Lorenzo Bini Smaghi: Economic policies on the two sides of the Atlantic
- (why) are they different?
Lecture by Mr Lorenzo Bini Smaghi, Member of the Executive Board of the European Central
Bank, at the Collegio Carlo Alberto, Moncalieri, 7 November 2008.
* * *
1. Introduction1
The United States and the euro area are the two main economic and monetary areas in the
world and they are reasonably similar in size, with a population of over 300 million (300
million in the United States and 320 million in the euro area) and GDP of around €10,000
billion at current prices (at the going rate of exchange of around USD 1.30 to the euro - US
GDP is worth around €11,000 billion, while euro area GDP is worth around €9,000 billion).
The economic policies implemented in these two areas act as a reference for the whole
world's economy. They are carefully scrutinised and compared by academics, market players
and commentators.
In recent years, the two economies have been compared in a largely asymmetrical way,
possibly a hangover from an obsolete institutional setup and analytical reference framework.
While in the United States economic policies are mainly assessed on the basis of the US
economy's underlying state, in the euro area the assessment is made on the basis not only
of European economic fundamentals, but also, and indeed above all, with reference to
economic policy decisions made on the other side of the Atlantic. On our continent, monetary
and budgetary policies are often judged in relation to what is decided in the United States
rather than in their own right. However, it is very rare that the opposite happens. Particularly
at moments such as we are experiencing right now, one often hears people asking how
come monetary and budgetary policies in the euro area do not closely follow the strategies
implemented in the United States, without their pausing for a moment to consider whether or
not those US policies are suited to the European economy. There is still a kind of unthinking
reflex in Europe that prompts some people to believe that our economic policy authorities
should adopt the same approach as the US authorities, and that we are making a mistake
when we do not do so.
This kind of asymmetrical assessment was perhaps alright under the Bretton Woods system,
in which the European countries pegged their currencies to the dollar, and under the
subsequent fluctuating system in which the individual European countries were relatively
small, which allowed them to benefit from a certain amount of autonomy from the decisions
reached on the other side of the Atlantic. But with the creation of the euro and the
development of the euro area to levels akin to the US economy, it would have been rather
ironic if economic policy decisions in Europe simply mirrored the conduct of other authorities.
It should be a given that the euro area's monetary and budgetary policies should be shaped
by the underlying trends and political objectives in Europe. So it is on the basis of those
trends and objectives that the policies should be judged.
That does not mean that the economic policies adopted on either side of the Atlantic cannot
be compared. But for such a comparison to be reliable, its control variable needs to be
precisely the underlying trends and policy objectives in the two areas. In other words, there
must be a symmetrical comparison conducted on an equal footing, capable of allowing us to
explain any differences encountered, including on the basis of the distinct characteristics of
the two economies.
Today I would like to present an analytical model that should help us to understand whether,
and why, economic policies - with particular reference to monetary and budgetary policies -
have been different in the euro area and in the United States. This may prove useful to
those, especially in Europe, who wonder why certain decisions are made on our continent,
and the reason why they sometimes differ from those reached in the United States.
2. Monetary policy
It does not take a huge number of graphs or tables to show that monetary policies in the euro
area and in the United States have partly differed over the past ten years. From the start of
Economic and Monetary Union in 1999 to the present day the ECB has altered its official
interest rate 25 times, including yesterday (see Figure 1). In that same time frame, the US
monetary policy rate has been altered fully 45 times, almost twice as often. And we can see
the difference also in terms of accumulated variations. For instance, the monetary tightening
- or rather the abolition of accommodating monetary policy after the bursting of the dot.com
bubble - which began in the United States in 2004 and in the euro area in 2005, was clearly
different in intensity. The accumulated rise in the official rate through August 2007 was equal
to 200 basis points in the euro area and to 425 basis points in the United States; from August
2007 to today the accumulated cut in reference rates was equal to 100 basis points in the
euro area and to 425 basis points in the United States.
