Fiscal policy remains in the stone age
With unemployment remaining saturated in the euro area and core inflation well below target, Simon Wren-Lewis argues that German fiscal policy, specifically, is too tight, calling for stimulus by means of public investment.
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Fiscal policy remains in the stone age.
Or maybe the center ages, but definitely not anything more recent compared to the 1920s. Keynes advocated using fiscal expansion in what he called a liquidity trap in the 1930s. Nowadays we use a different terminology and discuss the necessity for fiscal expansion when nominal interest levels are stuck at the zero lower bound or effective lower bound. (I slightly choose the latter terminology since it is up to central banks to choose at what point reducing nominal interest levels further will be risky or counterproductive.) The logic may be the same today since it was in the 1930s. When monetary policy loses its reliable and effective instrument to control the economy, you must bring in another best reliable and effective instrument: fiscal policy.
The euro area all together happens to be at the effective lower bound. Rates are simply below zero and the ECB is creating money for large-scale purchases of assets: a monetary policy instrument whose impact is a lot more uncertain than interest changes or fiscal policy changes (but certainly much better than nothing). The reason why monetary policy reaches maximum stimulus setting is that Eurozone core inflation seems stuck at 1% or below. Time, clearly, for fiscal policy to start out lending a hand with some fiscal stimulus.
The goal of the brand new German Finance minister, from the supposedly left wing Social Democrats, is to attain a budget surplus of 1%. For doing that, he’s cutting public investment from 37.9 billion euros in the year ahead to 33.5 billion euros by 2020. Yet German infrastructure, once globally renowned, is falling apart. Its broadband connectivity could possibly be greatly improved.
The macroeconomic case for a far more expansionary German fiscal policy is overwhelming. Germany includes a current account surplus of around 8% of GDP. There are several structural reasons why you may expect some current account surplus in Germany, however the IMF estimates these structural factors take into account not even half of the existing surplus. It estimates a third of the surplus surplus is because an overly- tight fiscal policy. As Guntram Wolff highlights, the primary counterpart to the surplus is saving by the organization sector. Perhaps more public investment might encourage additional private investment.
But this is simply not another article about how exactly Germany must expand to help all of those other euro area. The problem, as Matthew Klein highlights, is that the entire euro area does the same. In the region all together, the fiscal position is really as tight since it was in the pre-crisis boom. Unemployment in the Eurozone continues to be too high. And the reason why fiscal policy is too tight is that key Eurozone policymakers believe that is the right move to make. “The proper deficit is zero” says the French finance minister. He continues on: “ Since France isn’t in an overall economy, we have to have a balanced budget, in order that we are able to afford a deficit in tougher times.” You hear the same in Germany: the economy is booming so we should have budget surpluses.
A booming economy isn’t one that keeps growing fast, but one where in fact the degree of output and employment is above the particular level compatible with residing at target inflation. Measures of the output gap are just estimates of what that level is: underlying inflation may be the ultimate guide. Core inflation is well below target at this time, which is why interest levels are in their effective lower bound. That is why the actions and rhetoric of all European (and UK) finance ministers are simply just wrong.
You would believe causing another recession following the one following GFC is a wake-up demand European finance ministers to understand some macroeconomics. (Yes, I understand that the ECB raising rates in 2011 didn’t help, but I expect most macro models will let you know the collective fiscal contraction did a lot of the harm.) Yet what little learning there’s been is learning never to make huge mistakes but only large ones: we have to balance the budget when there is absolutely no crisis.
This is simply not a dispute between left and right since it is now in the united kingdom, but a problem with the policy consensus in Europe. What we are seeing, I suspect, is a potent mix of two forces: a German obsession with balancing the budget which includes its roots in currently dominant ordoliberal/neoliberal ideology, and Keynes’ famous practical men: advisers who learnt what economics they have within an era of the fantastic moderation where in fact the worst economic problem we’d was relatively benign deficit bias. Fighting the last war and all that.