Rethinking Global Economic Governance in Light of the Crisis New Perspectives on Economic Policy Foundations

Edited by Richard Baldwin and David Vines

Rethinking Global Economic

Governance in Light of the Crisis New Perspectives on Economic Policy Foundations

Global governance was, to put it charitably, one of the ‘steadier’ areas of economic research. Then the storm hit — the global crisis capsized existing concepts — pushing economists and political economists into uncharted waters.

For scholars, these horrible events were both daunting and exciting.

Cherished assumptions had to be binned, but global governance became a top-line issue for heads of state. Economic and political analysis of global governance really mattered.

This Report collects a dozen essays by world-class scholars on the full range of global governance issues including macroeconomics, fi nance, trade, and migration. These refl ect the research of nine research teams working in an EU-funded project known as PEGGED (Politics,

Economics and Global Governance: the European Dimensions). ^{sis: New P}

erspectives on Economic Policy Foundations

Rethinking Global

Economic Governance in Light of the Crisis

New Perspectives on Economic

Policy Foundations

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© Centre for Economic Policy Research, 2012 ISBN (print edition): 978-1-907142-52-9

Rethinking Global

Economic Governance in Light of the Crisis

New Perspectives on Economic Policy Foundations

Edited by Richard Baldwin and David Vines

This book is produced as part of the project ‘Politics, Economics and Global Governance:

The European Dimensions’ (PEGGED) funded by the Socio-Economic Sciences and Humanities theme of the European Commission’s 7th Framework Programme for

and Affiliates, based primarily in European Universities. The Centre coordinates the re- search activities of its Fellows and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a Euro- pean economics research organization with uniquely wide-ranging scope and activities.

The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions ex- pressed in this report are those of the authors and not those of the Centre for Economic Policy Research.

CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in England (No. 1727026).

Chair of the Board Guillermo de la Dehesa

President Richard Portes

Chief Executive Officer Stephen Yeo Research Director Lucrezia Reichlin

Policy Director Richard Baldwin

Contents

Foreword vii

Introduction 1

Richard Baldwin and David Vines

The governance of international macroeconomic relations

economic growth 17

David Vines

Fiscal consolidation and macroeconomic stabilisation 27 Giancarlo Corsetti

The Eurozone Crisis – April 2012 35

Richard Portes

The Triffin Dilemma and a multipolar international

reserve system 47

Richard Portes

Globalisation, financial stability, and global financial regulation

might return 57

Geoffrey Underhill

The crisis and the future of the banking industry 67 Xavier Freixas

Stijn Claessens

Cross-border banking in Europe: policy challenges in

turbulent times 85

Thorsten Beck

Credit default swaps in Europe 95

Richard Portes

Global banks, fiscal policy and international

business cycles 107

Robert Kollmann

The global trade regime

The Doha Round impasse 111

Simon J Evenett

The Future of the WTO 121

Richard Baldwin

Open to goods, closed to people? 135

Paola Conconi, Giovanni Facchini, Max F Steinhardt, and Maurizio Zanardi

International migration and the mobility of labour

The Recession and International Migration 143 Timothy J Hatton

A dangerous campaign: Why we shouldn’t risk the

Schengen-Agreement 157

Tito Boeri and Herbert Brücker

This report grows out of research carried out under the auspices of the project Politics, Economics and Global Governance: The European Dimensions (PEGGED) funded by the European Union’s Framework Programme. The project, as initially conceived, involved four workstreams: the governance of international macroeconomic relations;

globalization, financial stability and global financial regulation; the global trade regime;

and international migration and the mobility of labour.

This research agenda was conceived in the spring of 2007. Less than five years have passed since then, but the economic and political landscape has shifted enormously, and the early years of the millennium now seem rather distant and remote. Celebrations of the Great Moderation, arguments for the desirability of independent central banks and the virtues of markets and the discipline now seem not so much incorrect as somewhat beside the point.

Faced with this seismic shift, PEGGED responded in a sensible and pragmatic way, adapting its research agenda to the needs of policymakers as they grappled first with the turmoil in US subprime markets, then the growing disruption in global financial markets, and then the collapse of institutions at the heart of the financial system, such as AIG and Lehman. The output was disseminated through PEGGED working papers for the most part, but the urgency of the crisis and the need to deliver relevant research immediately to policymakers meant that new tools were needed. Fortunately, Richard Baldwin and CEPR had created just the right tool in the summer of 2007 – VoxEU.

VoxEU columns and eBooks proved to be the right way to deliver key research results in real time. Although VoxEU is a separate venture, independent of PEGGED, VoxEU has been supported by DG Education and Culture, a happy synergy between EU funding programmes.

Foreword

Richard Baldwin and David Vines have performed an important service by bringing together in this volume key results from each of the project’s four workstreams. Vines, a CEPR Research Fellow, has acted as Scientific Coordinator of the PEGGED project since its inception and has contributed in particular to the project’s work on international macroeconomic relations. Baldwin, CEPR’s Policy Director, has played an important role in PEGGED, leading its work on the global trade regime. Bringing together the results of an ambitious and wide ranging research project such as PEGGED is no easy task, and we are grateful to David and Richard for doing so.

Thanks are also due to Samantha Reid, who brought this volume to a publishable state with her customary speed and efficiency. Sam will be leaving CEPR at the end of this month. We will not be able to take advantage of her skills in future, but this volume is testimony to her skill and professionalism.

Stephen Yeo

CEO, Centre for Economic Policy Research 13 April 2012

A group of scholars banded together in 2007 to propose a four-year research on global governance – the Politics, Economics and Global Governance: the European Dimensions (PEGGED for short). While all the research was to be innovative and world-class, the project was most definitely sailing in familiar seas. Then the storm hit – the global crisis blew us off-course and into uncharted waters.

Born as the ‘subprime crisis’ in autumn 2007, the crisis metastasized in September 2008 via the financial system. Credit markets froze; equity prices plunged. Emergency measures by governments and central banks – loosely coordinated by the newly established G20 Leaders’ Summit – stabilised financial systems. A second Great Depression was avoided, but sharp credit contractions teamed up with precipitous declines in business and consumer confidence; the industrialised world was hurled into recession at an unexpected velocity. The shock transmitted to developing nations via trade and expectation channels again at an unparalleled pace. This was the Great Recession and the initial shock continues to reverberate – the Eurozone crisis is the latest ricochet. With its lethal combination of over-indebted governments, weak banking system, and a lack of consumer and investor confidence, the Eurozone crisis continues to threaten European and global economy with another massive shock. The global crisis is most definitely not over.

