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Issue 8/6 May 2009

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Today’s Issue Includes:

1) What’s happening in the EU? By Nigel Tree

nigelcropforezineThe forecasts for GDP are worsening
The European Commission (EC) has just forecast that the EU economies will contract by 4% in 2009 after growing by 0.8% in 2008. This is a downward revision from January when the forecast contraction was only 2% for this year. How many more revisions will there be?

According to Joaquin Almunia, the EU Economic and Monetary Affairs Commissioner: “The European economy is in the midst of its deepest and most widespread recession in the post-war era. But, he went on to say that, “…the ambitious measures taken by governments and central banks in these exceptional circumstances are expected to put a floor under the fall in economic activity this year and enable a recovery next year.”

The European Commission expects growth to resume before the end of this year although it still has a forecast for 2010 of -0.1% growth overall. But can we trust the figures? The International Monetary Fund believes that growth in the 16 eurozone countries will fall by 4.2% this year, whilst the latest figure for the European Central Bank is a contraction of 3.8%.

What about the UK? The EC has changed its mind about the severity of the UK recession and now expects that GDP will contract by 3.8% this year, followed by a growth of 0.1% in 2010. However, this is a lower forecast than the recent one made in the UK budget of 3.5%. If the UK forecast is too ‘generous’ it will have severe implications for government borrowing, spending and debt this year.

However, the UK does seem to be performing better than the EU average. In fact, some EU countries which are strongly export-oriented have been particularly hard hit by the collapse in global demand for manufactured goods. In fact, the German economy is expected to contract by 5.3% this year, whilst Ireland, Lithuania, Estonia and Latvia will all see falls of around 10% of GDP.eu_flags_400

Unemployment problems
The EC forecasts that unemployment will contract by 2.5% in both the EU and euro area this year, and that there will be a further fall in 2010 of 1.5%. They expect employment to fall by over 8.5m during this forecast period, which contrasts with the net job creation of 9.5m during 2006-2008.

Overall, the unemployment rate is expected to increase close to 11% in the EU by 2010 and 11.5% in the euro area. However, there are wide variations in unemployment between EU states.

At one extreme there is the Netherlands with an unemployment rate of 2.8% at the moment. On the other hand, Lithuania and Latvia both show current rates of 15-16% and Spain has an unemployment rate of 17.4%. There is an even greater contrast when we look at the youth unemployment rates (under-25s) which vary from 5.7% in the Netherlands to no less than 35.4% in Spain.

Public finances hit
The budget deficit is set to more than double this year in the EU to 6% of GDP, which is up from 2.3% in 2008, and will further weaken to over 7% in 2010. Overall, gross debt is expected to increase from 61.5% to 7.2.5% of GDP this year, and to rise to 79.5% next year. The euro area will fare worse, with gross debt rising to 84% next year.

The EC forecast is that Britain’s underlying government deficit will be equal worst in the EU by 2010.

In an article published yesterday by Simon Tilford, chief economist at the Centre for European Reform, he asks: Are the British the new French? He looks particularly at the recent increase in the size of the state in Britain. He says: “The figures are arresting. Britain has gone from having one of the smallest states in the EU to one of the largest. In 2000, public spending accounted for 37% of GDP in the UK, just three percentage points above the US and a full 15 percentage points below France. By 2010 the OECD estimates that state spending will account for 49% of GDP in Britain, against 53% in France.” He also claims that “Most of the money has gone on increased employment and wages, rather than improvements in services.” To access the full article click here.

Has Britain been fortunate to be outside the eurozone?
It seems as though the US and UK economies will recover faster than many economies in the eurozone. So, does some of the blame for this lie with the European Central Bank (ECB), which is responsible for monetary policy within the euro area.

We will see tomorrow whether the ECB makes a further cut in interest rates. Some commentators expect a reduction of 0.25 percentage points, down to 1%. However, the criticism is that the US and UK cut interest rates earlier and steeper than the ECB, and that this has hindered eurozone recovery. In fact, can the one-size-fits-all eurozone policy measures successfully deal with such a variety of countries in different circumstances. We have already seen the extremes in unemployment in the Netherlands and Spain, and the severe effect on the German economy of the manufacturing downturn.

One problem is that the ECB has allowed a strong euro which has worsened export sales, whilst the UK has seen sterling fall by around 25% during the past 12 months. Some also argue that the ECB is obsessed with controlling inflation, when this is now down to 0.6% compared to the target of “below but close” to 2%. The ECB has also shown concern about its independence and stuck to its monetary policy remit. This means that it has refused to buy government debt as it feels that this would overstep its monetary duties and move into the realms of fiscal policy.
With the worsening levels of unemployment in the eurozone we may yet see a “summer of discontent”.

On balance, the Bank of England may have served us better than would have been the case if the UK had been hostage to the decisions of the ECB within the eurozone.

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2) The fiscal stimulus debate: “Bone-headed” and “Neanderthal”?
By Volker Wieland, Professor for Monetary theory and Policy in the House of Finance at Goethe University of Frankfurt and Director of the Center for Financial Studies

volker-wielandUS economic advisers called for aggressive fiscal stimulus, and some support further measures. But many macroeconomists are not so sure. This column analyses fiscal stimulus using a New Keynesian model that exemplifies contemporary academic thinking on the subject. It says that the spending multiplier is much lower than the Obama administration’s estimates – government spending may quickly crowd out private consumption and investment.

