Daily Archives: December 17, 2012

For more than 30 years, from the mid-1970s to 2008, Keynesian demand management was in intellectual eclipse. Yet it returned with the financial crisis to dominate the thinking of the Obama administration and much of the UK Labour party. It is time to reconsider the revival.

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The rebound of Keynesianism, led in the US by Lawrence Summers, the former Treasury secretary, Paul Krugman, the economist-columnist, and the US Federal Reserve chairman Ben Bernanke, came with the belief that short-term fiscal and monetary expansion was needed to offset the collapse of the housing market.

The US policy choice has been four years of structural (cyclically adjusted) budget deficits of general government of 7 per cent of gross domestic product or more; interest rates near zero; another call by the White House for stimulus in 2013; and the Fed’s new policy to keep rates near zero until unemployment returns to 6.5 per cent. Since 2010, no European country has followed the US’s fiscal lead. However, the European Central Bank and Bank of England are not far behind the Fed on the monetary front.

We can’t know how successful (or otherwise) these policies have been because of the lack of convincing counterfactuals. But we should have serious doubts. The promised jobs recovery has not arrived. Growth has remained sluggish. The US debt-GDP ratio has almost doubled from about 36 per cent in 2007 to 72 per cent this year.


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The crisis in southern Europe is often claimed by Keynesians to be the consequence of fiscal austerity, yet its primary cause is the countries’ and eurozone’s unresolved banking crises. And the UK’s slowdown has more to do with the eurozone crisis, declining North Sea oil and the inevitable contraction of the banking sector, than multiyear moves towards budget balance.

There are three more reasons to doubt the Keynesian view. First, the fiscal expansion has been mostly in the form of temporary tax cuts and transfer payments. Much of these were probably saved, not spent.

Second, the zero interest rate policy has a risk not acknowledged by the Fed: the creation of another bubble. The Fed has failed to appreciate that the 2008 bubble was partly caused by its own easy liquidity policies in the preceding six years. Friedrich Hayek was prescient: a surge of excessive liquidity can misdirect investments that lead to boom followed by bust.

Third, our real challenge was not a great depression, as the Keynesians argued, but deep structural change. Keynesians persuaded Washington it was stimulus or bust. This was questionable. There was indeed a brief depression risk in late 2008 and early 2009, but it resulted from the panic after the abrupt and maladroit closure of Lehman Brothers.

There is no going back to the pre-crisis economy, with or without stimulus. Unlike the Keynesian model that assumes a stable growth path hit by temporary shocks, our real challenge is that the growth path itself needs to be very different from even the recent past.

The American labour market is not recovering as Keynesians hoped. Indeed, most high-income economies continue to shed low-skilled jobs, either to automation or to offshoring. And while US employment is rising for those with college degrees, it is falling for those with no more than a high school education.

The infrastructure sector is a second case in point. Other than a much-hyped boom in gas fracking, investments in infrastructure are mostly paralysed. Every country needs to move to a low-carbon energy system. What is the US plan? There isn’t one. What is the plan for modernised transport? There isn’t one. What is the plan for protecting the coastlines from more frequent and costly flooding? There isn’t one.

Trillions of dollars of public and private investments are held up for lack of a strategy. The Keynesian approach is ill-suited to this kind of sustained economic management, which needs to be on a timescale of 10-20 years, involving co-operation between public and private investments, and national and local governments.

Our world is not amenable to mechanistic rules, whether they are Keynesian multipliers, or ratios of budget cuts to tax increases. The UK, for example, needs increased infrastructure and education investments, backed by taxes and public tariffs. Therefore, spending cuts should not form the bulk of deficit reduction as George Osborne, UK chancellor, desires. Economics needs to focus on the government’s role not over a year or business cycle, but over an “investment cycle”.

When the world is changing rapidly and consequentially, as it is today, it is misguided to expect a “general theory”. As Hayek once recommended to Keynes, we instead need a tract for our times; one that responds to the new challenges posed by globalisation, climate change and information technology.