For a team of scholars, these horrible events were both daunting and exciting. Many of our initial assumptions had to be binned, but it made our work radically more relevant and pressing. For the first time in decades, global governance was at the top of the to- Richard Baldwin and David Vines

Graduate Institute, Geneva and CEPR; Balliol College, Oxford, Australian National University, CEPR, and PEGGED

Introduction

do lists of heads of state. Economic and political analysis of global governance really mattered.

While our work is far from over – the European perspective on global governance is still very much an ongoing effort – the funding and thus the formal project ends this year.

We are marking this with a final PEGGED conference in Brussels on 23 April 2012.

A new ‘Bretton Woods’ moment (in slow motion)

The pre-crisis global governance system, set up in the 1940s, came at lightning speed.

A few dozen meetings established: the UN to keep peace, the IMF to manage the international monetary system, the World Bank to foster development, and the GATT/

WTO to manage the global trade system. Today sees the world re-crafting this system in slow motion.

The longstanding partnership between the US and the EU and their joint dominance – the heart of the Bretton Woods governance system – are rapidly breaking down.

Emerging market economies are shifting economic realities, interdependencies, and power relationships. While long in train, such sea changes were accelerated by the impact of the global financial crisis – especially its asymmetric impact on long-term prospects. Since WWII, the economic prospects have never been dimmer for the rich nation, or brighter for developing nations. The emerging economies are back on track;

the industrialised nations are looking at a ‘lost decade’.

In this more complex, multipolar, world, the interests of new players need to be represented, and international cooperation must be organised in new ways. The economic impact of cross-border integration is coming to constrain national policy autonomy more than ever before.

Introduction

The PEGGED Research Programme

The PEGGED Research Programme has helped European policymakers to construct and project a vision for this new global system. Within the PEGGED Programme, political scientists and economists have worked together to develop workable, real- world policy solutions in four important areas of international cooperation. These four areas are:

• The governance of international macroeconomic relations

• Globalisation, financial stability, and global financial regulation

• The global trade regime

• International migration and the mobility of labour

Throughout its life, PEGGED has produced a number of working papers on each of these four topics. The Programme has also produced many policy publications on these topics, in the form of Policy Briefs, Papers, and Reports. These can all be found on http://pegged.cepr.org/. PEGGED has also held regular policy events in a number of places, including Amsterdam, Barcelona, Brussels, Florence, Geneva, London, Lisbon, Madrid, Oxford, Paris, Pisa, Rome, Tilburg, Tokyo, and Villars. Details of all of these meetings can also be found at http://pegged.cepr.org/.

In this introductory chapter we briefly describe the chapters included in this Report, grouping them by the four areas.

The governance of international macroeconomic relations

Global governance made remarkable progress with the establishment of the G20 Leaders’ Summit. The first cooperative steps – coordinated stimulus in reaction to the global crisis – were easy. Today, with monetary policy at its lower bound and fiscal policy at its upper bound in the advanced economies, global coordination is far more difficult. The chapter by David Vines outlines the main economic imbalances that require coordination: China must move towards a greater reliance on domestic demand;

the US must secure long-term fiscal consolidation; and Europe must embrace reforms that will allow southern Europe to grow. The world now needs a group of policymakers, from a number of countries, who act together so as to carry out the necessary policy adjustments. The G20 Mutual Assessment Process is a new framework in which these policymakers may well be able to do what is required.

Initial responses to the crisis led to the accumulation of a vast stock of public liabilities.

Since then, fiscal tightening has become the priority in advanced countries, and especially across Europe.In his chapter Giancarlo Corsetti asks whether governments should relent in their efforts to reduce deficits now, when the global economy is still weak, and policy credibility is far from guaranteed. He draws on two channels of recent research, which point in opposite directions. Recent work on the effects of fiscal contraction at the time of a liquidity trap suggests that multipliers may be large in these circumstances. Empirical evidence confirms this, especially at a times of recession in the presence of a banking and financial crisis. As a result, if monetary policy is constrained, there is little doubt that governments with strong credibility should abstain from immediate fiscal tightening, while committing to future deficit reduction.

However there is a difficulty in following this advice when the government is charged a sovereign-risk premium, since sovereign risk adversely affects borrowing conditions in the broader economy. That will cause fiscal multipliers to be much lower. And, due to the sovereign-risk channel, highly indebted economies can become vulnerable to a self-fulfilling economic downturn. This poses a dilemma for highly indebted countries:

they may be well-advised to tighten fiscal policies early, even if the effect of this will be to reduce activity. The presence of such a sovereign-risk channel provides a strong argument for focusing on ways to limit the transmission of sovereign risk into private- sector borrowing conditions. Recent unconventional steps by the ECB suggest that this is possible.

The Eurozone crisis of 2011–12 would have been much easier to contain and resolve had there been no global financial crisis, and no deep recession in the advanced countries. As a consequence, Richard Portes argues in his chapter that it is too facile to

Introduction

say that the Eurozone crisis is essentially due to inherent faults in the monetary union.

Nevertheless, the crisis has exposed genuine problems that were neither manifest nor life-threatening before 2008–09. They would not be remedied by exit of a few countries from monetary union, which would also be deeply harmful to those countries. The predicaments of the countries at the heart of the crisis (the GIPS – Greece, Ireland, Italy, Portugal, and Spain) are varied, and, he argues, are not primarily due to membership of the single currency, nor to fiscal profligacy (except Greece). It is also wrong to reduce the causes to inadequate ‘competitiveness’ that could be cured by currency devaluation.

Only from 2003–04 were these countries running large current-account deficits within the monetary union; and these were financed (some would argue caused) by equally large capital flows from the surplus countries. Germany played the same role in the Eurozone as China in the global economy. Unlike the US, however, the GIPS were not

‘free spenders’ – they saw a fall in consumption as a share of GDP and a rise in the investment share during 2000–07. And unlike China, the capital flows from Germany and France came primarily from banks – they were private not official flows. The macroeconomic problem in EMU now is the fiscal consequence of the financial crisis in bank-based financial systems. Creditor countries have been unwilling to let their banks suffer the consequences of bad loans – rather, they have managed to put the entire burden on the taxpayers of the debtor countries. This disregards the EU and Eurozone financial integration that policymakers have promoted. The longer-term refinancing operation (LTRO) was an inspired move to bypass German objections to the ECB taking on the lender of last resort (LLR) role. But it is a temporary expedient. The only stable solution is for the ECB to accept explicitly, in some form, the LLR role. To stop self-fulfilling confidence crises, the ECB should commit to cap yields paid by solvent countries with unlimited purchases in the secondary markets. Arbitrage will then bring primary issue yields down to the capped level. For the long run, debt sustainability requires economic growth. The current fiscal contraction is contractionary. Austerity policies are not the solution, but rather a major part of the problem. Moreover, fiscal contraction together with private-sector deleveraging is not feasible without a current account surplus. There will be no exit from the current debt traps and stagnation unless

the surplus countries accept that they must allow the others to run surpluses, so that either they relax fiscal policy or they adopt policies to reduce private net savings. And the overall position would improve if the euro were to depreciate significantly – another reason for further monetary easing.