Not long ago, Paul Krugman warned European governments that

“We’re rapidly heading toward a world in which monetary policy has little or no traction, … Fiscal policy is all that’s left… if Germany prevents an effective European response, this adds significantly to the severity of the global downturn. … in short, there’s a huge multiplier effect at work; unfortunately, what it’s doing is multiplying the impact of the current German government’s boneheadedness.”

Financial Times columnist Martin Wolf, taking a look at the US and Japan (17 Feb 2009), asserted similarly

“The bad news is that the debate over fiscal policy in the US seems even more Neanderthal than in Japan: it cannot be stressed too strongly that in a balance-sheet deflation, with zero official interest rates, fiscal policy is all we have.”

This urgent, almost desperate call for aggressive fiscal stimulus was reinforced by the economic analysis of President Obama’s advisers Christina Romer and Jared Bernstein, which underscored the power of discretionary fiscal policy. In a paper circulated in January 2009, Romer and Bernstein provide numerical estimates of the impact of an increase in government spending on US GDP and employment. Such estimates are a crucial input for the policymaking process. They help determine the appropriate size and timing of countercyclical fiscal policy packages, and they inform parliaments and their constituents about whether a vote for a policy is appropriate.

Romer and Bernstein make use of two macroeconomic models – one from the staff of the Federal Reserve Board and the other from an unnamed private forecasting firm. Averaging the impacts obtained from these two models, they estimate that increasing government spending permanently by an amount equal to 1% of GDP would induce an increase in GDP of 1.6% above what it would have been otherwise. They conclude that a package similar in size to the American Recovery and Re-investment Act passed in February 2009 would raise GDP by 3% to 4% and create 3 to 4 million additional jobs by the end of 2010.

Stimulus doubts

Nevertheless, many macroeconomists still admit to substantial uncertainty about the quantitative effects of fiscal policy. This uncertainty derives not only from the empirical estimates of model parameters and shocks but also from different views on the appropriate theoretical framework and empirical method. In light of such model uncertainty, it is crucial to evaluate the robustness of particular policy proposals in different models with different assumptions. Cogan, Cwik, Taylor, and Wieland (2009) conduct such a robustness analysis with New Keynesian macroeconomic models. Nowadays such models are used by many central banks and international institutions. We report findings from two models, Taylor (1993) and Smets and Wouters (2007), but focus more on the latter model, which has been described as representative of the current New Keynesian macroeconomic thinking (see Woodford 2009).

Unfortunately, we find substantially smaller government spending multipliers than those used by Romer and Bernstein. For example, the multiplier associated with a permanent increase in government spending by the end of 2010 lies between 0.5 and 0.6. In other words, government spending does not induce additional private spending but instead quickly crowds out private consumption and investment.

We also provide an assessment of the impact of the American Recovery and Re-investment Act. This legislation implies measures amounting to $787 billion and spread over 2009 to 2013 but peaking in 2010. Our estimate of the total impact is closer to 1/6 of the effect estimated by Romer and Bernstein. By 2010 we project output to be about 0.65% higher. Using the same rule-of-thumb as Romer and Bernstein, this increase in GDP would translate to about 600,000 additional jobs rather than three to four million.
Why is our assessment of government spending multipliers so different? Well, first of all Romer and Bernstein constrain the Fed to keep interests rates constant at zero forever.

Such an interest rate peg would lead to explosive behaviour and instability in New Keynesian models. Instead we allow the Fed to raise rates eventually, starting in 2011, or more realistically, in 2010. Committing to 1 or 2 years of zero interest rates still implies much additional monetary stimulus. Furthermore, people out there worry about the future. Thus, the models we use take into account that forward-looking households and firms will modify their expectations and change their behaviour in response to the new fiscal policy measures.

Finally, at least some people out there realise that higher government spending and debt today ultimately require raising more taxes in the future. Such households will consume less today. This negative wealth effect is particularly strong in the Smets and Wouters analysis. The model by Taylor implicitly allows for the presence of some consumers who consume all of their current income.

Fiscal policy focus

In light of these findings, European policy makers are well-advised to question the usefulness of further stimulus packages. They ought to carefully monitor the impact of decisions already taken on the burden imposed on future taxpayers. The available funds and remaining borrowing capacity should be utilised where it is still most needed – to prevent a collapse of the financial system and finance the necessary re-capitalisations and toxic asset removals. If governments exhaust their fiscal space in measures that have little aggregate effect, they will instead stimulate scepticism of their capability to back up the financial system.

Thus, it remains crucial to focus fiscal efforts on the financial front.

What else can be done? Monetary policy is still an option. Sure, nominal interest rates cannot decline below zero. This is a serious constraint on conventional interest rate policy. However, monetary expansion remains feasible, and increasing the relative supply of base money to other assets will lower its value. In other words, the central bank can stimulate inflation and reduce real interest rates by means of quantitative easing if necessary (see Orphanides and Wieland 2000).


Cogan, John, Tobias, Cwik, John B. Taylor and Volker Wieland (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.

Orphanides and Wieland, (2000), Efficient Monetary Policy Design Near Price Stability, Journal of the Japanese and International Economies, 14, 327-365.

Romer, Christina and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan”, January 8, 2009.

Smets, Frank and Raf Wouters (2007), “Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach”, American Economic Review 97, 3: 506-606.

Taylor, John B. (1993), Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation, WW Norton, New York.

Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279.

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