The Assignment Problem and European Adjustment: aligning policy with outcomes.

For policy to be successful, it has to be properly aligned with outcomes. People have to know why tough economic decisions are being made and how it benefits them; it also has to make sense. You can’t just tell someone that something will be good for them and expect them to do it if it doesn’t make sense and isn’t in their interests.

It occurred to TH after writing the last piece that the Assignment Problem for the euro area was particularly interesting. Correct him if he’s wrong, but it seems that what you would probably take away from a quick review of the literature on euro crisis adjustment (from the news, blogs, analysis, etc.) is that countries in the periphery, such as Spain, or Portugal or Greece are undertaking internal devaluations as a means of regaining external balance. This leaves open the question of what fiscal policy is being used for. Most people would probably argue that fiscal policy is being adjusted to maintain government debt sustainability. But it certainly isn’t clear that it is being assigned to maintain internal balance.

Such a view of fiscal policy while not necessarily wrong – but it is probably not completely right either and might be a bit confusing too. In TH’s mind the idea that fiscal policy can be adjusted to achieve a non-macroeconomic objective (i.e. not associated with key macro variables such as growth, employment, inflation and so on) is more consistent with the new macro orthodoxy for countries on flexible exchange rates, rather than those on fixed exchange rates. It is the assumption that fiscal policy is an extra policy lever that is largely unassigned to macro policy (recall that under flexible exchange rates, the exchange rate adjusts to maintain external balance, leaving monetary policy to maintain internal balance and fiscal policy free to meet non-macroeconomic social objectives such as roads, education and health). And before you stop reading, don’t think that TH doesn’t think improving fiscal sustainability is not important, it is but the problem might be more about national solvency than fiscal. Anyway, we digress.

Likewise the idea that an internal devaluation – cuts to wages to deflate the economy – to restore competitiveness and external balance is borrowed from theories about flexible (or at least adjustable) exchange rates. It is the idea that a depreciation is what is required keep the balance of payments in balance when faced with a situation where a trade deficit suddenly becomes unsustainable for some reason. But when in a common currency area, it is not quite as obvious that the real exchange rate (i.e. relative prices) is what adjusts – other things do too including labour, capital and income flows. This adjustment process is complex and not so well understood as we like to think.

TH wonders whether perhaps the better way of thinking about the euro periphery Assignment Problem for countries such as Spain might be this: Assign structural policies to achieve internal balance, leaving fiscal policy to be adjusted to generate external balance (assuming that you can adjust exchange rates or create an independent monetary policy – see the earlier rant on this here
It might just be semantics, but TH reckons that looking at how adjustment occurs and the policy tools that are required from this alternative perspective could help. For example, suppose that the Portuguese or Spanish governments target labour market reforms and wage cuts with the explicit objective of creating jobs. This would be more palatable to workers than being told that they needed to adjust to maintain competitiveness vis-a-vis Germany (not to mention other periphery countries in the same boat that are all going about a competitive internal devaluation at the same time).

Using fiscal policy to target external balance is not a bad idea either given that for most of the periphery fiscal solvency is directly linked to the solvency of the banking systems that financed the external imbalances. Thus targeting fiscal policy to achieve external balance helps to break the feedback between banks and sovereigns.

The basic message here is fairly simple. The euro area cannot go on ignoring internal balance at the expense of actions to restore external balance and fiscal sustainability (especially when the link between the policy instruments and objective is not well-defined nor aligns well with those having to make the adjustments). Saying that wages need to be lowered to reduce unemployment to a reasonable level is hard for workers, but it is straight forward, logical and justifiable, so is saying that government savings will be increased to boost national savings.

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