Consolidation tactics for the European integration strategy

To consolitade: to join together into one whole

To integrate: to form, coordinate, or blend into a functioning or unified whole

European strategy

Europe integration rests on two pillars. The first pillar consists in the adoption of arrangements between euro member states. These arrangements map into a sufficient set of conditions for the Union to function. The second pillar consists in policies adopted by each individual state. These policies map into a set of sufficient conditions to function within the Union. Both pillars are necessary.

At times, the first pillar is presented as the "grundnorm" that anchors the contents of the second pillar. For example most of the economic policies adopted by euro members during the current crisis were at least partially motivated by some european imperative. In reality, unconventional (= peaceful) European integration has been the main strategic objective of most European states for the last five decades. The effort, the commitment and the intelligence of the policies adopted by each individual member state to achieve European integration are ultimately the determinants of the Union. The individual state European impulses make of the second pillar another "grundnorm". They are twin pillars.

First crisis management tactical plan: frontal attack 

 One consequence of the Great Recession has been the fast deterioration of public finances across the Union. Given that Fiscal sustainability is a necessary condition for economies to function, fiscal consolidation has become, together with "structural reforms", a crucial policy objective for all member states. To achieve the stated objective, euro countries have decided to improve their budgets with a frontal attack: increase taxes and decrease expenditures, with a mix biased towards the former. In the mean time, broadly defined "structural reforms" would sustain the economy through increases in productivity, or if you wish assuring logistic support to the front line engaged in the consolidation. In most cases the tactic was not successful. Governments have been flanked by a larger than expected fiscal multiplier and by the lack of coordination between creditors and debtors. Put it simply: fiscal consolidation decreases internal demand, and when fiscal consolidation is adopted simultaneously by all your major trading partners, external demand also decreases. What was not foreseen (except by a few) is that demand/income/activity would decrease so much as to reduce revenues and possibly worse the medium run fiscal sustainability.  Figure 1 illustrates the point for Portugal. (click to enlarge)

The fiscal consolidation effort appeared to work at first: in 2011 expenditure decreased and revenues increased massively improving the budget deficit from -10% to -4% of GDP. The following year (2012) nominal GDP plunged to a lower level than in 2009 (the year of the Great Recession), revenues decreased (although tax rates had been increased both on income and value added) and even a further noticeable decrease in public expenditure was insufficient to stabilise let alone diminish the budget deficit that increased to -6.62% of GDP.  Structural reforms implementations/outcomes proved to be too slow to provide effective support. And as in a classical tragedy, the IMF, concerned with the macroeconomic/activity imperative, and the European commission, concerned with the microeconomic/efficiency imperative, clashed, creating a sense of mutually exclusive but equally legitimate causes.    

Evolving tactics to break the multiplier flanking

Sates have regrouped and are now ready for a second round. The new main tactical innovation is to shift the consolidation effort from tax increases towards expenditure decreases. The motivation is that, If done properly, fiscal consolidation through expenditure reductions gives the opportunity to increase efficiency of the public sector. Increased efficiency in the public sector translates into higher productivity, a force that should counterbalance the decrease in demand. This reminds the role of structural reforms in the first battle. However the frequency mismatch is still present. Improving efficiency takes time, say it delivers improvements in productivity in the medium run while the decrease in demand occurs in the short run. Furthermore, the discussion on public expenditure reduction inevitably initiate debates on more fundamental questions such as the size and the role of modern governments in the economy which also belong to a different frequency. I do not want to downplay the importance of having a more efficient government of the right size. This is certainly a strategic objective. However if fiscal consolidation prove to be not only contractionary but also self defeating the tactics followed are ultimately not coherent with our strategy. In what follows I will assume that best practices aimed at maximising efficiency are always implemented and focus on the macroeconomic issues.

Sources of strength of the multiplier        

To find the appropriate manoeuvre to break the multiplier flanking we need to identify what are the causes of its strength. To organise thoughts we can ideally (although artificially) separate between euro area (first pillar) and single state (second pillar) causes of large fiscal multipliers.

First pillar

The first identified cause is the malfunctioning of a policy instrument or the absence of accommodative monetary policy: rates are stuck. In the euro-core interest rates are stuck close to the zero lower bound and much worse, in the periphery, interest rates are stuck at high levels. The latter can be explained though fundamentals (positive probability of default ?) but is mostly the perverse outcome of the renewed financial fragmentation that impairs the monetary policy transmission. The ECB has adopted appropriate countermeasures: the Omt mechanism and the banking union plan.

