Keep reasoning

A tale of mixing two policies

Policy 1: Fiscal consolidation (FC)

In his massive fiscal consolidation effort, the actual Portuguese Government had decreased public wages by suppressing the 13th and 14th months (called Summer and Christmas subsidies in Portugal). Later the Portuguese Constitutional Tribunal (TC) found that this was illegitimate because it went against the equity between private and public workers (!) and forced the government to give back one of the subsidies. 

The immediate implication would be an increase in public expenditure and a worsening of the deficit. 

To maintain the decrease in expenditure the Government decided to increase the social security contributions (ssc) paid by public employees by 7% (which is equal to 1/14). Consistently with the TC the increase in ssc is extended to all the workers (remember the private-public equity).

transition to…

Policy 2: Fiscal devaluation (FD)

Now you find yourself with an increase in 7% of the ssc paid by private employees which allows you to decrease social security paid by all firms by 5.5% (assuming public employees are 15%-20% of total employees). 

The willingness to maintain the decrease in public expenditure, and avoid a further increase in the deficit created the room for a fiscal devaluation. A "creative" FD as this is not what was suggested in previous studies/posts. My preliminary bird-eye view is that 

- in the long run total TSU has increased, therefore the labor-wedge has increased. The increase is small, 1.5%, but goes in the wrong direction, augmenting the labor market distortion.

- in the short run, the efficacy on competitiveness crucially depends on which wage is rigid: the net nominal wage (take home) or  the nominal wage gross of social security. In the original version of the FD (with VAT), when the decrease in TSU paid by employers decrease, the nominal take home wage is assumed not to increase which allows the gain in competitiveness. In this version of the FD, the nominal take home wage decreases because of the increase in ssc paid by employees. 

There are other differences between the FD with VAT and SSC paid by employees. Especially on the negative impact of demand. I am not going to tackle them here. I will underline the need to introduce some progressivity in the TSU.

At present Portugal needs to maintain its calm, avoid precipitous decisions and present clear-minded scenarios together with policies and their trade-offs.

      

Portugal is in shock

These days, everybody in this country is shocked in a way or another and I am choked in my own way, of course. The reason for all that shock is the Government’s plan to change the social tax (Taxa Social Única), which will lead to an increase in labor's taxation by 7 pp (from 11 to 18%) and a reduction of employers taxation by 5.75 (from 23.5 to 18%; the remaining being an increase of the aggregate from 34.5 to 36%). Such change will imply a massive transfer of wealth from workers to employers, to the tune of 2.2 billion euro annually. But even more shocked I get when I read in the Portuguese press that the IMF's Director, Christine Lagarde, has stated that Portugal is "a success story in the eurozone". Following massive cuts in public wages, massive tax increases, and massive cuts in health, education and unemployment compensations, that success is measured by a 6.6% deficit over GDP, and unemployment estimated to reach 17%, by the end of the year. I wouldn’t call that success. One my just wonder how the 6.6% deficit is esasily compatible with a much lower unemployment rate (12, 13%?, your pick). Both staggering figures are the direct consequence of the way the crisis has been tackled by the close and unhealthy association we have in this country between the troika and the Government. And now everybody is also worried about what will happen politically in the near future.

Review literature on Fiscal Devaluations

Given the recent measures adopted by the government I post a small reading list on Fiscal Devaluations for the interested readers.

1. Emmanuel Farhi Gita Gopinath Oleg Itskhoki: Fiscal Devaluations
2. Ruud de Mooij, Michael Keen: Fiscal Devaluation and Fiscal Consolidation: The VAT in Troubled Times
3. Francesco Franco: Improving competitiveness through a fiscal devaluation: the case of Portugal (first attempt/cross section)
4. Francesco Franco: Adjusting to external imbalances within the EMU, the case of Portugal (second attempt/time series)

Back to national homework

As the plan for a deeper integration of the euro financial markets proceeds, ez-members need to continue their focus on macro rebalancing. An important aspect of the rebalancing relates to their fiscal consolidation plans. A new paper by Alberto Alesina, Carlo Favero and Francesco Giavazzi finds that: 1. Fiscal adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. More precisely: tax-based adjustments have been associate with prolonged and deep recessions while spending based adjustments have been associated with mild and short-lived recessions. 2. The heterogeneity in the effects of the two types of fiscal adjustments is mainly due to the response of private investment, rather than that to consumption growth. 

A Coherent Bund ?