A second chapter by Richard Portes concerns the Triffin Dilemma and its implications for moves, at present, towards a multipolar international reserve system. Robert Triffin set out his supposed dilemma for the international monetary system in the 1960s.

Meeting global demand for liquid reserves required continuously rising holdings of US dollars by other countries; but that would progressively undermine confidence in the dollar as a store of value. The contemporary version of this problem starts from the hypothesis that the global economy faces a shortage of reserve assets (‘safe assets’).

The empirical evidence cited is persistently low real interest rates. The supply of truly safe assets – US Treasuries – rests on the backing of the US ‘fiscal capacity’. But that grows only as US GDP grows, and US GDP grows slower than world GDP, which determines the growth of demand for those assets. Hence there must be a growing excess demand for safe assets, and we need to move to a multipolar reserve currency system in which other countries also provide safe assets. But the 1960s story was wrong, conceptually and empirically, in assuming the US would run current-account deficits in order to generate foreign dollar holdings; and now, real interest rates have not been historically low, nor is there a clear definition of fiscal capacity, nor is there a global liquidity shortage. The world will move towards a multipolar reserve system, but not because of the Triffin Dilemma. Official reserve holders want to diversify their portfolios, and the correction of global imbalances will promote this. The emerging- market countries will develop their domestic financial markets and will have less need for foreign financial intermediation. Some emerging-market countries may themselves become reserve suppliers. And more international facilities centred on the IMF could reduce the demand for reserves for self-insurance. Considering the Triffin Dilemma undoubtedly helps us to understand the forces underlying the development of the international financial system. But it is not the source of the system’s problems.

Introduction

Globalisation, financial stability, and global financial regulation

The global and Eurozone crises seem to have undermined, perhaps even destroyed, the traditional foundations for financial stability in the US and Europe. The chapter by Geoffrey Underhill focuses on recommendations for the provision of financial stability.

The three essential points are: First, there is little new here; the policy dilemmas of today are longstanding, well known, and can be informed by the host of historical experience and related research. Second, the potential and more obvious flaws of the pre-crisis system of financial governance were well known and debated pre-crisis but this did not prevent the crisis. Unfortunately, most reform proposals are based on such pre-crisis thinking and are therefore unlikely to achieve the reform goals. Worse, the Eurozone is descending into modes of crisis resolution that are known to be dysfunctional and destructive of successful economic growth and development. Third, reform that is more likely to provide financial stability for the long run requires new thinking. What Europe needs is new ‘ideational departures’ that draw on established historical experience.

This should include considerable institutional innovation, a reformed policy process, and institutionalised attention to the political legitimacy and long-run sustainability of financial openness. This new thinking is needed at both the global and EU levels.

The global economic crisis wreaked enormous social and economic cost on nations in Europe and beyond. It also shattered confidence in US and European banking systems.

The regulatory reform response has been aimed at curtailing the financial sector’s excessive appetite for risk. The chapter by Xaiver Frexias argues that for regulation to prevent future crises, we must understand the causes behind the excessive risk-taking in the first place. The first step is a working definition of excessive risk-taking. Drawing on recent research, the author defines it as a level of risk that corresponds to a negative net investment value. Obviously no well-run bank would knowingly engage in such projects so the question is: what went wrong to allow such investment? The chapter points to four possible answers. First managers’ incentives and corporate governance could have been wrong. Second, the business cycle risks might not have been properly

factored in (capital is excessively cheap and lending excessively permissive in upturns with the opposite holding in downturns). Third, regulatory supervision and market discipline could have failed to curb excesses in boom times. Finally, moral hazard could explain the problem, namely the idea that banks take too much risk in anticipation of being bailed out in the event of massive losses.

Massive support has been provided in the ongoing financial crisis to banks and other financial institutions including support for failed global systemically important financial institutions (G-SIFIs). Stijn Claessens argues that the ad hoc methods which have been adopted for this support have led to much turmoil in international financial markets and worsened the real economic and social consequences of the crisis. He argues that a better approach to dealing with G-SIFIs is sorely needed. To date, international efforts have focused on the harmonisation of the rules of supervision and on increasing supervisory cooperation. Instead, he argues that what is needed is an effective resolution regime, and that there are three reform models available. The first reform model is a territorial approach under which assets are ring-fenced so that they are first available for the resolution of local claims. The second reform model is a universal approach under which all global assets are shared equitably among creditors according to the legal priorities of the home country that can help address the global problem. He argues strongly that we will be driven towards a third intermediate approach, which combines aspects of the other two. As policymakers realise all too well, however, especially in Europe today, whatever approach is adopted to the resolution of G-SIFIs, there is a danger of conflict with three other policy objectives – preserving national autonomy, fostering cross-border banking, and maintaining global financial stability.

Turning to the banking system, Thorsten Beck points out that the Eurozone crisis is not only straining banks’ balance sheets, it is straining the cohesion of the EU’s single banking market. The key source of tension is the close interaction between national banks and their governments – both through banks’ holdings of their government’s bonds and the government’s implicit insurance of their banks. This tension raises fundamental questions about the need for greater institutional underpinnings. Indeed,

Introduction

rather than disentangling the sovereign debt and bank crises, recent policy decisions – such as the ECB’s LTROs – have tied the two closer together.

The problem, according to the author, is that Europe, and especially the Eurozone, did too little after the 2007–08 crisis to address the institutional gaps needed to ensure a stable banking market and manage the inter-linkages between monetary policy and financial stability. EU policymakers are facing the current crisis with too few policy tools and coordination mechanisms. What is needed is additional policy tools in the form of macroprudential financial regulation. One tool – monetary policy – is simply not enough to achieve asset price inflation and consumer price inflation, especially in a currency union where asset price cycles are not completely synchronised across countries. Such regulation would have to be applied on the national, but monitored on the European, level.

Beyond the lack of proper policy tools and mechanisms, the Eurozone faces a deeper crisis – that of a democratic deficit for the necessary reforms to make this monetary union sustainable in the long run. Political resistance in both core and periphery countries against austerity and bailouts illustrates this democratic deficit. In the long term, the Eurozone can only survive with the necessary high-level political reforms.

