New (short) paper

Click here to read my discussion of the paper by Tito Boeri and Juan Jimeno, “Unemployment in Europe: what does it take to bring it down?”, presented at the ECB forum on Central Banking, Sintra, Portugal, 21-23 May 2015.


Successes and failures in crisis countries

Below is a short statement made in front of the European Parliament in a hearing about “Successes and failures in adjustment program countries”. I was specifically asked to make a few references to Greece, Portugal and Italy.



The objectives of adjustment countries are two-fold :

  • In the short run, they need to reduce the financing needs of public administrations in order to restore fiscal sustainability
  • In the long run, they need to raise the level of potential output through structural reforms.


The financial crisis has induced policy measures that address both issues. Yet, at present, these economies show little sign of improvement. Unemployment has reached critical levels in Portugal, Greece and Spain. Growth remains anemic and the outlook for public debt is unfavorable despite the painful efforts that have been consented.

The structural adjustment strategy operates under considerable political constraints:

  • In the short run, to offset the contractionary  effects of fiscal adjustment, aggregate demand should be reallocated toward exports, which implies a depreciation of the real exchange rate. Because of the Euro, this is not doable through a currency depreciation. The only alternative is more downward flexibility of nominal wages, which in some countries (Portugal) simply does not seem to be happening, while in others  (Greece) is a protracted painful process replete with political risks.
  • In the long run, to increase incentives to work one needs to reconsider the generosity of the welfare state.  But this runs counter to the political platforms that most political parties had been selling to the electorate for decades. To increase competition one needs to remove barriers to entry in goods markets; but such barriers benefits some well organized interest groups that are likely to oppose deregulation.

These constraints reduce the margin of manoeuver of policy makers and make it all the more important to come up with the best possible structural adjustment package. To date, I believe the measures that have been implemented fall short of that objective, in particular because the consistency between the two objectives mentioned above has been ignored. For structural adjustment to be successful,

  • We need to avoid policy measures that consolidate the accounts in the short-run but have adverse effects on competitiveness and productivity in the long run, and
  • We need to avoid reforms that boost competitiveness and productivity in the long-run but have an immediate negative impact on economic activity and/or fiscal revenues.


The pitfall of ignoring those caveats is that the reform package may be unsuccessful overall, as different items in the package will have offsetting effects on both the short-term and the long-term performance of the economy.

Let me now discuss some aspects of structural reforms in program countries under the light of those principles. I will pick some items in the comprehensive reform packages of Portugal, Greece and Italy and discuss the extent to which there is some coherence between their long-run and their short-run effects.

