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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How Theresa May laid a trap for herself on the immigration target

When Home Secretary, she insisted on keeping foreign students in the figures – causing a headache for herself today.

When Home Secretary, Theresa May insisted that foreign students should continue to be counted in the overall immigration figures. Some cabinet colleagues, including then Business Secretary Vince Cable and Chancellor George Osborne wanted to reverse this. It was economically illiterate. Current ministers, like the Foreign Secretary Boris Johnson, Chancellor Philip Hammond and Home Secretary Amber Rudd, also want foreign students exempted from the total.

David Cameron’s government aimed to cut immigration figures – including overseas students in that aim meant trying to limit one of the UK’s crucial financial resources. They are worth £25bn to the UK economy, and their fees make up 14 per cent of total university income. And the impact is not just financial – welcoming foreign students is diplomatically and culturally key to Britain’s reputation and its relationship with the rest of the world too. Even more important now Brexit is on its way.

But they stayed in the figures – a situation that, along with counterproductive visa restrictions also introduced by May’s old department, put a lot of foreign students off studying here. For example, there has been a 44 per cent decrease in the number of Indian students coming to Britain to study in the last five years.

Now May’s stubbornness on the migration figures appears to have caught up with her. The Times has revealed that the Prime Minister is ready to “soften her longstanding opposition to taking foreign students out of immigration totals”. It reports that she will offer to change the way the numbers are calculated.

Why the u-turn? No 10 says the concession is to ensure the Higher and Research Bill, key university legislation, can pass due to a Lords amendment urging the government not to count students as “long-term migrants” for “public policy purposes”.

But it will also be a factor in May’s manifesto pledge (and continuation of Cameron’s promise) to cut immigration to the “tens of thousands”. Until today, ministers had been unclear about whether this would be in the manifesto.

Now her u-turn on student figures is being seized upon by opposition parties as “massaging” the migration figures to meet her target. An accusation for which May only has herself, and her steadfast politicising of immigration, to blame.

Anoosh Chakelian is senior writer at the New Statesman.

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