That sinking feeling

Are we really talking about fiscal consolidation already?

Former German finance minister Wolfgang Schäuble is known for his adherence to monetary and fiscal rigour and a recent opinion piece in the Financial Times confirmed his reputation. He argued for a “return to monetary and fiscal normality [and that] the burden of public debt must be reduced.  Otherwise, there is a danger that the Covid-19 pandemic will be followed by a “debt pandemic”, with dire economic consequences for Europe … Thus, all eurozone members must engage in efforts to return to stricter budgetary discipline.” It is striking that following the biggest economic hit since WWII we are already hearing calls for fiscal tightening. Whilst acknowledging that there will come a point when fiscal support will have to be eased back, such calls require more nuanced thinking than Schäuble tends to apply to fiscal issues.

In what sounded suspiciously like a lecture to the finance ministers of euro zone member states, notably Italy, Schäuble noted that “the need to pay back the debt later is often overlooked. Many governments focus on the “easy” bit of Keynesianism – borrowing – and then postpone repayment of their debts.” This is, of course, not true. If bond investors were worried about not getting their money back they would cease purchases of euro zone debt. Aside from the obvious case of Greece (of which more later) that has not happened. Indeed, many EMU member states have agencies dedicated to managing the national debt which is an indication of how seriously they take the problem.

The article appeared to be based on a misunderstanding of how fiscal policy works, which is somewhat unfortunate from a former finance minister. For a start, he makes the amateur mistake of treating public finances in the same way as those of a household. In other words, he fails to account for the near-infinite lifespan of a government which allows debt to be repaid over multiple generations. And if he is worried about governments borrowing but not repaying debt, Schäuble might want to take a look at the level of German public debt which has doubled in the past 25 years at roughly the same pace as Italy (chart below).

Schäuble’s Italian concerns

That said, Germany’s performance in holding down its debt-to-GDP ratio is far better than that of Italy (chart below). Whilst the level of gross debt has increased at roughly the same pace since the mid-1990s, the fact that Italian GDP has grown more slowly than Germany means that there has been a significant divergence in the debt ratio performance. Italy has struggled to generate decent growth in the two decades since it joined the single currency. This can partly be ascribed to low productivity growth in a fixed exchange rate environment and there are many who believe that Italy’s days in the euro zone may be numbered.

The travails of the Italian economy can wait for another day but you can be sure that if Italy proves to be the catalyst for another euro zone debt crisis it will shake monetary union to its foundations. Precisely because it is in nobody’s interests to allow the euro zone to fall apart, the economy has to be managed in a way that accommodates the fiscal position of southern European countries. Whilst this is not what Germany signed up for, and Schäuble’s views are coloured by those of the people he serves – the electorate – politicians across the euro zone have to take some of the responsibility for allowing Italy into the single currency knowing that it failed the excessive debt criteria.

And he has form on Greece

For all Schäuble’s concerns about Italy, his role in the Greek crisis as German finance minister highlighted the perils of adherence to economic orthodoxy. After Greece was forced to put in place stringent austerity measures in 2010 in return for an emergency loan that was sufficient only to pay interest on existing debt and keep banks capitalized, his insistence on further measures in return for additional aid were more than savage. Former US Treasury Secretary Tim Geithner has recorded how Schäuble was willing to sanction Greece being kicked out of the euro zone, and he continued to hold Greek feet to the fire even in the face of IMF concerns that Greece would be crippled by its ultra-high debt.

The cost to Greece of the fiscal measures forced on them by other euro zone states has been high – even before the pandemic Greek real GDP was almost 30% below mid-2007 levels. In anyone’s book that has to go down as a depression. We can argue about how Greece found itself in such a predicament in 2010 and the extent to which it was the author of its own demise. But the actions of the German government, spearheaded by Schäuble as finance minister, illustrate that the costs of applying orthodox solutions at the wrong time can inflict huge damage. Anyone tempted to heed the siren calls for fiscal consolidation would do well to ponder the Greek case.