I am puzzled by the primary market operations performed by Finanzagentur and its agent, the Bundesbank. Consider yesterday auction of the 1.5% bond of the Federal Republic of Germany of 2012 (click for official press release).
My reading is as follows:
The issue volume was 5 billion euro. Bids by primary dealers (institutions that have to take the bonds) amounted to 2.77 billion while bids by banks and other private agents summed 1.16 billion. Total Bids were 3.93 billion, well below supply. The Bundesbank accepted 100% of the bids by the primary dealers and approximately 72% of the competitive bids. Price did not respond because supply was artificially lowered through the retention mechanism: 1.39 billion of Bund were set aside in the account of the Federal Government (I presume an account at the Buba). The result is an average yield of 1.42% on the Bond. 
Why am I puzzled? I thought that interest rates in Germany were too low (and in Italy too high) according to fundamentals. If this is true, how are German auctions coherent with a normalization of the interest rate differentials and of the overall monetary policy transmission within the eurozone?
P.S.
Admittedly 5 billion is very small and practically there is a flight to quality (es: Siemens borrows at 0.375% for 2 years). Nevertheless coherence might be a good starting point. 

P.S.2
I am told that  my labeling of non-competitive bidders as primary dealers is imprecise. Most of them are primary dealers but not exclusively, they are bidders that focus on quantity instead of price and are willing to take paper at the average price.

On Fiscal Unions

Important paper by Emmanuel Farhi and Ivan Werning on Fiscal Unions. (A reading to be reconcilied with macroeconomics if needed).

Three questions to European leaders

I have been asked to prepare a short question for the european summit in October. I have prepared three. They are broad and purposely rethorical to quench my impatience.

I.

To date the Eurozone is the most highly civilized arrangement between former warring states to provide public goods of primary importance: peace and prosperity. By constructing  the Union, Europeans, want to maintain their status of paragon among other regions of the planet. 

Can you describe what would be the consequences for the international order of a failure of the European project?

II.

Do you think that the current institutional framework is able to provide for consistent macroeconomic policies in periods of calm and rapid and responsible decisions during period of crisis, or is it prone to free-riding behavior and naive "fallacy of composition" analysis by individual members?

III.

The current narrative ascribes the incapacity of European leaders to agree to the war between two world views. It is again the old dispute between the short run and the long run. (Strangely enough we had been taught that the dispute had been settled by the Samuelsonian neoclassical synthesis.) When do you think European leaders will present and offer a shared analytical framework on the economic functioning of the Eurozone?

4th revision update

the new documents from troika on Portugal, are available here, from the site of the Portuguese Government.

An update on wage adjustment

I am still looking for the quarterly time-series but I have managed to find data on General Government employment for 2010 and 2011. This was useful to compute the average compensation inflation (click to enlarge the graph) in the public (blue line) and private sectors (green line). So far the adjustment for the total economy (red line) came in large part from the public sector.

Public and Private compensation query

Query: I am trying to compute a measure of private labour compensation inflation. So far I have been unable to find quarterly data to subtract General Government (GG) compensation from Total Economy (TE) compensation. The annual national accounts by branches (Eurostat/INE) presents the data for the TE and the GG although GG employment ends in 2009. Does anyone knows where to find updated and quarterly data?

Bt the way: the graph above shows: 1) an average compensation premium of 1.95 for GG workers (obviously characteristics are different), 2) similar inflation compensation until 2009 (GG average 4.6, TE average 4.35, correlation 0.75), 3) a declining share of GG employees. 

A brief note on the Euro Symposium

"I would prefer not to"

Bartleby, the Scrivener: A Story of Wall Street", Herman Melville

Tonight representative of the 27 members of the EU will sit together around a dinner table to discuss a report, appropriately titled for the occasion "Towards a Genuine Economic and Monetary Union". The report was prepared by the four presidents of the European council, the Eurogroup, the Commission and the ECB; it identifies four essential building blocks for a "stable and prosperous" EMU to be put in place over the next decade (decade: a period of ten years).

They are, 1) An integrated financial framework, 2)An integrated budgetary framework, 3, An integrated economic policy framework and 4) ensuring the necessary democratic legitimacy and accountability.

 Let me focus on the first and most urgent block to be put in place over the next semester (semester: a period of six months), namely the integrated financial framework (from now IFF). For all practical means it consists in the creation of EZ-banks. The steps to transform euro-members banks into EZ-banks are to institute a single European banking supervision and a common deposit insurance and resolution framework. The motivation found in the report is totally correct: "the financial crisis has revealed structural shortcomings in the institutional framework for financial stability" and the IFF will "ensure financial stability in the euro area and minimize the cost of bank failures". Many commentators agree that the IFF will sever the incestous links between euro members banks and sovereigns, will increase confidence and stop deposits outflows, will help relax the consequent credit tightening. Fundamentally I think adopting a IFF goes beyond checking a list of shortcomings.

A while ago (the analysis is outdated and today would probably be more focused) I came to the conclusion that the architects of the Euro had focused on the necessary conditions to make it work. For example think of the competitiveness problems of the periphery from the financial angle. As long as the euro-members commercial banking system was working as one, the current accounts were intermediated. Then came the crisis and what was necessary turned out to not sufficient to make the Euro work. There are other important parts of the euro institutional infrastructure that can work with euro-member banking and financial sectors, and they worked before the crisis, but are likely to work less well, to say the least, than with a IFF. In normal times, we are entitled to think that the ECB would want to achieve a quasi-uniform transmission of its monetary policy across the EZ and along the EZ yield curve.

