The Proposed European Balanced Budget Rules: “How to Create a Depression”

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In these days where conservative orthodoxy has gone so far to the extreme right, it is encouraging to see a prominent conservative economist point out what should be obvious:  that adoption of stringent fiscal rules for balanced budgets by Eurozone members, as are being emphatically pushed by Angela Merkel and other Eurozone leaders, could easily cause an economic contraction turn into an economic depression.

Professor Martin Feldstein of Harvard, a prominent establishment figure, has made this point in his posting yesterday on the Project Syndicate web-site here.  The argument is clear and easy to understand, and should be read in its entirety.  I have copied below some of the key sections.  And Professor Feldstein is not a liberal economist:  he was Chairman of the Council of Economic Advisers under President Reagan, was the long-time head of the National Bureau of Economic Research, and was a prominent adviser to President George W. Bush, including as a proponent of Bush’s plan to privatize Social Security.

While the point being made by Professor Feldstein should be obvious, it appears that Eurozone members will soon adopt such balanced budget rules, and some have already adopted variants.  Germany is pushing strongly, and the members are currently in no position to oppose what Germany wants.  Yet implementation of contractionary policies in an attempt to cut fiscal deficits caused by an economic contraction will put economies on a path to depression.  And similar rules are being pushed for the US by prominent Republicans and especially by Tea Party activists.

It is a formula for turning a downturn into a depression, as was done in the 1930s.

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How to Create a Depression

2012-01-16

European political leaders may be about to agree to a fiscal plan which, if implemented, could push Europe into a major depression.

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[With the adoption of the Euro] the only countercyclical policy available to France [or any Eurozone member] is fiscal: lower tax revenue and higher spending.

While that response implies a higher budget deficit, automatic fiscal stabilizers are particularly important now that the eurozone countries cannot use monetary policy to stabilize demand. Their lack of monetary tools, together with the absence of exchange-rate adjustment, might also justify some discretionary cyclical tax cuts and spending increases.

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The European Union’s summit in Brussels in early December was intended to prevent such debt accumulation in the future. The heads of member states’ governments agreed in principle to limit future fiscal deficits by seeking constitutional changes in their countries that would ensure balanced budgets.

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The most frightening recent development is a formal complaint by the European Central Bank that the proposed rules are not tough enough.  Jorg Asmussen, a key member of the ECB’s executive board, wrote to the negotiators that countries should be allowed to exceed the 0.5%-of-GDP limit for deficits only in times of “natural catastrophes and serious emergency situations” outside the control of governments.

If this language were adopted, it would eliminate automatic cyclical fiscal adjustments, which could easily lead to a downward spiral of demand and a serious depression.  If, for example, conditions in the rest of the world caused a decline in demand for French exports, output and employment in France would fall. That would reduce tax revenue and increase transfer payments, easily pushing the fiscal deficit over 0.5% of GDP.

If France must remove that cyclical deficit, it would have to raise taxes and cut spending. That would reduce demand even more, causing a further fall in revenue and a further increase in transfers – and thus a bigger fiscal deficit and calls for further fiscal tightening. It is not clear what would end this downward spiral of fiscal tightening and falling activity.

If implemented, this proposal could produce very high unemployment rates and no route to recovery – in short, a depression. …

Why Have Productivity and Profits Gone Up During Obama’s Term?

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In the post immediately preceding this one (see directly below, or here), I noted that a glance at the economic data makes clear that productivity and profitability have both increased under Obama.  Hence, the argument made by Mitt Romney and the other Republican candidates that onerous regulations imposed by Obama are the cause of disappointing job and output growth, is simply not correct.  If new regulations were such a problem, one would have expected productivity and especially profitability to have suffered, and yet both have improved.  Indeed, profitability has sky-rocketed.

For convenience, here is the basic graph again:

But this naturally then also raises the question of why productivity and especially profitability have gone up by so much under Obama.  Indeed, some might wonder whether Obama’s administration has deliberately favored profits at the expense of wages.

While a full analysis cannot be done here, I find no reason to jump to such a conclusion.  The path of profits is what one would expect over the last few years, with the sharp collapse in output at the end of the Bush Administration and then only a slow recovery with unemployment staying high.  There is the separate issue of the longer term trends, where profits have been growing as a share of National Income since about 1980 (for the last decade, see here, and for the underlying data and the longer term see the BEA data at here).  But the fluctuations over the last few years can be well understood in terms of the short term dynamics of the economic collapse and subsequent slow recovery.

