the issues of the current political system. Moreover, as argued by Wyplosz, a much deeper Europe is simply not thinkable at a time when the rising political forces are the Front National in France, the Five Star Movement in Italy, Podemos in Spain, True Finns in Finland, the Party for Freedom in the Netherlands and, until recently, the Alternative in Germany (Wyplosz 2015). The raising of anti-European Union parties is now posing a significant threat to further step towards a more integrated European Union or Eurozone. Wyplosz itself argued that: Unsurprisingly, the response of the Five Presidents is to look for some ‘European government’ with real powers, including a budget and taxing power alongside a Eurozone parliament. As argued above, this solution is most unlikely to be politically possible. The German Finance Minister has suggested reducing the role of the Commission, thus further eroding the Community method. However, this means politicising crisis management, a sure recipe for ineffectiveness and divisiveness (Wyplosz 2015). Figure 27: Divergent spending; real domestic spending.
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CONCLUSIONS As explained in the previous chapters, fiscal consolidation was mainly unappropriated in countries with low public debt and other sound macroeconomic factors. European Peripheric Countries outside Eurozone relied on external resources and foreign funding, but their public sheets were absolutely sounds. However, these countries wanted to keep their currency pegged to euro and they have preferred to engage themselves in internal devaluations. This is particularly true for Latvians. As a matter of facts, Latvia joined the common currency in 2014, achieving its goal. However, as argued by Blanchard, Latvia is a relatively small country and it has a dynamic economy. Blanchard itself pointed out which the role of internal devaluation in Latvia cannot be compared to Mediterranean countries, such as Italy or Spain. Indeed, there is a dramatic lack of a mechanism of stabilization within Eurozone. However, as pointed out by Wolff: Redistribution could be a way to compensate for such lasting imbalances. However, I would consider this as undesirable. The reasons why such redistribution is undesirable are political and economic. From a political point of view, long-lasting transfers in the monetary union are unsustainable for the countries providing the payments. From an economic point of view, long-lasting transfers only cement and sustain the very same imbalances. In my view, it would be preferable to address these imbalances more proactively instead. 145 Fiscal consolidation could have been probably scheduled in a time of economic boom, as argued by Keynesian economist and Wren-Lewis. Moreover, tax-based fiscal consolidation, as argued by Alesina and others, especially in Italy, have worsened the economic condition of the country. Philip Lane pointed out that: “looking back, the failure of national governments to tighten fiscal policy substantially during the 2003 –2007 was a missed opportunity, especially during a For further information, see http://bruegel.org/2017/06/eurozone-or-eu-budget-confrontinga-complex-political-question/ (Wolff 2017) 145
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period in which the private sector was taking on more risk.” (P. Lane 2015) Lane itself argued that: In evaluating the cyclical conduct of fiscal policy from 2002–2007, domestic authorities and international organizations such as the IMF, OECD, and European Commission primarily focused on point estimates of the output gap in order to estimate the “cyclically adjusted” budget balance, without taking into account the distribution of macroeconomic, financial, and fiscal risks associated with the expansion in external imbalances, credit growth, sectoral debt levels, and housing prices. (P. Lane 2015) There was a tremendous problem of regulatory measures and this has fostered large capital inflows in an unsustainable way. If fiscal consolidation should be avoided, for its effects on the economy, fiscal consolidation was critically important to restore trustworthiness in peripherical countries. However, as argued by De Grauwe, this could have been achieved with the designation of the European Central Bank as the lender of the last resort. Even if, the natural lender of last resort, the ECB, was explicitly forbidden from playing the role (P. R. Lane 2012). Moreover, the key was foreign borrowing, not the public debt (Baldwin e Giavazzi 2015). Internal devaluation, instead, was unavoidable. As argued cynically by De Grauwe, flexibility and structural reforms mean that these people may have to accept a wage cut or may be forced to emigrate. As a matter of facts, Latvia emigration is a considerable example. As reported by The Telegraph: Emigration jumped to 40,000 people a year […]. Some 160,000 Latvians have registered to work in Britain since EU accession.146 But this is not limited to Latvia. If Italians in London formed their own city, it would be the 13th largest Italian city, coming somewhere between Verona and Messina.
Fur more data, see http://www.telegraph.co.uk/news/2016/04/29/latvia-fights-against-thegreat-eu-exodus/ 146
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Internal devaluation is a painful mechanism of balancing and, at least, as argued by De Grauwe and others, should have been accompanied by a revaluation of the core countries. However, this has not happened. In search of symmetry, as stated by De Grauwe. Moreover, peripherical countries, especially Italy, are particularly vulnerable to major economic challenges of the future, as globalization and automatization. Figure 28: Globalisation: is Europe prepared?
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The European Union should define itself and find new mechanism of balancing its economic imbalances. Moreover, it should be more democratic and institutionally integrated. As pointed out by Lane, “more deeply, a greater degree of economic convergence among member countries should be associated with less financial divergence in terms of external imbalances and asymmetries in credit growth” (P. Lane 2015). This is fundamental to support the European Integration process and to generate a true consensus for a deeper union. Moreover, it is fundamental to foster an institutional development within the Eurozone and the European Union. Public administrations should work together to ensure a progress in weaker countries. This is particularly important if in the future a fiscal union will be unavoidable. Democracy and institutions are the essential keys to a well-functioning free market. European Union could be the future of our generation – the so-called ERASMUS generation –, but it should reform itself, through higher degree of integration and a more democratic process. Of course, the support for the European Integration is now at the all-time lows. However, it must be highlighted the goals achieved by the EU and its institutions. United States, China, India, Russia and other countries have growing population, a dynamic workforce and high perspective of growth. European countries are small and with lower perspective of growth relative to these countries. Therefore, a united Europe could bring peace and prosperity, not only to the European citizens, but also to neighbouring countries. Unity makes strength and the European Union could really help its citizens towards a path of growing living standards, strengthening institutions and a more inclusive and sustainable society.
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RINGRAZIAMENTI Vorrei ringraziare per l’aiuto, il supporto e il contributo a questi tesi offertomi dalla mia relatrice, professoressa Grazia Graziosi; il professor Tullio Gregori per le ricerche accademiche inviatemi e le osservazioni espresse; il professor Marcello Signorelli per la gentilezza e i consigli; il mio compagno, Emanuele Cristelli, per la accortezza della sua visione; la mia amata Elisabeth, per l’attenzione alla struttura della tesi. Vorrei ringraziare la mia famiglia per avermi supportato in questo percorso: a mio padre Luciano per avermi istruito al piacere della ricerca, a mia madre Angela per avermi indicato la strada da seguire nella vita e a mia sorella Maria Chiara per insegnarmi ogni giorno la grinta e la passione. Voglio ringraziare mia nonna Antonia e tutta la famiglia che la circonda, per avermi sempre dimostrato stima ed affetto. Francesco, Barbara, Elisa, Rossella, Martina, Alice, Marco, Rosy, e tutta la mia bellissima famiglia. Vorrei ringraziare tutti i miei compagni di corso, che hanno condiviso con me dibattiti e progetti politici, fatiche e gioie universitarie. Voglio ringraziare anche gli amici e le persone che mi amano. Giulia, Gabriele, Emanuele, Mauro, Giovanni Enrico, Teodoro, Andrea, Federico, Tommaso, Giacomo, Stefano, Piero, Giancarlo, Marco, Vito, Massimiliano, Carlo, Luca, e tutte le persone che mi hanno accompagnato, mi accompagnano e mi accompegnaranno in questo bellissimo percorso che chiamiamo vita.
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