I really hope the room is green.

Portuguese Public Finance Council

Created in february 2012, the Portuguese Public Finance Council has published the first review analysis. It can be found in http://www.cfp.pt. There is a version of the report in English. The report is overall positive with the budget policies, but still finds room for recommendation about further improvements.

Guest author: U. Schuetz: Unintended Consequences

Unintended Consequences. Challenges for Portugal’s “Arranged Liberalization”
Ulrich Schuetz, University of Lucerne, Political Sciences (ulrich.schuetz@stud.unilu.ch)

Introduction
   After Ireland and Greece, Portugal was the third eurozone country to receive financial aid within the European Financial Stabilisation Mechanism (EFSM) framework of the so-called “troika”, composed of the European Union (EU), European Central Bank (ECB), and International Monetary Fund (IMF). In May 2011, the Portuguese socialist government, with support of the conservative opposition (which came to power one month later), accepted a reform plan conditional to the disbursement of financial assistance. The plan aims to improve Portugal’s economic competitiveness and performance through structural reforms towards a more liberal system. At the same time, it requires the state to substantially reduce public debt to regain fiscal solvency. Criticism of the reforms mostly reflects different macro-economic standpoints and comes mainly from economic observers. A frequent evaluation states that instead of fiscal austerity, expansionary monetary policy would lead the way out of the crisis (e.g. Krugman 2012). Because of the pro-cyclical nature of their conditions, past IMF programs were blamed for pushing countries into recession (Soros 2002:120). Missing from the debate on the effectiveness of the troika reform plan is the question if the reforms are embedded in an environment favorable for liberalization. A generalized “one size fits all” liberalization program might not produce the expected results, especially if non-economic factors are considered. Analyzing the separate aspects of the reform plan and trying to predict potential shortcomings in their application is necessary to be able to assess the chances of success. This essay is an attempt to do this by starting from the following assumption: If institutional complementarities and non-market relationships such as corruption and clientelism are ignored, the outcome of liberal reforms will be negatively affected.
   The first part of this paper provides a short overview of the troika reform plan. Subsequently, institutional complementarity and the Varieties of Capitalism approach are discussed regarding the Portuguese case. Finally, the impact of corruption and clientelism on a liberal reform process is addressed before summarizing the findings in a conclusion.

Troika Reform in Portugal
Details of the reform program were agreed on by both the old and new Portuguese government and troika. The agreed measures had broad political support as a result of a basic consensus on European issues between the country’s two biggest political parties, conservative Partido Social Democrata and socialist Partido Socialista (Fischer 2011). The two main pillars of the program relevant to this discourse are (1) increasing competitiveness and growth through liberal reforms and (2) regaining fiscal solvency through a substantial reduction of the public deficit (IMF 2012:4)1. Disbursement of financial assistance is subject to troika’s review of the implementation of the reforms. Portuguese authorities also committed to consult with troika on legislative changes that were not part of the agreement (European Commission 2011:1). As a consequence, the Portuguese government sends a quarterly letter of intent to the IMF and ECB with a review of the progress made so far and documenting the next steps, closing with a request to transfer the next installment. This is standard procedure for IMF-supported programs. The Fund itself argues that “conditionality can serve as a valuable commitment device that complements and enhances ownership of structural reforms” (IMF 2003:12).

1 year of troika

17 May 2011 - one year ago - the Memorandum of Understanding was signed and Portugal entered the financial rescue mode.

A year after we have
- new government, and a relatively large political consensus on the complying with the commitments set in the Memorandum, including the main opposition party
- lower wages - both in civil service, as the Government imposed a wage cut, and private sector (either negotiation of lower wages or through unemployment spells, taking lower paid jobs
- unemployment at historically high levels
- emigration rising again to levels unseen in peaceful
- public budget cuts
- price increases (transports, electricity)
- tax increases (both income and VAT) (tourists can still have back VAT, under certain conditions)
- give away 4 holidays (two historic dates + two religious dates)

but we also have
- sun and 30º C in May
- good roads and highways (though, rather empty ones, but hey, they are there to use)
- summer music festivals - Bruce Springsteen, Bryan Adams and Stevie Wonder will be at Rock in Rio
- good food, even if we take smaller portions
- waves
- exports growing, and to non-traditional markets
- GDP fall was smaller than expected this term (though one number is not yet a change in trend).

And if you want to keep tracking some key numbers in main areas of change under the memorandum of understanding, follow what our students are doing here.

What adjusts when a country deleverages

Normal blogging should soon come back. For the moment I continue the advertisement campaign on seminars: Friday we have (at Nova 12am) Pierpaolo Benigno presenting "Deleveraging and the real exchange rate"