The Draghi speech on structural reforms: mistakes, misunderstandings and defunct models
“As of 2005 Spain had the second highest immigration rates within the EU, just after Cyprus, and the second highest absolute net migration in the World (after the USA). … In fact, booming Spain was Europe’s largest absorber of migrants from 2002 to 2007, with its immigrant population more than doubling as 2.5 million people arrived.”
Contrary to what Mario Draghi tells us in his recent speech ‘structural reforms, inflation and monetary policy’, more ‘flexibility’ is not the answer to the Eurozone woes. Maybe even to the contrary. Flexible labour markets and deregulated financial markets did not just enable the buildup of housing bubbles and an oversized financial sector and unsustainable private debt levels in countries like Spain, Ireland and the Netherlands but also caused them. Fast ‘reallocation of resources between sectors’, lauded by Draghi, like mass immigration of construction workers in Spain and Ireland, mitigated wage increases. Which led to an even larger bubbles than would have been the case without this immigration. Considering the size of the bubbles especially Spanish wage increases were remarkably low! Also, the ECB ‘Eagle’ model which is the scribbling behind the speech of Draghi, does not have a financial sector which means that disequilibrium lending and money creation falls outside the scope of his speech. While something must have been the matter with this sector, when dozens of countries in and around Europe suddenly and at the same time are swamped with money and develop totally unsustainable current account deficits (look at table 1 of this IMF report by Zsófia Árvai, Karl Driessen, and Inci Ötker-Robe about financial regional interlinkages, especially at the 2004-2007 period, and also here for my take). But oh, the Eagle model of course does not have a financial sector, of course, which of course means that financial interlinkages can’t be important as we do not look at them… The speech is also riddled with factual mistakes, ideological and political misdemeanours and statistical misunderstandings. And oh, the Eagle model states that government production (education, road services and the like) produce by definition nothing of value… which means that it also by assumption rules out government solutions and underestimates the costs of cutting government services and investments. Time for a little take down of the speech.
Now, it’s not that I do not like and admire companies or underestimate the dynamism of markets. Look here. And here. And, about the epoch changing influence of supply side changes of the labour market, here. Also, like Draghi I do believe in the importance of structural changes in the Eurozone. But unlike Draghi I do not suppose that all financial market systems are stable by nature. And unlike Draghi I think that structural reforms should take account of the financial nature of the crisis – it’s not a labour market or a flexibility crisis. It’s good to enhance the ‘ease of doing business’ in Greece (which is what the present government sets out to do, for instance by changing insolvency laws). And in Italy the difference between ‘broad’ and normal unemployment is excessive, which suggests (!) that some kind of institutional or economic barriers prevent people (mainly women in this case?) from starting to look for jobs in a more active way. But our crisis is not a flexibility crisis – it’s a debt crisis of a rapidly aging society ruled by old men. Which means that structural reforms should not be aimed at protecting banks and increasing flexibility at the cost of households and families but at protecting families against piling up massive amounts of (mortgage) debt and at enhanced levels of writing down debt when a credit crisis strikes (and not just on the balance sheets of banks – but also on the balance sheets of households). If anything has become clear after 2008 it is the extent to which economists have underestimated the importance and the instability of the housing market/financial market nexus but Europe is not even trying to solve this problem (house prices in the UK are rising with 10% a year, once again, absolutely terrible). Restricting mortgage lending (directly or indirectly, using a land tax) will protect families and enhance the stability of the system while a more flexible system of writing down household debts will make the system more ‘resilient’, as Draghi calls it. But not a word about such solutions…
Draghi states that in the Eurozone monetary and fiscal policy is in fact impotent. Right! Which makes him state that economies have to become more flexible – which assumes that monetary market economies are stable by nature on only need the right amount of flexibility to ensure this stability. But what if they aren’t and when at least our kind of monetary market economies are not stable by nature and prone to business cycles, booms and busts. Might it be possible that, in such a situation, flexibility would not prevent but enable booms, busts and lasting crises, just like in the 2000-2008 period? About this:
1) Good: Draghi at least tries to give a definition of structural reforms which is worth repeating which makes the speech at least clear, unlike much other Troika statements:
“Structural reforms are, in my view, best defined as policies that permanently and positively alter the supply-side of the economy. This means that they have two key effects [he means in fact: three, M.K.]. First, they lift the path of potential output, either by raising the inputs to production – the supply and quality of labour and the amount of capital per worker – or by ensuring that those inputs are used more efficiently, i.e. by raising total factor productivity (TFP) [more inputs are an entirely different thing than changes in technology, M.K.]. And second, they make economies more resilient to economic shocks by facilitating price and wage flexibility and the swift reallocation of resources within and across sectors.”
Mind that the financial sector and debts are not mentioned. Mind that the second part of the first effect is totally vague: ‘permanently … raising total factor productivity’. Is this caused by technological development? The growth of high productivity sectors? A more efficient organization of our economy? Better roads? More competition which leads to the culling of inefficient producers? Mind that an idea like ‘the paradox of flexibility‘ (a rapid decline of wages and profits might lead to an even faster and larger decline of demand) is ignored. Or, the other way around: one of the reasons why the Irish and Spanish housing bubbles were as large as they were is the very fast increase in the supply of (construction) labour: immigration into Spain and Ireland soared. This is exactly the kind of reallocation of resources which Draghi mentions – and it was destabilizing, not stabilizing.