A further chapter by Richard Portes discusses credit default swaps (CDSs) which are derivatives; financial instruments sold over the counter. They transfer the credit risk associated with corporate or sovereign bonds to a third party. The outstanding gross notional positions in this market exceeded $60 trillion in early 2007 but have since fallen to a range of ‘only’ $15-20 trillion. The market first caught policymakers’

attention when AIG had to be bailed out because it had written huge amounts of CDS protection which it could not redeem; and in Europe when Greek sovereign CDS prices rose dramatically in spring 2010, apparently contributing to a self-fulfilling crisis, then when the authorities sought to avoid triggering CDS contracts on Greece in the eventuality of Greek debt default. Portes’ empirical work on Eurozone sovereign CDS prices during 2004–11 finds that for Eurozone sovereign debt, the CDS and cash market

prices are normally equal to each other in long-run equilibrium, as theory predicts. One interpretation is that the market prices credit risk correctly: sovereign CDS contracts written on Eurozone borrowers seem to provide new up-to-date information to the sovereign cash market. In the short run, however, the cash and synthetic markets price credit risk differently to various degrees. Second, the Eurozone CDS market seems to move ahead of the corresponding bond market in price adjustment, both before and during the crisis. And CDS contracts clearly do play a useful hedging role. An alternative interpretation of our results, however, is that the CDS market leads in price discovery because changes in CDS prices affect the fundamentals driving the prices of the underlying bonds. If the CDS spread affects the cost of funding of the sovereign (or corporate), then a rise in the spread will not merely signal but will cause a deterioration in credit quality, hence a fall in the bond price; and this mechanism could lead to a self- fulfilling vicious spiral. Recent theoretical work justifies such an interpretation and, in particular, attributes responsibility to ‘naked’ CDSs, bought by investors who do not hold the underlying bonds. Portes argues that naked CDSs are indeed destabilising, both for sovereigns and for financial institutions. The implication for policy is clear:

ban them.

The crisis – which started with the 2007 subprime crisis and exploded into a wider financial crisis in September 2008 – became the global crisis when it triggered the sharpest global recession since the 1930s. This chain of events revealed a major fragility in the global economy, but it also revealed a major hole in economists’ macroeconomic toolkit. Quite simply, this crisis could not happen in standard, pre-crisis macro theory.

The analytic framework just did not allow for financial intermediaries so macroeconomic shock could not emanate from the financial sector. Issues like bank balance sheets had been assumed away.

While filling this lacuna represents a challenge for economic research for years to come, Robert Kollmann describes several hole-filling elements in his PEGGED-sponsored research. He has focused on the role of global banks in business cycles in the EU and in the world economy. Banks that make loans across many nations but have their equity

Introduction

base in one connect the state of bank equity markets in one nation to lending and thus economic activity in many. For example, a loss on bank loans in one country reduces the global banking system’s capital which in turn triggers a global reduction in bank lending; a worldwide recession is the result.

The author points out that this economic logic provides a solid basis for policy. The key role of bank health for the overall economy suggests that government support for the banking system might be a powerful tool for stabilising real activity in a financial crisis.

The global trade regime

The chapter by Simon Evenett outlines the key factors responsible for the Doha Round impasse and argues that scholars ought to devote more attention to analysing such impasses. The emphasis here is not on the daily twists and turns of the Doha Round negotiations but on the underlying factors that have probably prevented WTO members from reaching a mutually acceptable deal.

The WTO is widely regarded as trapped in a deep malaise. Richard Baldwin argues that, in fact, the WTO is doing fine when it comes to the 20th century trade for which it was designed – goods made in one nation’s factories being sold to customers abroad.

But, he argues, the WTO’s woes stem from the emergence of ‘21st century trade’

(the complex cross-border flows arising from internationalised supply chains) and its demand for beyond-WTO disciplines. The WTO’s centrality has been undermined as such disciplines have emerged in regional trade agreements. The implication is clear.

Either the WTO remains relevant for 20th century trade and the basic rules of the road, but irrelevant for 21st century trade; all ‘next generation’ issues will be addressed elsewhere. Or the WTO engages in 21st century trade issues both by crafting new multilateral disciplines – or at least general guidelines – on matters such as investment assurances, and by multilateralising some of the new disciplines that have arisen in regional trade agreements. We are presented with a stark choice. The WTO can stay on the 20th century side-track on to which it has been shunted, or it can engage creatively

and constructively in the new range of disciplines necessary to underpin 21st century trade.

Trade policy poses tough questions for policymakers, but nothing like the problems arising from migration policy choices. Economists have a hard time explaining this as they typically work with analytic frameworks where trade and migration have quite similar economic effects. The chapter by Paola Conconi, Giovanni Facchini, Max Steinhardt, and Maurizio Zanardi discusses recent research that examines the similarities and differences in voting behaviour in the US Congress on the two issues.

What they find is that voting is influenced by the constituency’s skill mix (with the impact on trade and migration votes going in the same direction), and party affiliation leading to divergent voting patterns (Democrats voting in support of liberal immigration policies but against trade liberalisation). Additionally, the fiscal burden of immigrants for a constituency dampens the representative’s enthusiasm for liberal migration policies, but has no impact on trade. The ethnic composition of Congressional districts also matters with voting for immigration rising with the district’s share of foreign-born citizens. Taken together, the authors argue that these effects explain why legislators are more likely to support opening barriers to goods than to people.

International migration and the mobility of labour

Immigration policy is back in European headlines although perhaps not as much as one would expect given the dire economic straits in many European nations. The chapter by Tim Hatton admits that economists still do not fully understand how immigration policy evolves, or why it seems so different now than in the past. Current understanding is based on four factors. First, rising education levels have led to better informed attitudes towards immigration, especially as concerns competition of unskilled immigrants.

Second, concerns about the cost of the welfare state are counterbalanced by the way such safety nets ease worker-specific adjustments. Third, as international cooperation becomes more pressing on must-do issues like climate change and security issues,

Introduction

draconian immigration rules, which could potentially harm such cooperation, are less likely to be implemented. Nevertheless, such arguments remain speculative and must be subjected to more rigorous examination.

Playing politics with migration is dangerous but dangerously attractive in today’s climate of European malaise. The chapter by Tito Boeri and Herbert Brücker examines the case for more coordinated and forward-looking migration policies in Europe. The case rests on three key points. First, uncoordinated national policies are not the right way to govern migration in an area as economically integrated as Europe. Uncoordinated policies create prisoner’s dilemma situations with every member spending inefficiently large amounts on border controls, sub-optimal asylum and humanitarian policies, and inefficiently restrictive policies on illegal immigration. Second, the resulting zero immigration policy vis-à-vis northern Africa has backfired. Now migration is based on family reunification, humanitarian migration, and illegal migration. This means immigrants are, on average, less educated than economic migrants and natives, do not generally achieve native language proficiency, and typically have a poor performance in the labour market and education system of the host country. All this feeds back into negative perceptions thus making economic and social integration even more difficult.

