By Eric Heyer and Hervé Péléraux

At the end of 2012, five years after the start of the crisis, France’s GDP has still not returned to its earlier level (Figure 1). At the same time, the labour force in France has grown steadily and technical progress has constantly raised workers’ productivity. We are therefore more numerous and more productive than 5 years ago when output was lower: the explosion in unemployment is a symptom of this mismatch. Why had the shoots of recovery seen in 2009 been choked off by mid-2010?

The main factor stifling the recovery has been the austerity measures that were enacted in France and Europe in 2010 and then intensified in 2011 and 2012 (Table 1). The impact of austerity has been all the more marked as it has been generalized throughout the euro zone. The effects of domestic cutbacks have combined with the effects of undercutting demand from other European partners. Given that 60% of France’s exports are to the European Union, any external stimulus had virtually vanished by mid-2012, less due to the slowdown in global growth, which is still almost 3%, than to the consequence of the poor performance of the euro zone, which is on the brink of recession.

It is austerity that is at the root of the lack of growth: after shaving -0.7 GDP point off growth in 2010, its effects increased in 2011 and 2012 (respectively -1.5 and -2.1 points) because of the stepped-up measures and the existence of high fiscal multipliers. Indeed, in a period of low economic activity simultaneously tightening fiscal policy in all the European countries while there is very little manoeuvring room for monetary policy (real interest rates close to zero) has led to raising the value of the multiplier. There is now a broad consensus that the short-term fiscal multipliers are high, especially as full employment is still out of reach (see Heyer (2012) for a review of the literature on multipliers). The theoretical debate about the value of the multiplier and the role of agents’ expectations must give way to empirical observation: the multipliers are positive and greater than 1.

In addition to the fiscal drag, there is the effect of tight monetary conditions: the easing of monetary policy – seen in particular in the lower key interest rates – is far from enough to offset the negative effect on the economy of tighter borrowing conditions and the widening of the spread between private investment and risk-free public investment.

All things considered, including taking into account the impact of the resurgence in oil prices after the onset of the recession, the spontaneous growth of the French economy would have averaged 2.6% over the past three years. The realization of this potential would have led to a further reduction in excess production capacity and would ultimately have cut short the downturn in the economy that actually took place.

By Eric Heyer

On April 17, the government presented its Stability Programme for 2013-2017 for the French economy. For the next two years (2013-2014), the government has relied on the projections of the European Commission in forecasting growth of 0.1% in 2013 and 1.2% in 2014. Our purpose here is not to revisit these forecasts, though they do seem overly optimistic, but rather to discuss the analysis and outlook for France for the period 2015-2017 that is explicit and sometimes implicit in this document.

According to the document provided to Brussels, the government is committed to maintaining its fiscal consolidation strategy throughout the five-year period. The structural effort will lessen over the years, representing only 0.2 percent of GDP in 2017, i.e. nine times less than the effort required of citizens and business in 2013. Under this assumption, the government expects a return to 2% annual growth during the period 2015-2017. The deficit will continue to shrink, reaching 0.7 percent of GDP in 2017. This effort would even lead for the first time in over 30 years to a structural fiscal surplus in 2016, rising to 0.5 percent of GDP in 2017. For its part, public debt would peak in 2014 (at 94.3 GDP points) then begin to decline from 2015 to a level of 88.2 GDP points by the end of the five-year period, which is lower than the level when the Socialists came to power (Table 1). It should be noted, however, that in this official document nothing is said about the changes in unemployment that the government expects will result from its policies by the end of the five-year period. This is the reason for our introduction of a missing line in Table 1.

Based on assumptions similar to those of the government for fiscal policy as well as for the potential for growth, and starting from the same short-term situation, we have attempted to verify the analysis provided by the government and to supplement it by integrating the changes in unemployment related to its Programme.

Table 2 summarizes this work: it indicates that growth would accelerate gradually over the period 2015 to 2017, to over 2% in 2017. Growth over the period would average 1.8%, a rate close to but slightly lower than the 2% expected in the Stability Programme [1].

At end 2017, the deficit would be close to the government target, without however reaching it (1 GDP point instead of 0.7 GDP point). The public debt would also fall to a level comparable to that in 2012.

In this scenario, which is similar to that of the government, the trend in unemployment will not reverse until 2016; by the end of the five-year period, the unemployment rate is expected to be 10.4% of the working population, i.e. a level higher than that prevailing at the time François Hollande assumed office.

