Viv Davies: Hello and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I’m Viv Davies from the Centre for Economic Policy Research, it’s 13 September 2012 and I’m at the London School of Economics talking to Professor John Van Reenen. We discuss his recent work on fiscal consolidation, and whether he thinks that in Europe fiscal austerity has gone too far. I began the interview by asking John whether he thought fiscal austerity was self-defeating.

John Van Reenen: Fiscal austerity can be self-defeating in two senses. In a very narrow sense, if your problem that you face as an economy is what most economies in the world do face at the current time, you have relatively high structural deficits, then it might seem obvious that the way to do something about that is to reduce the deficit by increasing taxes or reducing spending, or some combination of both. In the medium term that’s absolutely true, you have to do some of that and you have to plan to do some of that, and many countries, like the US, don’t. But the problem is that if you cut too fast and too deeply during a period of recession, like in many countries like the UK for example, that can actually be self-defeating in two senses. In one sense it can be defeating in that it will exacerbate the degree of recession, so for example if you cut spending back very quickly and consumer demand falls and investment by firms falls, this is going to mean that you end up with higher unemployment and therefore lower tax revenues, because people who aren’t employed are not paying tax and also you have to pay more for welfare benefits. And as Keynes classically showed, under both circumstances you can end up having a very prolonged depression or a prolonged period of much lower output than you would have had if you took a slower path of fiscal consolidation.

The second sense in which it can be self-defeating is that you may even end up with making your budget deficit position worse. So if you have a real fall of demand generated by the austerity programme it makes such deep cuts to tax revenues and such big increases in welfare spending, that can actually mean that you end up with even lower levels of revenue and leave you with a worse budget deficit than before. So you may end up, even on the measures of just public finance, with worse public finances than you would have done had you chosen a different fiscal path. There are caveats to that because obviously in normal times an independent bank responds to low demand by things like cutting interest rates, and that’s often a much better way of maintaining demand in response to fiscal consolidation. The problem is when interest rates are close to zero the central bank can’t do that, because you can’t go below a zero interest rate. So that so-called zero lower bound means that in those circumstances the bank can’t use monetary policy in order to maintain a level of demand in the economy. That’s a big problem.

VD: So some of your recent work has really focused on fiscal consolidation during depression, particularly in the UK, and on quantifying the costs and benefits of delaying austerity measures until a recovery is clearly established. Could you briefly describe some of that research and the various scenarios that you outlined?

JVR: We wanted to think about several questions in terms of the degree to which the timing of your fiscal consolidation can make a different effect on output or on jobs. You could approach this question in different ways: as an example of thinking about that we looked at the UK case, and we looked at what would’ve happened if Britain had delayed its fiscal consolidation by three years, the idea being that the consolidation happening now is happening during a period of recession. Delaying it for three years or so would have meant that we were in a more expansionary phase. The reason you might believe that was a beneficial thing to do is that the effects of fiscal consolidation are very different depending on where you are in the business cycle. The so-called fiscal multiplier is not the same in a boom as it is in a recession, so austerity during normal times, good times or average times may have not such a big effect, whereas austerity cuts in a recession have had much more strong negative effects on the fall of demand for a variety of reasons, among them the difficulty of cutting interest rates near zero.

So we wanted to see how big those effects were quantitatively, building in the fact that there may be this differential response between booms and busts, and taking into account something that most macroeconomists don’t really account for, which is that you get what’s called hysteresis effect. That’s the idea that in unemployment increases then people who lose their jobs may lose their skills, lose their motivations, lose their networks.

VD: Why can’t those macro models include the hysteresis?

JVR: In principle they can do, it’s just that typically most macro models don’t do that because it makes them more complex and many people don’t believe that they’re so important. If you thought that unemployment was fundamentally due to people just being less skilled and has nothing to do with the fact that skills are endogenous in the sense that you can lose your skills if you’re unemployed, then these things may not be so important. But a lot of the work in microeconomics and macroeconomics over the last ten or 20 years has found that hysteresis effects are important, so I think it’s because macro models haven’t caught up to some of the developments which have happened.