Finally, the authors point out that today incomes in northern African are not much lower than those in central and eastern Europe at the time of the 2004 EU enlargement.

Moreover much of the north African youth urban labour force is, at least on paper, relatively well educated. The authors estimate that north African immigration could create EU economic gains that are larger than those experienced from east European migration last decade. The key would be to adopt more realistic restrictions vis-à-vis northern African countries. This skilled immigration would reduce pressures for illegal migration while creating substantial economic gains in both the receiving and sending regions.

Concluding remarks

Plainly more work is needed on this pressing set of issues. Global governance is a work in progress and scholars have an obligation to continue analysing and informing the choice governments are making on an almost daily basis. We hope that this collection of essays provides an accessible bridge to the academic work in the area as well as a stimulus to others scholars to take the research further and deeper.

5 April 2012

Introduction

About the authors

Richard Edward Baldwin is Professor of International Economics at the Graduate Institute, Geneva since 1991, Policy Director of CEPR since 2006, and Editor-in-Chief of VoxEU.org since he founded it in June 2007. He was Co-managing Editor of the journal Economic Policy from 2000 to 2005, and Programme Director of CEPR’s International Trade programme from 1991 to 2001. Before that he was a Senior Staff Economist for the President’s Council of Economic Advisors in the Bush Administration (1990–91), on leave from Columbia University Business School where he was Associate Professor.

He did his PhD in economics at MIT with Paul Krugman. He was visiting professor at MIT in 2002/03 and has taught at universities in Italy, Germany, and Norway. He has also worked as consultant for the numerous governments, the European Commission, OECD, World Bank, EFTA, and USAID. The author of numerous books and articles, his research interests include international trade, globalisation, regionalism, and European integration. He is a CEPR Research Fellow.

David Vines is Scientific Coordinator of the PEGGED Programme. He is Professor of Economics in the Economics Department, Oxford University, and a Fellow of Balliol College, Oxford as well as Director of the Centre for International Macroeconomics at Oxford’s Economics Department. Formerly a Houblon-Norman Senior Fellow at the Bank of England, he has advised a number of international organisations and governmental bodies. He has published numerous scholarly articles and several books, most recently The Asian Financial Crisis: Causes, Contagion and Consequences, with Pierre-Richard Agénor, Marcus Miller, and Axel Weber.

1 The global policy problem

It is clear that the world needs global rebalancing – at some stage the scale of international imbalances must be reduced. As is well known, two things are necessary for this rebalancing: changes in relative absorption between deficit and surplus countries in the world – including cuts in absorption in the deficit countries - and changes in relative prices between deficit and surplus countries.

But the world also needs to ensure that the recovery from the global financial crisis is sustained, ie it needs a satisfactory absolute level of global growth. There are significant global risks to this outcome:

• Continued deleveraging in many G20 countries;

• A rapid fiscal consolidation in many countries;

• The gradualness of the adjustment in East Asia;

• The macroeconomic outcome of the crisis in Europe.

Unemployment in the US, Europe, and elsewhere in the OECD remains disastrously high. To solve this unemployment problem will require a sustained global recovery. Yet financial markets, and policymakers, are now focused on reducing public deficits and debt. Temporary stimulus packages are unwinding, and fiscal consolidation is setting in. There is a danger that the attempts to rebalance – including the cuts of absorption in deficit countries – will add to the attempts to fiscally consolidate, add to the other risks, and put global growth prospects seriously at risk.

David Vines

Balliol College, Oxford, Australian National University, CEPR, and PEGGED

The G20MAP, global rebalancing,

and sustaining global economic

growth

In response to this danger, too many countries appear to be looking for export-led growth. But we cannot nearly all have export-led growth. There only a small number of countries with an appetite for exports. This is a systemic problem.

The G20 Mutual Assessment Process, or G20MAP, is a new global institutional structure forum in which this systemic problem is now being tackled.

2 The need for international macroeconomic cooperation

In the period after the Asia crisis there was high saving in emerging market economies (and elsewhere). East Asia set exchange rates to ensure export-led growth. The US Federal Reserve set US interest rates. The outcomes ensured satisfactory growth in both the US, and in other advanced countries, as well as in East Asia (Adam and Vines 2009). Because of high savings the real interest rate needed to be low. This system led to the Great Moderation – the ‘Greenspan put’ emerged as a part of what happened (as is well explained in an IMF Staff Note by Blanchard and Milesi Ferreti 2011).

• This system ensured satisfactory global growth;

• It did not require detailed international cooperation in policymaking (Vines 2011b);

but

• It gave rise to global imbalances.

For a time, these imbalances were not treated as a policy problem and removing them was not a target of international policy. Such a system – with its low interest rates – also led to high leverage, to financial instability, and ultimately to the global crisis (Obstfeld and Rogoff 2009).

Global cooperation in response to the crisis was initially easy; the outcome at the G20 summit in London in April 2009 was remarkable. But it was straightforward to bring about what happened. All countries had an interest in using monetary expansion, and then fiscal expansion, to avoid global collapse. And the costs of the resulting fiscal expansion – in the form of ballooning debt –– only gradually led to fiscal crises.

The G20MAP, global rebalancing, and sustaining global economic growth

The world is now in a more complex position that it was immediately after the crisis, and cooperation is now much more difficult. Interest rates are at their zero bound. And, because of the high levels of public debt, there is little fiscal space.

China is rebalancing its growth model towards one in which there is a more rapid expansion of domestic demand. But China is necessarily doing this at a slow speed (Yongding 2009). During this period of adjustment the dollar-renminbi real exchange rate will continue to be one which leads to East Asia having a large export surplus. At the same time, world interest rates are too low for China, which continues to attempt to deal with this difficulty with capital controls.

Europe is in danger of re-creating the global problem at the European level (Vines 2010, 2011a). Countries in the southern European periphery are now embarking on demanding austerity programmes. The difficulty of adjusting wages and prices in these countries of the periphery, which are greatly uncompetitive vis-à-vis Germany, creates a need for the euro to depreciate, so as to encourage growth in these countries. At the same time, the German economy is difficulty because European interest rates need to be low. The position in Germany would become even more unbalanced if the euro were to depreciate further.

