There are similarities in the nature of the economic problems facing affected economies around the world:
- The US, Japan, the Eurozone periphery countries, the UK, France, Slovenia, Cyprus and some other countries are suffering from gross inadequate aggregate demand.
- Economic growth in anaemic in many countries, or else recessions/depressions are progressively deepening, and this malaise is spreading.
- Public debt continues to increase, and in many affected countries public debt is already excessive (confusion over the interpretations of Reinhart and Rogoff causality notwithstanding).
- The latest IMF forecasts show that budget deficits will persist in all these countries till at least 2018, the end-point of the IMF forecast period.
- A number (including, for example, Spain) will, according to the IMF, still be running budget deficits (general government net borrowing requirement) of 5.6% of GDP in 2018.
If these budget deficits are financed by new government bonds, public debt will rise and the risk of recurring financial crises will remain high.
Unemployment and excess capacity are high relative to the postwar experience. Under current policies, current high unemployment rates in these countries are forecast by the IMF to be broadly unchanged at 2015, and are expected to increase in some countries. Spain has the worst unemployment outlook: Spain’s unemployment rate is expected to be at 23% by 2018.
In periphery countries a continuing lack of international competitiveness is an additional factor constraining growth possibilities.
Current policies: Austerity
Based on the experience of periphery countries, in particular, there is now increasing evidence that austerity policies have been misplaced:
- The analysis of multipliers undertaken by Blanchard and Leigh (2013), the analysis of the effects of austerity conducted by De Grauwe and Ji (2013) and, one should add, the latest IMF forecasts, strongly suggest (in my view) that the objectives of austerity are not being achieved.
It is likely that the effects of austerity are in fact counterproductive. Growth continues to weaken while public debt continues to increase.
At the same time wages and prices have not fallen sufficiently under the market-based philosophy that asserts that increased austerity will drive up unemployment sufficiently to push down wages and prices in the relatively uncompetitive countries. Wage rigidities, ossified labour markets, regulations, restrictions and a lack of strong competition policies are all likely sources of these outcomes.
The latest IMF database shows that the inflation rates recorded in 2012 for high unemployment countries – Italy, Portugal and Spain – are higher than the inflation rate recorded in Germany (Greece being a significant exception). With known rigidities, it is unimaginable that governments would impose further austerity, in the case of Spain, say, to take the current unemployment rate (27%) even higher in the hope of crushing wages and prices.
If maintained or enhanced, austerity will, arguably, continue to produce ‘bad' budget deficits by further slowing growth, reducing government revenues, raising government spending, and driving economies deeper into the ground. And it is not sufficient, on the basis of the available evidence, to assert that if one merely slows the pace of austerity this would be sufficient to create an economic recovery. A wholesale reversal to fiscal stimulus (to supplement weakened private demand) would be necessary for that to happen in current circumstances.
Nor is it reasonably adequate to argue that, with its fiscal space, if Germany would increase its budget deficit then debt problems and deficient demand elsewhere would necessarily be defeated, particularly as many affected peripheral countries are suffering from inadequate international competitiveness. That is not to say that increased deficit spending by Germany would not provide some increased ‘external demand’ to countries which are more competitive, probably on a limited scale.
And, none of this is to suggest that government spending is not excessive relative to GDP in many countries (France, in particular), or that over the longer term it will not be necessary to address this problem.
Current policies: Further quantitative easing
Where the short-term policy interest rate is above zero, there is no doubt that a strong case can be made for the policy rate to be reduced in cases such as in the Eurozone, where confidence and activity are collapsing, and where inflation has dropped to around 1.2%. However, where quantitative easing goes further, and seeks to lower the longer-term government bond rate to zero, there are very substantial economic and financial risks created.
In this context, Japan’s predicament is concerning. Some officials and some economists have argued that the recently announced aggressive asset-purchase programme (further quantitative easing) is desirable in Japan’s effort to achieve its 2% inflation target. The underlying logic here is highly questionable: the asset-purchase programme will increase ‘asset’ prices, not ‘consumer’ prices. This point is made in Bernanke (1999), when carefully read.
Other economists have defended Japan's latest monetary expansion on the basis of possibly favourable, but highly uncertain, announcement/confidence effects. This is a very remote basis on which to justify one of the largest monetary expansions in modern history.
Take the case of the US. After years of quantitative easing, inflation has been declining and has recently fallen to around 1% or so. Inflationary expectations are now lower than in 2012. In the UK consumer price inflation has fallen from 4.5% in 2011 to 2.8% in 2012, and according to the IMF will be 1.9% in 2017. While this suggests that inflation targets will ultimately be met in the case of the UK, these figures, taken overall, do not represent a strong endorsement of the proposition that the quantitative easing undertaken to date has significantly lifted consumer inflation. Why will Japan be any different from the US and the UK?
But there is more to be concerned about. The combined quantitative easing programmes now being conducted by Japan, the US and the UK, and the liquidity injections in Europe, are now on an unprecedented scale. As a consequence, commercial-bank reserves, asset prices, commodity prices, stock-market prices, house prices, bond prices and the exchange rates of foreign countries could now be expected to rise on an equally unprecedented scale if these policies are continued. Hot money flows and volatile cross-border capital movements could increase the possibility of unpredictable instability. As exchange rates abroad rise monetary authorities in affected countries will come under pressure to lower interest rates (to lower exchange rates) to limit damage to local production and exports. Ultimately, there could be downward pressure on interest rates around the globe which could spark excessive credit growth in some countries. There is some preliminary evidence that some of these trends are already underway.