VD: So what were the conclusions of your UK research?

JVR: In terms of our UK research we did find that there was a very large cost, in terms of lost output, from cutting or putting fiscal consolidation in place as early as we did in the UK. If the UK had delayed that by three years or so then it would have led to much smaller losses of output over the long run, and would have been essentially a better proposition for the UK. So at least in the UK case, delaying would have had these positive economic effects. That’s not to say that we should never consolidate; in the key scenarios we looked at it was the timing of consolidation which happened, so the key thing was that by making that consolidation happen during a period when times are hopefully better than they are now the overall economic costs in terms of unemployment and GDP would have been better than they currently have been. Now that will differ depending on which country you look at.

VD: Yes, I was going to ask you that. So timing is everything, but generally has austerity gone too far in Europe?

JVR: I think it has, in the sense that the emphasis we’ve placed in Europe on quickly trying to balance budget deficits has had the negative effect of pulling down demand and keeping Europe in a much more depressed state than it needs to be. We have multiple problems facing the world at the moment, but one of the key problems is the classical problem, the Keynesian problem of demand being simply too low and the state needing to support demand, the only actor to solve that problem is ultimately the government when the interest rates are close to zero. That, actually, is true in the US, it’s true in Japan and it’s true in Europe.

Europe has particular extra problems on top of that, and this is where the debate has got confusing. Europe does have an additional problem, which is that in the period leading up to the crisis in 2008 there were very deep structural problems between northern and southern Europe. The consumption of countries like Italy, Spain and in particular Greece was much higher than is sustainable. Even without the crisis there would have needed to be some adjustment, so a period in which there was slower growth or consumption in order to make up for the structural deficit situation they were in, which was disguised by the boom. So on top of the general economic crisis there’s a European-specific crisis, and of course that exacerbated in the European case because of the single currency, so because of the single currency within Europe there wasn’t the option in Spain, Ireland, Portugal or Greece to the big negative shock of the crisis by allowing your currency to depreciate as has happened in the UK, which has mitigated some of the costs for the UK and many other countries. Because that has been switched off the other option as happened in the US which also had a much bigger shock in some states than others (for instance Arizona had a much bigger shock than New York did), is huge fiscal transfers – so a lot of money comes from the federal government to support those places. The fiscal transfers in Europe are nothing along those levels. So you can shield or keep up demand through fiscal transfers. That, plus the weakness of the banking system as a whole, is going to push the southern European countries and peripheral countries into extreme crisis.

On top of the demand problem you have this particular problem of structural adjustment. The solution to that, as those countries have got into deep problems, massive spreads on their sovereign bonds, bank crises and so on, has basically come from bailouts brokered from the European Commission and the IMF and the bailout funds. But attached are very tough fiscal austerity conditions, and I think that the kind of mistake that’s been made is to assume that you can make all those adjustments to internal devaluation, so basically the way these countries have to adjust is to have very big wage cuts very quickly, and that’s extremely hard to do, and also causes the same spiral of cuts of demand and increasing unemployment and reduced tax revenues and so on. So I think, and this is commonly recognised now, that there has to be simultaneous movement for these countries on several fronts, doing things like recapitalising the banking system, having some medium-term fiscal consolidation plans but not as front-loaded as they currently are.

VD: Do you welcome the ECB’s decision to make unlimited purchases of government bonds in the secondary markets?

JVR: I think that’s an entirely sensible thing to do. The ECB seems to be the best-functioning pan-European organisation at the moment and it was a very good move of Draghi’s to do that. But the caveat is of course that the purchases the ECB would make are conditional on a country signing off on a bailout agreement. Of course it depends on what that bailout agreement is; if the bailout agreement is excessively tough, if it’s demanding cuts of the budget deficit far more quickly than is economically sensible, then it’s going to be self-defeating. So if a government were to sign up to that it’d reduce its sovereign bond spreads but the economy would go into freefall, and that’s what’s happening in Greece right now. You can see it very vividly. It’s reasonable for the ECB to make that action conditional on bailout, the question is what form the bailout agreement is in.