And the US is caught in a fiscal trap. The inability of the US political system to promise longer-term fiscal correction has made it difficult to for the US to sustain its shorter-term fiscal stimulus. The resulting fiscal withdrawal is part of the reason why unemployment seems likely to remain so persistent in the US.

Many activities in the US are now globally uncompetitive because of the depreciated real exchange rates of China and of other East Asian countries. The outcome may well be one in which the US wishes to have a lower real exchange rate against not just East Asia, but against Europe as well. Quantitative easing has become a tool which influences the dollar in this direction. But many activities in the European periphery are also globally uncompetitive, because of the depreciated real exchange rate of Germany

within the euro – and also because of the depreciated real exchange rate of China and other East Asian countries.

All this means that Europe may wish to see the opposite outcome from that desired by the US – a lower real exchange rate for Europe against both the US and East Asia, in order for growth in the European periphery to resume. The LTRO of the ECB appears to be pushing the euro in such a direction. There is, in short, a genuine possibility of policy conflict over monetary policy, and exchange rates among China, the US and Europe.

Protectionism in trade is another possible response to this problem (Eichengreen and Irwin 2009). Plainly there is a pressing need for international macroeconomic policy cooperation.

3 The G20MAP and international macroeconomic cooperation

The G20MAP is in the process of producing a group of policymakers from G20 countries who come to share the ownership of an international cooperative process.

That is, it is creating policymakers who are concerned with the global problem (such as those mentioned above), rather than being concerned only with national objectives (IMF 2011a). The aim is to produce something much better than what was achieved in the IMF’s previous process of multilateral surveillance process, or MSP. The governance structure of the IMF meant that the US was able to ensure that the IMF made no criticism of the US as part of the MSP – and was able to ensure that the IMF did not exercise any sanction on the US – as a response its large current-account deficit. The Fund was also unable to exercise any sanction on China as a response to its undervalued exchange rate.

The G20MAP was established at the Pittsburgh G20 summit in 2009. G20 leaders then agreed that their aim would be to pursue growth collectively. At that meeting, and at the Seoul summit in 2010, there was an agreement that the objective was a ‘Framework for Strong Sustainable and Balanced Growth’ where ‘sustainable’ included the need

The G20MAP, global rebalancing, and sustaining global economic growth

for global rebalancing. Since then the G20MAP has gone through a number of stages, some of which are set out in IMF (2011a). It was decided at an early stage that the IMF would provide technical analysis to support the G20MAP.¹

Subsequently it was decided that the Fund would evaluate how members’ macroeconomic policies should fit together, providing an assessment of whether national policies, taken collectively, are likely to achieve the G20’s goals. Since then, during 2011, the IMF carried out a detailed investigation of the policies of a particular set of countries, rather than just concentrating broadly on the world, or on regions of the world. These countries were the US, China, Japan, Germany, India, the UK, and France. The decision as to which particular set of countries to investigate in detail was taken in April 2011, and depended on a chosen set of indicators. The choice of indicators attracted much attention at the time. But the most important thing about these indicators is that the use of them enabled a decision to be made as to which countries would be analysed in detail. That decision enabled the G20MAP to be given a much clearer focus. The analyses were published at the time of the Cannes G20 Summit in November 2011. The IMF also carried out an analysis of how the policy projections of the seven countries, and of the rest of the world, would fit together into an overall global outcome (IMF 2011b).

These analyses revealed the risks which have been described earlier in this essay. But, importantly, the IMF was able to identify a number of policy changes which would lead to a better outcome. These potential policy changes are now on the table for countries to examine, and respond to, as part of the G20MAP which is taking place in 2012.

The G20MAP is in its early days. Decisions on the possibilities identified by the IMF will not be immediate.

1 The Framework for Strong Sustainable and Balanced Growth is not just about achieving satisfactory macroeconomic outcomes; it is also concerned with achieving financial stability, with environmental issues, and with the raising of living standards in developing countries. The broader set of international discussions about that wider range of concerns is being assisted by technical inputs from a range of international institutions far beyond the IMF.

But what has happened already provides a number of useful insights.

• Coordination, of course, works best when countries share a common objective.

This was the case immediately after the crisis. But it has become less so, for reasons which will be obvious from the earlier part of this essay.

• What is often required for coordination is not so much an agreement to act in the pursuit of a shared objective but instead a clearer understanding of what other play- ers intend to do.

Such an understanding will make clearer for each player what that player needs to do. The G20MAP has engaged a number of international policymakers in a global policymaking process and seems likely to lead to greater understandings of this kind.

Progress of this kind will not, of course, be immediate, but it may be significant.

Such understandings are especially necessary if the processes of adjustment which are required will be a gradual. In that case each policymaker needs to be able to trust that other policymakers will carry out the adjustments which are required of them. I have described in this essay three kinds of policy adjustments which are necessary:

• That China moves towards a greater reliance on domestic demand;

• That the US moves towards longer-term fiscal consolidation; and

• That Europe moves towards reforms which enable southern Europe to begin to grow again.

All of these adjustments will be gradual, and all of them need to be carried out in a way which relies on other policymakers playing their part as well.

The world now needs a group of policymakers, from a number of countries, who act together so as to carry out the necessary policy adjustments. The G20MAP is in the process of creating a new global institutional structure, one in which these policymakers may well be able to do what is required.

The G20MAP, global rebalancing, and sustaining global economic growth

References

Adam, C, and D Vines (2009), “Remaking Macroeconomic Policy after the Global Financial Crisis: A Balance Sheet Approach”, Oxford Review of Economics Policy, December 25(4): 507–52.

Allsopp, C, and D Vines (2010), “Fiscal policy, intercountry adjustment, and the real exchange rate within Europe”, in Buti, M, S Deroose, V Gaspar, and J Nogueira Martins (eds), The Euro: The First Decade. Cambridge: Cambridge University Press.

Also available as European Economy. Economic Papers. No 344. October 2008. http://

ec.europa.eu/economy_finance/publications/.

Blanchard, O, and J Milesi Ferretti (2011), “(Why) should current account imbalances be reduced?” IMF Staff Note.

Eichengreen, B and D Irwin (2009), “The protectionist temptation: Lessons from the Great Depression for today” VoxEU.org, 17 March. Available at http://global-crisis- debate.com/index.php?q=node/3998.

House, B, D Vines, and M Corden (2008), “The IMF”, New Palgrave Dictionary of Economics, London: Macmillan.

IMF (2010), “Strategies for Fiscal Consolidation in the Post-Crisis World”, paper prepared by the Fiscal Affairs Department, and available at http://www.imf.org/

external/np/pp/eng/2010/020410a.pdf.