  • Regarding the short-run fiscal adjustment, priority should be given to expenditure-reduction measures as opposed to revenue-augmenting ones. The latter must be associated with a greater tax burden which as such has negative long-run distortionary effects on the economy.  There is a unanimous consensus over the benefits  of greater tax compliance, which is part of the reform package in all program countries. Indeed, in principle, a greater efficiency in tax collection should allow to collect the same amount with lower tax rates, thus reducing distortions. Yet it may also pave the way for future tax increases by opportunistic governments – by simply making such increases less costly, and expectations of such developments may be harmful for investment and growth.
  • In Portugal, severance payments for workers with permanent contracts have been considerably reduced, bringing them in line with the European average. While this reform was long overdue, and will certainly raise productivity and reduce unemployment duration in the long run, I believe it should have been postponed. Its immediate impact is to trigger a wave of job destructions in the middle of the recession, which jeopardizes the country’s short-term macroeconomic objectives. Furthermore, it will have little impact on job creation because most new hires are under temporary contracts whose terms are not affected by that reform.
  • Symmetrically, the attempt to tax temporary contracts in Italy (and France) may be viewed as a useful step toward a unified labor contract that would do away with the inefficiencies of the dual labor market system. But in the short-run it may critically reduce job creation and postpone recovery.
  • On the other hand, the reform of collective bargaining in Portugal, which among other things limits the automatic extension of wage agreements to an entire sector, especially whenever those agreements are signed by unions representing a minority of workers, yields positive benefits both from a long-run and a short-run perspective (A somewhat similar reform in Italy tries to allow firms to bypass collective bargaining by resorting to individual bargaining). In the long-run, it will reduce the equilibrium rate of unemployment, in particular since intersectorial labor reallocation will proceed through wage differentials instead of unemployment spells . In the short-run, it makes it easier to obtain the necessary level of wage moderation in order to restore external balance and bring down unemployment back to acceptable levels. I should hasten to add that, in the case of Portugal,  unfortunately this is likely to be insufficient, as the required adjustment in wages is probably around a 10-20 % reduction in nominal wages, which could only be obtained through a devaluation that the Euro precludes.
  • Presumably in order to alleviate the immediate consequences of the crisis, in particular the very high unemployment rate, Greece is extending its social safety net.  This includes relief jobs, vocational training, basic guaranteed income as well as an extension of health benefit coverage.  These programs are being financed by European structural funds and by the World Bank.  While these measures are understandable given the political context, they are unwise; relief jobs are inefficient and  schemes like basic minimum income are very difficult to undo and will create poverty traps. Greece probably cannot afford a level of social protection on par with Scandinavian countries. I believe this illustrates how a poor macroeconomic situation may create political support for policies that have long-run adverse consequences for the economy.
  • Deregulation of protected professions – that is part of the reform package in Greece and Italy – should have positive effects both in the long run and in the short run. In the long run, the allocation of labor is more efficient and the cost of services to consumers falls. In the short run, the unemployed may enter those professions which alleviates the unemployment problem.

The severe fiscal crisis has brought forward a “day of reckoning” which has led countries to implement a catch-all adjustment program including many structural reforms that had long been discussed under different macroeconomic contexts. I think the above examples illustrate that one should have been more discriminating in selecting those reforms given the specificities of the Euro sovereign debt crisis.



The political economy of the Breton upheaval. II: A symptom of collective mad cow disease.


I will continue my discussion of the Breton upheaval by discussing its economic, or rather mad-cow-nomic, roots.

Over the last two decades French public opinion has become increasingly vocal against globalization. All political parties have to some extent a protectionist stance, if only a nominal one. The “extreme” parties are outright protectionists. The ruling parties’ platforms include a cosmetic industrial policy agenda to make-up for the fact that they will abide by international treaties and therefore are in no position to close frontiers.

The arguments of the opponents to globalization are simple. How can a French firm with high labor costs compete with a Romanian firm with low labor costs? The French firm will have to close and its employees will be out of jobs. If globalization puts people out of jobs, why does the European Union write reports saying it is good for the economy? And why is it imposed upon the French people, increasingly against their consent?

At the same time, there is much less support for protectionism in other countries with similar levels of developments, such as the U.S., the U.K., Sweden or Germany. These countries seem to adapt better to globalization, in fact they are more globalized than France; the Bolkestein directive has been implemented to a greater extent in the UK and then Germany than in France, and yet their population is more sympathetic to trade. Indeed, in Germany the unemployment rate has constantly fallen throughout “the worst crisis since the great depression” and is now at a minute 5 %. (According to a French magazine, this is “the example not to be followed”.)

We could believe that the French are brainwashed, and that may be true to some extent, but facts seem to confirm their views. Every day a prominent firm announces that it will close or downsize, and the Breton food and agricultural industry is one of the most exposed ones. Could it be that globalization is good for Germany and bad for France? And what differences between these economies could account for that?

To answer those questions, we need to understand why wages are low in Romania in the first place. And we need to understand why we may gain from trading with them despite that some firms can’t compete with their low wage producers.

Suppose we only trade with countries with a similar level of development. Then, clearly, no firm would have to shut down because its foreign competitors have lower costs. Consumers would gain not because they would import cheaper products, but only because they would consume a broader range of products. Yet even in such a situation, some firms would have to close, because they are less productive than their German competitors; and some German firms would have to close, because they are less productive than their French competitors. This should be no problem; because France and Germany have a comparable distribution of skills, trading between them does not impact the distribution of wages. So if lose my job because some German firms are more efficient than my employer, I can expect to find another job at a similar wage elsewhere. In fact, reallocating resources to the most productive competitors increases the productive capacity of both economies and makes everybody better-off.

