The Rebalancing Challenge###
J. Bradford DeLong :: U.C. Berkeley
OëNB Conference on European Economic Integration :: Vienna :: November 24-25, 2014
There is an important purpose of an opening keynote talk like this one. Its task is to start from first principles and then give a large-scale bird's-eye overview to what is to come. We have panels to come on monetary policy, balance-sheet adjustment and growth, inequality and its role in generating internal macroeconomic imbalances, external macroeconomic rebalancing, and banking sector regulation. They all presuppose that Europe, and within it the regions of Central, Eastern, and Southeastern Europe that we focus on here, need not just higher aggregate demand in the short-term but more. They need large-scale sectoral rebalancing. And that sectoral rebalancing needs to be rapid. Why? Because these economies will not grow smoothly without deep structural reforms--in these reforms need to be not just at the bottom but at the top, reforms of institutions, governance structures, and regulatory practices and mandates need to be carried out as well.
Note that the need, while urgent in Central Europe, Eastern Europe, and Southeastern Europe, is not by any means more urgent here then in the other regions of Europe.
So why is more than higher aggregate demand right now what is needed? And which of the many things that go under the labels of "rebalancing" and "structural adjustment" are most needed? And why?
If in the next half-hour I can answer these questions convincingly then there will be an intellectual framework into which the rest of the conference's pieces will fit naturally, and we will all go back to our day jobs with a firmer grasp of the rebalancing challenge in Central, Eastern, and Southeastern Europe.
Thus let me try to place the rest of today in its proper perspectives.
The first perspective to take is the very long-run perspective.
Let me note three dates: September 12, 1683; June 18, 1815; and November 19, 1942.
September 12, 1683 was, of course, the end of the Turkish imperial project. It was the date of the last truly mass slaughter right here. On that day the defending armies commanded by Ernst Rüdiger von Starhemberg, reinforced by the relieving forces of King John III Sobieski of Poland, defeated and forced the retreat down the Danube Valley of the armies commanded by Grand Vizier Merzifonlu Kara Mustafa Pasha.1 That was the last time that this segment, at least, of the Danube Valley saw the chaos, destruction, and death of large-scale long-lasting war. If von Starhemberg and Mustafa Pasha could see Southeastern Europe now, while they might mourn the loss of power of the dynasties they served, they would both be very pleased at the state of the people who live her--and both be very grateful that the peoples and states are, for the most part, not still locked in what looked then like an eternal region-encompassing destructive war of intolerant, militant faiths.
June 18, 1815 was, of course, the end of the French revolutonary-imperial project with the final defeat at Waterloo in Belgium of the army of the French Emperor Napoleon I Bonaparte by British, Dutch, and German forces under the command of the Irish-born Arthur Wellesley, Duke of Wellington. We all do owe a great deal to the implementation and then transmission of the good ideals of the Enlightenment by the French Revolution. We owe less than zero to the habit of deadly ideological purges introduced by the Convention in Paris and in the Vendee. And the practice of introducing and maintaining those ideals by every four years having a French army come through, burning as it went and living off the land, leaving famine in its wake, is something we can live without.2 If either Metternich or Talleyrand could see right now that we are now longer engaged in the military destruction of the struggle for French dominance over Europe that consumed the sixteenth, seventeenth, and eighteenth centuries and that seemed to them to be perpetual, they would be pleased.
And November 19, 1942 was, of course, the end of the Nazi imperial project with the initial breakthrough of the Soviet Union's Red Army at Stalingrad on the Volga.3 It was followed by two-and-a-half more years of fire, blood, and death, and then a process of reconstruction that hang in the balance in Western Europe for a decade and is still not complete in Eastern Europe. Nevertheless, if those whose job it was to start rebuilding in 1945, if the Adenauers and de Gaulles could see us now, they would be very pleased. Right now the European project is a success. And we could not have said that on September 12, 1683; on June 18, 1815; or on November 19, 1942.
In fact, we can take a much longer perspective in which the post-World War II project of European community, unification, and peace has been a success. It was not far from here that the tribes of the Kimbri and the Teutones who had left their previous homes somewhere in or near Jutland crossed the Danube River into Noricum in 113 BC.