IMF (2011a) “The G-20 Mutual Assessment Process (MAP)”, an IMF Factsheet, available at http://www.imf.org/external/np/exr/facts/g20map.htm.

IMF (2011b), IMF Staff Reports for the G-20 Mutual Assessment Process, available at http://www.imf.org/external/np/g20/pdf/110411.pdf.

Obstfeld, M and K Rogoff (2009), “Global Imbalances and the Financial Crisis: Products of Common Causes”, available at http://elsa.berkeley.edu/~obstfeld/santabarbara.pdf.

Vines, D (2010), “Fiscal Policy in the Eurozone after the Crisis”, paper presented at a Macro Economy Research Conference on Fiscal Policy in the Post-Crisis World, held at the Hotel Okura, Tokyo, 16 November.

Vines, D (2011a), “Recasting the Macroeconomic Policymaking System in Europe”, Zeitschrift für Staats- und Europeawissenschaften (ZSE) [Journal for Comparative Government and European Policy], November.

Vines, D (2011b), “After Cannes: The G20MAP, Global Rebalancing, and Sustaining Global Economic Growth”, available at http://www.bruegel.org/fileadmin/bruegel_

files/Events/Event_materials/AEEF_Dec_2011/David_Vines_PRESENTATION_

UPDATE.pdf.

Yongding, Yu (2009) “China’s Responses to the Global Financial Crisis”, Richard Snape, Lecture, Productivity Commission, Melbourne, November, available at http://

www.eastasiaforum.org/wp-content/uploads/2010/01/2009-Snape-Lecture.pdf.

The G20MAP, global rebalancing, and sustaining global economic growth

About the author

David Vines is Scientific Coordinator of the PEGGED Programme. He is Professor of Economics in the Economics Department, Oxford University, and a Fellow of Balliol College, Oxford as well as Director of the Centre for International Macroeconomics at Oxford’s Economics Department. Formerly a Houblon-Norman Senior Fellow at the Bank of England, he has advised a number of international organisations and governmental bodies. He has published numerous scholarly articles and several books, most recently The Asian Financial Crisis: Causes, Contagion and Consequences, with Pierre-Richard Agénor, Marcus Miller, and Axel Weber.

The initial response to the crisis led to the accumulation of a vast stock of public liabilities. Since then, fiscal tightening has become the priority in advanced countries, and especially across all of Europe. The measures adopted so far have not proved a cure-all for financial market concerns about debt sustainability. Tighter fiscal policy has, however, coincided with renewed economic slowdown or even contraction, raising questions about the desirability of fiscal austerity.

The key question is whether governments should relent in their efforts to reduce deficits now, when the global economy is still weak, and policy credibility is far from guaranteed. Under what circumstances would it be wise to do this?

Countries fall into three categories. At one extreme we have countries already facing a high and volatile risk premium in financial markets. At the other extreme we have countries with strong fiscal shoulders, actually enjoying a negative risk premium. A third category includes countries not facing a confidence crisis, yet with inherent vulnerabilities – a relatively high public debt, a fragile financial sector, high unemployment. The question of how to ensure debt sustainability is vastly different across these.

By way of example, how much of Italy’s slowdown is due to austerity and how much is due to the near meltdown of debt last summer? There is little doubt that the credit crunch which followed the sudden loss of credibility of Italian fiscal policy (whether or not justified by fundamentals) has a lot to do with the severe slowdown that Italy is Giancarlo Corsetti

Cambridge University and CEPR

Fiscal consolidation and

macroeconomic stabilisation

experiencing. The current fiscal tightening is arguably contractionary, but the alternative of not reacting to the credibility loss would have produced much worse consequences.

Things are more complex for the UK; it hasn’t lost credibility and it borrows at low interest rates. Does this mean UK policymakers are shooting themselves in the foot?

Are they keeping the economy underemployed for years and thus destroying potential output with their austerity drive? Or, are they wisely forestalling a bond market rebellion like those seen on the continent that would prove much costlier?

Much of the work carried out in the PEGGED project over the years provides a conceptual and analytical framework to address these issues. The question of course is not only about restoring safer fiscal positions after the large increase in gross and net public debt in the last few years. Rather, it is about which fiscal policy path would be most effective in helping the global economy and the economy of the Eurozone overcome the current crisis.

This issue requires solution both at country-level, and at regional and global level.

International considerations complicate the analysis; a policy which may be perfectly viable and desirable for a country conditional on an international context, may not work in different circumstances. The outcome will depend on the degree of international cooperation, especially in the provision of liquidity assistance and in the establishing of

‘firewalls’ against contagion.

Fiscal policy at a crossroads: Self-defeating tightening in a liquidity trap?

Recent contributions about the mechanism through which fiscal contraction in a liquidity trap is counterproductive have led to an important change in perspective, relative to initial views.

A key point here is the recognition that much of the advanced world is currently in an unemployment and underemployment crisis. Destruction of jobs and firms today may

Fiscal consolidation and macroeconomic stabilisation

be expected to have persistent effects on potential output in the future. These effects in turn translate into a fall in permanent income, and hence demand, today (see DeLong and Summers 2012 and Rendahl 2012).

In a liquidity trap, this creates a vicious self-reinforcing circle. Today’s unemployment creates expectations of low prospective employment, which in turn causes an endogenous drop in demand, reducing activity and raising unemployment even further. This vicious cycle may have little to do with price stickiness and expectations of deflation at the zero lower bound, an alternative mechanism which was stressed early on by Eggertsson and Woodford (2003) and more recently by Christiano et al (2011). Independently of deflation, the vicious cycle can be set in motion by expectations of lower income when shocks create a high level of persistent underemployment. Theory suggests that this effect can be sizeable. The question is its empirical relevance.

The empirical evidence indeed weighs towards large multipliers at a time of recession and especially at times of banking and financial crises (Corsetti et al 2012), as opposed to very small multipliers when the economy operates close to potential and monetary policy is ‘unconstrained’. The point estimate of the multiplier conditional on crises is of the order of 2 – a value not far from the one used by several governments and commentators, but higher than most estimates in the literature that fail to distinguish across different states of the economy. In light of these results, it can be safely anticipated that the current fiscal contractions will exert pronounced negative effects on output.

It is worth stressing that fiscal adjustment is currently happening at different levels of government – both central and local. An analysis of spending multipliers at local level carried out in the context of the PEGGED model suggests that differences in cuts and budget adjustment at subnational level can also generate sizeable contractionary effects on the local economy, holding constant the macroeconomic conditions at national level.

