How important was the “structural balance” screw-up in driving European austerity?

I’m really glad to see that this European screw-up is, eventually, making headlines and that the European Commission is reconsidering the operational details of its production function method to estimate potential output and structural deficits (see WSJ).

As reported by the WSJ’s Real Time Brussels blog, the issue has become important, as the new European Fiscal Compact, which entered into force on 1 January 2013, requires that the structural deficit for euro-area Member States be less than 0.5%. So since “the European Commission uses [the structural balance] metric — the actual government budget balance adjusted for the strength of the economy – to determine how much austerity is needed; getting it wrong has big consequences.”

The question is whether “getting the structural balance wrong” in 2010 – the time at which Europe started to become obsessed with fiscal austerity – mattered in driving the amount of consolidation.

I first came across and pointed out the weakness of the structural balance calculations of the European Commission in 2010 in a series of Goldman Sachs publications that I then summarized with my co-author Natacha Valla on VoxEU. The basic storyline was and remains simple. The European Commission drastically revised downward its estimates of potential GDP as the crisis hit, which automatically increased its structural deficit measures for European countries.

This raised 2 questions?

1/ Did it make sense? 2/ And did the downward revisions to potential GDP matter for the size of consolidation packages?

First, did the downward revisions to potential GDP – that the European Commission introduced early in the crisis – make sense?

The European Commission uses a production function methodology for calculating potential growth rates and output gaps (see here). It features a simple Cobb Douglas specification where potential output depends on TFP and a combination of factor inputs (potential labor and capital). Importantly for what follows, potential labor input is calculated as:

Working age Population x Participation rate x Average hours worked x (1 - NAWRU)

It’s important to focus on potential labor input since the bulk of the revisions applied between 2008 and 2010 to potential GDP arose because of revisions to labor input.

Figure 1. Decomposition of the revisions (2010 vs. 2008 vintage) to potential GDP: Spain

Source: VoxEU. Note: The vertical axis is in percentage points.

And as you can guess from the drawing by Manu Cartoons, a large part of that decrease came from an increase in the Commission’s estimate of structural unemployment: the now infamous NAWRU. The European Commission uses the non-accelerating wage rate of unemployment (NAWRU) as an estimate for structural unemployment. We can discuss the pros and cons of NAWRU as a dynamic measure of structural unemployment in normal times, but the following graph should basically scream at you that this measure has failed at separating cyclical and structural unemployment during these extraordinary times.

Figure 2: Actual unemployment and NAWRU: Spain

Source: European Commission, 2013 spring forecast exercise

So although one can argue that a crisis can temporarily – as workers need time to adjust to the new sectoral and geographical composition of jobs – or permanently – because of hysteresis effects – decrease potential labor input, the size of the adjustments applied by the European Commission appears clearly inadequate.

Second, did it matter and was it more important than the fiscal multiplier screw-up in driving austerity?

As pointed out by Real Time Brussels, a reconsideration of the methods that the European Commission uses for estimating potential output could now cut the estimated structural deficits of the periphery countries and mean less austerity given the 0.5% rule of the Fiscal Compact. But I don’t think that, back in 2010, the structural deficit numbers played an important role for the countries that were under the heavy pressure of bond markets as they mostly focused on the nominal deficit and debt to GDP ratio metrics in designing their consolidation packages.

The structural balance screw-up may have mattered, however, for Germany (and for other core countries to the extent that their fiscal strategy mostly mimicked that of Germany) as it designed its consolidation plan for the 2011-2016 period based on the structural balance metric. In my VoxEU piece, you can see that the downward revision to potential GDP applied to core countries was not negligible. For Germany, the European Commission revised the potential GDP growth rate by about 0.5 percentage points.

I need to find the output gap and the cyclical-adjustment parameters used both in 2008 and 2010 by the European Commission to quantify by how much austerity would have decreased had Germany followed the same consolidation path (similar speed and end-points in terms of structural deficit) but used the 2008 vintage version of its potential output estimates rather the revised 2010 estimates. But my guess is that the consolidation efforts Germany planned for were to a significant extent unnecessary restrictive, even taking as given its objective of converging to a structural deficit of 0.35% by 2016.