Was it 111 BC that the Kimbri and the Teutones, having moved down from Jutland to what is now Austria and crossed the Danube, decided they would rather cross the Rhine into the land of feta and olives in the Rhone Valley rather than eat Sauerkraut and sausage--or, back then, probably auroch jerky--in Noricum, near what is now Salzburg? So they went. And so they looted, burned, ravaged, killed, and ruled until a decade later they were broken at the battles of Aquae Sextiae and Vercellae by the new-model Roman Republican army commanded by Gaius Marius C. f. seven times consul.4 Ever since then, by my count, it is every thirty-seven years that a hostile army crosses the Rhine going one way or the other bringing fire and sword. The original Swiss--the Helvetii. Julius Caesar. All of those who claimed to be Julius Caesar's adoptive descendants. The Visigoths heading for Andalusia. Louis XIV commanding his armies to make sure that nothing grows in the Rhinish Palatinate so that his armies attacking Holland have a secure right flank. And, last, Remagen bridge in 1945. Every thirty-seven years, with increasing destructiveness as time passes.
Thirty-seven years after 1945 carries us to 1982. Thirty-seven years after 1982 will carry us to 2019. By 2019 we will have missed two of our appointments with slaughter. Even with Stalin's legacy, the difficulties of post-Cold War transition, everything that has happened in the republics of the Former Yugoslavia, and the current struggle over austerity and adjustment between the northern and southern pieces of the Eurozone, things have gone very well indeed recently.
Yet, I believe, most think that we desperately need political union in Europe as insurance to keep the bad old days from 111 BC to 1945 from coming again. We do not want Europe to once again fall victim to the tragedy of great power politics5. That means that politicians find some way to union--so that differences are thrashed out in conference rooms in Brussels and Strasbourg rather than in the streets with Molotov cocktails, submachine guns, armed drones, and worse. That is the necessity.
This does not mean that we should minimize Europe's current problems, just note that the problems are not as large as the achievements. The problems facing us are many. A very quick list consists of five. There are two major political problems:
- Incorporating ex-superpowers into the common European home--a problem Europe has faced over and over again since 1600, first with Spain, then with France after 1815, then with Germany after 1870, and now with Great Russia.
- Building institutions for continental governance in our late-Westphalian nationalist age.
And there are three major economic problems and opportunities:
- Grasping rather than letting drop the enormous fruits of continent-scale economic integration that nearly all studies of economies of scale and economic integration say are there.
- Accelerating the painfully and disappointingly slow convergence of both east and south to northwest European standards. Looking at the Asian Pacific Rim reveals that if we can get the institutions, the trade patterns, and integration more than half-right we can look forward to a régime of convergence in which living standards and productivity levels in a region converge halfway to the standards of that region's core in a generation. We can do it. We have done it elsewhere in the past. We should be doing it now in Central, Eastern, and Southeastern Europe. And, frustratingly, we are not: it is more the slow-boring-of-hard-boards than it is the thirty-glorious-years.
- Successfully resolving and recovering from the shock of 2008 and its aftereffects. This is, mostly, what concerns us today. The other four problems are, mostly, in the background right now.
And the need is to do all of this in a global context that is not terribly supportive.
The global context of 2008 is a world that was characterized either by a global savings glut6 or a global investment shortfall, depending on which blade of the scissors is your favorite to focus on. That imbalance in turn produced either what one might call a global overleveraging: the gap between desired global savings at global full employment and planned global investment at global full employment was filled-in by credit creation to create funding for long-term investment projects that was not backed by savings commitments to long-run patient capital.7 One might, alternatively, call it a global shortage of risk tolerance: the gap between desired global savings at global full employment and planned global investment at global full employment was filled-in by promising savers that they were not bearing large amounts of systemic business-cycle risk when they in fact were.8 These are alternative ways of labeling the same underlying economic failure of expectations to be consistent that focus on somewhat different things--the apocryphal tale of the five wise men and the elephant comes to mind.9
We had a world in which there was no global hegemon, in a Keynes-Kindleberger sense, in Washington, willing to take responsibility for managing the level of global aggregate demand, even if the consequences for the domestic United States were potentially unfortunate.10 If in the 1950s and 1960s the U.S. under Bretton Woods had made a durable commitment to serve as the world's importer of last resort, its falling into the same role during what some called Bretton Woods II was contingent and evanescent.11
Moreover, we had a world in which there was no alternative local continental-scale orchestra-conductor focused on balancing effective demand to potential supply over the European continent as a whole. Instead, there were many countries, some of them very large, most of them focused inward, none of them thinking that responsibility needed to be taken. That, it was thought, ws the business of the European Central Bank, which had the proper monetarist tools to do the job of managing continent-wide demand. But what if those tools proved insufficient? The ECB did not have the power, and nobody had the power to do banking regulatory or fiscal policy in Europe on the proper continent-wide scale.12
Plus there was little sense in the years before 2008 of what a North Atlantic-wide Keynes-Kindleberger international economic hegemon would actually do. Such are used to dealing with problems of excessive aggregate demand, de-anchoring inflation expectations, and upward price spirals on the one hand; or with problems of liquidity shortage on the other. But we did not have a liquidity shortage--certainly not after the start of 2009. The monetarist playbook for how the Great Depression ought to have been handled was taken down from the shelf, dusted off, and applied.13 As a result the North Atlantic economy floated on an absolute sea of liquidity from the start of 2009 to the present day: so much has there been not-a-shortage-of-cash that central bank deposit velocity has fallen to low levels that I, at least, never thought I would ever see.