The scenario proposed by the government in the Stability Programme seems optimistic in the short term and misses the goal in the medium term. On this last point, it seems surprising to want to stick to a policy of austerity after the economy has seen the public finances balanced in structural terms and while the unemployment rate is rising above its historical peak.

A more balanced approach could be considered: assume that from 2014 the euro zone adopts a “reasonable” austerity plan aimed at both restoring the structural balance of the public finances and reducing the unemployment rate. This alternative strategy would involve rolling back the planned fiscal stimulus in all the euro zone countries and limiting it to 0.5 GDP point [2]. This would constitute a fiscal effort that could be sustained over time and allow France, for example, to eliminate its structural deficit by 2017. Compared to the current plans, this would provide a greater margin for maneuver that would spread the burden of the adjustment more fairly.

Table 3 summarizes the results of simulating this new strategy. Less austerity leads to more growth in all the countries. However, our simulation also takes into account the impact of economic activity in one country on other countries via international trade. In 2017, in the “less austerity” scenario, the public finances would be in the same state as in the baseline scenario, with the additional growth offsetting the reduced effort. However, in this scenario, unemployment would decline in 2014, and by 2017 would have fallen to a level comparable to the 2012 level.

[1] The difference in growth can arise either because of not taking into account the impact of foreign trade due to the austerity plans being implemented in other partner countries, or because the fiscal multiplier used in the Stability Programme is lower than in our simulation, where it is around 1. Indeed, we believe that in a period of low economic activity, adopting policies of fiscal restraint that are applied simultaneously in all the European countries and when there is little maneuvering room for monetary policy (real interest rates are close to zero) leads to pushing up the value of the multiplier. There is also now a broad consensus on the fact that the short-term multipliers are high, especially given that full employment is still out of reach (see Heyer (2012) for a review of the literature on multipliers).

[2] This strategy has already been simulated in previous OFCE work, such as that by Heyer and Timbeau in May 2012, by Heyer, Plane and Timbeau in July 2012 and by the iAGS report in November 2012.

By Eric Heyer

This text summarizes the OFCE’s 2013-2014 forecasts for the French economy.

In 2013, the French economy should see negative annual average growth, with a fall in GDP of 0.2%, before a modest recovery in 2014, with growth of 0.6 % (Table 1). This particularly mediocre performance is far from the path that an economy pulling out of a crisis should be taking.

Four years after the start of the crisis, the French economy has a substantial potential for recovery: this should have led to average spontaneous growth of about 2.6% per year in 2013 and 2014, making up some of the output gap accumulated since the onset of the crisis. But this spontaneous recovery is being hampered mainly by the introduction of fiscal savings plans in France and across Europe. To meet its commitment to cut the public deficit to 3% by 2014, the French government will have to hold to the course of fiscal consolidation it adopted in 2010, which was imposed by the European Commission in all the euro zone countries. This budget strategy should slash 2.6 percentage points off GDP growth in France in 2013 and 2.0 percentage points off GDP in 2014 (Table 2).

By setting a pace far from its potential, the expected growth will aggravate the output gap built up since 2008, with the labour market thus continuing to worsen. The unemployment rate will rise steadily to 11.6% in late 2014.

Only a shift in European fiscal strategy could halt the rise in unemployment. This would mean limiting the negative fiscal stimulus to 0.5 percent of GDP instead of the total of 1.0 points planned in the euro zone in 2014. This reduced fiscal effort could be repeated until the public deficit or debt reaches a defined goal. Compared to current plans, because the effort would be measured the burden of adjustment would be spread more fairly over the taxpayers in each country, avoiding the pitfall of drastic cuts in the public budgets. This new strategy would lead to a slower reduction in the public deficit (-3.4% in 2014 against -3.0% in our central scenario), but also and especially to higher economic growth (1.6% against 0.6%). This “less austerity” scenario would allow the French economy to create 119,000 jobs in 2014, i.e. 232,000 more than in our central forecast, and unemployment would fall instead of continuing to increase.

By Xavier Timbeau

This text summarizes the April 2013 forecasts of the OFCE.

The global economic and financial crisis that began in late 2008 is now entering its fifth year. For the European Union, 2012 has been another year of recession, showing just how much the prospect of an end to the crisis, heralded so many times, has been contradicted by economic developments. Our forecasts for 2013 and 2014 can be summarized rather ominously: the developed countries will remain mired in a vicious circle of rising unemployment, protracted recession and growing doubts about the sustainability of public finances.