How should we explain these differences in the degree of activism in monetary policy? We
may consider three potential factors. The first concerns the macroeconomic shocks that have
struck the two areas during this period. If the shocks have been different, then that may
explain different monetary policy responses. The second criterion concerns the underlying
economic structure in each area. For instance, if the labour and product markets are
different, then the mechanisms with which the shock spreads and the mechanisms for the
transmission of monetary policy may be different, and that in turn may entail different
responses in terms of interest rate variation and levels. And finally, the third criterion
concerns the preferences of the central bank and, on a broader level, of society as a whole,
which may justify differences in approach.
I would like to take a brief look at these three aspects (shock, structures and preferences) in
greater depth, on the basis of analytical considerations and empirical results.
2.1 Macroeconomic shocks
Let us consider the extreme case of two countries whose central banks are absolutely
identical in terms of preferences and of their decision-making systems. In other words, let us
pretend that European monetary policy is not decided by the ECB, but by the Federal
Reserve System. Next, let us suppose that the two areas are hit by macroeconomic shocks
that are different in terms of their magnitude, nature and timing. If that were so, even if the
same central bank were making the monetary policy decisions in both areas, the difference
in the shock could be such as to demand broad and frequent official rate adjustments in one
instance, while more moderate and gradual intervention might be sufficient in the other. Thus
the degree of monetary policy activism can be different; this, however, is not on account of a
different decision-making strategy, but on account of the different nature of the shocks
impacting on the two areas.
Comparative analyses show that the macroeconomic shocks on both sides of the Atlantic,
while of similar magnitude, appear to be partially different in their nature.2 Over the past ten
years the euro area has been worse hit by "supply shocks" than the United States. A supply
shock tends to have an effect on growth with the opposite sign to that of inflation. One
example is the decline in total factor productivity (TFP) in the early part of this decade which
brought upward pressure to bear on inflation at a time when economic activity was slowing
down, as occurred following the bursting of the dot.com bubble. Indeed, available evidence
seems to suggest that the exacerbation of negative supply shocks is a recurring feature of
economic slowdown phases in the euro area. As a result of that phenomenon, inflation in the
euro area tends to react to an economic slowdown less rapidly than it does in the United
States. This difference may explain why, especially in cyclical slowdown phases, monetary
policy action in the euro area tends to be less aggressive than it is in the United States.
In the United States, on the other hand, analysis seems to show that demand shocks tend to
prevail, which puts pressure on inflation and on economic activity simultaneously. Supply
shocks like those related to productivity tend to have a considerable impact on demand if
agents expect them to have an impact on permanent income, affecting consumption. For
example, the increase in productivity in the second half of the 1990s led to strong growth in
consumption in the United States, financed by debt. In this context, the monetary policy
reaction can be more decisive, and transmitted through relatively more marked and more
frequent official rate adjustments. This is true in phases both of economic growth and of
economic slowdown.
In conclusion, if Europe's economy and the US economy suffer shocks of a different nature,
it is only natural that the responses should be partly different. Some studies suggest that the
role of shocks is the predominant factor in explaining the differences in conduct between the
ECB and the Federal Reserve.3
2.2. Economic structure: the propagation of shocks
Now let us move on to the possible differences in the two economies' structures. In deciding
interest rates, central banks do not only look at the nature of economic shocks but also at the
way in which those shocks are spreading to the economy and at the mechanism for the
transmission of monetary policy. These characteristics are determined by institutions and
practices that develop gradually by comparison with the time frame within which monetary
policy influences economic trends, and thus the central bank tends to regard them as given.