We have, instead, since the middle of 2008 had another kind of deficiency in the macroeconomy: aggregate demand has fallen below potential supply because there has been an excess demand for and a shortage of safe assets in the North Atlantic economy. That has been a consequence of an excess of risky assets, of an excess of nonperforming loans, of the transformation of assets formerly seen as safe into risky status. These problems are more sophisticated and less tractable to monetary interventions. Open-market operations that simply swap one interest-paying, or potentially interest-paying government liability with duration for a non-interest paying government liability with zero duration have next to no effect on the supply-and-demand for safe assets as a class.14
If we view the big shock of 2008 as a collapse on the demand side of risk tolerance and on the supply side as the recognition that very large classes of assets sold as safe were in fact not safe, one driven by events in the United States, then we would think that this collapse is both good and bad. It is good in that savers are no longer easily fooled: people who are in fact bearing systemic business cycle and other forms of risk are now aware that they are doing so, and if full employment is reattained it will not be under the shadow of expectations that are inconsistent and cannot be fulfilled. Creditors will not let debtors borrow and borrow and borrow until not only their solvency but the creditors' solvency is at risk as well. It is bad because attaining anything close to full employment in a capitalist market economy requires that savers bear risk. The provision of risk-bearing capacity is an important factor of production that only those who have current wealth--are savers--can provide. And right now they are not doing so on a sufficient scale.
I was told this morning (November 24, 2014) that the ten-year Spanish government-bond nominal interest rate is now less than 2%/year. Whatever we think of those of you and of our friends who invest in Spanish government bonds, 2%/year nominal for ten years in euros does seem a little low given the existence of a great deal of value in the world today in the form of potentially-storable commodities, and given the existence of political uncertainties--black swans--over the net decade that are not things we can today quantify or even imagine. Compare a sub-1%/year German 10-year nominal bond rate to the 6%/year real earnings yield on a diversified portfolio of equities of European non-financial operating companies. With a 2%/year inflation target, 6+2-1 = 7. 7%/year is a huge premium return to get on equity investments in a diversified portfolio of corporations rather than government bonds subject to inflation risk--especially when one reflects that this is not a duration risk, for dividends plus stock buybacks today make up a very healthy cash payout, and the covariance of interest rates and corporate profits further reduces the effective duration of equities.15
That suggests that the collapse of risk tolerance has gone much, much too far. Right now we are in a world in which savers do not view the risks and opportunities of the world with clear eyes, but rather with eyes that perceive through a distorted negative bubble. Financial markets thus seem to be failing on a very large scale to successfully mobilize the risk tolerance of economies. This is doubly unfortunate. To undertake new enterprise or to invest to produce economic growth requires that someone peer through the veil of time and ignorance. That means that somebody must provide the risk-bearing capacity, must be willing to eat the losses if something goes wrong.