He ain’t no Keynesian

In his opinion piece Schäuble invoked the spirit of Keynes. Unfortunately he seems not to have understood Keynes’ prescriptions. He noted that “Keynesian economic experts like Larry Summers or Olivier Blanchard lament the crossing of red lines on public debt and point to the increased likelihood of runaway inflation.” But there is no clear link from high debt to inflation, other than that it is to the debtors advantage if the debt burden can be inflated away. High levels of debt do not, per se, result in high inflation – just ask the Japanese. The criticism levied by the likes of Summers and Blanchard is that a US economy with little spare capacity which receives a big fiscal boost may be prone to inflation, but it is not a question of the debt level itself.

In any case, the treatment of debt did not get a lot of attention in Keynes’ most famous work. In The General Theory of Employment, Interest and Money, I counted 22 uses of the word “debt” and one of them was to point out the perils of reducing it too quickly. As Keynes pointed out, “the desire to be clear of debt” may exacerbate existing economic problems by stimulating more saving than would otherwise occur, resulting in “a diminishing … propensity to consume” – the famous paradox of thrift argument. This is not merely a 1930s problem. IMF simulation analysis conducted in the wake of the GFC pointed out that when all countries are involved in fiscal consolidation with interest rates at the lower bound, the costs of lost output are twice as large as when one country performs fiscal contraction in isolation. If Keynesian analysis offers any insight, it is that there can simply be too much fiscal consolidation.

But we do agree on one thing

Despite the fact I disagree with most of his policy prescriptions Schäuble did make one argument that I found very appealing, suggesting that “a promising approach for Brussels to take would be a eurozone debt redemption pact, similar to the sinking funds devised by Robert Walpole and Alexander Hamilton.” Indeed, I made this very proposal some years ago (here). As I pointed out at the time “few investors will buy undated Greek consols, so the fund would have to be guaranteed by a body such as the ECB.” Last year’s joint borrowing plan suggests that maybe the European Commission itself might be an appropriate guarantor. There are many issues regarding how such a fund might work. Would all countries place debt in the fund or simply those with excessive debt (anything above an arbitrary limit such as 120% of GDP)? The issue of guarantor would almost certainly provoke a political storm.

However we are at the stage where the old pre-Covid orthodoxy no longer holds. As the last decade has demonstrated, unsophisticated consolidation is not guaranteed to produce good outcomes. If Europe is to emerge strongly from the pandemic it cannot afford to be encumbered by navel-gazing over appropriate debt levels. A sinking fund in which a large proportion of debt can be converted into undated consols might be one way to deal with the problem. If even someone as orthodox as Schäuble is talking about it, maybe this is an idea whose time has come.

Warning signs

A running theme throughout this blog has been the quality of governance, particularly in the UK. As concerned citizens this is something we should all care about but as an economist this normally has only tangential relevance for the way in which mature western economies operate – at least in the short-term. But the alleged failings in the handling of the biggest health crisis in a century has had a huge economic impact, with only Spain amongst the major economies registering a worse output collapse in 2020 than the UK. There is also some evidence to suggest that the quality of national governance has an impact on corporate social performance. Good governance therefore continues to matter.

Pandemic pandemonium

Having spent much of the spring reporting on allegations of corruption in government, the British press had yet another field day this week following the testimony by Boris Johnson’s former adviser Dominic Cummings before a parliamentary committee on the handling of the Covid crisis. One of the unremarked ironies of the saga was that those media outlets which have been criticised for giving Johnson an easy ride over issues such as Brexit were happy to directly report Cummings’ allegations that the government mishandled the process from the start which resulted in many thousands of excess deaths. He was scathing of the competence of many members of government, including the prime minister (“he made some terrible decisions, got things wrong, and then constantly U-turned on everything”) and the health secretary (he “should’ve been fired for at least 15-20 things, including lying to everybody on multiple occasions”).

As much as people might wish to believe Cummings’ version of events, the fact that he was effectively sacked from government last November suggests he has an axe to grind. Whilst revenge is as good a motive as any to stick the boot into someone else’s political career, we should be very wary of taking his seven-hour testimony at face value. It is indeed ironic that many of those who had previously viewed Cummings as the devil incarnate were quick to accept his version of events, largely because they have an even bigger problem with Johnson. As the journalist Jonathan Freedland points out “Cummings is an unreliable witness”, as anyone who listened to his risible defence as to why he flagrantly breached lockdown rules last year will recall.