A distinctive feature of the euro area's structural context is the level of both real and nominal
market inflexibility. The Product Market Regulation indicator compiled by the OECD, which is
often cited as a measure of market inflexibility, is 50% higher in the euro area than in the
United States. All available indicators on real labour market inflexibility are higher in the euro
area. One has but to recall the OECD indicator on Employment Protection Legislation, which
is ten times weightier in the euro area than it is in the United States. Collective bargaining
mechanisms cover 76% of the euro area and only 14% in the United States.4 The most
exhaustive empirical evidence is available for nominal inflexibility. The mean duration of
consumer prices - a yardstick for measuring time used by retailers to change the price of
their produce - is 13 months in the euro area, while it is under seven months in the United
States.5
These characteristics have a particular impact on the dynamic properties of inflation. Prices
in the euro area are slower to reflect changes in economic conditions. This means that
inflationary pressure has a slower impact on price dynamics. Adjustment to macroeconomic
shocks initially tends to have an effect above all on employment and economic activity, only
impacting on prices later. It follows that if inflation is allowed to grow, it is then far more costly
and difficult for monetary policy to bring it back down to an acceptable level. In other words,
the so-called "sacrifice ratio", or the cost of restoring price stability in terms of GDP and
employment, appears to be higher in the euro area than in a more flexible economy such as
the US economy. Empirical evidence based on the Phillips curve, which I shall discuss in
greater depth in a minute, confirms that inflation in the euro area is less reactive to the
degree of resource use than it is in the United States.6
The euro area's greater inflexibility in price formation has an impact on the mechanism for
the transmission of monetary policy. Empirical analysis confirms that, if the European
economy were as flexible as the US economy, a given interest rate hike would have a
greater impact on inflation.7 This has a direct implication for the desirable level of monetary
policy activism. First of all, according to neo-Keynesian economic models, the greater the
degree of price inflexibility, the higher the impact will be of a drop in the interest rate. Thus,
for a given variation in the interest rate, the impact on economic activity tends to be greater in
the euro area than it is in the United States. In other words, to achieve the same impact on
economic activity as that achieved in the euro area, the Federal Reserve has to change the
interest rate to a larger extent. Several studies have shown that in the negative phase of the
cycle, even though the interest rate in the euro area is changed to a lesser degree than it is
in the United States, the impact of monetary policy on economic activity is nevertheless
stronger.
Secondly, the European markets' greater inflexibility makes it necessary to adopt a
"preemptive" monetary policy strategy capable of stably anchoring inflation expectations. This is
a direct consequence of the fact that, in the context of a high degree of inflexibility, the more
inflation is allowed to grow, the more costly it then is, in terms of interest rate increases, to
bring it back down to price stability. Indeed, the challenge that the central bank has had to
face from the outset in the euro area has been precisely to boost monetary policy's ability to
pre-empt inflation from gaining a foothold in the private sector expectations.8 The irony is
that, the more monetary policy is able to act in a pre-emptive fashion and to anchor people's
inflation expectations, the more inflation stays under control and thus the less need there is
to intervene aggressively on interest rates. If such a strategy is successful and the central
bank is credible in its anti-inflation policy, statistics commonly used to assess monetary
policy activism (such as the frequency and breadth of changes to the official interest rate)
ironically show the opposite, namely that monetary policy is not very active or even that it is
passive, whereas precisely the reverse is true.
One way of boosting monetary policy's effectiveness is to reduce the overall persistence of
inflation, which can simply be defined as the period of time that inflation takes on average to
return to its initial value after a shock. The overall persistence of inflation can be represented
as a function of two factors,9 apart from the price inflexibility that I have just mentioned. The
first factor is linked to the extent to which, when determining prices, agents stay focused on
the long-term inflation target rather than allowing themselves to be guided by the most recent
inflation trends; in the Phillips curve this is represented by the coefficient on past inflation.
The second factor is a result of the process whereby expectations are formed and in the new
Keynesian model it is represented by the term indicating inflation expectations. If there isn't
full information on the nature of the shocks and the structure of the economy or the central
bank's determination to ensure price stability, then businessmen have a long learning curve
to embark on. This increases the danger that a shock that temporarily raises the inflation
level, such as a major hike in oil prices, may end up gaining a foothold in inflation
expectations rather than rapidly disappearing. That is why an effective monetary policy
depends to a large extent on pegging those expectations to the goal of price stability.
2.3 Preferences
The third element of difference between both sides of the Atlantic can lie in the approach
adopted by the central banks, which to some extent reflect also their mandate, in accordance
with the institutional setup prevailing in each individual country. In the euro area, the
European Central Bank's mandate is enshrined in the Maastricht Treaty, which clearly
emphasises price stability maintenance as being monetary policy's primary goal. To support
the implementation of that principle, the ECB has adopted a quantitative definition of price
stability - namely, an inflation rate below but close to 2%. This facilitates learning by the
private sector and diminishes market uncertainty, thus promoting macroeconomic stability.10
This stability means that there are fewer variations in the interest rate. The US central bank's
mandate, on the other hand, envisions two goals: maintaining price stability and
guaranteeing sustainable growth. No quantitative definition of price stability has been
adopted.