Yet if you describe this scenario to a French, he will object that once he has lost his job, he won’t find another one. The scenario only works if the economy is sufficiently flexible to smoothly reallocate labor between firms. And that is not the case of the French economy.

Suppose now that instead of trading with Germany, we trade with Romania. These people earn much lower wages. Yet that must be for a reason. If they were as productive as the French in all sectors, they would have the same real wage and real living standards. Any differences in nominal wages would then just be a matter of exchange rate misalignment. The Romanians must therefore be less productive than the French. But if they were uniformly less productive than the French, they would not be able to undermine the competitiveness of French firms. A French firm which pays 100 to workers who produce 100, can sell its good at the same price as a Romanian firm which pays 50 to workers who produce 50.

The problem comes from the fact that the Romanians are not uniformly less productive. They may be far less productive at making airplanes, but equally productive at producing poultry. They only earn 50 because of their low productivity at making airplanes, but their poultry firms pay 50 to their workers who produce 100, while the similar French competitor has to pay 100 and needs to sell its production at twice the price. When forced to compete with the Romanian firm, the French firm has to close unless its own wages fall down to 50. If that happens, its workers will become much more attractive to hire for the aircraft industry and will relocate there. The aircraft industry will grow and indeed it would attract all the former workers of the poultry industry if workers were identical. Given that the aircraft industry does not suffer from competition from Romania, eventually no worker has suffered a wage loss and people are better-off because they can consume cheaper Romanian chicken that is financed by exporting aircrafts. But perhaps workers in the poultry industry are not so productive in the aircraft industry because they are  “unskilled”, and through trade they have to indirectly compete with Romanian unskilled workers who are relatively more abundant. Then the unskilled workers end up with lower wages, but their wage losses are smaller, the better their ability to relocate.

Then, you might ask, why would the unskilled accept trade with Romania if their wages fall? The answer is: they wouldn’t! But in theory we may design the shift to globalization in such a way that they are compensated for the wage losses. We could levy a tax on the consumers, who benefit from cheaper imports, and finance a transfer to the unskilled, who also benefit from cheaper imports but not enough for this to offset the effect of their wage losses, in such a way that everybody is better-off. This is because free trade generates global net gains at the aggregate level.

Of course, one does not have to do it. It is written nowhere that the losers from public policies have to be compensated. In fact most public policies are zero-sum (or even negative-sum) redistributive ones such that compensating the losers is impossible because the policy does not generate any gains. Its legitimacy comes from “consent” of at least a majority of voters. But, as we have seen, that kind of “consent” has been denied to the French in the case of the Eastern enlargement of the European union.

But the central issue is that the French economy does not work as described. In fact it has been designed in such a way that participation in a free-trade zone with low wage countries has catastrophic consequences.

On the one hand, market rigidities make the adjustment to foreign competition more painful, and magnify the losses for the social groups exposed to it. Workers who can no longer compete with their Romanian counterparts have to lose their jobs, because minimum wages and collective agreements make it impossible for them to have a wage cut. Regulation makes it harder for them to relocate to another industry or location. For example, they would have to buy a costly license should they want to become a taxi driver, or to spend years getting a degree should they want to open a hair salon. They would lose their order of priority in access to social housing should they want to accept a job elsewhere.

On the other hand, participating in a global market increase the economic distortions associated with taxes and regulations. For example, in a closed economy, an increase in social minima would make unskilled labor more expensive to hire, and firms that employ lots of unskilled workers could adjust by raising prices. This would generate some employment losses and welfare losses for consumers. But these losses would be smaller than in an open economy, where those firms could no longer raise prices, since their customers would then shift to foreign competitors. Instead they would have to close and their workers would become unemployed.

Many other handicaps compound those issues, such as the working time regulation, the gradual piling up of safety and environmental regulations, the ever crawling up payroll taxes, and the Euro.

