Interview with Paul de Grauwe

This is the first part of a series I am trying to develop, aimed at audio-visual interviews with leading scholars, experts and commentators in political economy. The motivation is to open up the analytic space in political economy, and challenge the orthodoxy that governs contemporary public policy. Prof Paul de Grauwe is the leading expert on the economics of the monetary union, and a regular contributor to the Financial Times. This interview took place prior to a public lecture in Amsterdam last week and the core theme is that “macroeconomics is in deep trouble”.

You are very critical of the ECB at the moment. Why are the ECB not directly intervening in sovereign bond markets?

There are several reasons. One is German opposition. Germans just don’t want to have it. Your question then, might be, is why do the Germans not want it? Here it is a combination of different things. First, a basic misunderstanding that has not been explained to the Germans. The basic misunderstanding is they think this is just a case of creating money that will lead to inflation. This has a strong emotional content, an element of ‘just rejection’, it is something ‘bad’, it is very much emotional, linked to history, which makes people very upset. From my experience it is very difficult to talk to Germans about this, even German economists. That is one of the reasons.

The other reasons is moral hazard, there is a fear that if the ECB does intervene in bond markets, it will give a license to governments to go on creating deficits and debt. Here, of course, there is a serious problem, but it is no different from the moral hazard you create when you give money to the banks.  It is the same, maybe even worse. But this seems to be acceptable. It is quite irrational: it is ok to do it with banks but not government bond markets? So these are the reasons. It has become laden politically and emotionally, that it is very difficult to do it.

What is the implication for the politics of adjustment?

Now that the ECB does it all indirectly through the banking system it has to create much more liquidity than it would otherwise had to do, because banks don’t use all the cash that is created to invest in government bonds. Another problem  is that you delegate the entire responsibility to stabilize government bond markets to banks, who themselves are subject to fear, and who may not have the general interest at the back of their mind. It is better for the central bank to take on this role. It is also much more efficient way to do it.

Will the fiscal compact improve economic governance in the Eurozone?

 I am not very much in favor of this, as it has so little to do with the causes of the crisis. But, again, it is necessary for the German chancellor, to be sell the other pieces of what she has been doing. It is not that much different from what is contained in the stability pact. This also says that you should maintain equilibrium over the business cycle. This is what the compact says but it specifies the ‘structural’ budget which should be in ‘equilibrium’, over the business cycle. From a practical point of view it doesn’t make much difference. But what it will do is lead to interminable discussions about ‘structural budgets’, there is nothing more imprecise. It will lead to discussions, disagreements. I mean, I have worked with these measures, in a few seconds I can produce very different structural budgets, very very different, just by statistical tricks. And the kind of smoothing you can apply to the numbers, there are parameters you can change in one click. It is ridiculous. It will not work.

In Ireland there seems to be a general consensus amongst economists that the fiscal compact is to be accepted. Critics would say it makes Keynesianism illegal?

Maybe that is a little bit too far. It is all in terms of structural budgets. If you apply it well, and that is the whole problem, you allow budget deficits during a recession, provided you have surpluses during a boom. The problem is that the cycles are not smooth. We don’t know. For example, let’s take 2008-2009, the downturn, I can produce numbers that say it is all cyclical, some would say, ‘no it is a structural change’.  As a result, it will be difficult to apply. It simply will not work. It is such a waste of time and energy, that will lead to endless discussions that are counter-productive.

But of course, I agree with you, there is a more fundamental problem here. It is very much based on the view that all of what government’s do is unproductive. Therefore, the debt-GDP ratio should go to zero, that is what is implicit in a balanced budget over the long run. This doesn’t make sense. Why should governments not have debt, like private companies, if they do useful things, spread the cost over many years? There is nothing wrong with this. The problem is unsustainable debt. But there is so much cynicism these days about what governments do.

So, it is really about ideas?

Yeah, it is a really bad idea. It is going back 100 years in economic thinking.

Do you think Ireland will default?

I don’t think so. I don’t think Ireland will default. I think Ireland is a solvent country but has been pushed into a corner by the markets. Instead of providing more financial help that could have alleviated the problem, other countries have not been willing to do that sufficiently, and therefore has made things worse for Ireland.

But given the level of debt involved, do you think Ireland can get out of the crisis without restructuring at least some of it?

Yeah, why not. What is the debt-GDP ratio now?