The second identified cause is the absence of a policy instrument or the impossibility of a nominal devaluation. Although policies that could mimic a devaluation through budget neutral manipulation of taxes have been suggested, the efficacy of a devaluation (fiscal or nominal) is impaired by the lack of coordination between trading partners. Devaluations (fiscal or nominal) can help cost realignments across the euro zone, help employment, but if internal demand decreases simultaneously in all major trading partners the stimulative effect will be small.

Second Pillar

At a more granular level, a third cause of large multipliers is the presence of credit constraint households or more simply households that need to spend most, if not all, their disposable income. The appropriate countermeasure is to target expenditure decreases away from the credit constraint households that have larger marginal propensity to consume. Take again the case of Portugal who has committed to reduce public expenditure by 4.7 billion euro by end 2014. How to minimise the size of the multiplier?

Heterogenous advance to break the flanking

Let me proceed with a simplifying assumption and use the income distribution to proxy for credit constraints and marginal propensity to consume.  The assumption is that the poorer you are the more likely you are credit constraint and the higher your marginal propensity to consume. It follows that to minimise the contractionary effects of a decrease in public expenditure you need to target reductions according to income (share) distribution. Figure 2 shows how much of the decrease should weight on each decile or quintile of the income distribution. (click to enlarge)

A priori it is not obvious than the better off receive sufficiently large share of spending to enable such a reduction. In the case of services this might require a fee.  Or when the better off do receive a larger share of spending it usually reflects their contribution history. In general criticisms to this approach are closely linked to criticisms that would appear with an incase in taxes. The "details" of the Portuguese plan are that the wage bill is expected to decrease by 2.2 billion, pensions to decrease by 1.4 billion and intermediate consumption by 850 million. The logic is that the  government’s spending reduction target can only be achieved by focusing on major budget items, and these three are the largest. Figure 3 shows both the amount of public pensions received by each income quintile and the cuts for each quintile implied by the income share distribution. (click to enlarge)

For what regards the wage bill reduction, the specified measures contemplate 50% of savings through reductions of employment (summing attrition, termination and voluntary separation) and 50% through a remodulation of the wage schedule. The latter should also follow a mapping with the income share distribution to achieve progressivity of the compensation reduction (as opposed to the proportionality of cancelling extra months wages). Again let me stress that this recommendation is inspired by the sole consideration of minimising the number of households with larger propensity to consume from the fiscal consolidation.

Concluding remarks           

Do we have evidence inequality is related to the size of the multiplier? To answer we should know the size of the multiplier, and on this from progress has been made only very recently. Furthermore the link between income distribution and credit constraints might be less tight than assumed above. Certainly the recession has increased inequality, and if the link between inequality and the multiplier exists we have potentially another channel through which the state of the economy affects its size. Finally there is growing evidence that fiscal consolidations success stories are related to taming inequality.

  Coherence between policies and ethical values can ensure the type of broad consensus that is needed to support the adjustment process. The suggestion of reducing spending according to income distribution might have a better chance to reduce its contractionary effects and achieve greater consensus. Especially where inequality is larger. Certainly the issues of efficiency, size and modernisation of the state have to be addressed. But the latter are a continuously evolving process as opposed to a sustained but temporary macroeconomic policy. It is not impossible to project the reduction in expenditure by income share distribution into a bridge towards a state that charge fees for services according to income or even moves away from being the main service provider towards a guardian of standards. 

Today the first pillar shakes under the uncertainty of what will be the future common arrangements. The latest scene regards the questioning to the Omt mechanism put into place by the ECB. Can a currency area work without a lender of last resort? Let me rephrase the question. Is there any currency area in the last two centuries that worked without a lender of last resort? (and I count "reluctant" LLR as a de facto LLR). 

The second pillar must show the way. States have challenges ahead to continue the ascendance of Europe: they need to get back to growth, implement reforms and attain fiscal sustainability. Each state can propose solutions that fit best their society and their culture. How their solutions/proposals will perform will determine their right and their relative weight in the Union. This is the beauty of the European project, no country needs to abdicate his culture nor his language. It requires strength and vision but maintaining the status of exceptional cultures is an enduring process.