A guest post by Mark Sadowski
Simon Wren-Lewis responds without mentioning who he’s responding to here:
“If fiscal policy is important at the zero lower bound, why did the US recovery continue in 2012 and 2013 despite a large fiscal contraction? Or to put the same question in a comparative way, why was the Eurozone’s fiscal contraction in 2012/3 associated with a recession, but not in the case of the US?
GDP growth had been reasonable in both the US and the EZ in 2010 and 2011. While US growth continued into 2012/3, EZ growth collapsed. Yet as the chart above shows, fiscal tightening was only slightly greater in the EZ in 2012, and became considerably tighter in the US in 2013.”
I have several problems with this analysis. First of all he’s using OECD estimates of the cyclically adjusted primary balance (CAPB). Personally I prefer the equivalent IMF estimates. Secondly, fiscal contraction started in the U.S. and the Euro Area in 2011, not 2012, and this is true regardless of whose estimates of the CAPB we use. Furthermore the second Euro Area recession started in 2011, not 2012, despite the fact that annual GDP did not decline until 2012, and the sovereign debt crisis also grew much worse in 2011, not 2012. So I think it is important that we look at 2011 as well as 2012 and 2013, as Wren-Lewis’ post that set off this discussion implicitly did. Third, if we’re going to use a single metric for the effects of policies meant to have an impact on aggregate demand (AD) I think it’s important that we actually look at AD (nominal GDP or NGDP) and not real output (real GDP or RGDP). It’s always possible that aggregate supply (AS) shocks could muddy the waters, and I already notice that one commenter has brought up this very issue at Wren-Lewis’ post.
Here’s NGDP growth in the U.S. and the Euro Area in 2011-13.
And here are the IMF’s estimates of the change in CAPB in the U.S. and the Euro Area in 2011-13.
Right away we notice that US NGDP growth has been much less variable than the Euro Area’s, falling within the comparatively tight 3.4% to 4.6% range. In contrast Euro Area NGDP growth fell off a cliff in 2012, going from about 2.8% to 0.7% in a single year. Also, the IMF’s estimates of the CAPB show that US fiscal policy has been tighter than Euro Area fiscal policy all three years. In contrast to the OECD numbers, there is a slight increase in the Euro Area fiscal contraction, not a significant decrease. The unadjusted primary balance increased by 0.5% of GDP in 2012 and 0.6% in 2013. Since the Euro Area output gap increased by almost the same amount in 2012 as in 2013 according to both IMF and OECD estimates, and the unadjusted primary balance increased by nearly the same amount in each year, I think it is reasonable to expect the CAPB to have increased by about the same amount in both 2012 and 2013. This is one reason why I find the IMF’s estimates of the CAPB more believable than the OECD’s.
So, in particular, note that the IMF’s estimates of the change in CAPB suggest that fiscal policy was more or less equally contractionary in all three years. This stands in sharp contrast to the NGDP performance which declined severely. Quarterly RGDP data show that the Euro Area was in a recession from 2011Q4 through 2013Q1, and that the Netherlands, Spain and Portugal had fallen into recession in 2011Q2 and that Austria, Cyprus, Italy and Slovenia followed suit in 2011Q3.
Which is the more logical explanation of this highly variable NGDP and RGDP performance? Fiscal policy, which was more or less equally contractionary throughout? Or monetary policy, which was tightened through an increase in the Main Refinancing Operations rate (MRO) from 1.0% to 1.25% in April 2011 and then to 1.5% in July, and then loosened through subsequent decreases in the MRO to 1.0% by the end of 2011 and down to 0.5% by May 2012, as well as through a dramatic expansion in the ECB’s “enhanced credit support programmes” (i.e. LTRO) starting in December 2011, which are the Euro Area analogue of the Fed’s now by and large concluded “credit and liquidity programs” (i.e. the alphabet soup of CPFF, MMIFF, PDCF, TALF, TSLF TAF etc.)?
Simon Wren Lewis assigns one reason for the Euro Area’s poor performance in 2012 to the Euro Area sovereign debt crisis, which in my opinion is a case of circular reasoning.
“In comparative terms, there are two obvious answers looking at 2012. The first is the EZ crisis. Although this began in 2010, it reached a critical position in 2012, when Greece was almost forced out. It is hardly surprising in these uncertain circumstances that EZ investment fell by nearly 4% in 2012.”
It’s important to recall that the Euro Area sovereign debt crisis had two phases: one from October 2009 to June 2010 and another from April 2011 to July 2012. The first matches Greece’s initial surge in spreads which finally paused after Greek Prime Minister Papandreou, Euro Area leaders, and the IMF agreed to the Euro Area’s first sovereign bailout. The second phase started with Portuguese acting Prime Minister Socrates’ bailout request, was marked by peaks in the spreads for all of the GIIPS, and concluded shortly after Spanish Prime Minister Rajoy requested a bailout. The beginning of the second debt crisis more or less coincided with the ECB’s decision to raise the MRO rate in April and July of 2011. Here is a graph of 10-year bond spreads of the GIIPS nations relative to Germany.
You can see that during the nine months from June 2010 to March 2011 that the bond spreads of barely changed in Italy and Spain, and increased moderately from already elevated levels in Ireland, Greece and Portugal. But in the next four months through July, which encompassed the two MRO increases, Italian and Spanish bond spreads increased by over 100 basis points and Greek and Portuguese bond spreads increased significantly more than they had in the previous nine months.