Another principle guiding the ECB's monetary policy is the notion whereby, if monetary policy
pursues a more stable and less volatile course, that fact will boost its effectiveness, thus
increasing the central bank's long-term ability to influence interest rates throughout the yield
curve. This characteristic is particularly important in the context of relatively inert economies
such as the euro area economy. On the other hand, a monetary policy that tends to react
strongly to new data and to short-term economic developments is less effective in controlling
inflation expectations, with the risk that inflation takes longer to return to price stability after a
shock. Empirical analysis based on estimating a central bank's "response function", typically
in the shape of the so-called "Taylor Rule", proves that monetary policy's degree of
persistence is greater in the euro area than in the United States, even taking into account the
different trends in the business
cycle.11
However, we should not overstate the differences in the conduct of monetary policy between
the euro area and the United States. On the one hand, the US central bank, too, assigns
primary importance to price stability, as has been stressed on more than one occasion by the
Federal Reserve's most recent chairmen. For instance, the current Federal Reserve
chairman himself argued (and I quote): " Experience shows that low and stable inflation and
inflation expectations are also associated with greater short-term stability in output and
employment, perhaps in part because they give the central bank greater latitude to counter
transitory disturbances to the economy. [...] In sum, achieving price stability is not only
important in itself; it is also central to attaining the other mandated objectives of maximum
sustainable employment and moderate long-term interest rates."12 The ECB, for its part,
aims to maintain price stability in the "medium term", thus minimising economic fluctuation in
the short term. In other words, in line with its mandate as enshrined in the Maastricht Treaty,
the ECB is not indifferent to short-term economic growth trends.
2.4 Empirical results
So, on balance, what have been the factors underlying the difference in approach between
European and US monetary policy?
From the empirical results we see that the overall persistence of inflation is basically alike in
the euro area and in the United States, even though inflexibility is far more pronounced in the
euro area. Secondly, the evidence suggests that monetary policy impacts on the process
whereby inflation expectations in the euro area are shaped. These expectations have
remained basically in line with the quantitative definition of price stability provided by the ECB
for the best part of the last ten years, and have displayed low variability, as can be seen in
Table 1. Recent studies have confirmed the importance of a clear definition of price stability.
For instance, the response of long-term interest rates (which should respond better to the
anchoring of inflation expectations) to economic news has virtually disappeared.13 Thirdly,
structural analysis suggests that agents assign less importance to past inflation trends - one
of the factors that determines the persistence of inflation mentioned above - in the euro area
than they do in the United States.14 Moreover, it is important to highlight the fact that not only
has there been less inflation variability in the euro area compared to the United States, there
has also been less variability in economic growth.15 And, contrary to popular belief, the euro
area's greater stability has not been achieved to the detriment of its growth, which in per
capita terms has been broadly the same as in the United States for the past ten years. The
same is true regarding the creation of new jobs, with 17 million new jobs having been created
since the euro was first introduced. Thus it is incorrect to argue, as people often do, that the
stabilisation of inflation in Europe has damaged economic growth.
3. Budget policy
The differences between the European and US budget policies can be attributed to a
combination of factors including: the political-cum-institutional setup, the general public's
preferences regarding the role and size of government and the structure of the economy in
the broader sense. Just like monetary policy, so also budget policy in Europe appears on the
whole to be less proactive and more regulation-based than in the United States, where
discretionary powers are broader.
I would like to begin by briefly analysing government budget's two component parts, namely
automatic stabilisers and discretional measures, in order to allow me to better examine the
differences between European and US policies using the same model for interpretation as I
used with monetary policy.
3.1 Automatic stabilisers and discretionary budget policies
The automatic stabilisers are the component of government expenditure and revenue that
automatically varies with the economic cycle, without requiring any explicit decision on the
part of governments. These mechanisms are the result of the social protection and welfare
system, of the institutions underlying the labour market and of various components in the
taxation and public expenditure system. They depend largely on political decisions and
operate in an automatic and anti-cyclical fashion, in the sense that they reduce revenue and
increase expenditure when the cycle slows down, and vice versa.