Just under 130 percent

That is the level Italy has reached and should be able to stabilize this. Let’s not forget that after world war two, the debt to GDP ratio of the UK was more than 200 percent. They got out of this. Now of course there is the added difficulty that you are part of the monetary union, and you cannot do the same thing, like devalue your currency and all that. It is not going to be easy but I think it is possible.

On the design of the monetary union, would it be fair to say that given the monetary constraints of the EMU, the politics adjustment has to fall on wages and the labour market?

(Phone rings). Excuse me.

Will this focus on labour market flexibility work?

It puts a lot of pressure on labour market flexibility and I have mixed feelings about this. Of course, flexibility is ok, but sometimes flexibility is not ok. In particular, I like to make a distinction between shocks that are permanent and shocks that are cyclical. If you have permanent shocks, like competitiveness, then you need flexibility in the labour market. But if you have cyclical shocks, then flexibility is a bad idea. Then you better don’t have flexibility. In a demand shock, like the recession now, having flexibility in the labour market means reducing wages, which means people earning less, and making the recession worse. So one must distinguish between different types of shocks. Unfortunately, the thinking has been in such a one dimensional way, that assumes for any shock we need more flexibility. I am saying, no, not necessarily. It all depends, we have to be much more sophisticated. Sometimes you are wrong to have too much flexibility.

Look at Spain. Now that there is a deep recession they are changing the law to make it easier to fire workers. You may say in the long run, structurally, it is a good thing to do,  because there will be more hiring. But when you do it in the middle of a recession there will only be firing and no hiring. As a result, unemployment increases and the recession gets worse. We should be very careful with these things.

What is driving this emphasis on labour market de-regulation and flexibilisation?

It is a particular paradigm. It is also very much driven by academic theories. The theory of optimal currency areas, as you know, says that when you have asymmetric shocks you need flexibility to deal with it. What is flexibility? Well, labour market flexibility, wages, mobility and all that. That has been quite influential I must say, that is now the paradigm.

So it all comes back to ideas? Would it be fair to say that economics is in crisis?

Macroeconomics is in deep trouble. It has been based on a very narrow view of human behavior and not taking into account the problems that exist at a macro level. The paradigm of macroeconomics has become a paradigm of individual atomistic behavior, of representative agents that optimize plans over their lifetime, and are perfectly informed. That is so useless. Most of the problems we have now is a reflection of the reality that people were not informed, did not understand, did not understand the nature of the rules. There was a divergence in beliefs. As a result you get a totally different dynamic from what these models are predicting.

As a result macroeconomics has been totally useless. Modern macroeconomics that is. The paradox is that when the crisis erupted, modern macro-economists had nothing to say. They were saying consumers are doing their utility maximization, in infinite horizons, nothing can go wrong in a model like this. They are all rational. So these guys couldn’t say anything. In fact their model had predicted that the crisis would not occur. Not only did their models not predict the crisis but much stronger than that, they predicted it could not occur at all!

You can’t ask these guys for advise when the crisis erupts. So you had to go back again to Keynes. It’s amazing, suddenly everybody went back again to Keynes, took out the old textbooks. Oh yeah, here, look at this, the ‘savings paradox’, ‘oh wow, never heard of this’. A savings paradox arises because of a coordination failure. In these economic models, coordination failures cannot occur, because it is on one agent. He coordinates everything himself. It is internal.

And it is these same models that are being used to form the strategic response to the crisis?

That is right, and they are still being taught. It is incredible that people continue to use these models that have been massively rejected. They even receive Nobel prices. Like last year, two guys who worked on this, received Nobel prices. I fail to understand this.

Where do you see Europe in five years’ time?

I don’t know, very difficult to say. I don’t know how we will get out of this, will we get out of this? I hope so. It seems to be a case of just muddling through, going from one crisis to another. We overcome one, and then there is another. I am just afraid that we will apply such deflationary policies that people will be disgusted by all of this, and want something else. But five years is too far into the future. I cannot make predictions because there is nothing to draw upon.

But does it ultimately come down to a choice between a breakup of the Euro or further integration?

Yes, that is my view. We have to make choices and we have to work toward further integration. But that is going to be very difficult. In this country (the Netherlands) people don’t want political integration, Germany the same, everywhere is the same. So, yes, hard choices will have to be made.

Thank you

It was a pleasure.

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