Nonetheless, the many independent fact checks (here and here for example) that have been conducted into Cummings’ claims conclude that there is some truth to them. The single most damning is that Johnson failed to take mounting evidence of the pandemic sufficiently seriously and that the government reacted too late. It is possible that in January and early February 2020 the government was basking in the glow of finally having delivered Brexit which may have caused it to take its eye off the ball (not that this is any excuse). Moreover, the advice from the SAGE committee was not as unequivocal as is often remembered today (as I pointed out in this post).

One of the bigger criticisms which Cummings failed to bring up was that many senior politicians believed there to be a trade-off between protecting the economy and protecting the health of the nation. This has been widely debunked. The greater the ring fence that can be put up to prevent the virus from taking hold, the smaller the hit to the economy – as Germany has demonstrated. It is certain that all these issues will be debated again when a public inquiry into the handling of the pandemic is established. However, since its terms of reference will be decided by the government it is a safe bet that it will not be allowed to undermine the government’s position (for one thing it will deliver its report sufficiently far in the future that it is unlikely to derail Boris Johnson’s front line career in politics).

The bigger picture

Much of what we learned from this testimony merely repeats what has been said at various times by other people. It was given added significance by the fact that Cummings was in the room when the decisions were made. Aside from the political points scoring, the evidence reveals that the political culture in which we now operate is one in which truth has become an elastic concept. As Freedland points out, Cummings is one of the fathers of this culture, particularly since he knowingly plastered the false claim on the side of the Brexit battle bus that the UK would save £350 million per week by leaving the EU. It is therefore ironic (to say the least) that he should accuse the health secretary, Matt Hancock, of lying.

All of this intrigue makes for good copy and has kept journalists busy in recent days but as we discovered with the furore surrounding financial impropriety allegations at the heart of government, this may not have much cut-through with voters. But there is evidence to suggest that governmental culture matters for the way in which the economy is run. In particular, there is solid empirical evidence to suggest that the quality of overall governance matters for corporate social performance. The authors of the study[1] identify a series of good governance attributes (accountability, political stability, government effectiveness, regulatory quality, rule of law and control of corruption) and explore the relationship between these factors and corporate social performance for a number of OECD countries. They find a positive correlation between the two and conclude that “policymakers that want to stimulate the transition toward a more sustainable society should consider their country’s overall governance quality.” What is significant about this study is that it does not simply focus on emerging markets where this pattern has long been observed – it holds for the industrialised economies too.

It is important to stress that the UK is not some ungovernable basket case economy. Like (nearly) all western economies, it retains a strong institutional framework that is able to impose some checks on the way in which government operates. But the warning signs flashed by efforts to prorogue parliament in 2019 or the NAO’s findings that the pandemic “laid bare existing fault lines within society, such as the risk of widening inequalities, and within public service delivery and government itself” suggest there is clear room for improvement. Mounting concerns about the cost of Brexit in those areas which were initially most enthusiastic (notably farming and fishing) have done little to enhance trust in the government’s operating methods.

We should discount some of the more rabid media commentary which focuses on personality rather than policy. But there are creeping signs that a decade of fiscal austerity, a pandemic and the bitter Brexit fall out are eroding the quality of governance. This trend needs to be nipped in the bud for otherwise we will all pay the price.

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[1] Kaufmann, W. and A. Lafarre (2020) ‘Does good governance mean better corporate social performance? A comparative study of OECD countries’, International Public Management Journal, DOI: 10.1080/10967494.2020.1814916

 

Not the 1970s but not the 2010s either

Inflation concerns have been rising up the market agenda during the course of this year. These fears appeared justified following last week’s release of US CPI inflation data which showed a jump from 2.6% in March to 4.2% in April – the highest rate since September 2008. This week’s UK release also showed a big jump in CPI inflation from 0.7% in March to 1.5% in April, and whilst the pickup in euro zone inflation was more modest (to 1.6% from 1.3% in March) it is now at its highest in two years. Obviously there are base year effects at work with last year’s total shutdown in activity making price measurement in April 2020 extremely difficult. Nonetheless, there are indications that price pressures are building. How worried should we be?