With a rigid economy, losers lose more, and gainers gain less, from globalization. It is no longer obvious that there are aggregate gains from trade. To compensate the losers one needs a greater tax hike than in a flexible economy, and it may be impossible for everybody to gain.

The  inherent contradiction in French economic policy is to insist on implementing ideologies that hamper markets, while at the same time participating in globalization, which makes flexible markets more necessary. French politicians live under the delusion that they can survive that contradiction by making it up with subsidies. Last week only the government spent 5 billion Euros of taxpayer money to appease interest groups, including the angry Bretons. They hope that they can find some more malleable people willing to remain silent while they have to pay more taxes to finance the subsidies that the more vocal, connected, or violent groups managed to get for themselves.

Suggested reading: Saint-Paul, Gilles (2007) Making Sense of Bolkestein-Bashing: Trade Liberalization under Segmented Labor Markets.Journal of International Economics, 73 (1). pp. 152-174.

Suggested movie: Que la fête commence, by Bertrand Tavernier, with French actor jean-Pierre Marielle at his best in the role of Breton dissident Pontcallec.

The political economy of the Breton upheaval: I. No taxation without representation



The central government in Paris is facing an old-style peasant wave of unrest in the westernmost part of the country. Small entrepreneurs, workers, farmers and many other people have congregated to oppose, with some degree of violence, a new tax on commercial road transport (with the trendy P.C. label “écotaxe”) that is currently being implemented and had been decided by the preceding government in the name of “sustainable development”.

France is famous for its street protests of a more or less violent form, and this tradition is continuing because it works. Historically, governments have backed down on many policy measures because opponents managed to make life impossible for them.

On paper, there is nothing legitimate in trying to cancel the choices of a democratically elected government through violence. And Brittany has given a large majority to the current government in 2012, thus endorsing more expenditures, more redistribution, more regulation, and more taxes. Who did they expect would foot the bill?

If however we turn to the substance, the root cause of the upheaval is two-fold. First, if you administer people a hefty dose of mad-cow-nomics, they predictably become crazy. Second, people are increasingly taken hostages by a ruling elite which seems totally out of control.

The mad-cow-nomics of the Breton upheaval are the following. On the one hand, people are asked to be competitive in the European single market. On the other hand, the institutional context in France and most recent policy measures are just prohibiting them from becoming competitive. The écotaxe is just the turburlence which triggers the final blast of the pressure cooker.

On the one hand, the Breton agricultural producers are supposed to compete with large German plants that reportedly hire workers from Romania and Bulgaria at Romanian and Bulgarian wages, thanks to the Bolkestein directive.

On the other hand, they have to pay their own workers French minimum wages, topped up by high social security contributions, abide by a myriad of costly regulations, and are a privileged target for more regulations and taxes in the name of “sustainable development”. In particular, the Bolkestein directive is not implemented in France to the same extent as Germany, so they cannot replicate the German strategy of importing cheap labor from the East. The French road transport tax is more severe for medium-size trucks than the German one, adding to the problem. And Schröder-style reforms are unheard of around here, meaning that the minimum wage has kept crawling up — some 17 % of the employed are paid the minimum wage, an astronomical proportion by international standards.

Historically these handicaps were offset by subsidies. But as the subsidies are phased out, the Breton producers can no longer break even.

In the context of the upheaval, we notice repeated attacks on speeding radars, which may sound anecdotal. In fact people have been furious against those radars from the start; they epitomize the contempt of the ruling class for them. They are strategically located at places where the speed limit is abnormally low given the configuration of the road. They impose a mental torture on drivers, especially of course on those who have to drive constantly in their profession. Nobody believes they have anything to do with road safety. They are a consequence of a global ideology where politicians incarnate some moral principle — sustainable development, gender equality, public health, solidarity, European unification — and consequently people are accountable to politicians instead of the other way round. In turn this ideology serves as an excuse for the elites to increase their power and extract more resources from the population.

In 2007 people voted for Sarkozy because he sounded more receptive to the actual problems of the people. Immediately after he was elected he scattered the territory with those radars, while at the same time hiring politicians from the defeated socialist party in his government. At that point people understood that they had been grudged.

