by Angel Ubide, Peterson Institute for International Economics
Op-ed published in El Pais as "Tres lecciones de 2013"
December 27, 2013
English language version © Peterson Institute for International Economics
After a long period of crisis in Europe, 2013 was first year in which (with the exception of the Cyprus crisis) we have not suffered the agony of the weekend, featuring decisions taken in a rush out of fear of the response as markets in Asia open. It was the year of the end of recession in the euro area, the government shutdown in the United States, the resurgence of Japan with Abenomics and the aggressiveness of the Bank of Japan (BOJ), the disenchantment with emerging markets, the widespread disinflation, the acceleration of reforms in China, the beginning of the end of quantitative easing by the Federal Reserve, and the European banking union fiasco. We can draw three main lessons.
First, monetary policy is asymmetric. It is becoming clear that central bankers have both the tools and the institutional structure to reduce inflation if it is too high, but they are ill-prepared to be aggressive and raise inflation if it is too low. Despite the use of "unconventional" policy tools—which we should rename, as central banks have already spent half a decade using them—too low inflation in most of the developed world indicates that monetary policy has been enough to avoid disaster but insufficient to stabilize inflation at acceptable levels.
Fear—especially political fear—of an excessive central bank balance sheet and uncertainty about the impact of quantitative easing has limited the actions of central banks. We saw this concern in Japan in the past two decades, and we are seeing it now in the United States and Europe. It is becoming clear, however, that monetary expansion in the context of lack of demand does not generate excessive inflation, as some feared. This generates two conclusions: We must strengthen the institutional structure of central banks to eliminate this asymmetry, for example endowing them with more capital to avoid the fear of possible losses from asset purchases; and, given this experience, central banks should adopt a somewhat higher inflation target, for example, 3 percent, to reduce this asymmetry.
Second, politics continue to dominate economics. No country has left the euro area, despite the many economic analyses that saw it as inevitable. The process of restructuring Greek debt was conditioned by the political needs of the various players. The restructuring could not happen at the start of the crisis because German banks had too much Greek debt. Once this debt was unloaded, German domestic politics prevailed and a restructuring became essential, even if it was of dubious benefit—with a high contagion effect on the rest of the European periphery and great harm to Cyprus.
In a short six-month period the United States has gone from a government shutdown and almost defaulting on its debt to reaching a budget deal that avoids a repetition of the episode and softens the fiscal adjustment. No, it was not the economic analysis of its impact that brought about the deal but the message from the polls after the government shutdown that showed great political cost to the Republican Party.
The debate over a European banking union has ended with great disappointment. Yes, there will be European supervision, but combined with a very complex process of resolution where the political balance will prevail over economic rationality (remember what happened to the Stability and Growth Pact in 2004, when sanctions to Germany were avoided for political reasons) and with a resolution fund of national nature that will perpetuate the link between banks and sovereigns and consolidate the fragmentation of the European banking system. It is a big step backwards that will reduce the potential growth of the euro area dictated, as always, by German domestic political needs. One day the euro area will say enough to the tyranny of the German minority.
Third, most emerging markets have wasted a great opportunity in recent years to consolidate economic reforms that could generate higher potential growth in the absence of permanent commodity price gains and declines in interest rates. The summer wobbles revealed that, to a very large extent, the emperor had no clothes, the best of the BRICs (Brazil, Russia, India, and China) has passed, and most emerging markets now face challenges similar to those of developed countries: cutting unproductive expenditures and red tape and improving the sustainability of the welfare state, increasing tax revenues, and adopting structural reforms to boost productivity growth.
To be sure, this agenda does not apply to all emerging markets. The reforms being undertaken by Mexico are very positive, for example, and therefore investment in emerging markets has to start differentiating clearly across countries—exactly the same as what happened with the euro area in 2010.
The year 2013 has also brought the conclusion of several economic debates. The impact of the debt-to-GDP ratio on growth does not increase abruptly after crossing 90 percent. Excessive fiscal tightening in liquidity trap situations is detrimental to growth and may increase debt-to-GDP ratios. The conclusion of these debates has opened other debates, however, such as the impact of rising inequality on growth. If most of the revenue generated during the recovery is going to the wealthier classes—true, almost by definition, because the main instrument for the transmission of monetary policy when interest rates are zero is the increase in the price of financial assets—and these wealthier classes have a higher propensity to save, it follows that total growth will be lower.
This problem should open a debate on the rationale of the orthodox policy mix of fiscal adjustment and monetary expansion. Combined with the asymmetry of monetary policy discussed above and the usefulness of a slightly higher inflation rate, and the debate on the risk of secular stagnation and negative equilibrium interest rates, introduced by Larry Summers, former US Treasury Secretary—due to the overall increase in savings and risk aversion and the shortfall in investment, both public and private—one could wonder if the right policy mix, right now, would not be an expansion of both fiscal (mostly infrastructure spending) and monetary policy to reduce unemployment more quickly and, at the same time, reduce inequality.
We will continue discussing this, plus all the new surprises, in 2014.
This posting has been translated and adapted from an op-ed that appeared in El Pais on December. 27, 2013.
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