Do economists ever get it right?

There is one example when they did . . .

According to popular belief, economists rarely manage to predict correctly the consequences of important policy actions. Nevertheless, the case of the European Economic and Monetary Union (EMU) is one of those instances which economists did get it right.

Indeed, as far back as 1977, the MacDougall Report to the European Commission concluded that because the European Economic Community budget was very small, “… in present circumstances monetary union is impracticable.” Moreover, many economists on both sides of the Atlantic were cautioning against the planned single currency in the absence of a significant fiscal redistribution facility and/or the ability to run countercyclical fiscal policy.

Nevertheless, the political bandwagon prevailed, and the Delors Report threw caution to the wind and assumed that EMU could proceed without significant increases in the size of the EU budget, which was hovering around 1% of GDP (the 1977 Report was deeming it as necessary that the federal budget be as large as 10% of GDP). The only “concession” to economists’ concerns was the Maastricht Treaty rules imposing limits on government debts and deficits — as encapsulated in the Stability and Growth Pact (SGP).

However, the precedence given to moral-hazard considerations (and the defective way they were applied) over countercyclical fiscal policy — due to the fear that profligate governments would be too keen to run large budget deficits in recessions but very reluctant to run offsetting budget surpluses in booms — proved detrimental. Since the main focus of the SGP was on deficit limits, the resulting reduction (due to the euro) in real interest rates and concomitant boom experienced by some of the ‘periphery’ countries of the Eurozone made it very easy for governments to run (or to claim that they do) budget deficits below the 3% (of GDP) limit. Yet, this semblance of fiscal prudence — when in fact governments should be running budget surpluses — undermined their ability to conduct appropriately expansionary fiscal policy, when the boom ended, without running excessively large budget deficits.

To a large extent the semblance of fiscal prudence was aided by the very large current account deficits which some of the periphery countries were allowed to run during the Euro’s first decade. Although this appears to run counter to the well-known “twin deficits hypothesis” (i.e. that a larger budget deficit leads to a larger current account deficit), the experience of the periphery countries suggests that it is possible the direction of causality to be from a larger current account deficit to a smaller budget deficit.

For the periphery countries, EMU participation facilitated international borrowing at lower interest rates, allowing for a huge deterioration in the current account while the budget deficit improved. The reason is that imports, which become possible through international borrowing, need not fully displace spending on domestically produced goods (they may even increase it!). Moreover, they can create a revenue boon for the government. For example, car imports generate immediate tax revenue (VAT, registration taxes, etc.). They also allow for increases in domestic value added (e.g. services related to sales, advertising, and repairs of automobiles), thus allowing for second-round increases in income tax revenue. In the same vein, foreign loans (intermediated through the domestic banking sector) allowed for housing booms and created unsustainable increases in tax revenue.

The upshot of the above is that cynical governments may “achieve” a seemingly strict adherence to the SGP limits on budget deficits (they may even run budget surpluses as Spain and Ireland did), for some years, by running current account deficits; however, once foreign capital dries out the lack of fiscal space for countercyclical fiscal policy becomes evident. With the benefit of hindsight we know that the SGP provided the wrong signals about the exercise of countercyclical fiscal policy. It also failed to provide a replacement for the lack of market discipline. The moral is that the warnings of economists about the ability of the SGP to provide a framework for “monetary and fiscal stability” should have been heeded.

George Economides and Thomas Moutos, Guest Editors of the CESifo Economic Studies Special Issue on ‘EMU: The Way Forward’, are Professors of Economics in the Department of International and European Economic Studies, Athens University of Economics and Business, and CESifo Research Fellows.

CESifo Economic Studies publishes provocative, high-quality papers in economics, with a particular focus on policy issues. Papers by leading academics are written for a wide and global audience, including those in government, business, and academia. The journal combines theory and empirical research in a style accessible to economists across all specialisations.

This article first appeared on blog.oup.com, and is republished here with permission

A statue outside the European Commission. Photo: Getty
George Economides and Thomas Moutos, Guest Editors of the CESifo Economic Studies Special Issue on ‘EMU: The Way Forward’, are Professors of Economics in the Department of International and European Economic Studies, Athens University of Economics and Business, and CESifo Research Fellows.
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Russian pools, despatches from the Pole, and disagreeing with my son Boris on Brexit

My week, from Moscow to Westminster Hour.

With the weather in Moscow last week warm, if not balmy, I thought about taking a dip in the vast heated open-air swimming pool that I remembered from a previous visit. My Russian host shook his head. “That would have been the great Moskva Pool. Stalin actually tore down the Cathedral of Christ the Saviour to make way for it. But, after perestroika, they filled in the pool and rebuilt the church!” So I didn’t have my open-air swim, though I did visit the cathedral instead.