Back in 2008 we thought--I thought--I gave many speeches about how we were experiencing a shock that boosted demand for safe liquid savings vehicles, and that this shock was going to trigger a sharp downturn in the North Atlantic economies. But, I thought and said, the downturn would be short. At first, I thought it was going to just be a liquidity squeeze--and we knew how to deal with liquidity squeezes by using open-market operations to boost the money supply. Then it became clear that it was more than a liquidity squeeze. Yet even though it was not a liquidity crisis--even though taking down, dusting off, and applying the monetarist depression-fighting playbook would not be sufficient--the examples of the Great Depression and of Japan since 1990 would provide a guide for what not to do. So, I believed and I said, the North Atlantic would quickly resolve insolvent institutions and write down unpayable debts. The recession would be sharp. But recovery would be rapid. And afterwards the global economy would have been reknit into much the same pattern it was in before 2008.
This was wrong.
We have not reknit the global economy into the same pattern. We have not restored the long-run growth path that the North Atlantic was on before 2007. After a liquidity squeeze is brought to an end, asset prices return to normal, the sea becomes calm again, and, broadly, patterns of the societal division of labor that were profitable before the squeeze are profitable again. Hence all that needs to be done to reattain full employment is to reknit the same division of labor.
Not true this time.
This time, because there has been no recovery of risk tolerance--whether because of incomplete deleveraging, or the inability to reattain levels of risk tolerance that turned out ex post to be absurd but that nevertheless those engaged in enterprise required and expected, or for other reasons. Since there has been no recovery of risk tolerance, the previous division of labor across Europe cannot be profitably and sustainably reknit. There must be "structural adjustment" before anything like full employment can be reattained.16
Now nobody thinks that there ought to be a full recovery of risk tolerance to its levels in the days when a simple demonstration involving mark-to-model finance would convince a rating agency that a security deserved AAA, with which it could then be marketed at a spread of less than 25 basis points over the debt of credit-worthy sovereigns like Germany.
The pre-2008 European convergence equilibrium employed peripheral labor in Eastern, South Eastern, and Southern Europe in extremely risky long-duration enterprises: bets on the value of long-lived construction, bets that governments would resolve unresolvable public finance problems, bets that human capital would emerge to make profitable enterprises that would use new infrastructure. All of these bets seemed reasonable because risk tolerance was high. And perhaps most of them were reasonable--in the context of permanently-high risk tolerance. Hence the strong demand pushed relative real wages in peripheral Europe high relative to the regions' relative productivity at producing tradable goods.17
All this came to an end in 2008.
Now, in order to properly rebalance--even though rebalancing has been ongoing for six years--peripheral workers in Europe must either boost their productivity in making tradable goods or find something safe to do, must find something that does not require the mobilization of any substantial amount of European core risk tolerance in order to make the financing work, or must accept large real wages declines. These are the options. If it were not for the existence of the eurozone, all or nearly all peripheral European economies would choose the third: real wage reduction via depreciation of the currency. But for many that is not an option, or not a good option, or not seen right now as the best of the bad options. Peripheral depreciation for countries not in the eurozone and peripheral internal deflation for countries that are may in the end be the road chosen, in spite of all the economic pain and chaos it is generating now and will generate in the future. Euro-core inflation--"structural adjustment" in the northern core rather than in the periphery--is another possibility. Real "structural reforms" that successfully and substantially boost productivity in making tradable goods would be an option, if that unicorn could be found.
The problem is that "structural reform" too often stands as a placeholder for all good things that would increase an economy's productivity. The danger is that when commitments to "structural reform" are not accompanied by any political economy strategy to successfully disrupt the current stakeholders blocking reforms in order to confiscate their current rents.
Attempting to restore financial-market risk tolerance--but, we hope, not to go-go levels--is another possible strategy. A 7%/year gap between the returns to properly-diversified real European equity baskets and the returns to lending money to the German government could be greatly lessened without, in my judgment, running any risk of a new round of bubble finance. There is using the governments' powers to tax to mobilize the risk-bearing capacity of Europeans continent-wide--but if taxpayers are bearing the risk they deserve the returns of enterprise as well, and history had not been kind to those who think that governments' interventions in industry can take the form of a very large and high-return investment portfolio. Better, probably, for the government to boost the supply of safe assets via deferring the taxation to ultimately amortize expenditures it ought to be undertaking anyway than to involve governments on a larger scale as venture capitalists and industrial financiers.