How can one explain to the Bretons that there is any good for them in enlarging the European Union to the East and in implementing the Bolkestein directive? This is made more difficult by the fact that there is no democratic legitimacy to such enlargement. Nobody in France was asked their opinion about whether Bulgaria, Slovenia or Latvia should be part of the Union: There was no referendum. To be sure, the parliament agreed. But the two main parties are unanimous over everything European. That is, the scope and scale of the European Union are simply taken out of the debate — in the former Eastern Germany there were 11 political parties; but things like freedom of speech, a market economy or reunification were, similarly, taken out of the debate.

At the same time as we have no say on the frontiers of the Union, we are told that we need more political unification, which of course makes it even more important that enlargement should be subject to referendum. It’s as if the U.S. congress suddenly decided that Mexico, Venezuela and Colombia would now become U.S. states. What would the American people say? In fact such a scenario is not even conceivable.

Once upon a time, transfers of political sovereignty to Brussels were subject to referendums. In 1992 the French said yes to the Maastricht treaty, after a campaign which skillfully lumped together membership of the Euro area with the very existence of the EU (then EEC). In 2005 the French said no and since then there has not been a referendum. We are allowed to have referendums only if we say yes.

The Bretons are angry because they (and other French people alike) have not given consent to any of the things that are imposed on them. They have not consented to the Eastern enlargement, they have not consented to the Bolkestein directive, they have not consented to the écotaxe, and they have not consented to the speeding radars (another bipartisan consensus).

From 1300 to 1660 the kings of France, when levying new taxes, needed the consent of a popular assembly called the Etats Généraux. While political representation was not equal across people, the members of this assembly were not professional politicians but genuine representatives of their constituency. It was not rare for the assembly to say no to a tax proposed by the king. The scope for manufactured consensus to make a mockery of popular representation was lower, precisely because the representative of shopkeepers was not a career politician but a shopkeeper, who would personally experience the pain of any new tax on shopkeepers. Circa 1660 the Capetian dynasty stopped resorting to the Etats Generaux and became a dicature called absolutism. It lasted another 130 years.

Is the Laffer curve a joke, or not?

There is currently much unease with the fact that austerity programs may backlash because their contractionary effects would eliminate any potential gains for the public budget. This is certainly a shared view among many Keynesian economists, as evidenced by this Krugman post. Indeed, there is no reason why, in the current circumstances, the maximum feasible budget surplus in say Greece or Spain should be positive. In other words, the surplus need not be an increasing function of the degree of austerity. This function instead could be hump-shaped and have a maximum at, say, -4 percent of GDP.

Ironically, the same mainstream Keynesian economists have always sneered at the idea of the Laffer curve, which states that because of the disincentive effects of taxation total tax receipts eventually fall as tax rates go up. Yet this is a very similar idea to the current view that austerity programs may backlash. However mainstream Keynesians do not believe in the empirical relevance of the Laffer curve, at least at the margin of our historical experience. This is because they believe that the supply (of labor and capital) is rather inelastic to prices (i.e. wages and the return to capital). However the story is entirely different in  a recession, because the theory says that output is then demand-determined, and that demand is quite elastic to government policy. Thus from a Keynesian perspective there is a short-run Laffer curve which is more pronounced than the long run one. Just the opposite is true from a Classical perspective: the long run Laffer curve is then supposed to be more constraining than the sort-run one, because in the long run people are more reactive to changes in tax rates than in the short run.

In principle, one should also be careful to distinguish between adjustments based on tax hikes versus expenditure cuts. Expenditure cuts are supposed to work their way through the expenditure multiplier and therefore to have a strong Laffer curve effect. Tax hikes should have only indirect effects through their non-Ricardian consequences [1] for consumption and investment. Thus in principle tax hikes should be preferred from the pure  viewpoint of balancing the budget in the short run. Of course things are more complex: the more the party in government increases taxes, the more it signals to the public that it intends to spend a lot in the future. Those news may trigger a far more substantial drop in consumption and investment than pure non-Ricardian effects.