From 2010 to 2012, the fiscal measures already taken or announced have been unprecedented for the euro zone countries (-4.6% of GDP), the United Kingdom (-6% of GDP) and the United States (-4.7% of GDP). The fiscal adjustment in the US that has been long delayed but finally precipitated by the lack of political consensus between Democrats and Republicans will take place again in 2013 and 2014. In 2014, austerity in the euro zone will ease, although it will continue at an intense level in the countries still in deficit, which are also those with the highest fiscal multipliers.

In a context of high multipliers, the fiscal effort has a cost in terms of activity. This phrase, taken from Marco Buti, chief economist of the European Commission, sounds like both a confession and a euphemism – a confession, because the acknowledgement of the high value of the fiscal multipliers came late and was neglected too long; Olivier Blanchard and David Leigh recall that this problem led to systematic forecast errors and that these errors were much larger in countries in the worst situations undertaking the largest deficit reductions.

But the undervaluation of the multipliers also meant that the hopes accompanying deficit reduction were disappointed. The “unexpectedly” heavy impact of the austerity plans on activity has meant lower tax revenues, and thus a smaller reduction in the deficit. In attempting to meet their nominal deficit targets regardless of the cost, the States have only exacerbated the fiscal effort.

A confession like this might suggest that the error was inevitable and that the lesson has been drawn. This is not the case. First, since 2009, many voices were raised warning that the multipliers might be higher than in “normal times”, that the possibility of the kind of expansive consolidation described and documented by Alberto Alesina was an illusion based on a misinterpretation of the data, and that there was a real risk of neglecting the impact of the fiscal consolidation on economic activity.

In October 2010, the IMF, under the impetus even then of Olivier Blanchard, described the risks of pursuing an overly brutal consolidation. The general awareness finally emerging in early 2013 reflected an acknowledgement of such a substantial accumulation of empirical evidence that the opposite view had become untenable. But the damage was done.

Nor was the lesson learned. According to the European Commission, the multipliers were high. [1] The use of the past tense reveals the new position of the European Commission: while the multiplier were high, they are now back to their pre-crisis value. This means that, according to the European Commission, the euro zone is again in a “normal” economic situation. The argument here is theoretical, not empirical. Normally, economic agents are “Ricardian” in the sense that Robert Barro has given this term. Agents can smooth their consumption and investment decisions and are not constrained by their income over the short-term. The multipliers would therefore be low or even zero. Fiscal consolidation (which is the name given to the unprecedented budgetary efforts made since 2010 in the euro zone) could therefore continue, this time without the hassles previously observed. This argument is undoubtedly relevant in theory, but its use in practice today is puzzling. It amounts to forgetting far too easily that we are in a situation of high unemployment, that long-term unemployment is increasing, that company balance sheets are still devastated by the loss of activity that started in 2008, and have never really recovered except in Germany, that the banks themselves are struggling to comply with accounting standards and that the IMF Managing Director, Christine Lagarde, has urged that some of them be closed. It means forgetting that the famous credit that is supposed to smooth consumption and investment has collapsed, i.e. amidst a rampant and powerful credit crunch. It means forgetting that in this era when the injunction to prefer the private sector over the public sector is stronger than ever, panic in the financial markets is leading savers and investment advisers to opt for investments in State sovereign bonds with yields of less than 2% at 10 years. And this is taking place despite downgrades by the credit rating agencies because these States are perceived (and “priced”, to use the jargon of the trading floors) as having the lowest risk. Such are the paradoxes of a time when one voluntarily submits to taxation by accepting negative real interest rates on investments and paying dearly for default insurance.

So if the confession seems belated and not to have had much impact on the dogma for escaping the crisis, it also involves a euphemism. For what are these costs that Marco Buti refers to? The price to be paid for an unavoidable financial situation? A hard time to get through before we return to a healthy future? It is by turning away from a detailed analysis of the risks run by continuing the current economic strategy, which has finally been acknowledged as having been incorrectly calibrated, that we miss what is most important. By pursuing the short-term goal of consolidation, while the fiscal multipliers are high, the conditions that make the fiscal multipliers high in the first place are maintained or even reinforced. The period of unemployment and underutilization of capacity are thus prolonged. This prevents the reduction of private debt, the starting point of the crisis, thus perpetuating it.