There is too great a consensus in Europe that you have to very, very quickly eliminate the structural budget deficit. I do think it’s important, and this is part of the bailout agreements, to push for structural reforms in many of the southern European countries – so to have greater flexibility in the labour markets like firing costs, have more open product markets and reducing barriers to entry there, to move more activity into the private sector. Those are all beneficial things to have, and to the extent that you can push governments into making those needed structural adjustments that’s all to the good. But those are very long-term reforms; the benefits are not going to come in 12 months or 24 months, they will come over a number of years as they did in countries that did do that sort of thing, like the UK and Germany.

VD: Then should Spain be swallowing its austerity medicine right now?

JVR: Spain has not gone and got a bailout fund or asked for this yet. The problem in Spain is that it hasn’t started properly embarking on some of these structural reforms. Italy has, for example. Italy under Monti has been a good example of a country which has started to make inroads into these necessary adjustments in terms of labour and product markets. They’ve also made some fiscal consolidation, mainly on the tax side. Spain itself needs some degree of austerity, less than the degree that many people have asked for, but it does need some plan for adjustment. Its main problem, though, is its failure to recognise the crisis in the banking system.

So what’s happening in Spain is effectively the state taking on a lot of the debts that places like Bankia and other kinds of banks and regional cajas have, so loads of bad loans, huge bad debts, mainly institutions that are fundamentally insolvent. This is the mistake Ireland made, when Ireland took on all the bad debts of banks, that’s basically what caused the sovereign debt crisis in Ireland. Exactly the same thing will happen in Spain unless some proper recognition happens of the size of the bad debt problem in Spanish banking and other institutions, and there’s a set of reforms to effectively liquidate many of these assets, former bad banks with bad assets, and unfortunately to close down a lot of the institutions which are not performing. The current plan is that there’s going to be a revelation of the state of the Spanish banking sector, but unless there’s also a plan for what to do with those bad debts, all that’ll happen is huge market panic. So I think the prime minister, Mr Rajoy, has to bring these two things together, there has to be a full set of proper stress tests and transparency over that. But at the same time, on the day that’s announced there also have to be things put in place to recapitalise some part of the system and also close down some of the underperforming loans on parts of the system, and that’s necessarily going to lead to many bond holders losing money. But that’s the nature of capitalism.

VD: So finally, John, do you see a positive future for the Eurozone?

JVR: It’s hard to be positive. I’m an optimistic person by nature, so I think there is a way through this. From an economic point of view, I think there’s a clear way through the crisis. On the demand side of things it’s a question of the timing of consolidation, and that can be done with a plan which is back-loaded rather than front-loaded. There has to be a move to a greater banking union, in terms of supervision of banks, in terms of deposit insurance which has to be done centrally as the EC is proposing. It doesn’t have to be every bank but it has to be the most important systemically. The banking reform has to happen, there has to be some way of dealing with fiscal problems. There has to be a kind of competitiveness union, to get the Lisbon Agenda back on track and do the kinds of reforms to product and open markets that are needed, and there has to be some political centralisation. If the euro is to survive the richer northern European countries are going to be subsidising the southern European countries; there has to be a way for greater oversight, for a more federal Europe. That is absolutely inevitable; it’s not going to happen overnight but there have to be some paths towards that. Crudely speaking, to allow German and Dutch and Finnish taxpayers to have the confidence that they’re not just going to bail out southern European countries who will continue with the sort of overconsumption as they did before. Primarily this is not a government problem, it’s equally a problem with the private sector, of insufficient control of the banks. That’s what happened in Ireland and Spain. But the fiscal union, the banking union, the competitiveness union and the more democratic union have to go hand in hand.

VD: John Van Reenen, thanks very much.

Romesh Vaitilingam interviews Professor Olivier Blanchard for Vox

November 2010

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/5745]

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Professor Olivier Blanchard, who is currently Economic Counselor and Director of the research department at the International Monetary Fund. Olivier and I met in London in early November 2010, where he was delivering the first in a series of lectures to celebrate 21 years at the Centre for Economic Performance at the London School of Economics. His lecture was entitled, "The State of the World Economy" and I began by asking him about progress on the two rebalancing acts that the IMF has called for on the world economy.