So what would happen if a country is at the top of the short-run Laffer curve with a budget deficit of, say, 5 % of GDP? This deficit has to be financed somewhat. If at such a deficit level the country can no longer access borrowing, it will have to rely on support from abroad or from the ECB, for as long as the recession lasts. And it would be obviously foolish for the rescuers to ask for austerity measures, as the 5 % deficit is the smallest possible figure. The problem with such a strategy is that it postpones any required structural adjustment and relies on the belief that the slack will disappear soon enough, at which point austerity will no longer have adverse consequences on activity. In principle, then, one could at that point increase taxes and reduce expenditure so as to produce a budget surplus that would allow to reduce the debt. To believe in such a strategy one has to be pretty optimistic and believe that (i) such future tax hikes will have only small distortionary effects (in other words one has to believe that the Keynesian Laffer curve is important, but not the Classical one) and (ii) it will be politically feasible to reduce public expenditures once things are back to “normal”, even though in the case of Greece this never occured before the crisis.

If, on the other hand, the country is not rescued and lending stops, the Keynesian Laffer curve tells us that some catastrophy must occur: the government will have to cut expenditures immediately by an amount equal to the primary deficit, which will in turn deepen the recession, reduce tax receipts and call for further austerity measures, until the economy reaches the zone where the top of the Keynesian Laffer curve delivers a primary surplus. Such a point must exist, for at a zero expenditure level, there is no primary deficit. But it can be a very low point.

[1] Note: people expect budget deficits to be met by future taxes. Reducing them now by tax hikes should reduce expected future taxes, therefore people need not feel poorer and need not react by cutting their own private expenditures. This is what is called Ricardian equivalence. But if people expect future generations rather than themselves to pay for the future taxes, a tax hike today will make them feel poorer overall and they will cut consumption. This is what I mean by non-Ricardian effects.

The ECB as a lender of last resort: the final delusion.

I will start this site with a text I wrote one year ago on ECB purchases of sovereign debt. This text was turned down by a major economics web site on the grounds that I am incompetent. Indeed, the crisis has triggered a new orthodoxy among the macroeconomic mainstream that (i) any idea of an inflation risk is ludicrous and (ii) it makes no sense to look at the quantity of money. My current view is that (i) we are getting the same inflation rate in a recession as we used to have during an expansion, and talks of deflation have not been validated by reality, and that (ii) the market has absorbed large injections of money because, given all the policy uncertainties, the demand for liquidity is very large. Remember,though, that liquidity is just an option to spend in the future. When people finally make up their minds and decide to allocate their liquidity to more productive uses, we may witness very sharp rises in goods and/or asset prices.

Anyway, here is the text.


Given the current difficulties facing the overindebted eurozone governments, an increasing number of experts  recommend that the ECB should simply purchase these liabilities. This sounds like a miracle cure, as markets would suddenly infer that there exists a buyer of last resort for these liabilities and would no longer have a reason to ask for a spread reflecting their perceived probability of default.

Alas, just as the German and French governments do not have a deep enough pocket to be able to commit to bail out all the troubled countries, and therefore are incapable of avoiding contagion, so  does the ECB have a limited ability to intervene.

Forget that such purchases are precluded by the Maastricht treaty (The European Union now has a long tradition of breaking its own rules).

The ECB has two kinds of assets:

-The financial claims it has acquired as a counterpart to the monetary base (i.e. the euros it is issuing).

-Its credibility, i.e. the belief that it is able and wants to achieve a low inflation rate in the Eurozone, which ensures that holding euros is a reasonable proposition.

To bail out Greece or Italy, the ECB must deplete its stock of at least one of those two assets.