The writer is director of the Earth Institute at Columbia University

Last week’s summit of European leaders as well as finance ministers marks an important step in completing the eurozone architecture. At the same time, the summit’s results fall short of what could have been hoped for.

Start with banking union. When launched on 29 June, the project was widely and rightly interpreted by markets to indicate that Europe’s leaders had changed their assessment of the euro crisis. Until then eurozone heads of state had behaved as if a mere tightening of the existing budgetary provisions could suffice to restore confidence in the euro. But in June they recognised that the arrest of financial flows within the euro area had deeper roots. Banking union was designed as the first component of a systemic response to a systemic problem. Together with the announcement by the European Central Bank of a new bond-purchase facility, it was instrumental in convincing markets that the worst was not certain.

Last week finance ministers agreed on the first important step towards banking union: the establishment of a single supervisory mechanism (SSM). The compromise they have reached seems to be a good one. The ECB will be in a strong position and responsible for the overall functioning of the SSM. It will have direct oversight of eurozone banks in a differentiated way depending on size. The size threshold of €30bn means that perhaps 85 per cent of assets and more than 180 banks in the eurozone will be under direct oversight of the ECB. The press communiqué suggests that ECB will also have the right to scrutinize banks below the threshold, which will reduce banks’ incentives to fall below or above the threshold. This is important to avoid competitive distortions but also to prevent major problems among small banks, which taken together are still large. Moreover, when financial assistance is given, the ECB will be the supervisor which allows extending the coverage to a number of Spanish Cajas that are smaller in size than €30bn. The compromise also appropriately allows non-eurozone countries to participate in the SSM.

That first step was, however, the easiest of the three steps towards an integrated financial framework. Establishing a common resolution framework will be harder, because it implies giving a European authority the power to distribute losses among shareholders and creditors in several countries, close down banks and lay-off employees. Still, heads of state and government made quite some progress on this front. They explicitly acknowledge that a single resolution mechanism is required and call for the mechanism to be finalised before the European elections in 2014. They also wish the resolution mechanism to be based on resources from the financial sector itself and there is an acknowledgment that a fiscal backstop is needed.

So which principles should the single resolution mechanism be based upon? First, given the distributional choices and the fiscal resources needed, the resolution task should be completely distinct from the new supervisor at the ECB as otherwise there will be a temptation to use monetary policy to reduce the fiscal burden. Second, bank resolution should be exercised by an independent authority. This authority should be guided by clear rules and it should be politically accountable ex-post. However, the actual decisions should be done at arm’s length from the fiscal authorities to avoid excessive politicisation of decisions. Third, the authority should rely on an appropriate fiscal backstop. A clear decision-making framework is needed to determine under which conditions aid can be requested. Defining those conditions will be controversial, because budgetary decisions are always the most acrimonious. Furthermore, agreeing on banking regulation that proves appropriate for reducing fiscal costs will also be controversial. The next steps to be taken for the completion of banking union are therefore clearly on the table but far from easy to achieve.

As regards fiscal union, the summit is a disappointment. The founding fathers of the euro were aware of the need to complement monetary with fiscal union but put off difficult choices to future decision makers. The time has come to address a series of unanswered questions. Should there be a proper euro-area budget? Should a new system be conceived as an intergovernmental transfer scheme? Or should sovereigns’ ability to borrow be restored through some form of mutual guarantee? What should be the degree and type of conditionality? What does a euro area fiscal union mean for the EU as a whole? It was evidently too early to take any decision now, yet a reflection process should have been initiated. Hermann Van Rompuy, the President of the European Council, was willing to conduct it. By giving him a mandate, the European leaders would have shown that they are able to think strategically, not only to respond to market pressure.

The writer is director of Bruegel, the economic think tank. This paper is co-authored by Guntram Wolff, Bruegel’s deputy director

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