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Consequences of New Macroeconomic Insights for Economic Policy and Economic Performance in the Europe 1 Idea of this ...

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Consequences of New Macroeconomic Insights for Economic Policy and Economic Performance in the Europe

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Idea of this talk

•  Discuss some new economic insights •  Discuss potential impact on economic policy •  Discuss relevance for economic growth in Europe

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Four Areas of Macroeconomic Research

1.  (Super) hysteresis & secular stagnation 2.  Causes of the Euro crisis 3.  Keynesian economics & fiscal policy 4.  Monetary policy

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(Super) hysteresis & Secular stagnation

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Growth before & after recessions Portugal log real GDP

Source: Blanchard, Cerutti, and Summers (2015) 5

Hysteresis versus Secular Stagnation Hysteresis: •  Recessions, especially unemployment, has permanent damage •  (Regular) hysteresis: pemananent level effects •  Super hysteresis: growth rate affected •  Many stories: Loss of human capital, loss of networks

Secular stagnation: •  More than just a long recession or period with low growth •  Some disequilibrium that does not automatically disappear 6

Secular Stagnation Example •  Young: •  Work •  Borrow funds •  Middle-aged: •  Work & run firms •  Save to invest •  Save by lending to the young •  Old: •  Eat their savings 7

Secular Stagnation Example •  Suppose supply of savings middle-aged ↑ supply of savings >> demand for funds

•  Standard mechanism: ⇒ interest rate ↓ ⇒ demand for funds ↑

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Secular Stagnation Example •  Standard mechanism less likely to happen if need for funds not very sensitive to interest rate and/or equilibrium real interest rate low or negative •  Standard mechanism impossible if equilibrium real rate < - inflation ⇒ negative nominal rate

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Secular Stagnation Example

• If savings middle-aged ↑ ⇒ less demand for consumption goods • If standard mechanism does not work ⇒ reduction in demand for goods not compensated ⇒ middle-aged sell & produce less ⇒ middle-aged have less income ⇒ actual outcome attained by middle-aged not saving more

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Consequences for Economic Policy Fiscal policy: •  Really good time for •  Government investment: infrastructure, education, health care •  Structural reforms

Monetary policy:

•  Increase inflation target

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Consequences for growth in Europe •  Increase in government investments highly unlikely •  Increase in inflation targets unlikely •  ⇒ secular stagnation remains a concern •  ⇒ pessimistic outlook

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Causes of the Euro Crisis

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Causes of the Eurozone crisis Not irresponsible sovereign debt accumulation! • 

Except Greece

1. Large current-account imbalances 2. Large/unhealthy financial sector 3. No governance structure to detect risk and deal with crisis

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Jan-1990 Dec-1990 Nov-1991 Oct-1992 Sep-1993 Aug-1994 Jul-1995 Jun-1996 May-1997 Apr-1998 Mar-1999 Feb-2000 Jan-2001 Dec-2001 Nov-2002 Oct-2003 Sep-2004 Aug-2005 Jul-2006 Jun-2007

10 yr gov't bond yields (%) 16 14 12 10 8 6 4 2 0

Greece Ireland Italy Spain Portugal Austria Belgium France Germany Luxembourg Netherlands Finland

Eurozone sovereign debt yield spreads vanished, ⋅⋅⋅ 15

Cumulative current-account balance 1999-2007 (% of own GDP)

FANG countries

GIPSI countries Greece

-84%

Finland

+61%

Ireland

-21%

Austria

+16%

Portugal

-96%

Netherlands

+48%

Spain

-60%

Germany

+27%

Italy

-8%

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0 Jan-1990 Oct-1990 Jul-1991 Apr-1992 Jan-1993 Oct-1993 Jul-1994 Apr-1995 Jan-1996 Oct-1996 Jul-1997 Apr-1998 Jan-1999 Oct-1999 Jul-2000 Apr-2001 Jan-2002 Oct-2002 Jul-2003 Apr-2004 Jan-2005 Oct-2005 Jul-2006 Apr-2007 Jan-2008 Oct-2008 Jul-2009 Apr-2010 Jan-2011 Oct-2011 Jul-2012 Apr-2013 Jan-2014 Oct-2014 Jul-2015