Specifically, profits fell sharply in the economic downturn at the end of the Bush Administration, and started to to fall (per unit of production) as far back as 2006.  It is worth noting that housing prices peaked in the first half of 2006, and the economy began to slow after that.  A collapse in profits when the economy collapsed is as one would expect.

In response to the economic downturn, the Federal Reserve Board cut interest rates, ultimately to historically low levels of essentially zero for rates on risk-free assets.  Coupled with other aggressive Fed measures, as well as the TARP program to stabilize the banks (launched by Bush) and then the Obama stimulus program, the collapse was halted and the economy then started to grow in the middle of 2009.  Profitability then recovered.

The business response to the downturn was to lay off workers, as they always do in a downturn, and then later they invested in new machinery and equipment.  The investment was spurred in part by the low interest rates following from the Fed policies, and indeed the recovery in non-residential private fixed investment was surprisingly strong (see here).  Both these actions increased labor productivity, as shown in the diagram above.

But aggregate demand growth remained sluggish, despite the growth in private investment.   The downturn was due primarily to the bursting of the housing price bubble that the Bush Administration regulators had allowed to build up (or at least made no attempt to limit).  As housing prices collapsed, home owners became poorer and many ended up with mortgages that were larger than the now lower values of their homes.  Stock prices also fell, hurting retirement and savings accounts.  Coupled also with worries generated by high unemployment, households hunkered down to consume less and try to save more.  Private consumption stagnated.  And after the Obama stimulus plan was passed (helping to stop the free-fall in output and to turn around the economy), political pressures from the Republican Party and especially the Tea Party wing made it impossible for government to maintain a high enough demand to fill in the still large gap in aggregate national demand.

As a consequence, the recovery in growth was limited and unemployment has stayed high.    This has kept wages largely flat.  But labor productivity rose due to the large early lay-offs and later the growth in business investment.  With wages flat but labor productivity higher, unit labor costs fell.

In addition, there are non-labor costs (not shown in the diagram) which also fell.  The main component of such costs that fell was interest payments, which the Fed reduced to the maximum extent it could to try to spur the economy.

With both unit labor costs and non-labor costs down, profits rose and rose sharply.

Regulations Under Obama Cannot Be Blamed: Productivity and Profits Have Gone Up

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The Republican Presidential candidates, and especially Mitt Romney, have repeatedly asserted that burdensome regulations imposed by the Obama Administration are to blame for the disappointing performance of the economy during the recovery, and especially the disappointing job performance.  The evidence points to the opposite:  productivity has in fact performed quite well and profitability has sky-rocketed.  If regulations were a problem, one would have expected productivity to have declined and profitability to have suffered, and they haven’t.

The disappointing performance of the economy in recent years can rather be attributed to slow growth in aggregate demand.  Households have had to scale back consumption after the housing bubble burst, while conservative fiscal policies forced by a Republican Congress have not allowed government expenditures to fill in the resulting gap.

The chart above shows how labor productivity, unit labor costs, and unit profits have performed in recent years (for non-financial corporations), each indexed so that the 2005 average equals 100.  Labor productivity (in green in the chart) is the amount of output produced per unit of labor.  It was basically flat prior to Obama taking office, rising by just 2.2% total in those four years, but then jumped by 8.6% total in the subsequent 2 1/2 years.  If regulations imposed by Obama were a major hindrance, productivity would not have gone up like this.

But while labor productivity improved, labor compensation (not shown in the chart to reduce clutter) was basically flat.  Indeed, hourly wages in real terms have declined slightly since Obama took office (by 0.8% total).  This is consistent with a slack labor market, with high unemployment depressing wages.  With higher productivity and wages not increasing, the result was falling unit labor costs (labor costs per unit of output), as shown in blue in the chart.

What did shoot up after Obama took office was unit profits (profits per unit of output, in red in the chart).  This is much more volatile, but it is interesting to note that it peaked in the third quarter of 2006 and then fell sharply well before Obama took office.  If someone is to be “blamed” for this, it would have to be Bush.  Unit profits then reached its low point in the second quarter of 2009, as the recession came to an end, and then skyrocketed by over 75% up to the third quarter of 2011 (the most recent data available).  This is of course all consistent with what has been observed at the level of the aggregate National Income accounts, which was reviewed in an earlier post (see here) on this blog.

Mitt Romney and the other Republican candidates assert that burdensome regulations under Obama have stifled the ability of business to make a profit, and with that, businesses have been unwilling to employ more workers.  But productivity has improved and profitability has soared.  The evidence simply does not support their assertions.