Dissecting CPI inflation data reveals the extent to which it has recently been driven by the recovery in oil prices. Recall that in April 2020 the price of Brent dropped to a monthly average of $18 versus $64 in January and $56 in February and whilst it subsequently recovered, it was only in February/March 2021 that oil got back to pre-pandemic levels. But whilst US core CPI inflation stood at only 3% in April – more than a percentage point below the headline rate – it was still almost double that in March and its highest in 25 years. On the basis of price trends further down the chain, consumer prices are likely to rise further. Aside from oil, industrial metals such as copper have reached record highs whilst there have been well-publicised warnings that shortages in key industrial components such as semiconductors will also push up prices. A further warning sign is that Chinese producer prices are now running at their fastest pace since late-2017 (6.8%) suggesting that price pressures in the workshop of the world need to be viewed with caution.

In addition to the base year effects, the inflation pickup in 2021 reflects the concerns expressed a year ago that the damage to the supply side of the economy during the lockdown would generate a pickup in inflation as capacity bottlenecks emerged. If this is the case, then surely the recent resurgence in inflation will prove temporary. This is not to say we will not see a further big rise to levels which many people might think scarily high, but it does suggest that we are not on the verge of a 1970s rebound. To the extent that inflation is driven by the difference between what economies consume and what they can produce (the output gap), and given that output gaps across the OECD remain in negative territory, suggesting that there is plenty of capacity to accommodate any pickup in demand (the average across the OECD is estimated at -5.2% in 2021 - see chart below), there is no obvious sign that a sustainable burst of inflation is in the offing.

It is true that lax monetary policy has helped support the rebound, leading in effect to a monetary-induced burst in inflation, but the expectation is that this will be temporary. As the demand catch-up from 2020 begins to fade, so it is widely expected that demand-supply pressures will ease and price inflation will slow (hopefully back towards central bank targets). The likes of the BoE have adjusted to this by slowing the pace of asset purchases although it has not adjusted the overall target for the stock of asset purchases which is ultimately what matters for the degree of monetary easing. 

Although it is expected that inflation in the UK and US will overshoot the central bank’s central 2% target we should view this in part as a consequence of the post-pandemic adjustment process. Indeed, there is likely to be a change in the product supply-demand mix which will leave an overabundance of productive capital tied up in areas where demand has declined, whereas there is a shortfall in areas where demand has increased. Accordingly we might expect strong inflation in some classes of goods and services, whereas in others it is weaker, which might persist for some time until the demand-supply balance has been restored.

Central bankers will thus be closely watching inflation expectations for some time to come for indications that it is set to take off. But inflation expectations differ according to who we ask. For example, the BoE’s survey of UK households shows that they have consistently overestimated expected inflation over the past 20 years. There is thus a strong argument for attaching a low weight to household expectations. In any case, households have limited bargaining power when it comes to setting wages so their weight in the price setting process is limited. Moreover, financial literacy amongst many households is not as high as it could be with the result that the concept of inflation is often hazily defined. Much of the academic literature thus attaches greater weight to the expectations of companies and those priced into financial markets. From a financial market perspective there has been a small pickup in inflation expectations, as derived from 5y5y swaps in the US and euro zone (chart below), but it is no higher than at any time in the last five years. Nor does corporate survey evidence across the industrialised world suggest that a pickup in wage inflation is likely anytime soon.

For all these reasons, some of the more lurid headlines suggesting that we may be on the brink of a 1970s-style inflation pickup are likely to be wide of the mark. There appears to be plenty of spare productive capacity; inflation expectations remain well anchored (for the moment); the ability of organised labour to push for higher wage claims is much more limited than it was 50 years ago plus – and this is perhaps the critical difference – in an increasingly global economy, inflation is a function of world rather than local conditions. None of this is to say that inflation will not run above target. The BoE, for example, looks for a UK inflation rate above 2% until around autumn 2022 although crucially it is not expected to exceed the upper 3% band.

If, however, we are about to experience higher inflation there is also a case for taking away some of the extreme monetary easing put in place over the last year. Over the last decade, central banks have used the argument of low inflation as a reason for keeping the pedal to the metal. Above-target inflation surely warrants a move in the other direction.