Professor Olivier Blanchard: First, I think there's a question of whether that's the way to think about things. And we introduced that way of thinking maybe a year and a half ago, and I think it has turned out to be very, very useful. In short, to caricature, we were in a world in which US consumers were spending too much, and this had all kinds of implications for the current account deficits of the US, the current account surpluses of other countries and so on, and they are now largely gone. And the result is that the world has to rebalance in many ways. Hopefully, they're not going to go back to their old ways, which would be very good in the short run but surely an issue in the long run.

And so this implies two things, right? What we call internal rebalancing, which is that, as private demand went down, the governments just came in, increased spending, decreased taxes. But it cannot go on forever. So you basically need to increase private demand and slowly phase out fiscal. So that's the internal rebalancing, which is very important in advanced countries, right?

But that's not enough, because private domestic demand in a country like the US is not going to go back to anything like what it was before. If US consumers spend less of their income, housing is going to be dead for a long time. And so the demand has to come from somewhere else. It has to come from higher net exports. Or another way of saying it is the current account deficit of the US has to decrease, which means that the current account surplus of the other countries has to increase.

There is this identity, which is very unpleasant but we have to deal with. And so this is the external rebalancing, which is, in general, the way the world will get back to health is by having this rebalancing of demand, which means a change in exchange rates, an appreciation of many emerging market surplus countries, and a depreciation of the deficit countries.

So these are the two processes, right? And the hope is that they just happen, and the world gets back to shape and things are fine. The problem is it's happening slowly, maybe not terribly surprisingly. So if you look at internal balance, getting consumption up to reasonable levels is hard because many people are still constrained. Housing, as I said, in a number of countries, is a mess, so housing investment is very weak. So there is only so much you can do. And the result: private demand is not growing very fast, which means it's very difficult to do fiscal consolidation without taking the risk that growth is going to stop, which would be bad.

So, on internal rebalancing, it's fairly slow. What could save things would be the external rebalancing happening faster. But again, here there are many constraints. China probably wants to rebalance, but it wants to do it slowly. It doesn't want to do it all in 2011, which is what the rest of the world would dream of. It surely intends to do it over 2011 to 2015, 2020. I think it's serious about doing it, but it's happening at a relatively slow speed.

So the question is, in terms of policy, can we do things to increase private domestic demand and, therefore, be able to consolidate a bit faster? And can we basically accelerate the process of the external rebalancing? I think these are the challenges.

Romesh: We can come back, perhaps, to these broad, global issues, but it might be very helpful if you could outline the three big regions, for the US, Europe, and the emerging markets, what the state of things are at the moment, if we could perhaps start off with the US, which has a very interesting position. Yesterday the election results, clearly a reaction to the bad economic data there, very high levels of unemployment. And then, at the same time, we've got the Fed embarking on a second round of quantitative easing.

Professor Blanchard: The US is the country which probably had misbehaved the most before the crisis, so that not only are there effects of the crisis, but there are things which happened before the crisis which have to be corrected. So this is really a country in which, again, private domestic demand, consumption in particular, just is very slow. And so that's what they are fighting, and the result is we expect growth to be such that unemployment remains basically, more or less, constant. So for the US, that's the big issue. The other issue is fiscal consolidation. What we think countries should be doing is not necessarily to consolidate a lot today but put in place plans which credibly get you to some stable level of debt. The US really had not done that very much until now, and it's not going to be easier as a result of the elections. So these are the uncertainties for the US.

Europe, in some ways, is in better shape, in the sense that in most countries consumers had behaved decently. In many countries, the housing problem is less serious. So in principle, private demand could become stronger. I think a country like Germany, was actually - there had been no crisis - was on the verge of a very strong expansion, and I think we're seeing signs that this may actually happen.

So these are reasonably good news, although, in general, even when Europe is in good shape, the rate of growth of Europe is not very impressive. But going to that or a bit higher seems reasonable, except that Europe has this problem in a number of countries. Greece, Portugal, Ireland have very a serious competitiveness problem, a very serious fiscal problem.

