Is the ECB Intent on Replacing Euro Hara-Kiri by Euthanasia?

Another useless EU Summit - thank you Mr. Cameron for killing the new “Merkozy” version of an absurd fiscal union for the entire EU. This time, the absurdity of setting a budget limit of 0.5% of GDP (when it has been unable to comply with the existing limit of 3%), was compounded by requiring its inscription as a rule in national legal systems at constitutional or equivalent level (see here why this is a mistake).

Let us now hope that a referendum in Ireland or any other country will kill the alternative proposal for a fiscal union among Euro Zone members through a new "fiscal compact". As we said here, a fiscal union between Germany and France may make sense but it would be a disaster for the entire Euro Zone.

The potential collapse of the Euro Zone will not be due to a fiscal problem in the Euro Area; which does not exist, despite the fact that three smaller members have excessive debt and Germany has an excessive current account surplus. The problem resides in the ECB’s refusal to act to stop the speculation against the Euro by invoking that its charter does not allow for the monetization of fiscal deficits.

Mr. Draghi is either naïve or wants us to believe in fairy tales. During his last press conference, he said that funding the IMF to finance exclusively the Euro Zone governments would be against the ECB charter. However, the ECB practice of accepting modern day versions of accommodation bills, in the form of bank drafts and bonds issued and subscribed by the same bank with a government guarantee and used to purchase the debt of the said government, is a more dangerous form of debt monetization since it lacks any kind of conditionality. Moreover, it puts those governments in the position of sitting ducks for speculative attacks.

As we said before bank-to-bank loans with strong conditionality are preferable. Obviously, we do not advocate that the ECB should negotiate or monitor such conditionality. Specialized institutions such as the IMF or the EFSF/ESM should do that.

Unfortunately, as we said repeatedly and the experience of Greece, Ireland and Portugal shows the IMF adjustment policies for monetary unions are seriously flawed.

Yet the ECB did not demand from the European Council that the ESM should take its place. Instead, the Council decided that all EU member states would lend to the IMF an extra 200 million Euros in the hope that non-EU countries might do the same.

In summary, by accepting the self-inflicted fiscal Darwinism of Germany that will lead to expelling peripheral countries from the Euro Zone, despite a half-baked mix of ECB and IMF support, will not restore confidence in the Euro. All it does is to replace the previous ECB hara-kiri intent with a slow euthanasia carried out by an IMF firing squad.

Government Stimulus and the Expenditure Multiplier

I am quite fed up with the way professional economists discuss the pros and cons of stimulus spending. I would like to remind them that textbooks teaching the income and expenditure multipliers also explain that the effects of increased spending are partially offset by two types of leakages – savings and imports. So, one would expect that economists would fight their corner by fencing with different estimates about these two effects. But that is not so.

Surprisingly, they keep discussing government spending in general terms rather than the various types of stimulus spending. These can be grouped into four main categories: a) useless spending; b) capital write-off spending; c) productivity enhancing spending; and d) unallocated spending.

The first group includes the so-called roads to nowhere, paying someone to dig a hole and after paying him to fill it again, creating new services that nobody is willing to pay for or wants, etc. The main purpose of these spending programs is to put money in the pocket of those delivering such services and hope that they will go on spending their earnings. So, basically this type of spending is similar to the fourth group of spending.

The fourth group of government spending includes various forms of tax breaks and rebates, showering notes with helicopters or through bank transfers and paying subsidies to various types of recipients. Under these proposals the government does not know where to spend the money and leaves it to the private sector to decide whether to hoard or to spend it. Its advantage in relation to the first group of spending is that taxpayers know best how to use this is “manna from heaven”; its main drawback is that it cannot be targeted to minimize the leakage through savings and imports.

A common problem with these two groups of spending is that they are seen as a waste of resources and taxpayers assume that they will have to pay for them later on. So, they undermine the credibility of governments, raising more the fear that causes inaction than lifting the hope needed to stimulate entrepreneurial animal spirits.

The second type of spending is based on the idea that destruction requires reconstruction and this galvanizes the spending needed to start-off the economy. It may be justified by anticipation or after the disaster. This is often the case with rearmament and war reconstruction or in dealing with natural and manmade catastrophes. Other types of policies within this group include subsidizing the anticipation of capital replacement (e.g. the recent program of cash-for-clunkers) and the acceleration of depreciation charges.

This type of spending is obviously inefficient because the wealth created by the extra people employed as a result of the stimulus is offset by the costs of destroying existing wealth. Moreover, you could use the same money to fix broken assets rather than breaking and then fixing them. But, unfortunately, this is occasionally seen as the most efficient way to stimulate aggregate demand because often politicians only act fast in the presence of calamities.

