you good afternoon everyone welcome to this meeting entitled watch tax architecture for the european union the our guest needs no introduction in general and at the festival in particular he attended the festival many times it's worth reminding who he is he is senior fellow at the peterson institute of international economics professor emeritus at the mit in boston he used to be the chief economist till 2008 he was the chief economist of the international monetary fund he was the chairman of the econometrics society member of american academy of science and past president of american economic association he has written many books an entire generation of economists trained by reading and studying his texts were at our appella research in particular macroeconomics which one of the most used texts in the universities five continents uh is the most advanced uh teaching approach of the mainstream economic theory he also has been one of the main economists identifying some limitations and proposing some improvements to the approach as chief economist of international monetary fund he admitted that sometimes institutions are not able to understand the severity of crisis he proposed many changes to the mainstream economic theory with a clear objective of making traditional analysis less abstract and more consistent with the complexity of contemporary capitalism one year ago at the festival uh in trento uh remotely he discussed with tito bowery about the recession and the tax instruments to be used at european level many things have occurred during this year we know that there has been a major change of paradigm uh the european union with the next generation eu the sharing of take the discontinuation of the stability pact at least till the end of 2022. the pandemic has also changed another important paradigm which had settled in most advanced economies i.e that uh public intervention was doomed uh to leave the floor to the free markets as a matter of fact we have realized that the rules of the state have been key uh in particular in the field of vaccines and the uh a large part of the public opinion is in favor of giving more space to the role of the state in the economy spending means making debts mario draghi often said that there is a girl and a bad dipped the latter not producing growth high indebted countries and i quote commissioner gentile ernie should limit the growth of a current expenditure now we are at the center of today's meeting we are here to talk about uh the fiscal or tax rules for the european union after the stability pact it is clear that with a high level of indebtedness due to the pandemic the rules of the past cannot be restored as they used to be it is it is therefore necessary to adopt uh sustainability quality standards for depth taking on boards parameters like private saving productivity and that means making fiscal policy choices there should be courageous choices so that we can go beyond the domestic competition within europe we would be able to say that the union make us stronger which is not yet the case so the floor to professor olivier blanchard at the end of the lecture we will be able to entertain some questions uh good evening you have the floor thank you very much let me try to share a few slides that i have i hope you now see them but it's uh it's a great pleasure to participate in the toronto festival it is really one of my most loved conferences or discussions that i have every year i'm very sad that i cannot be there in person but hopefully next year i shall be i decided to talk about the european fiscal rules and why did i do this because on the one hand it is an extremely technical and difficult issue i would say even maybe a boring one but it is one which has a major effect on our lives it can bad wolves can have a terrible effect on the economy and by implication on on us and so i think it's very important to understand what what is at stake i'm going to proceed in in five steps and the first one is why are the european union union rules uh in the first place and why don't we just let governments do what they want in most you know in most dimensions governments are free to do exactly what they want why should there be an exception uh for fiscal rules i think it's a very fair question because governments have very different mandate objectives some want to help the poor more some want to do it less some want to build things some want not to and so on but there is one dimension in which what one country does has potentially very big and catastrophic effects on other countries which is that if it doesn't behave if it starts spending too much increasing that and markets start thinking that maybe it's going to default that can have major effects on the financial system on basically the holders of the debt especially they's default evas default of the state then you know many of the banks which hold the bonds are going to be in trouble if they are in trouble then the banks which hold claims on these banks are going to be in trouble and therefore that can be catastrophic and therefore it's very important to make sure that basically no country misbehaving is taking risks which might lead to default now this is not an abstract concern it's a very real concern and we saw it during the the great financial crisis and it came in the form of what's known as doom loops what happened is that there were worries about the fault of public debt in some countries including italy and that led investors to think well maybe the banks which are holding italian debt or greek that was a more extreme example but even italian that could be in trouble and then they said oh but if the banks are in trouble the state will have to intervene to help them and therefore the state in turn might have to spend much more and be in trouble itself or but if the state is in trouble then you know the banks are in trouble and then there's a vicious circle a doom loop fortunately we didn't quite get there