Purchasing public debt while maintaining its credibility means that such purchases are not associated with a change in monetary policy.  This is what we call “sterilized intervention”. When acquiring Greek or Italian debt, the ECB does not issue Euros but instead sells some other asset (for example Gold or foreign reserves).  Unfortunately, the assets of the central banks are insufficient for any sizable bailout to take place. They are valued at some 2,200 bn EUR but a large part of it consists of loans to the banking sector that are necessary for it to get liquidity. At most roughly 1,000 bn EURs could perhaps be used, which is 3 times Greek debt but only 50% of Italian debt. This illustrates how the recent attack on Italy changes the equation completely:  It was once believed that bailing out Greece could eliminate contagion, but the countries that are next in line under the contagion scenario are too large, whether we consider national governments or the ECB; for this precise reason that scenario could not be eliminated even under a 100% Greek bailout. Note that at present the ECB only holds a minute 30 billion EUR in national debt.

An interesting question is: how much redistribution between citizens of the Eurozone is going on when the ECB purchases Greek or Italian debt? The question is relevant because the ECB is not democratically appointed. A non representative entity redistributing money between social groups is tantamount to “taxation without representation”. This was considered as a form of tyranny two centuries ago. If Greece and Italy were perfectly solvent, then selling French or German bonds to purchase Greek or Italian debt would be irrelevant. This is because the proceeds from those assets are rebated to the national governments according to a sharing rule based on population and GDP, in which there is no role for the geographical origins of the assets. However, if there is default, then it is associated with a loss for the other shareholders of the ECB, which means that implicitly the taxpayers of those countries have been forced to bailout the creditors of Greece and Italy with their own money. At the end of the day, there is no difference between ECB monetization of Greek debt and direct bailout by the taxpayer. In principle, if markets price the default risk correctly, debt purchases at market prices by the ECB or the German taxpayer can be “fair”, but in such a case they do nothing to alleviate the burden on the Greeks; instead they forcibly transfer ownership of debt from private to public creditors.

The alternative option would be to increase the monetary base and print the euros needed to finance the bailout. This would in effect deplete the other asset of the ECB, its credibility.

There seems to be a widely held opinion that since there is a recession and we are not far from a liquidity trap, people would just hold the extra euros and the money financing of the debt would not be inflationary.  That is, printing money would just afford us a free lunch, while all other exit options entail considerable pain. If so, then all the ongoing austerity packages must be really stupid, as is the current fight  between Euro politicians about who will bail out whom and by how much.

There are two typical  “free lunch” arguments.

Argument 1: The ECB’s balance sheet has expanded considerably during the crisis, and we observe no clear adverse consequence of that, and in particular no inflationary pressures.

The answer to that argument is that the ECB has increased the monetary base in response to the liquidity crisis in the banking sector, that is, there has been an exceptional  surge in the demand for central bank money, due to a failure of the banking system to continue creating liquidity through deposits and loan. Indeed, broader monetary aggregates like  M2 have not exploded during the crisis, instead they grow at a stable rate which is lower than before the crisis (see  In other words, the end user demand for liquidity has not increased; the ECB has just made up for the fall in the banking sector’s ability to generate liquidity. Thus it does not follow that an increase in the supply of central bank money for mere fiscal motives would be accommodated by the private sector.

Argument 2: During a crisis many assets are under-priced and the bail-out pays for itself when the securities that are purchased are eventually sold back at a profit. Thus, the US Fed and US government have made money in the bailouts of Bears Stern and General Motors. Similarly, the ECB could just purchase public debt and sell it back at a profit if and when one exits the crisis. After this operation is completed, the ECB’s balance sheet would be back to normal.

This argument is an ex-post facto rationalization. Surely it was not obvious ex-ante that the price would go up and that the bail out would be profitable. And there are plenty of examples of loss-making government investments. If governments were better at arbitrage than private markets, we would need more speculation by the governments and we could eventually get rid of taxes and fund public expenditures with the gains from such speculation. Why did not governments buy the Internet and housing bubbles and then sell those assets at the peak of those bubbles? Not only would it have been profitable but it would have stabilized asset prices. The answer is that no one knew for sure whether these were bubbles and where the asset prices were headed.