And I think they have all embarked on very ambitious adjustment programs. But reestablishing competitiveness within the euro is tough, and so there are going to be many years, and probably a few bumps along the way. The worry is that the bumps not only affect the country, which they may well, but affect Europe in general, and maybe even the world. So I think that's the issue.

Emerging market countries are facing a different set of issues. Putting all of them in the same basket is probably not right. Asia is basically back to potential, to their own path, signs of even overheating. Latin America is not very far from that. In general, emerging market countries are nearly back to their old output trend.

And there the urgent question is how to handle the capital flows. Now, again, these countries need an appreciation. They need to rebalance, increase domestic demand, decrease their reliance on exports. It varies across countries. It's clearly most relevant for China.

So they have to accept some appreciation, but they are worried that these capital flows, which are triggered both by fundamentals and by interest rate differentials, may happen much too quickly and much too strongly, and they are very reluctant to let the exchange rate appreciate a whole lot, which I understand. So their problem is a bit different. It's to avoid overheating, control capital flows, and try to avoid bubbles and various other things which may happen.

Romesh: Can we talk about the issue of fiscal consolidation and its relationship with growth? Because this seems to be one of the most contentious areas in economic discourse at the moment, the question of whether fiscal consolidation can be expansionary or whether it's going to be contractionary, and when you should be implementing the austerity packages in a country to deal with the public debt issues.

Professor Blanchard: There is no question that the deficits were needed, or at least the fiscal stimulus was needed when it was done. But there is also no question that this had led to levels of debt, not so much the stimulus but the fact that output is far below potential for a long time, which implies that there has to be fiscal consolidation. Now, could it be that consolidating today is going to be expansionary? I think the reasonable answer is, in general, no. There are a few cases. There are cases in history which have been well documented: Denmark, Ireland. If you start with a risk premium, which is, say, 1, 000 basis points, and you put in place a program which convinces markets that it's going to be OK, then with a bit of luck, your interest rate goes down by 1,000 basis points. Well, that can help a whole lot, right?

So there are cases where you're basically so close to the abyss that you do something and people say, "OK, it's not going to be the end of the world. It's going to work." Then you may actually have expansionary effects, even in the short run. But this is the case for very few countries at this point. So when a country like the UK does it, it doesn't start with a large risk premium. It may reassure people that the future is brighter, but in the short run, it's probably going to affect aggregate demand in a negative way.

I think that has to be accepted. Then the question is, how much do you want to consolidate now? The point that you made at the front is the important thing is, again, to reassure markets. So it's much more to put in place what we've called a medium term credible plan. Maybe we don't do a whole lot today, but we put in place all kinds of rules and changes which, five years from now or 10 years from now, will make that stable and maybe lower. That's the way to go. Once you have this in place, then you probably have a bit more leeway at the short end.

Romesh: The crisis that we're, I guess, still in began in the financial sector, and the IMF have talked about the need for financial repair and then for financial reform. I'd be interested in your reflections on where we've got to in terms of that process. Have we done the repairs, and are we making enough progress with the reforms?

Professor Blanchard: I think we've made some of the repairs, but there are clearly places where more repairs are needed, and some banks are still under capitalized. The housing situation in the US, with a very large number of people underwater, is a big issue. It really is leading to an overhang and very little spending by these people. So repairs have taken place. Capitalization has improved. So we're not there, but I think progress is being made.

On reform, it's infinitely complex. I don't think we understood exactly how regulation interacted with decisions of banks. We clearly have learned a lot. But what regulation to put in place is not clear. I think that Basel III has a kind of simpleminded approach to it, which is the right one, which is increase capital ratios and, if everything goes well, increase liquidity ratios. These are rough tools, but we kind of understand how they work. We can probably do much more refined work. Let's also explore various ways.

We're going in that direction. I think various countries are going to explore different things. It's going to take many years, I think, before we converge on either one way of doing it or a few ways of doing it and knowing what we're doing. So it's happening.