we we got close to it but it shows that when a state looks like it could default and even more so when it defaults things can go very bad so i think it's completely right to say that the european union should have a structure in place so that it makes sure that the debt of every member is sustainable it should stop there it should not basically design the whole fiscal policy of countries if a country is not taking any risks then the way it collects taxes overweight spends should be the privilege of a country and should reflect the democratic views of the people in that country but making sure that that is sustainable is clearly uh one thing that the european union should do so let's go quickly through history it started uh with maastricht and it introduced very simple rules that you probably have all heard of which is that the debt to gdp ratio should be 60 and the maximum deficit that a country could run should be three percent so two simple numbers it looked great and i think to defend this simple rule one can say that when the euro was created it was quite important that uh that the the rules be credible and simplicity these two numbers were in that way uh a major plus it made the rules very transparent but the only problem is that the rules were much too simple and states found that they really could not abide by them and in particular they did not allow for enough fiscal expansion when there was a recession in a recession you want to have a larger fiscal deficit to help the man to help the economy recover and the constraints that the rules were putting were too strong an example of this which many of you probably remember is the excessive fiscal austerity that we saw in the eurozone just at the end of of of the great financial crisis and at the beginning of what turned out to be the euro crisis so in 2010 2011 and i think it can be said that there was too much fiscal austerity then but it was a reflection of the rules that had been put in place so over time what happened is that the european union realized that there were loopholes that countries were not quite doing the right thing but the rules were too simple so they complexified the rules they added more and more conditions that countries had to satisfy in order to avoid countries finding loopholes and if you look at how the rules look today it is a gigantic document and it must be one of the few living people who actually have read all of it and i can tell you that it is totally incomprehensible but basically i do not see how any government can really understand what is loud and what is not um so there that's why there is this picture on on the right which is the cathedral and evil of avila and it's the same idea it started simple and then they added stuff and stuff and stuff and it's very hard to see the coherence of the building at the end now that was one issue the other issue is that the world changed in many ways since uh maastricht and in particular what happened many many things happened but the main change was that interest rates both nominal rates but real rates rates adjusted for inflation steadily declined from 1985 which was the peak they have come down fairly steadily uh every year with few bumps but uh really it's just when you plot it it is really just a downward trend and it's clear that in that context you know how you think about that when interest rates are ten percent or when interest rates are zero percent is completely different but the words didn't change did not accommodate this in any way and therefore they became more and more off relative to what they should have done so i think it's fair to say that although maybe at the beginning it for some countries to be more responsible it has been a mess it has created more unemployment than was needed and it just doesn't fit in many cases it hasn't as we know there has been plenty of cheating and here i didn't cite your country but i cited two countries which are france and germany which both did not respect the rules at bios points in time so clearly something something has to be done what happened is that when the covet crisis started at the beginning of of last year it was very clear that the countries could not basically satisfy the wars it was clear that they needed to spend a whole lot for protection of people who had lost their jobs and for protection of firms which have which had lost sales and therefore they were going to spend much more than anything allowed by by the rules the rules had an escape clause which said that when things are really exceptional then the walls can be suspended and they were suspended in early 2020 and they have been suspended until now and i think the plan now is that they are going to be suspended until until the end the end of the year but and you may have seen articles in the newspapers there is now a strong push to have rules back in place by early 2023 a number of countries and a number of people are worried that in the absence of rules uh countries are going to misbehave again and therefore we have to go back to uh two rules now should it be the same rules i think everybody agree but it's not possible to go back to the old rules i mean if you look at the debt ratios you know in most countries now not most but in many countries the debt ratios are substantially above 100 of gdp there is no way that countries can go to you know the goal in the mass switch code of 60 60 anytime soon reducing that by one or two percent of gdp each year is very difficult to do it has major effects on output so going from 110 to swap to 60 is something which is going to take many many years if you try so following the rules if the same rules were put back in place would require a fiscal consolidation of fiscal contraction of an enormous magnitude which would lead to a very large recession again why that well there's one additional factor which is that in normal times or at least in the past when you had a fiscal contraction you could actually use