Source: German Stability Program

Given the sheer size of core countries for the euro area, this operational mess-up may have been quite significant in delivering an inappropriate overall fiscal stance and hindering rebalancing. As a matter of fact, I wonder if this operational mess-up wasn’t more important than the fiscal multiplier screw-up in delivering this outcome. Granted, fiscal consolidation would have been less drastic in the periphery without the fiscal multiplier screw-up. But the biggest European fiscal policy failure wasn’t so much that of the periphery, which had pretty much no choice than drastically consolidate in the absence of a proper lender of last resort. The biggest fiscal policy mistake was the early consolidation efforts of the core, which started - and were amplified by the structural balance screw-up - in 2010 although “in the absence of default risk, debt adjustment should be very gradual”.

Jeremie Cohen-Setton (@JCSBruegel) is a PhD candidate in economics at UC Berkeley and an Affiliate Fellow at Bruegel. He specializes in Macroeconomic Policies and Macroeconomic History and worked previously as an economist at HM Treasury and at Goldman Sachs. Jeremie blogs at ecbwatchers.org and is the main author of the blogs review at bruegel.org.

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How to Revise a Tweet

I recently tweeted something that got several dozen immediate retweets:

When you get to the end of a first draft, it's always a great feeling because you know you're at least 1% of the way there.

Many of the retweets and "amens" were from screenwriters, journalists, and professional wordsmiths.

The tweet came about because I was reading William M. Akers's Your Screenplay Sucks (a fine book, BTW), and I found myself smirking when Akers said, on p. 126, "When you get to the bottom of your first draft, congratulations, you're about 1/10 of the way done!" Smirking because, as any writer knows, "1/10 of the way done" is off by a factor of ten. With a screenplay, especially, you're nowhere near 1/10 of the way done after a first draft.

So yeah, I swiped Akers's line for my tweet, but I rewrote it (Akers won't mind, he's a screenwriter), because frankly it needed work. "Get to the bottom" needed shortening to "get to the end," and the word "congratulations" isn't exactly right; it conveys sarcasm rather than conjuring the false sense of security you get when you've finally written a draft of something.

I thought about replacing  "you're about 1/10 of the way done" with "you're about 1/100 of the way done," but the latter is weak. The word "about" weakens it, plus 1/100 is low-impact/fuzzy. Far better to say 1% (crisp, light, less filling).

When I thought I was done, I had:

When you get to the end of a first draft, it's always a great feeling because you know you're 1% of the way there.

Still not the best wording, because I wanted to maximize the irony of "1%." Remember, the whole point is that you have a tremendous false sense of confidence after finishing a first draft. To bring out the irony a bit more, I decided to say "at least 1%."

Every writer knows that the real writing happens during revision. (As Hemingway famously quipped, every first draft of something is shit.) Turns out, it applies even to tweets.

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How I Learned to Stop Worrying and Love Trillion Dollar Platinum Coins

Back in January, when it looked like there might be another debt ceiling showdown, it seemed like all anyone could talk about was trillion dollar platinum coins (for those not familiar with the platinum coin idea and how it relates to the debt ceiling, read this and then come back). Most of the discussion was derisive, and I confess that at the time I was among the scoffers and mockers.

Now, with yet another debt ceiling crisis looming, I'm beginning to have second thoughts. It's true that, at least at first blush, the coin solution seems absurd. Part of that absurdity is probably based on misunderstandings about what the plan would entail (some people, for example, seem to have been under the impression that it would require the coin contain a trillion dollars worth of platinum). The important thing to remember is that there's nothing special about platinum coins per se; its just a legal loophole that allows the president to evade the debt limit. It's a bit like if there was an obscure statutory provision allowing the government to borrow unlimited amounts so long as the Treasury Secretary dressed like a pirate. It would be undignified and humiliating, but at the end of the day it would be better than risking default.

President Obama confers with an economic advisor. 

Or would it? My original concern with the coin idea was that it might precipitate the sort of crisis it was supposed to prevent. Ultimately, bond holders don't care about whether this or that solution to the debt ceiling crisis is "dignified." They just want to get paid. If the Administration were committed to using the coin if necessary, that might reassuring markets that default was not likely. On the other hand, it's also possible that committing to the coin might paradoxically make the risk of default seem more likely. After all, if a government has to resort to such tricks to keep paying its bills, how confident can we be that it will continue to do so, coin or no coin?

While the legal case for the coin may seem strong, it's not air tight. Courts have been known to imply limitations not explicitly in statutes based on concepts like "reasonableness," and it's clear that the intent of the law was not to allow the government to evade the debt ceiling. Given that a court would only be dealing with the matter after the fact, there would be enormous pressure to uphold the government's actions to avoid a financial crisis (in the Gold Clause Cases, for example, the Supreme Court basically eviscerated an entire provision of the Constitution to avoid a similar crisis). But what really matters is not my assessment, but rather the collective assessment of the market.