2) Not so good. Fact free and wishful non-thinking:
“In terms of resilience, the ability of each economy in a monetary union to adjust quickly to shocks is essential for price stability and, over time, for the long-term viability of the union. This is because, faced with a negative demand shock, a more flexible economy will tend to react by immediately lowering prices, but agents will then expect inflation to rise again as the shock fades, ensuring a firm anchoring of inflation expectations. By contrast, an inflexible economy is more likely to adjust through higher unemployment, which exerts a more prolonged downward pressure on inflation and is therefore more likely to weigh on inflation expectations. This in turn can lead to higher real interest rates and compound the effect of the shock.”
Where to begin? It’s just not true. No economy lowered wages as fast and as much as Greece – but we all now that this did not resolve the Greek problems. To the contrary – it led (contrary to the statements of Draghi) to structural deflation which disabled the ability of the Greeks to pay back their debts. Greece did adjust wages and prices – but had higher unemployment, too… The Draghi statement is, also considering the situations in Portugal and Ireland, pretty much fact free. Should Greece really have decreased wages with an additional 10 to 15% (without changing nominal private and public debt levels)? By the way – austerity poster child Latvia after 2008 increased the minimum wage with about 60%... And again: lowering prices does not work, in reality, on the macro levels as these prices (wages!) are the main determinant of income, too. Keeping nominal debts at the old price level will of course exacerbate this.
3) Bad. Insulting and as far as I’m concerned a wilful misreading of the facts:
“The way different euro area economies have reacted to the crisis bears this point out. Labour and product market rigidities contributed to a more painful adjustment process in the stressed economies, which was initially driven more by compression of demand than by a reduction of costs relative to other economies, albeit with differences across countries based on their initial degree of flexibility (Chart 1). As a result, we now face a situation of significant divergence in unemployment across the euro area (Chart 2).”
Does Draghi really state that if wages in Ireland and Greece had decreased even faster domestic demand would (consumption!) would have been higher while gross exports would have exploded? It is good to see that Draghi does not use ‘Unit Labour Costs‘ anymore as an indicator of competitivety by the real effective exchange rate. But our empirical experience with deflation (internal of external) shows that it does not really boost exports (I had to get used to this idea too, but read this, though it seems to me that external devaluations lead to less disastrous decline in domestic demand than internal devaluations). Any way – in the wake of housing bubbles and wage cuts domestic demand will suffer and export increases require investments and technological developments instead of low wages and austerity in your trade partners… It’s not that low wages never work – tourism is pretty price sensitive.. But even then the whopping 5% of GDP improvement in the Greek ‘trade and tourism’ balance since 2010 (absolutely massive and beyond expectations) was not enough to make even a dent in the 25%+ rate of unemployment… And about the same thing can be told for Spain. There is no way that even faster and larger wage cuts would have led to lower unemployment. By the way – wage moderation in Germany, often mentioned as an example, pales in comparison to what happened in countries like Portugal, Spain and Greece.
4) More fact free statements
“Several countries have however made significant progress with structural reforms during the crisis, and we can already see how this has altered the relationship between inflation and unemployment. Various estimates of the euro area Phillips curve show that, while the slope has varied over time, it has steepened in recent years. In particular, there is evidence that inflation has become increasingly responsive to cyclical conditions in countries that have reformed their product and labour markets, such as Spain and Italy”
Considering unemployment of 25% any kind of steep Phillips curve should have led to 5% deflation or so, in Spain… And a Euro Area Phillips curve does not exist and is a statistical artefact. Interestingly, the link also shows that the German and Spanish Philips curve showed opposite movements, a pattern consistent with the idea that the banks (there they are again…) channeled German savings to Spain, therewith depressing German wages increases and increasing Spanish wages increases.
5) Draghi goes on by explaining how we have to boost growth. He is right the be afraid of ‘hysteresis’ (long-term unemployed tend to leave the labour market or to lose valuable skills). And he’s right to point at the very low growth of total factor productivity. But do we, like Draghi, really want to boost growth to make monetary policy more effective? Isn’t it a better solution to leave the Euro, if that’s the goal, surely when we consider the Draghi (rightly) states that the Euro necessitates more centralized governance? And is increasing the labour supply by rasing the pension age really urgent when unemployment is about 11%, as in the Euro Area? By the way – labour market participation by the ‘vintage’ generation (say, 50+) is already increasing by leaps and bounds, everywhere in Europe. Draghi seems to be behind the curve, here.
6) Draghi also points to the large difference in productivity between firms, which according to him shows ample scope to improve average productivity. As Salter however showed about 60 years ago, such differences are characteristic for market economies.
7) According to Draghi, reforms should be well designed. Duhhh….
8) But I agree that there might be some low hanging fruit in some countries when it comes to ‘the ease of doing business’.Generally, however, I believe more in this Ekhatimerini article about ‘Israels tech miracle’, which stresses that there has to be a mixture of entrepreneurial and technical spirit, necessity and a supportive government and also states:
“A basic thing you must do is locate what fields you are strong in, like tourism and the agricultural sector for Greece. Something which seems to be quite misunderstood is the impression that innovation only refers to technology. So, you do not begin with something you don’t know. You do not start from scratch. You begin with what you know and build on that. I had the opportunity to meet with around 40 entrepreneurs who do mentoring and I discovered that there are interesting ideas, which are not necessarily related to technology but deal with how to make your tourist product attractive. There is innovation in services and the agricultural economy“.
But even that will falter when we, as we do in the Eurozone, continue to depress households and consumer demand to serve the demands of creditors and banks. It would be good when the next Draghi speech is not based upon the defunct scribbling of the authors of the Eagle model but upon sound, scientific economics.