This is the paper by Acconcia et al (2011) on provincial multipliers in Italy, which takes advantage of the quasi-experimental setting generated by the Italian law mandating the dismissal of city councils on evidence of mafia infiltration. When a city council

is dismissed, the commissaries sent by the government ensure that the administration keeps working according to national standards, but suspend public works. This generates a spending contraction of the order of 20%. The multiplicative effects on output, calculated holding monetary policy constant, are of the order of 1.2 or 1.4.

This is why, with a constrained monetary policy, there is little doubt that governments with a full and solid credibility capital should abstain from immediate fiscal tightening, while committing to future deficit reduction. The virtues of such a policy are discussed in the aforementioned PEGGED paper by Corsetti et al (2010).

The problem is that, in the current context, promising future austerity alone may not be seen as sufficiently effective. Keeping markets confident in the solvency of the country has indeed provided the main motivation for governments to respond to nervous financial markets with upfront tightening.

The challenge: How to stabilise economies with high and volatile sovereign risk

In a recent PEGGED paper, Corsetti et al (2012) (henceforth CKKM) highlight issues in stabilisation policy when the government is charged a sovereign-risk premium. The root of the problem is the empirical observation that sovereign risk adversely affects borrowing conditions in the broader economy. The correlation between public and private borrowing costs actually tends to become stronger during crises. Perhaps in a crisis period high correlation is simply the by-product of common recessionary shocks, affecting simultaneously, but independently, the balance sheets of the government and private firms. Most likely, however, it results from two-way causation.

In the current circumstances, there are good reasons to view causality as mostly flowing from public to private. First, in a fiscal crisis associated with large fluctuations in sovereign risk, financial intermediaries that suffer losses on their holdings of government bonds may reduce their lending. Second, both financial and non-financial firms face a

Fiscal consolidation and macroeconomic stabilisation

higher risk of loss of output and profits due to an increase in taxes, an increase in tariffs, disruptive strikes and social unrest, not to mention lower domestic demand.

There are at least two implications for macroeconomic stability of this ‘sovereign-risk channel of transmission’ linking public to private borrowing costs.

First, if sovereign risk is already high, fiscal multipliers may be expected to be lower than in normal times. The presence of a sovereign-risk channel changes the transmission of fiscal policy, particularly so when monetary policy is constrained (because, for example, policy rates are at the zero lower bound, or because the economy operates under fixed exchange rates). When sovereign risk is high, the negative effect on demand of a given contraction in government spending is offset to some extent by its positive impact on the sovereign-risk premium.

Some exercises by CKMM suggest that, typically, consolidations will be contractionary in the short run. Only under extreme conditions does the model predict either negative multipliers (in line with the view of ‘expansionary fiscal austerity’) or counterproductive consolidations (in line with the view of ‘self-defeating austerity’). To the extent that budget cuts help reduce the risk premium, there is some loss in output, but not too large.

Second, due to the sovereign-risk channel, highly indebted economies become vulnerable to self-fulfilling economic fluctuations. In particular, an anticipated fall in output generates expectations of a deteriorating fiscal budget, causing markets to charge a higher risk premium on government debt. Through the sovereign-risk channel, this tends to raise private borrowing costs, depressing output and thus validating the initial pessimistic expectation.

Under such conditions, conventional wisdom about policymaking may not apply. In particular, systematic anti-cyclical public spending is arguably desirable when policy credibility is not an issue. In the presence of a volatile market for government bonds, however, anticipation of anti-cyclical fiscal policy may not be helpful in ensuring macroeconomic stability. A prospective increase in spending in a recession may lead to

a loss of confidence by amplifying the anticipated deterioration of the budget associated with the fall in output.

This possibility poses a dilemma for highly indebted countries. In light of the above considerations, countries with a high debt may be well-advised to tighten fiscal policies early, even if the beneficial effect of such action – prevention of a damaging crisis of confidence – will naturally be unobservable. From a probabilistic perspective, even a relatively unlikely negative outcome may be worth buying insurance against if its consequences are sufficiently momentous. In the current crisis, unfortunately, we know that such insurance does not come cheap.

Beyond country-level fiscal correction

The near-term costs of austerity mean we should keep thinking about alternatives, such as making commitments to future tightening more credible (eg the reform of entitlement programmes). However, the presence of a sovereign-risk channel also provides a strong argument for focusing on ways to limit the transmission of sovereign risk into private- sector borrowing conditions.

Strongly capitalised banks are a key element here. The ongoing efforts, coordinated by the European Banking Authority, to create extra capital buffers in European banks correspond to this logic. Another element is the attempt by monetary policymakers to offset high private borrowing costs (or a possible credit crunch) when sovereign-risk premium is high.

Normally, the scope to do this is exhausted when the policy rate hits the lower bound.

Recent unconventional steps by the ECB, however, suggest that more is possible. The extension of three-year loans to banks, in particular, appears to have reduced funding strains, with positive knock-on effects for government bond markets.

These arguments are especially strong, either for countries already facing high interest rates in the market for their debt, or for countries reasonably vulnerable to confidence

Fiscal consolidation and macroeconomic stabilisation

crises. These countries would be ill-advised to relax their fiscal stance. The arguments apply less to governments facing low interest rates. The main issue is where to draw the line.

References

Acconcia, A, G Corsetti, and S Simonelli (2011), Mafia and Public Spending: Evidence on the Fiscal Multiplier from a Quasi-experiment, CEPR DP 8305.

Christiano, L, M Eichenbaum, and S Rebelo.(2011) When is the government spending multiplier large? Journal of Political Economy, 119(1):78–121.

Cottarelli, C (2012), “Fiscal Adjustment: too much of a good thing?”, VoxEU.org, February 8.

Corsetti, G, A Meier and G Müller (2009), “Fiscal Stimulus with Spending Reversals”, CEPR discussion paper 7302, 2009, Forthcoming, The Review of Economics and Statistics.

Corsetti, G, K Kuester, A Meier, and G Müller (2010), “Debt consolidation and fiscal stabilisation of deep recessions”, American Economic Review: P&P 100, 41–45, May.

Corsetti, G, K Kuester, A Meier, and G Müller (2012), “Sovereign risk, fiscal policy and macroeconomic stability”, IMF Working paper 12/33.

Corsetti, G, A Meier, and G Müller (2012) “What Determines Government Spending Multipliers?” Prepared for Economic Policy Panel in Copenhagen April.

DeLong, B and L Summers (2012) Fiscal Policy in Depressed Economy,

Eggertsson, G B and M Woodford (2003), “The zero interest-rate bound and optimal monetary policy”, Brookings Papers on Economic Activity, 1:139–211.

Rendahl, P (2012), Fiscal Policy in an Unemployment Crisis, Cambridge: Cambridge University Press.