Those who will be the main beneficiaries of this approach will be the banks, the investors, the traders, the hedge funds and the speculators, all of whom have a very low marginal propensity to consume ordinary goods and services. When they capitalise on profits, they reinvest the proceeds, further raising asset prices. Under quantitative easing, the new money does not get into the real economy.
Further quantitative easing, like further austerity, is most likely to be highly counterproductive over time, and if persisted with, will lead to further asset-price booms and busts, and financial crises. Have we not been here recently? Have we learned nothing?
Other grave risks
Further quantitative easing based on bond purchases will distort the yield curve and disrupt risk allocation mechanisms. Longer-term debt will become cheaper relative to equity and the corporate debt/equity ratio will rise. Risky longer-term investments will become cheaper relative to shorter-term investments; purchase and production decisions will be equally distorted; and firms that would otherwise be unviable will remain in existence. Retirees, insurance companies, superannuation funds and ordinary investors will be deprived of low-risk interest incomes, and consumption will, consequently, be adversely affected. These entities and individuals will be forced to invest in more risky assets: a totally undesirable result.
And finally, at some point in time, all these excesses – the distorted central-bank balance sheets, the asset- and bond-price bubbles, the distorted investment, savings, production and purchase decisions – will need to be unwound. When the bubbles are pricked, new financial crises will naturally follow, as in the past.
A proposed economic plan
It is time for serious debate on changing course. We need more research on: ‘Will austerity and further quantitative easing achieve their objectives and, if they could do so, could those objectives be achieved without creating a whole new set of instabilities?’. Since the answer to both may turn out to be ‘no’, there may be a case for changing course – for steering policy in a different direction. But what would these better macroeconomic policies be?
Some economists have called for better coordination between monetary and fiscal policies (see Lord Turner 2013). Could the coordination and balance between monetary and fiscal policy be improved sufficiently to restore growth without further raising public debt? Is there a way to get new money into the real economy rather than have it service commercial banks, other financial institutions and speculators? Is there a better way to improve international competitiveness where it is lacking due to exchange rate inflexibility and downward wage and price rigidity?
The elements of a new pro-growth policy strategy could be as follows:
- Discontinue further quantitative easing (based on new money creation) when short-term policy interest rates are at zero bound.
- Wind-back austerity policies.
- Use new money creation (instead) to finance expansionary fiscal policies to raise demand and stimulate economic growth.
- Adopt general price and wages policies and competition policies to lower wages and prices in an orderly manner, as needed in different countries, to facilitate improved international competitiveness without compressing real wage incomes unnecessarily, raising unemployment or raising business costs.
- Establish a medium to longer-term fiscal strategy, testing the scope for debt rescheduling.
- Aggressively pursue regulatory/restructuring policies to correct banking malfunctions.
This set of policies would have the following advantages:
- Asset-price bubbles, beggar-thy-neighbour policies and exchange-rate disputes will be avoided.
- Trade and current-account imbalances will be unwound.
- Incomes and confidence will rise.
The new money will enter into the real economy through public infrastructure spending, and as supplements to the incomes (including via tax-cuts) of wage earners, the unemployed and to other disadvantaged sectors of the economy.
- As a consequence, aggregate demand will expand (not contract further), and unemployment will stop rising, and then fall.
- Interest rates will not rise, and public debt will not increase and in some cases will fall.
The public debt-to-GDP ratio will retreat. Credit ratings will improve. Monetary transmission will become more effective.
- Inflation targets will be able to be met as capacity increases and if liquidity is adequate.
If ever inflation became excessive the new money could safely be sterilised (by open-market operations) as it would be appropriate then for interest rates to rise.
This long-term plan requires close cooperation between monetary and fiscal authorities. It is likely that the ministries of finance and not the central banks will be responsible for the new money creation, although the details and mechanics of new money creation would be the subject of cooperative discussions between central banks and the ministries of finance (for further details and possible mechanisms see Wood 2012 and 2013).
This plan represents a new policy paradigm and could have general application to afflicted countries (Europe, Japan and the US), taking into account, of course, the particular circumstances in each case. Spain is arguably most seriously at risk, as viewed from the present. The general plan applies whether countries are inside or outside the Eurozone, and it would also be relevant even if the Eurozone was disbanded, as economic recovery would still be required. In that latter case, of course, there would be an added degree of freedom: more appropriate exchange rates.
Blanchard, O and Leigh, L (2013), “Growth forecast errors and fiscal multipliers”, IMF Working Paper, WP/13/1.
Bernanke, B (1999), “Japanese Monetary policy: A Case of Self-Induced Paralysis”, Presentation at ASSA meetings, December.
De Grauwe, P and Ji, Y (2013), “Panic-driven austerity in the Eurozone and its implications”, VoxEU.org, 21 February.
Stiglitz, J (2013), “The lessons of the North Atlantic crisis for economic theory and policy”, VoxEU.org, 9 May.
Turner, A (2013), “Debt, Money and Mephistopheles: How Do We Get Out Of This Mess”, Cass Business School Lecture, 6 February.
Wood, R (2012), Solving the European Economic Crisis; challenging orthodoxy and creating new policy paradigms, Amazon books.
Wood, R (2013), “Periphery economies: National governments must be prepared to provide stimulus”, VoxEU.org, 4 March.