In the evening, spiritually if not physically refreshed, I addressed a gathering of Russian businessmen and bankers who were keen to learn what impact Brexit might have on the London property and investment scene, the UK being a prime destination for their money. We met in the old Ukraina Hotel, now splendidly refurbished and relaunched as the Radisson Royal, Moscow. A Rolls-Royce Silver Wraith was parked in the foyer, a snip at £150,000. “There is a great democratic debate going on in Britain at the moment,” I told my audience. “The issues are finely balanced. I’m for staying in. But on 23 June, the British people, not the politicians, not the tycoons, nor the lobbyists, will decide.”

I noted some uneasy laughter at this point. Russia’s fledgling democracy probably still has some way to go before matters of such moment are left to the people.

 

Culture club

I spent the next afternoon in the Tretyakov Gallery. A rich businessman, Pavel Tretyakov, collected thousands of items of Russian art (mainly icons and paintings) and donated both them and his magnificent house to the state in 1892. Over time, the state has added many more artefacts, including some from the vast storerooms of the Hermitage Museum in St Petersburg.

My guide, Tatiana Gubanova, a senior curator, had recently organised the loan of several items from the Tretyakov to London’s National Portrait Gallery, where they are currently still on display in the splendid “Russia and the Arts” exhibition. She said that she was looking forward to returning to London next year: “The Royal Academy is planning a special exhibition to celebrate the 100th anniversary of the Russian Revolution.” Whatever happens at the political level, it is good to know that our cultural links with Russia are still flourishing.

 

Heading south

Just before I left for Moscow, I attended ­Adrian Camrose’s funeral in St Bride’s Church, off Fleet Street. The scion of a great newspaper family, Adrian made his mark as the Daily Telegraph’s science correspondent.

In early 1984, I went to Antarctica with him. We shared a cabin on a British Antarctic Survey ship while it visited research ­stations “down south”. I was writing a book on Antarctica, subtitled “the Last Great Wilderness”, while Adrian sent a series of crisp despatches to the Telegraph via the ship’s radio-telex. Adrian’s dateline was “On board the John Biscoe, Antarctica”. Distant galaxies were Adrian’s consuming passion. I am sure he is filing stories from the spaceship Spacey McSpaceFace even as I write.

 

Green surge

As co-chairman with Baroness (Barbara) Young of Environmentalists for Europe, my life has been fairly hectic recently. I am sure it will get more so as the referendum day approaches. I know perfectly well that one of the reasons the invitations to speak or write articles ping into my inbox is the titillation factor. Are Families Divided on the Referendum? Is “Boris’s Dad” (that’s me!) going to Disagree with Boris?

Notwithstanding the family relationship, which I deeply treasure, the answer is “yes”. I am going to disagree. Boris and Michael Gove and other key members of the Brexit team have injected a wonderful level of vigour and energy into the referendum debate. They have raised issues, besides the economy, which needed to be discussed, particularly sovereignty, immigration and the EU’s general direction of travel. For this, the nation owes them a debt of gratitude. That said, I am convinced that this is not the moment to call time on the UK’s membership of the EU. As I see it, the best way to address the obvious problems is not to leave the EU but to “Remain” and to fight for change from within. In the end, this will benefit not just the UK but Europe as a whole.

 

Quiet no more

Last Sunday evening, I took part in the BBC Radio 4 programme Westminster Hour. My fellow panellists were the former work and pensions secretary Iain Duncan Smith and Baroness Smith of Basildon, formerly Angela Smith MP, now the shadow leader of the House of Lords.

We had a very lively and sometimes rowdy discussion. IDS is the “quiet man” who, since his resignation from the cabinet a couple of months ago, has regained his voice in no uncertain terms. Baroness Smith, a delightfully unpushy lady, sometimes found it difficult to get a word in edgeways. I don’t think I did so well myself.

But I did, I hope, make it clear that, from my point of view, there was still time to build on all that was good in the EU (such as its environmental record), while seeking common rather than unilateral solutions for the problems that persist.

On 24 June, if the Remain side wins, the government should go into action in Europe with all cylinders firing and with our politicians and diplomats working overtime, to get the arrangements that we need and deserve. On the way out, IDS said to me, “It won’t work. They won’t have it.”

He may be right. But I still think we should give it a go. You don’t file for divorce as a result of a single tiff, not after more than 40 years of marriage.

On the issues of immigration, for example, and possible changes to the EU’s freedom of movement rules, we may find more allies in Europe than we think.

Stanley Johnson is co-chairman of Environmentalists for Europe: environmentalistsforeurope.org

Stanley Johnson is an author, journalist and former Conservative member of the European Parliament. He has also worked in the European Commission. In 1984 Stanley was awarded the Greenpeace Prize for Outstanding Services to the Environment and in the same year the RSPCA Richard Martin award for services to animal welfare. In 1962 he won the Newdigate Prize for Poetry. He also happens to be the father of Boris Johnson.

This article first appeared in the 26 May 2016 issue of the New Statesman, The Brexit odd squad