The fiscal effort has been disappointing in the short term, as the consequence of a high multiplier is that the deficit is reduced less than expected, or even not at all. Public debt in turn increases, as the effect of the denominator outweighs the slower growth of the numerator (see the iAGS report for a discussion and a simple formalization). There are numerous examples, the most recent of which was France, and the most spectacular Spain. But the disappointment is not just in the short term. The persistence of zero growth and a recession changes expectations about future growth: what was analyzed a few quarters ago as a cyclical deficit is now considered structural. The disappointment also modifies the future potential. The hysteresis effects in the labour market, the reduction in R&D, the delays with infrastructure and even, as can be seen now in Southern Europe, the cutbacks in education, in the fight against poverty and in the integration of immigrants all obscure the long-term outlook.

In 2013 and 2014, the developed countries will all continue their fiscal consolidation efforts. For some, this will mean the repetition and thus the accumulation of an unprecedented effort over five consecutive years. For Spain, this amounts to a cumulative fiscal effort of more than 8 percentage points of GDP! With few exceptions, unemployment will continue to rise in the developed countries, reaching a situation where involuntary unemployment exceeds the capacity of the national unemployment insurance systems to replace the lost employment income, especially since these systems are facing budget cuts themselves. In this context, wage deflation will kick off in the countries hit hardest. Since the euro zone has ​​fixed exchange rates, this wage deflation will inevitably be transmitted to other countries. This will constitute a new lever perpetuating the crisis. As wages decrease, it becomes impossible for economic agents to access the financial system to smooth their economic decisions. The debts that have been targeted for reduction since the onset of the crisis will appreciate in real terms. Debt deflation will become the new vector of entrapment in the crisis.

There is, in this situation, a particularly specious argument to justify this conduct: that there was no alternative, i.e. that history was written before 2008 and that the errors in economic policy committed before the crisis made ​​it inevitable, and above all that any other choice, such as postponing the consolidation of the public finances to a time when the fiscal multipliers were lower, was simply not possible. Market pressures and the need to restore lost credibility before 2008 made prompt action essential. If the actions carried out had not been carried out just as they were, then the worst would have happened. The euro would have collapsed, and defaults on public and private debt would have plunged the euro zone into a depression like that of the 1930s, or even worse. The great efforts undertaken made it possible to avert a disaster, and the result of these measures is, at the end of the day, quite encouraging. Such is the story.

But this argument ignores the risks being run today. Deflation, the prolongation of mass unemployment, the collapse of the welfare states, the discrediting of their policies, the undermining of consent to taxation, all carry the seeds of threats whose consequences can only be glimpsed today. Above all, this dismisses the alternative for the euro zone of exercising its sovereignty and demonstrating its solidarity. This argument is based on the idea that for the States fiscal discipline is to be exercised through the markets. It obscures the fact that the public debt and currency are inseparable. An alternative does exist; it requires that the public debt in the euro zone be pooled; it requires a leap towards a transfer of sovereignty; and it requires completing the European project.

[1] “With fiscal multipliers higher than in normal times, the consolidation efforts have been costly in terms of output and employment”, Marco Buti and Karl Pichelmann, ECFIN Economic Brief Issue 19, Feb. 2013, European prosperity reloaded: an optimistic glance at EMU@20.

By Jérôme Creel and Francesco Saraceno

Since 21 September 2011, the US Federal Reserve has launched Operation Twist to reallocate its balance sheet to reduce long-term interest rates. This American activism contrasts once again with the caution displayed by the European Central Bank. On 7 September 2011, a US central banker declared that an unemployment rate of 9% in the US was as serious as an inflation rate of 5% would be. He concluded that US monetary policy needed to make the fight against unemployment a priority. We believe that this should be even more the case for the euro zone economy, which leads us to re-consider the mandate of the ECB.