A more specific version of this argument is that during a financial crisis, some assets are clearly underpriced because of their liquidity premium – people do not want to buy them because they fear being unable to sell them back when needed. By using its deep pocket, the government could possibly inject liquidity into the market while making a capital gain (in some sense the government is acting as an insider trader by making a capital gain on the news about its own decision to inject liquidity, but that is for the common good).  The bail-out would then pay for itself, the pieces of papers issued in exchange for the bonds would be withdrawn in due time, much as if this speculative operation had been financed by leverage.

The question is whether the argument applies to Euro-zone sovereign debt and I doubt it. What markets are seeing is insolvency due to poor growth and demographic perspectives, on the one hand, and political stalemate in attempts to reduce public expenditure, on the other hand. For example, France has not been able to run a budget surplus since the early 1970s. The austerity cure of the Barre government between 1978 and 1981 led to a quick reduction in deficits despite the country’s dismal economic performance, but the government lost the subsequent election, not least because of the bitter pill administered by Barre.

Yet another point is that attacks on sovereign debt are self-fulfilling: as expectations of default occur, interest costs go up, which in turn accelerates the growth in the stock of debt, thus leading to inevitable default. If only people believed that the debt would be repaid no matter what, for example by ECB monetization, then spreads would never go up in the first place, and the crisis would be avoided. For this argument to be valid, it must be that holders of public debt would make no losses under the attack scenario, and therefore have no incentive to participate in the attack.  Given the sheer amount of money that would have to be created, I doubt it entirely. Rather, the Eurozone would join a club of emerging, unstable countries (such as many Latin American ones) where money printing is a substantial source of fiscal revenues and, as people will eventually want to get rid of their excess money balances to purchase goods and services, the price level will, in the long run, rise in line with the rate of money growth. This means that the Euro would depreciate in the short run as people would try to exchange their Euros against sounder currencies. Initial holders of public debt denominated in Euros would lose money, not because of default, but because of such depreciation. Hence the commitment to monetization would fail to kill the attack scenario.

Currently the monetary base is around 1400 billion Euros, i.e some 14% of Euro area GDP. To bail out say half of Italian debt plus the entire Greek debt (which does nothing for Portugal, Ireland and Spain,), this amount would have to double. It is hard to believe that private agents would not get rid of this liquidity as fast as they can.

But the worst consequence is that we would be in a new policy regime where each Euro area country will have an interest in running large deficits, in order to increase its share of the seignoriage generated by debt monetization, at the expense of taxpayers in other countries. A while ago Sargent and Wallace argued, in their “unpleasant monetarist arithmetics” paper, that a tight monetary policy without budgetary discipline would eventually be defeated, as the central bank would be eventually compelled to accommodate budget deficits with monetary policy. This is exactly the scenario that may happen right now in the Eurozone, only that it will be made worse by the fiscal race to the bottom of national governments trying to beat each other to the ECB booty.

How much inflation can we expect? Suppose public debt purchases by the central bank lead us to a policy regime where debt financing for many governments in the area has become too costly, in particular because the bailouts have left them with no incentives to set their accounts straight (and it would be foolish to do so under such a policy regime). Then, in addition to the initial bailouts, the central bank will have to finance the budget deficits of the Euro area countries. Suppose, say, that  these deficits are equal to 3% of the euro area GDP. With a monetary base of 14%, this means that to purchase the flow of new debt issued by the governments, the ECB would have to increase the monetary base by 3%/14% = 21 %. Even allowing for real growth (and nobody expects much of it in the coming decade) at a generous 3% rate, this means an 18% inflation rate in the long run[1].  Even ignoring the chances that this could degenerate into hyperinflation, the Euro will be dead before that point is reached.

During the accession phase to the Euro, economists were seriously debating its costs and benefits. Some of them pointed out that member countries diverged notably in their ability to raise taxes, and for that reason some countries like Greece and Italy needed inflation to finance their public expenditures, while at the same time others like Germany insisted that the ECB mandate should be to insure a stable price level. This conflict of interest this is proving to be a fatal flaw in the design of the EMU.

[1] This may be less because of the secular growth in the demand for liquidity, as evidenced by the fact that broad aggregates grow faster than nominal GDP. However we do not know that this trend will continue, as there is no reason why it should.