It was pretty obvious to nearly everyone at the time that what had precipitated the second Euro Area sovereign debt crisis was the decision by the ECB to raise the MRO. As Paul Krugman said in November of 2011:
“Ryan Avent joins the chorus of those suggesting that the European Central Bank’s decision last spring to start raising rates — a decision that seemed crazy then, and looks even crazier now — was the point at which everything started to fall apart.”
Simon Wren-Lewis’ other reason for why the Euro Area performed so much worse than the U.S. in 2012 is monetary policy.
“The second is monetary policy. The ECB raised rates from 1% to 1.5% in 2011, and compared to the US there was no Quantitative Easing. Combining the two, monetary conditions tightened considerably in the periphery as a result of the crisis. There was no comparable crisis in the US, which allowed investment to increase by 5.5%.”
But of course there was no comparable crisis in the U.S., because the Fed did not choose to tighten monetary policy in the middle of a financial crisis!
However, Simon Wren-Lewis seems genuinely puzzled by the differing performances of the U.S. and Euro Area economies in 2013.
“Explaining 2013 seems more difficult. Monetary policy had eased in the EZ (although of course not by as much as it should have, and OMT had brought the crisis to an end. In the US there was considerable fiscal tightening. So why did the US continue to grow and EZ GDP continue to fall?
For the EZ one proximate cause was a sharp decline in the contribution of net exports. Net exports added 1.5% to GDP in 2012, but only 0.5% in 2013. If this contribution had been more even at 1% in each year, GDP would have fallen by over 1% in 2012, and stayed roughly flat in 2013. Fiscal policy continued to tighten, which also would have reduced growth.”
In fact, according to Eurostat, Euro Area net exports rose from 1.3% of GDP in 2010 to 1.4% in 2011 to 2.6% in 2012 to 3.4% in 2013. Thus net exports “added” 1.2% to GDP in 2012 and 0.8% in 2013 which is not significantly different. Moreover such huge back-to-back increases in net exports are symptomatic of an economy that is starved of adequate domestic demand, as was evidently true of the Euro Area in 2012-13. In contrast, it’s not surprising that since the recession ended, net exports have actually fallen as a percent of GDP in the three large advanced currency areas that are all at or near the ZLB and that have done QE (i.e. the U.S., Japan and the U.K.).
Simon Wren-Lewis then points to a falling U.S. household savings rate, which in my opinion is another example of circular reasoning.
“In the US something else happened: the savings ratio, which had been elevated at 5.5% or above since 2009, fell to 4.5%. This could have been a result of fiscal tightening, but it seems more probable that it represented the end of a prolonged balance sheet correction. (The US savings ratio averaged 4.5% between 1996 and 2007 and the OECD’s forecasters expect it to fall further this year and next.)”
I think a better measure is the private sector financial balance, which by my calculations has indeed decreased every year since the recession ended, and in contrast increased in the Euro Area in 2012 and 2013. But once again, we usually see the private sector financial balance fall in economies that are doing relatively well, and rise in economies that are in recession.
It’s probably more coherent to actually look at the private sector balance sheets for clues. And what you will find there is that, as Wren-Lewis alludes to, U.S. nominal private sector debt has been rising since 2011Q3. But even though it is rising, the ratio of private sector debt to NGDP, the leverage ratio, continues to fall because NGDP is increasing at an even faster rate. In contrast, Euro Area nominal private sector debt rose straight through 2013Q1, and the leverage ratio at that time was almost as high as it was in 2009Q2 when the first recession ended. As long as NGDP growth is laggard, the Euro Area leverage ratio likely will remain high.
In the final analysis, the question is why is one economy doing well and the other not? And for that you have to look at policy differences. The U.S. has pursued a relatively expansionary monetary policy, whereas with respect to monetary policy the Euro Area has persistently done too little too late.
Simon Wren-Lewis concludes by looking at the U.S. output gap and argues that more could be done, and that the more that could be done is obviously fiscal stimulus.
“The OECD estimates that the US output gap in 2013 was -3.5%, which was much the same as their estimate for 2012. So growth of 2% did nothing to close the output gap in 2013. This was despite a large fall in the savings ratio, perhaps bringing to an end the balance sheet correction that began with the Great Recession. So US growth in 2013 should have been very strong, and the obvious explanation for why it was not is very restrictive fiscal policy.”
This of course assumes that if U.S. fiscal policy had not been so restrictive that U.S. monetary policy would still have been just as expansionary. I think this is a highly dangerous and enormously improbable assumption. One of the primary justifications for the initiation of QE3 was in fact the then impending “fiscal cliff”. If there was no likelihood of a fiscal cliff then the FOMC probably would never have approved QE3.
In fact I see this as a persistent problem with Simon Wren-Lewis’ analysis. He keeps suggesting fiscal stimulus as a way to promote a faster economic recovery implicitly thinking that nothing will change in terms of monetary policy as a result. Either he inexplicably thinks that monetary policy is always impotent (we’re always in a “liquidity trap”), or he bizarrely thinks that the monetary authorities would always welcome additional aggregate demand stimulus, when there’s already considerable evidence that the opposite is very much the case.
The key to a faster economic recovery everywhere is better monetary policy.