monetary policy to undo some of it so a fiscal contraction was decreasing in demand but you could decrease interest rates in order to upset and by coordinating fiscal and money you could actually limit the adverse effect on output but we are not in that situation now and we're not going to be there for quite a while which is that the ecb cannot offset fiscal contractions it's basically doing as much or maybe even more than what it can do and there is no way can you know counteract a fiscal contraction so it's clear that going back to the old rules is just a non-starter so what needs to be done well change the rules and and there are many proposals um and it's funny they felt they fall in two categories the first one is well the rules are much too much too complex so we have to simplify them try to go back to some simple rule two numbers which will do the trick it just has to be different numbers but it's the same idea that's going to fail exactly for the same reason as the initial rules failed which is this is a very complex issue i'm going to discuss it in the next slide but assessing that sustainability just cannot be reduced to two numbers you're just going to go wrong and then there are people saying well you complexified more so but you know we complexified but not enough and i can tell you that given the level of complexity there is today if we complexified them even more then you know nobody would understand what's going on so i think that i understand the desire to simplify i understand the desire to make them more complex but never i think is going to to do the trick and so what i want to do now is just think about okay what is it that what is that sustainability how can we actually measure that sustainability and what i'm going to argue is that depends on on many factors and and so many factors in such complex ways that is just too hard to capture in a you know an arithmetic or quantitative role so here to be a bit technical but not much which is i'm going to define what is known as the primary balance the primary balance is the overall fiscal balance but taking out interest payments so primary balance typically looks better than the overall physical balance it's basically what you have to pay interest right so the tentative definition of sustainability is the following i've put it in bluetooth to make it clear that is sustainable if with high probability and i think we have to understand that sustainability is a problem probabilistic statement it's never it's nearly never sustainable with probability one maybe 0.99 but it's not so with high probability the government can generate a primary balance which is sufficient to cover interest payments and if it does this then it will keep the ratio of debt to gdp from exploding it basically has to have enough of a primary balance to pay for the interest rates under that i'm being for those of you who actually know the arithmetic behind this i'm i'm cheating a bit but that's conceptually that's what you have to understand is the government going to be able to generate enough of a primary balance to cover what it has to pay in interest payments now let me make one remark which is you know if there was an article by mr shobra in the financial times today ago two days ago which said well the governments will have to reimburse the date and it's a lot of debt to reimburse indeed if a government had to reimburse 100 of gdp it would be in trouble now there's a difference between you me and the government which is the government doesn't have to reimburse for that basically can keep a level of debt or debt to gdp ratio constant and just roll over issue new debt when all that comes due we cannot do that when we take a mortgage you know we have to pay the interest on it but at some point we actually have to pay back the mortgage the government doesn't have to do this the other whatever aspect is that the government can borrow at a much lower rate than you and i and there are good reasons which is that the government can basically tax people more when we have upon paying the mortgage we don't have this option of you know taxing people so these are differences and that's why the palm of the government is a bit different from the one that you and i have now let me now go for the rest of the slide into what's needed to kind of take the the two blue lines and make them operational okay so you look at the country what is what are going to be the factors which determine whether the debt is sustainable or not well the first thing is clearly the interest rate right if the interest rate is very low as it is now and it's basically nearly zero in nominal terms it's even negative in real terms adjusted for inflation then that looks good and because interest payments are going to be very small how however what matters here is not just the expected rate but it's the range right it could be and that's a very important aspect of how we think we have to think about things in the current environment which yes the interest rates are roughly zero now but you know maybe in five years they could be two percent or they could be minus two percent or four percent so you have when you think about the future you have to take into account this uncertainty uncertainty is really of the essence at this point if i were sure that the interest rate was going to be zero or negative forever it would be great but i can't i can't just assume that same thing for the golf rate although there's probably less uncertainty about the range but you have to think about the expected growth rate potential growth rate and then you have to think about the distribution then you have to so this is going to determine how much you basically have to pay what you have to pay is the primary balance and here again it's going to be you're going to see it try to extrapolate you know what the revenues are going to be what the spending is going to be you have to take into account implicit what we call implicit