Through Operation Twist, the Federal Reserve will be trading in 400 billion dollars worth of short-term government bonds for long-dated Treasuries. The Fed’s strategy of reallocating its balance sheet is aimed at reducing the long-term interest rate. This approach is consistent in spirit with the recent remarks of the President of the Chicago Fed.
The speech by Charles Evans on 7 September is worthy of our attention for at least two reasons. First, it indicates that today, even though the United States has slipped into crisis, with persistent unemployment and a new recession threatening, attention is being paid too much to inflation and public deficits rather than to the kind of action that would counter the crisis by conducting a policy commensurate with its scale. Using a target-function of the Fed and Okun’s law, Charles Evans said that an unemployment rate of 9% of the US workforce would be as worrying as an inflation rate of 5 %: the 3-point gap with each of the two targets – a “natural” rate of unemployment of 6% (which he calls a conservative assumption, as the unemployment rate should fall if the United States were to recover the 8 growth points lost during the crisis) or an inflation rate of 2% (again, a conservative assumption) – is very comparable in a country like the United States that does not impose any hierarchy between the targets of inflation and of growth (more precisely, between inflation and maximum employment, see here). Evans noted that the unemployment rate in the United States has actually come to differ by 3 points from its target, but inflation hasn’t … and he then observes: “So, if 5% inflation would have our hair on fire, so should 9% unemployment.” This led Evans to consider that the inflation target, legitimate in the medium term, is not the priority, and therefore that an expansionary monetary policy should be accentuated by conventional or unconventional means, even at the cost of a short-term boom in prices (which is unlikely in an economy in crisis).
The second factor that leads us to take an interest in this discourse is the rapprochement, or rather the great difference, with European policies. Indeed, in reading these words and observing the actions of the Fed, the contrast with the discourse and actions of the ECB is striking. The ECB’s difficulties in pursuing a policy suited to the state of the euro zone result from an overly orthodox approach to monetary policy, with all due respect to certain members who have resigned from the ECB. This is rooted in the fundamental Treaty on the European Union, where priority is given to inflation rather than growth (Articles 119 par. 2 and 127 par. 1). This leads the ECB to neglect the target of growth, to minimize it or, when circumstances ultimately so require (in a period of recession or slow growth) to pursue it in a non-transparent and thus ineffective way. We only have to look at the new joint effort, between in particular the Federal Reserve and the ECB, to ensure dollar liquidity for Europe’s banks, without any change in the key rate. The repeated procrastinations in European monetary policy from 2007 to 2008 – which were of course in support of the private banks, but, because of rising commodity prices, over which the ECB has no control, did not give any impetus to active monetary policy to counter the deterioration in activity – should not be repeated today. Consumer price inflation in the euro zone in July 2011 is close to the medium-term target imposed by the ECB (2.5%), and it is being pushed upwards by rising raw materials prices (energy, coffee, tea, cocoa), by their impact on the prices of certain services (transport), and by the products used as the basis for the taxes that governments are wont to raise to try to restore a semblance of balance in their public finances (tobacco). Ultimately, in July 2011 the rate of inflation excluding energy and processed food products came to 1.5%. The unemployment rate in the euro zone is, for its part, on the order of 10% of the workforce. To paraphrase Charles Evans, one can say that while 5% inflation would certainly raise the hair on the heads of Europe’s central bankers – and fortunately we are far from this – this should also be the case when the unemployment rate reaches 10% of the workforce!
The big difference between a Fed official’s expansionist drive and the ECB’s policy of prudence in comparable economic circumstances (the gaps between the inflation and unemployment rates from their respective targets are more or less the same) also finds a striking parallel in the fiscal policy speeches and actions on either side of the Atlantic. While the European debates almost invariably concern the imposition of additional constraints on the fiscal policies of the euro zone countries (the adoption of “golden rules” in Germany and Spain; the litany of fiscal austerity programs, the latest being in Italy), the need in the euro zone to be able to rely on a strong economic policy instrument comes down solely to the ECB. But this is not necessarily the case in the United States, where the federal government has proposed a new plan to revive the economy in the short term, together with fiscal consolidation over the next 10 years. The speech by Charles Evans should be given by Jean-Claude Trichet, but we are a long way from that. Standing firmly on the impeccable character of the ECB’s past actions (see the nuanced critique by Paul Krugman), the ECB Chairman, when he does talk, does not seem to take the measure of its responsibility for the future performance of its current policies. If the ECB fails to take the lead in boosting activity in a period of low inflation, then the governance of the euro needs to be reviewed. Two critical choices for the future are posed. The euro could disappear, which would not take place without serious difficulties (see the note from Jean Pisani-Ferry about Greece, whose conclusions could be extended to all the euro zone countries, including Germany) and must be firmly rejected. The status of the system of euro zone central banks could be amended to give equal dignity to the goals of economic growth and inflation, along the lines of the Fed, whose performance has made it possible to minimize the fears of an explosion of inflation.