By contrast the better type of stimulus – the productivity enhancing spending – is often slow to impact on the animal spirits of entrepreneurs and consumers. This type of spending includes infrastructures, research and development, health, education and the arts. Indeed, the development of profitable programs in these fields takes a long time to implement which often is not consistent with the short run impact needed from stimulus programs. Attempts to rush in programs in this field risk turning such spending in useless spending of the type one. Another unfortunate nature of this type of expenditure is that productivity enhancing policies often require lay-offs to reduce the productivity drag caused by over manning and this offsets the intended goal of employment creation.

Apart from discussing the various types of spending stimulus, two other important issues on which economists should focus are the trade-off between speed and efficiency and the phasing out of stimulus programs to prevent perpetuating the consequent growth of the public sector at the expense of the market capitalism sector. Also the potential for collateral damages resulting from increased government spending – unsustainable debt levels, crowding-out and inflation risks – should be discussed in a dispassionate way.

In conclusion, instead of searching for abstract and absolute yes or no answers on the working of the expenditure multiplier and business cycle management policies, economists should focus on the when and how to make the stimulus programs work.

Should the IMF try a new approach in Portugal?

The IMF has a long experience of adjustment programs which have been exhaustively audited. Some of those programs were executed in situations of dollarization, which are the closest one gets to a full monetary union like the Euro area. The success rate of the IMF programs is over 50%, which is a major achievement when compared with company restructurings whose success rates are generally lower. Failures, often occur in countries who waited too long to ask for the IMF intervention, negotiated softer terms and applied reluctantly the adjustment policies.

On theses counts alone Portugal is already a likely candidate for failure. This fear is compounded by the failure so far of the Greek and Irish programs. This raises the issue of whether the IMF programs for dollarization situations can be applied to full monetary unions. One fundamental difference is the absence of an autonomous monetary policy and the option of a one-off devaluation of the local currency.

The policy of using cuts in nominal wages as a form of devaluation does not work for reasons explained long ago by Keynes. Although it might improve export growth it will only discourage imports by causing a recession via a reduced aggregate demand. The cost of such policy is disproportionate to its benefits because it reduces aggregate demand for both tradable and non-tradable sectors.

I teach my students why other alternatives such as exchange controls and open or disguised forms of subsidies paid to exporters have also a limited impact and cause costly distortions. However, I also list a number of alternatives that might work in the short run. Here are a few: a) the sale of state-owned assets; b) temporary price-controls on oligopolies with a major impact in the cost structure of exporters (mostly energy, transports and telecommunications); c) extended working hours; and d) competitive tax rates.

There is certainly a case to include all these alternatives in the Portuguese adjustment program. Let me just illustrate with the potential impact of on extra hour of work per day. Theoretically, that would be equivalent to a real wage cut of about 11%, but it would not change the nominal wage and would not depress aggregate demand. Even assuming that this real wage cut was halved through shirking and other avoidance strategies the impact on the competitiveness of Portuguese economy would still be significant. Moreover, this “patriotic extra hour” could be rewarded later on with tax credits.

Now that Portugal seems to be ready to get rid of Prime Minister José Socrates who bankrupted the country, it is also the time for the IMF to try new approaches to adjustment in countries within a monetary union.

Krugman finds the Portuguese macro story harder to tell...

It is simply a question of looking deeper. I posted a comment on his blog that lists five of the major cancers killing the Portuguese economy.

Why the IMF therapy is not working in Greece

The main role of IMF-sponsored adjustment programs is to facilitate a normal access of the borrowing countries to external markets. With the CDSs on Greek debt at 11% (above those of Venezuela) and yields on 10-year debt higher than they were before the IMF program (see chart above) the failure of the program is unquestionable.

One of the reasons why markets do not believe that Greece will be able to avoid defaulting, is probably due to the fact that the IMF approach can only use one of the three tools of their standard treatment - fiscal and budgetary policy. With Greece being a member of the Euro-zone, the other two - monetary and exchange rate policy are not available unless Greece is forced out of the Euro.

Unfortunately, the IMF has no experience of dealing with balance of payment adjustments within monetary unions. Moreover, even in relation to budgetary policy, the IMF does not realize that Greece (like Portugal and Spain) has an economic system based on state capitalism. Thus, unless they starve the Greeks (in a Ceausescu experiment) it will not be possible to achieve an external balance without destroying the state capitalism system, which the Greeks are not willing to do.

Thus the only three alternatives for Greece (and to Portugal, who is trying to mimic an IMF program without the IMF) are: a) to force a significant hair-cut on its bond-holders, b) to receive a major grant from other EU countries, or c) a mix of both. None of these is a pleasant solution but there is no other way out.