So the title of the post is (as yet) not quite accurate. I am still worrying, and I don't love trillion dollar platinum coins, though they may end up being the best of a bunch of bad options. Were I the president, I might leak that I was considering the idea as a means of testing the market's reaction.

Hopefully, though, it won't come to that. Hopefully the Congress will conclude that, however strongly they might disagree over policy, the disagreements aren't worth risking the full faith and credit of the United States. For in the words of Group Captain Mandrake, "we don't want to start a nuclear war unless we really have to."  

UPDATE: On Twitter, John Hendrickson points me to a post of his arguing that the coin could result in more inflation, even if the Fed attempts to offset it, because of the way that monetizing the debt rather than buying more bonds could affect market expectations. Of course, a little more inflation right now wouldn't be such a bad thing, but this is another reason why you would want to test the waters first.  

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What Your Customers Care About

I've been in business for myself many times over the years, and it's been my experience that when you're in business for yourself (especially if the product is YOU), you have to unlearn some common marketing myths before you can expect to succeed. For example:

No one really cares how long you've been in business.

No one cares how many happy customers you have. (Have you ever eaten at McDonald's? Do you really care how many burgers they've sold?)

No one cares that you won an award, unless it's a Nobel Prize.

No one cares about most of the stuff that's on your resume.

No one cares that your product sucks less than the competition's. McDonalds, IBM, Ford, General Motors, Microsoft (the list goes on) all compete in markets where competitors make better goods than they do. It's not always necessary to have the best product.

Was Bruce Springsteen the best singer in the world? Was Prince? Madonna?

No one cares about your moneyback guarantee. Because if you screw up, nine times out of ten the damage done won't be undone by merely refunding someone's money.

No one cares about your special two-for-one discount offer or your "special introductory price" or other price gimmicks.

If you have what someone needs, price is seldom, if ever, an issue.

What do people care about, then?

People care that you have a stable, predictable business or product that won't introduce new risk to whatever they're doing.

People care that you will commit to taking care of their needs and that you'll make good on your commitments.

People care that whatever special thing you bring to the project helps them get the results they're unable to get any other way.

People care that once they've decided to go with whatever you're offering, they'll never regret the decision.

People care about trust.

People care about flexibility.

People care about their own reputation. Yours is secondary.

Your job is to deliver what people care about. All the other stuff, all the stuff on your resume and website, all the stuff in the media kits and brochures, that's all important, but it's only there to validate and justify, after the fact, the decision that's already been made based on other, more important things.

Deliver on those important things.

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Modeling Policy When Policy Is Inside the Model

Without much comment, a very strange thing has happened to economic theory in the past two decades or so: models of the macroeconomy incorporate monetary policy as just another component of “the economy”, along with the behavior of households and firms.  I don’t mean that these models include central bank decisions on interest rates, the way they include the fiscal choices of government; that’s unavoidable.  No, they go even further and include the reaction functions of monetary authorities as determinate behavioral foundations of how the economy works; there is no corresponding behavioral rule on this fiscal side.

Here’s what I mean: Once upon a time, we had models over here (hand sweeps to the left) and policy choices over there (hand sweeps to the right).  Back in the days of IS-LM with a fixed money supply (fixed for some unmentioned reason by an almighty central bank), the model consisted of behavioral responses in the money and goods markets, leading to a predicted outcome, equilibrium levels of national income and interest rates.  In principle, monetary authorities could run this model on various money supply choices to see what economic results to expect.

OK, the model had some flaws, but in a very general way it corresponded to what we all thought models should do.  They were prediction devices: you plugged in a policy choice and it told you how the economy was supposed to respond.

Now it’s different, at least on the monetary side.  In the new versions of IS-LM and AS-AD, as well as the more elaborate models in the professional literature, monetary policy is inside the model.  The choices of central bankers are built in.  You may have interest rate targeting, inflation targeting or some version of a Taylor Rule, but in all of them the monetary choices themselves are predetermined.  The most you can do is alter a targeting parameter, like “what if monetary authorities panic when inflation hits 3% rather than 2%?”  In other words, the only choices the model can inform are those the model itself doesn’t build in.  When you build in a central bank reaction function, policy space is seriously constrained.