This would be the case even were there not the additional problem that the risk-bearing capacity of taxpayers is mostly in the core of Europe, while the need for additional demand right now is mostly on the periphery. In the United States we do not track economic flows between states as Europe tracks flows between nations. We do not assign our national debt to individual states. We do not have to worry about this. In the United States back in 1991-2 after the collapse of the Savings and Loan bubble the United States central government transferred to Texas a sum equal to 25% of a year's Texas GDP--an amazing no-strings bailout--without there being any complaint or worry about fiscal transfers or about encouraging a feckless culture of moral hazard in rattlesnake country. Part of it was that we did not notice. Part of it was that the senior senator from Texas was in the key position of being Chair of the Senate Finance Committee. Europe cannot do the equivalent, or anything close, without political upset.
If structural reform and demand management are not both successfully performed, the alternative for Europe is then a long and uneven depression. Such might produce political pressures to set European economic integration into reverse. That, however, is a low-probability scenario. The higher-probability scenario in the event of the failure of structural reform and demand management is for European union and the euro to be held together by, year after year, just enough fiscal transfers and debt relief from the core to keep the grinding pain of deflation in the euro periphery from becoming so great as to trigger reversal. This would, in the end, be a much more expensive strategy for the core's than taxpayers than one of biting the bullet and immediate resolution and debt writedown.
What can we say about the roads toward structural adjustment--toward an economic configuration that could sustain continent-wide full employment without relying on unreasonable expectations of risk and return?
For some countries, exchange rate policy is possible. Exchange-rate policy is very effective medicine. It is a very good way of improving competitiveness and sharing social burdens. The problem is that it is such only as long as inflation expectations are anchored in domestic nominal terms. When they are not--especially when inflation expectations become anchored to inflation in import prices--relying on exchange rate depreciation is worse than useless. It is a medicine that is effective until resistance develops, and the fear is that alongside resistance there will also develop addiction to this mechanism. Hence it should be resorted to gingerly, lest overuse lead to high inflation and to even more intractable structural problems.
Nevertheless, if the largest global financial shock in a century is not a time to resort to it for those countries that can, when would the proper time to resort to it be?
But how can we know whether tolerance has developed? That is a question. I do not have an answer.
Within the eurozone, internal devaluation is not a possibility. External devaluation--chiefly vis-a-vis the dollar, hoping that the United States will once again be willing to take on the role of importer of last resort--is a possibility. However, it does not resolve Europe's internal structural problems. What it does do is make life very pleasant for the export powerhouse that is Germany. And while life is pleasant for Germany, perhaps its politicians can be induced to make concessions and provide funding and take policy steps that do resolve Europe's internal structural problems.
There is the possibility of replacing the missing private risk-tolerance for large-scale loan guarantees, asset purchases, or public spending to create demand for products that enterprises in peripheral regions can produce. That requires that European politicians know and understand and be willing to use the debt capacity of Europe's core for the benefit of primarily the periphery but of the eurozone as a whole. There is "structural reform", and the knotty question of whether structural reform is harder when unemployment is high or when it is low. Those in Frankfurt and Berlin are sure that structural reform can be accomplished only when unemployment is high and politicians feel a sense of crisis in their bones. Those in Washington are sure that structural reform can be accomplished only when unemployment is low and politicians can assemble fleshpots of resources to be distributed to assemble majority political coalitions. I avoid taking a stand on this issue by saying that I am just an economist. I do, however, note that the fact that at most one of these can be true does not mean that at least one of these is true.
And, as noted above, inflation in the European core and deflation in the European periphery round out the list. We have not had much of the first. We have had a lot of the second. A 2%/year inflation rate for the eurozone as a whole with a 0%/year inflation rate in the eurozone's poorer half does mean 4%/year inflation in the eurozone's richer half. I do not see how anything good could come out of a monetary target that turns into a mandate that inflation in the European core must always be less than 2%/year. Whether all who staff the ECB fully understand this is not clear.
But among all these possibilities, why choose? These all seem to me to be not substitutes but complements.
Yet the political economy of today in Europe seems curious: these are all, overwhelming, posed as either-or substitutes, as mutually-exclusive alternatives. And I hear the same thing in the United States as well. Yet I have never understood this. I have always thought that the best and obvious strategy is to attempt them all--and to be willing to, pragmatically, reverse course on those that appear to turn out to have implementation costs greater than their potential benefits.
I have been waiting for five years for somebody to tell me why what seems obvious and best to me is not obvious and best.
And I am still waiting.