Posted by: Dirk | November 12, 2008

Getting the European stimulus right

China has announced its fiscal stimulus, the US stimulus is under way, but nothing yet from the EU. Some national policies have been enacted, but nothing serious so far. Bloomberg reports:

A memo prepared for the French-led summit of EU leaders in Brussels underscored the need for “macroeconomic discipline,” bowing to resistance to a pump-priming program. The memo, proposing a European strategy to take to next week’s global economic crisis summit in Washington, endorses “macroeconomic policies that are sustainable and oriented toward stability.”

“Interest in a fiscal stimulus varies considerably from country to country,” Michael Mussa, former IMF chief economist, said in an interview from Washington. “Germany is not very enthusiastic.”

This is bad. Policy seems to be guided by dogma instead of pragmatism. The Stability and Growth Pact stands in the way of a serious fiscal stimulus. It should be possible to push the concern about deficit spending aside, since this is a once in a lifetime (hopefully!) crisis that needs solutions. Also, all this reminds me of Herbert Hoover, who increased taxes during the Great Depression in order to balance the budget. That was bad policy then and the mistake should not be repeated. It is time to take bold and decisive action now, otherwise the recession will be unnecessarily deep and long and may turn into something very nasty. How much should be done?

Paul Krugman did some wonkish stimulus math for the US, which might be worth repeating for the European Union. In order to do this, we have to determine the natural rate of unemployment. Using Okun’s Law, the employment gap can be translated into an output gap. The output gap can be measured in terms of GDP, and this gives us the size of the fiscal stimulus (after incorporating the multiplier, which is assumed to be 2). One problem arises: we have many economies with different output and employment gaps.

Let us focus on the euro zone. The ECB collects the euro area wide Industry Survey: Current level of capacity utilization. In times of boom, it stands between 84 and 85 percent. Since 1985 it dropped to 77 as a minimum. Now it stands just above 80. 80/85 is about .94, which would an output gap of 6% (Krugman finds an output gap of 7% for the US). This is a very rough calculation, of course. After incorporating the multiplicator of 2, we arrive at a stimulus roughly the size of 3% of euro zone GDP, which according to the ECB stands at around €8.143 trn., coming up with would be around €245 bn.

Now for the coordination part. Countries have to come up with their national stimulus numbers by calculating their share in the euro area economy. Germany makes up around a third of the euro zone economy, so the bill would be around €80 bn. Other countries would calculate their shares accordingly, maybe adjusting to national output and employment gaps.

Of course, this is a rough calculation and I would urge some more precise handling of the numbers before getting to work. However, there is a special problem that comes with euro. A fiscal stimulus is a very rough instrument. It will take time to be in effect, and it might be too much of a good thing, increasing demand too much and causing inflation. If that would happen, then the ECB would have to increase the interest rate.

However, the fiscal stimulus might affect the euro zone economies in different ways. Spain and Ireland, with their housing markets in shatters, might need a higher stimulus to begin with. It must be clear from the beginning that if the stimulus is too big, the ECB can hit the brakes only for all euro zone countries at the same time. On the other hand, a fiscal stimulus that fizzles out without any effect at all would be a great mistake. Then, it is better roughly right than precisely wrong. I would hence argue to have a significant fiscal stimulus.

UPDATE 14/11/2008: I have updated the above calculation by including the multiplier, which I forgot in my first calculation. Also, the Sachverständigenrat (the German council of economic advisers, which reports twice a year) published its own recommendations. Here is an abstract of the press release, in which they advise a fiscal stimulus of between 0.5 and 1.0 percent:

Angesichts der ausgeprägten realwirtschaftlichen Schwäche der deutschen Ökonomie ist die Finanzpolitik gefordert, eine konjunkturgerechte Wachstumspolitik einzuleiten, die gleichermaßen kurzfristig die Binnennachfrage stimuliert und das Produktionspotenzial erhöht. Aus diesem Grund rät der Sachverständigenrat dazu, im nächsten Jahr wachstumsfördernde Maßnahmen durch ein temporär höheres Defizit zu finanzieren. Dieses Wachstumspaket sollte in einer Größenordnung von etwa 0,5 vH bis 1 vH des Bruttoinlandsprodukts liegen.

Die Stabilisierung der Finanzmärkte und die Stärkung der Wachstumskräfte sind die derzeit vordringlichen Aufgaben. Sie dürfen allerdings nicht als Alibi dienen, in den Bemühungen nachzulassen, die Verzerrungen im Steuersystem abzubauen, die Sockelarbeitslosigkeit weiter zu senken und die Nachhaltigkeit der Sozialversicherungen zu gewährleisten.


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