10 yr gov't bond yields (%) 30 Greece

25 Ireland

20

15 Italy

10 Spain

5 Portugal

Germany

But spreads reappeared! 17

Eurozone Imbalances Large current-account imbalances • 

⇒ Periphery financed deficits by borrowing from core countries

• 

Capital flows went to non-tradable sectors

• 

When confidence plummeted ⇒ foreign lending stopped = “sudden stop”

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Eurozone Financial Sector •  Large financial sector; in some countries very large •  Unhealthy balance sheets: low equity and bad assets •  Very exposed to own government sector

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Large financial sector

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Governance Problems

•  Periphery countries did not have the usual lender of last resort: •  Central banks can guarantee that sovereign debt can be rolled over; ECB not allowed to do this ⇒ Euro-denominated borrowing similar to borrowing in foreign currency

•  Stability and Growth Pact did not work •  Eurozone banks were overleveraged, but oversight left to individual countries •  No joint response mechanism ⇒ ad hoc crisis management

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New Theoretical Insights?

The are several, but many macroeconomists stress old wisdom that the Eurozone is not an optimal currency union

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Consequences for Economic Policy 1.  Banking union 2.  Euro exits? 3.  Substantial financial reform? 4.  Fiscal union? 5.  Euro bonds?

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Consequences for Eurozone growth?

• 

Lots of uncertainty!

• 

No convincing structural improvements any time soon

• 

⇒ at best low growth

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Keynesian Economics & Fiscal Policy

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New & Old Keynesian Macroeconomics New Keynesian paradigm: •  All about sticky goods prices

Old Keynesian paradigm: •  Firms do not hire because of concerns they cannot sell & consumers do not buy because of job concerns

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“Old” Keynesian Models

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Fiscal policy in Keynesian Models Traditional view about “b”: •  •  •  • 

High b: Poor people that cannot borrow: C depends on current income (hand-to-mouth consumers) Low b: Rich people: C depends on life-time income Rich people more important for aggregate ⇒ b not that high ⇒ fiscal policy not very effective

New evidence: •  • 

Empirical: There are many rich hand-to-mouth consumers Theoretical: If central bank’s policy interest rate ≈ 0 ⇒ fiscal policy can be effective even if there are not many hand-tomouth consumers 28

Consequences for Economic Policy •  Keynesian fiscal policy has become very popular again among academics •  What about politicians?

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Financial Crisis & European fiscal policy Countercyclical tightening

Change in cyclically-adjusted primary deficit (p.p.)

3 Pro-

cyclical tightening

2012

2013

2011

2104

0

2007

2010 2009

2008

Countercyclical -3 expansion

-5

2006

Pro-cyclical expansion

0

5

Output gap (% of potential GDP)

Source: Baldwin and Giavazzi (2015)

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Consequences for growth in Europe •  Austerity popular among European politicians •  ⇒ pessimistic short-term outlook for economic growth

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Monetary Policy

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Monetary Policy During Financial Crisis

•  Flattening of Phillips curve: •  Large unemployment fluctuations, but •  Inflation remained relatively stable

•  Very expansionary monetary policy •  Policy interest rates close to zero •  Large asset purchases: Quantitative easing •  Forward guidance

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Crisis and Deflationary Pressure?

Source: Blanchard, Cerutti, and Summers (2015) 34

Theoretical developments •  How to stimulate an economy when policy interest rate is at zero lower bound •  Forward guidance can be very powerful when 1.  policy interest rate is at zero-lower bound and 2.  central bank commits now to future policy that will be wrong policy in the future

•  Forward guidance can also be helpful in better explaining central bank’s views & intentions •  Theoretical support for QE based on old-fashioned models 35

Consequences for Economic Policy •  Flattening Phillips curve: Target real activity not inflation? •  Structural changes to allow more easily for negative interest rates? •  Increase the target inflation rate? •  Wörgl Experiment 1932-33

•  Will monetary policy be more responsive to signals of financial risk such as increased leverage

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Consequences for growth in Europe 1.  More experienced central bankers & new tools 2.  Future monetary policy uncertain •  Unclear what set of policy tools will be used in practice •  Unclear how and when central banks asset positions will be unwinded •  Unclear how prudential policy will interact with traditional monetary policy #1 is probably good for economic growth #2 is probably good not for economic growth

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