As far as discretionary measures resulting from specific fiscal policy decisions are
concerned, their usefulness as a an anti-cyclical tool has been a matter for debate for a long
time now, both in the euro area and in the United States. All in all, the evidence points to
discretionary fiscal policy having a moderately positive impact on economic growth in
advanced economies. Yet the effectiveness of such measures depends on the way in which
they are taken and their timing, in particular with regard to delays in the recognition, decision
and implementation process. Precisely because of such difficulties, a budget policy which is
aimed ex ante in an anti-cyclical direction tends to produce pro-cyclical effects ex post.16 The
effectiveness of discretionary measures also depends on the temporary nature and on the
possibility of withdrawing them in a timely manner once the shock has passed so as to
guarantee fiscal sustainability.
3.2 Comparing the importance of automatic stabilisers and discretionary policies
in the euro area and in the United States
If we compare budget policy on the two sides of the Atlantic, we see that the automatic
stabilisers play a more important role in the euro area.17
First of all, the greater the percentage of government spending over GDP, the greater the
budget position's response to fluctuations in economic activity. Automatic stabilisers are
smaller in the United States, where government is smaller in relative terms (government
spending is worth 37% of GDP, whereas it tops the 45% mark in the euro area countries).18
Furthermore, the level of government welfare services (including unemployment insurance,
social security and welfare services, and senior citizens' assistance insurance) is
systematically lower in the United States than in the euro area countries; at present it stands
at 12% of GDP in the United States and at 15% of GDP in the euro area.19 Thirdly, the
importance of automatic stabilisers depends also on the taxation system, in terms of its level
of taxation and of the overall fiscal drag in the tax system. Not only do Europe's governments
have far higher revenue as a percentage of their GDP, they also show a broader quota of
social security contributions in respect of direct and indirect taxation (15% of GDP in the euro
area, as against 7% in the United States), which tends to make the system more gradual.
Fourthly, redistributive policies are also expressed in other ways than through government
expenditure, for instance through the regulation of labour markets. On the basis of a series of
indicators such as minimum wages, the legal safeguards protecting those in employment and
the unemployment benefit replacement rate, the United States is at a lower level than the
average level for the EU.20
One way of measuring the magnitude of automatic stabilisers is the budget's overall
sensitivity to cyclical fluctuations in the economy, which can be expressed in terms of the
elasticity of the primary budget balance (as a percentage of GDP) in relation to the output
gap, in other words the gap between real revenue and its potential level.21 If budget policy is
anti-cyclical, the coefficient should be positive (in other words, it increases in a phase of
expansion and decreases in a recession). An OECD study gives us a correlation of 0.48 for
the euro area and 0.34 for the United States.22 The lower overall budget responsiveness to
the economic cycle in the United States can be ascribed both to lower current expenditure
elasticity and to low tax responsiveness compared with most of the countries in the euro
area.
The discretionary component of budget policy, by contrast, can be measured by the
variations in the primary balance adjusted to account for cyclical effects. According to the
OECD's figures, the budget balance in the United States, adjusted for the economic cycle, as
a percentage of GDP shifted from a break-even situation in 1998, to a 0.9% surplus situation
in 2000, and then to a 4.5% deficit in 2003 (and a 3.2% deficit in 2007; Figure 2). The
aggregate deficit in the euro area adjusted for the cycle fluctuated between 2.7% in 2002 and
0.7% of GDP in 2007. The budget balance fluctuation range has thus been significantly
narrower than in the United States.23
To summarise, automatic budget stabilisers are more important in the euro area, while in the
United States there is greater recourse to discretionary policies.
3.3 Shocks
As with monetary policy, the difference in the shocks hitting the two economies may explain
the varying degrees of fiscal activism. In theory, an economy which is hit principally by
demand shocks should make greater use of anti-cyclical budget policies than an economy hit
mainly by supply shocks. This is a topic on which, as far as I know, no empirical studies have
been conducted to date and it is thus a particularly interesting field of research. A hypothesis
worth examining is the extent to which the greater frequency of demand shocks in the United
States has justified greater fiscal activism in an anti-cyclical direction. In the euro area, by
contrast, the adoption of active budget policies ought to have been discouraged by the
greater frequency of supply shocks.
