Strict monetary and fiscal rules do not work at times of economic shock or drastic structural changes
A curious trend became fashionable in the 18th century: aristocrats loved to build half-demolished castles, to create an artificial past. Nostalgia for the past, for those good old times, has been a common phenomenon since time immemorial, and has a neurological foundation: the memories of adolescence and early adulthood are the most persistent, and they condition, sometimes decisively, future behavior. Just as athletes visualize plays and movements to improve fluidity and speed in competition – visualization generates neuronal modifications similar to the practice of movements – nostalgia for the past yearns for the comfort of the known, of the context already “visualized.”
Similar phenomena occur in economics. The generations of economists trained in the last decades of the 20th century were educated in the context of the inflation of the 1970s and the Latin American debt crises of the 1980s. Monetarist theories, inflation targets, central bank independence, the risk of fiscal dominance of monetary policy, price-wage spirals, time inconsistency of decisions, the Lucas Critique, debt sustainability and restructuring models … most of the macroeconomic research developed until the beginning of the 21st century was the result, directly or indirectly, of the fight against inflation and fiscal indiscipline. For these generations of economists, this nostalgia is often a determining factor in their opinions. And nostalgia, at times, clouds the view.For generations of economists trained in the last decades of the 20th century, nostalgia is often a determining factor in their opinions
Remember the inflationary alarms when the Fed started buying bonds in 2008? Remember the panic about moral hazard and fiscal misbehavior that European Central Bank (ECB) bond purchases would create? The reality is that fiscal policy has been excessively austere, and inflation is nowhere in sight. In Japan, average inflation has been zero during the 25 years of zero interest rates. Since the Federal Reserve announced its 2% inflation target in 2012, inflation has averaged about 1.4%, and it has been below target 95 out of 107 months. Eurozone core inflation is 0.2%, and has not exceeded 1.5% since 2012. The weakness of inflation requires a review of priorities that does not fit well with nostalgia.
Nostalgic people long for the good old days, the wrongly called “normality,” when interest rates were positive and monetary policy embodied the austere, serious, and disciplined character of being the spoilsport who, as the saying goes, took away the punch bowl when the party was just beginning, when central bankers incessantly reminded governments of the imperative need to reduce deficits. But the world has changed. Now central bankers must ask for more fiscal support and aim to increase inflation, and that doesn’t make them less serious or disciplined.
In the United States, the Federal Reserve has revised its strategy, reorienting it towards maximizing employment in order to increase inflation to 2%. Last week, Jerome Powell, the chairman of the Federal Reserve, repeated the need to keep policy easy for as long as necessary, extolling the virtues of rapid economic growth for reducing inequality. Just hours later, President Joe Biden announced his first fiscal package, a stimulus of 7 percent of gross domestic product (GDP) with a special focus on reducing poverty and inequality – which will add to a deficit that will already reach around 20% of GDP in 2020. This coordinated fiscal and monetary attack on unemployment and inequality, with such a large deficit, would have unsettled many a nostalgic: compare this with the mandate of the European Stability and Growth Pact to reduce the deficit to 3%, and with the criticisms of the ECB for its bond purchases. But it is the right decision.
This change in attitude is also evident in other policies, such as the minimum wage. In 1978, 90% of the respondents of a survey of members of the American Association of Economists said that the existence of a minimum wage reduced the employment of low-income workers. In a similar survey in 2015, this percentage had dropped to 26%. A granular and detailed analysis of the empirical evidence suggests that the initial theoretical intuition of the negative effect of the minimum wage was not correct, that its impact on employment is ambiguous, at least for minimum wages of up to 60% of the median wage. It’s therefore not a surprise that Joe Biden has also proposed raising the minimum wage to $15 (€18) an hour.The US has abandoned nostalgia and is now ready to generate all the growth the economy can digest
Nostalgia prefers strict rules and objectives anchored in the past, such as the 3% and 60% rules of the Stability and Growth Pact. But these rules and objectives only work when the shocks to the economy are predictable, with a known probability distribution. And, as we have seen so far this century, the shocks – the financial crisis, the euro crisis, the Fukushima tsunami, the Covid-19 pandemic – have neither been predictable nor have they generated the inflationary surprise for which the rules were designed.
The rules and objectives do not work either when the structure of the economy changes drastically: since 1995, deficits and debt forecasts have been based on an expected path of interest rates that has always been, with few exceptions, higher than what has later materialized. Therefore, the concern about what could happen if interest rates rise with these levels of public debt must be balanced by the growth that has already been foregone because of excessive caution against possible rate increases.
Hence the clamor among economists to abandon numerical deficit and debt targets – which not only are arbitrary, but can also be counterproductive by generating perverse pro-cyclical incentives – and focus on debt service as a measure of sustainability and on increasing the quality of fiscal policy, by improving the effectiveness of automatic stabilizers, the design of public investment programs and the complementary reforms necessary to maximize their impact, the coverage of tax bases, or the structure of public debt. This is an opportunity that mustn’t be wasted.
The US has abandoned nostalgia and is now ready to generate all the growth the economy can digest. In 2021 it is the turn of the European Union, with the pending reform of the Stability Pact and the ECB’s strategy. We will address this in future columns.