Romesh: You said that a key part of the rebalancing globally is about currencies appreciating and depreciating against one another. But of course, a lot of talk at the moment is about countries getting very defensive about that and getting involved in currency wars, wanting to protect their currencies, either to keep them from rising too much or keep them from falling too much. Where are we on these currency wars? Do you feel they are a real threat to getting a proper global policy coordination to tackle these global problems?

Professor Blanchard: I think, first, words matter. It's not a very good idea to use the word. I don't think it's a war in the sense that there's one winner and one loser. I think that, basically, there can be only winners. The question is how to achieve that. And as I've said before, we are in a world in which there is a need to readjust parities. And in general, emerging market countries should appreciate, not all of them, but many of them, and then the advanced countries should depreciate relative to them. That has to happen. And the question is how to do this in an orderly way. Now, the capital flows are going in the right direction. They are going, typically, to the emerging surplus countries. But again, they are happening at a rate which is such that these countries are scared.

So I think the solution there is to say, "Look, some appreciation is needed. You have to accept it. You have to basically take the structural measures which will make it work." But if the flows become too large, then it is understood that other measures can be taken. So it can be macro prudential measures, restrictions on foreign exchange borrowing, for example, or it could be some form of capital controls. I think we just have to define the rules of the game. And if we do, which I hope we do, then I think everybody can be better off.

Romesh: And where are we, generally, in terms of global policy coordination, in terms of the institutions of the international economy that bring countries together to try and work out solutions collectively rather than to fall into dangers of talking about wars, for example?

Professor Blanchard: I think we're in a much better place than we were before the crisis. But it was easier during the acute phase of the crisis because, in a way, most of the countries had to do the same thing, where now it's clear that there are these relative price adjustments, and some countries feel that they are reluctant to do it, at least at the speed at which the markets force them to, and so and so on. So we are now seeing more disagreement as to what needs to be done. I still think the G20 process is incredibly useful in showing how it can be done. Now, whether it is actually done, whether the G20 agrees on everything, or at least on a set of things, we'll see. But I think the process is incredibly useful in terms of mutual understanding, agreeing as to what needs to be done, agreeing about what we disagree about. So I see it every day. I think the discussion is infinitely more productive than it was; there was no discussion, in effect.

Now, again, it's very hard to agree. So in most of these meetings, decisions are taken in the 11th hour, or the 12th hour, or the hour. After that, we suspend the clock! So one cannot predict what will happen at the next one. But in general, I think the process is very useful, and I hope very much that it continues.

Romesh: Final question, Olivier. I'd be interested in your reflections on the state of macroeconomic research and macroeconomic analysis. The profession has come in for a lot of flak following the crisis. Where do you think it now stands?

Professor Blanchard: What I would say is, clearly, macroeconomics had understated, that's a fairly obvious statement, the importance of financial plumbing.

If I think about myself, I'm happy to criticize myself in that case. For me, finance was a set of arbitrage equations. The Fed would choose a policy rate, and then there would be some kind of term structure relation which would determine the long rate, and then there would be risk premia which basically would determine the other rates, and then some PDV equation which would determine the stock market, and then maybe bubbles. And the notion that there were banks involved and they had balance sheets and all that stuff, I thought, "Look, I don't have time to waste. Let me just ignore." And I think what we've learned is the plumbing is terribly important. The notion of leverage, which I'd not thought about, is terribly important. We clearly missed the implications of finance for macro, and I think that it's true of me, but I suspect it's true of many people who had understood it, who are more on the margin or outside macro. I think some of the people in corporate finance had understood it. They had not always drawn the macro implications, but they have made much progress.

Beyond this, should we start from scratch in macro? No. Basically, I find that I now have a much better understanding of plumbing. And I find that what I would call that elaborate version of the Mundell Fleming model really helps me enormously when I go around the world. Now, does this mean that I'll only use pre 1975 macro? It's not true. I think there are many phenomena which I understand better as a result of recent theoretical developments. All the stuff about precautionary saving, precautionary behavior, option value of waiting, all these things were absolutely central in the crisis.

So, I don't think macro is in terrible shape. I think we just have to extend it. We could have done better. We'll do better.

Romesh: Olivier Blanchard, thank you very much.

Professor Blanchard: Good. It was a pleasure.