3.4 Structural factors
I shall now discuss structural factors, which are political-cum-institutional, as well as more
strictly economic in nature.
3.4.1 Political and institutional factors
In general terms, factors of a political and institutional nature offer greater assistance in
understanding the differences in fiscal policy compared with monetary policy. In particular,
there is a strand of political economy literature suggesting that the principle of a majority
system as implemented in the US political system, together with more marked fiscal
centralisation, tends to prevent minority interest groups from achieving the political power
needed to foster greater redistribution of revenue.24 A deep-seated tradition of stringent
safeguards for private property and the legal system itself have further curbed redistribution
trends in the US. Even the United States' federal structure may have helped to restrict the
role played by central government in budget policy. The EU Member States' constitutions, on
the other hand, tend more towards the principle of proportional representation, which some
consider to be in favour of universal programs designed to benefit various groups and thus
higher government spending.25
It is common knowledge that, in an effort to avoid the pitfalls of unsustainable budget
policies, the Maastricht Treaty and the 1997 Stability and Growth Pact lay down the
conditions necessary for safeguarding budget discipline within a monetary union. The Pact's
underlying philosophy in the budget field is that countries must structurally pursue
breakeven budgets or a budget surplus, in order to then allow automatic stabilisers to function
without any restriction.
This institutional setup, comprising constraints of an almost constitutional nature in the field
of budget policy, is different from that in the United States where tax regulations are in some
ways more flexible, although they have been much altered in recent decades. It has been
repeatedly proposed to introduce a break-even budget rule in the United States, but it has
not happened yet. Another example of the importance assigned to discretionality over
regulations in the United States can be seen in the fact that, while the overall debt is
nominally subject to a ceiling approved by Congress, that ceiling is in fact regularly modified,
thus in actual fact it is not binding at all.
For example, the deficit targets established in the 1985 Budget and Emergency Deficit
Control Act (Gramm-Rudman Act) were abundantly breached and later relaxed. In light of
this, the 1990 Budget Enforcement Act (BEA) introduced restrictions to the discretionary
component of expenditure and ground rules designed to restrict spending to real revenue; on
the basis of those rules, any new discretionary spending (apart from the legislation on social
security and revenue) was to have a neutral impact on the budget. Thanks to this method, a
positive budget balance was achieved and maintained for a certain amount of time under the
Clinton administration. Yet the deficit's disappearance proved short-lived; negative balances
were repeatedly recorded in the wake of the taxation and spending policies adopted by
President Bush's administration.
3.4.2 The economic structure
Moving on to the deep-seated differences in economic structure, a crucial difference between
the United States and the euro area lies in the far smaller size of the US government sector.
It follows that the automatic stabilisers, in particular, operate in somewhat different contexts
in the two economic areas. This could partly explain why countries with larger governments
generally show less product variability. On the other hand, however, there appears to be a
threshold beyond which this ratio evens out or even starts to go the other way. Indeed it has
been estimated that an increase in the size of government has a negligible and marginal
impact on income variability if government spending exceeds 40% of GDP.26 Moreover,
recent figures tend to suggest that the negative correlation between government size and
income variability appears to have decreased since the 1990's, and thus the role of budget
stabilisation policies in attenuating fluctuations in consumption has also diminished.27 Fiscal
multipliers appear to have decreased over time (and may even have gone below zero) both
in the United States and in the euro area countries.
3.5 Preferences
Finally, the different level of fiscal activism in the United States and the euro area can be
ascribed to the general public's preferences, which are then mirrored in the budget
authorities' decisions. People often argue that the Europeans are more averse to inequality
than the Americans, and that this has led to a higher level of fiscal redistribution in Europe.
People's attitude toward inequality may well be influenced by their expectations of social
mobility. Even though income mobility in the United States is not particularly high, several
statistics28 show that the "American dream" ideal continues to have a major psychological
impact on people at the grassroots level as well as on the country's political choices.
Trends which have been ongoing in the past decade, such as rising inequality in
AngloSaxon countries and the current financial crisis, could determine, however, a shift in the
preferences of the US population in favour of greater State intervention in sectors such as
education and health care. This is, at least, what seems to come out from the el