Now, we don’t see this on the fiscal side.  The only thing the models assume is that there is some fiscal policy: the government sets tax rates on various activities and makes various spending commitments.  Actual revenues and spending levels may fluctuate with national income in a more fully specified model, but government discretion over fiscal policy is not constrained at all.  That is, pretty much all the fiscal policy choice is outside the model, which means you can run the model with just about any hypothetical choices you care to make.  This is the way models used to be for monetary policy too.

So why on earth has this happened?  Why do the economists who create, propagate, use and teach these models want to limit monetary policy freedom, and the range of usefulness of the models themselves, by putting so much policy inside?

I don’t have a single answer, and I’m not sure there is one.  But I do have a couple of hypotheses, one or both of which might be true.

First, there is an internal, logical reason, which is that earlier generations of macro models rested on untenable assumptions about how monetary aggregates are determined.  After the brief monetarist experiment in the US and the UK in the late 70s–early 80s, it was clear that (a) there is no single measure of “the money supply” that captures the full economic effect of monetary policy and (b) in any case the central bank can’t control it. Trying to do so in a single-minded way would be a recipe for causing massive economic damage.  Models that were based on a fixed money supply, set by the central bank in the short run, lost credibility.  (You can still find them popping up in introductory textbooks, which says something about the textbook business.)

So there needed to be other equations in the model that took the place of money supply setting.  The only alternative economists could come up with was fixed central bank reaction functions.  Maybe this is not perfect either, but it’s what we’ve got.

I suspect there is a measure of truth to this, but it doesn’t explain why such a dramatic change in modeling strategy, one that tinkers with the fundamental purpose of modeling itself, was swallowed wholesale without comment or debate.

Here’s a second hypothesis: modern macro is based on intellectual predispositions that crave fixed policy rules.  I can think of two of them.  First, the shift to built-in monetary policy coincided with the microfoundations revolution.  But these were not any old microfoundations; they were formulations based on optimizing behavior by everyone, with the result that outcomes could be evaluated according to whether they were optimal for society as a whole.  The purpose of macro was no longer to simply connect policy inputs to economic outcomes and leave it to “decision-makers” to make the pick, like those Old Keynesian models used to do.  No, the point is to identify the optimal policy and the corresponding optimal outcomes.  You solve for that.  Throw in some assumptions about the natural rate and utility maps for income and inflation and, behold, you can specify exactly what policy should be.  If that’s what it’s all about, you don’t need to run a model across multiple policies—you’ve already got the policy set you’re looking for.

A second bias is related to the first but is more obviously political.  According to this mindset, economics is technical and has the capability, or should, to generate correct answers to policy questions.  Politics is at best haphazard, however, and at worst is subject to shameless pandering.  Politicians compete by one-upping each other on populist irresponsibility, promising short run boosts to interest groups or even the economy as a whole, whatever the long run costs.  Economics, by showing everyone what policies are truly best over a long time horizon, is a weapon against populism.

If economists think this way, it makes sense that they would be predisposed to fixed rules that eliminate the very possibility of political interference in policy-making.  If you know what’s optimal, why mess with it?  Putting monetary policy inside the model not only closes it, it also represents how the world ought to work.

Ah, you ask, but what then about fiscal policy?  If hypothesis #2 is correct and economists insert central bank reaction functions into their models because they believe in a policy world that is rule-based and predictable, why don’t they do this on the fiscal side?  My answer would be, they don’t need to because there shouldn’t be any discretionary fiscal policy at all.  In the ideal world inhabited by modern macro, automatic stabilizers would be allowed to stabilize, and that’s pretty much it.  All the heavy lifting would come from the monetary side, and that is where fixed rules matter.

In addition, there is no structural need for inserting fiscal policy reaction functions, since existing behavioral equations for households and firms take care of the goods markets just fine, thank you.

Up to now, my only purpose has been to describe and understand what has happened in the world of macro modeling.  I haven’t taken sides, although it’s probably because I don’t like this trend that I am noticing it in the first place.  To close, I just want to mention a few problems.  First, estimated central bank reactions functions, like Taylor Rules, rely on just a few years of data.  It is a huge leap to assume that regularities established over a decade or so are fixed in stone.  Second, even this thin evidence base does not support the presumption that central banks predictably follow fixed rules.  Third, any pretense of rule-based policy was jettisoned in response to the economic crisis that struck in 2008, and rightly so.  Fourth, the supposed anti-political bias of economics is itself very political and has dangerous implications.

But my point is not to get you to agree that this revolution in modeling methodology is bad, but simply to see that it has happened.

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