liabilities which is if you have a retirement system which is which has a large deficit then sooner or later basically you'll have to make up the difference from the budget so your primary balance is going to look worse right so you have to take all these elements you basically at the distribution of outcomes say five years out or ten years out and we have methods to do this and you see what is the probability that we find ourselves with a primary balance which is not enough to cover the interest payments on the debt in which case you know an alarm bell just goes off right there is it's not going to happen with 100 probability but suppose that the answer is with 15 probability you're in trouble five years out then the question becomes okay so will the government be able to take measures to improve a primary balance efficiently so you've found that you have to increase the primary balance by say two percent of gdp in order to decrease the probability of uh of unsustainability okay then you have to look at all kinds of factors again which is if you need to have say a primary surplus of two percent of gdp but you start in that situation with a primary deficit of four percent of gdp this means you you have to improve the primary balance by six percent of gdp that's enormous so the level of a primary deficit matters a whole lot then you know the natural way of improving the primary balance is to cut spending or increase taxes if a level of taxation is already very high then you just don't have much room to increase it so it's going to be even harder then we get to political dimensions which are very relevant the nature of the government matters if it's a coalition government it may be very hard to agree on a set of measures to improve a primary balance if you're a single party government it may be easier the nature of the prime minister matters you know markets felt much more relaxed about that sustainability in italy when mario draghi was named prime minister right the last point which matters very much is the maturity of the debt because suppose that the interest rate increases and the debt has very short maturity it's basically one year debt then your interest rate bill is going to increase very much this year so you have to adjust very quickly if you have a maturity of a debt which is say 10 years then you know most of your bonds are going to have a low interest rate only the new ones will have to have a high interest rate so what you have to do you have much more time to adjust if you need to adjust the primary balance by say four percent then you have ten years to do it rather than one year and clearly it it's much easier so all these factors matter when you actually want to assess whether a country has sustainable debt or not and so as i said the bottom you could have a country which is 150 debt to gdp and you look and you do this and you say it's fine it knows what it's doing i don't have to worry now the example of this is japan which has 170 percent net uh ratio of net debt to gdp 250 percent caused that to gdp and at this stage the interest rate on tenure jgbs which are bonds issued by the japanese government is actually negative so it's clear that the investors don't don't worry very much about default but you could have a country where that is 80 percent and worry because the government which came to power is some populist government which makes crazy statements and you have a sense that they're going to run deficits and we really have to worry so the point is you know all these factors matter so what you do so two more slides so in this slide i'm going to give you what i would call the economist solution which is the solution that i would suggest that i have suggested which is very much a point of view of an economist not a policy maker okay so the first point is to repeat what i just said which is think of writing a rule exante which would take all the elements on the previous slide into consideration so just to take an example how do you get you know mario draghi as prime minister into a rule i don't know how to do that but i know that if mario dwight is prime minister i will act a bit more right so it seems to me it's absolutely impossible to write a good rule but this is not to say that nothing can be done if i'm actually looking at italy today i can actually say well mario draghi is prime minister uh that level is this the deficit is that the implicit liabilities are this the distribution of interest rates and growth rates is this so for a given country at a given time i can basically do the exercise i can think about the distribution of interest rate r for corporate g the primary balances i do this year by year i take into account the uncertainty and then i can compute the probability that you know i've taken five years or ten years that is on an exploding path and if it looks like this probability is not negligible then you know there is an issue of sustainability right so i think as an economist i say how should you proceed you should basically have not a fiscal rule but a fiscal standard basically the fiscal standard should be the country should keep that from exploding can be a bit more complex than that but that's basically the goal this is what you want to do and then you'd say well let's see whether the country is doing the right job you would basically do the analysis which i've just described that has a technical term which is called the stochastic that sustainability analysis sdsa okay which is just a tool to do exactly what i've talked about and basically in each country each year you would basically do this and say things are fine at this point things are probably fine okay but you would not write down an exante before the fact rule because you could not capture everything so in a proposal that i've made with uh jeremy and zettelmayer and alvaro leondo two co-authors basically are good for doing this and the way we describe how it could be done is that you will have the eu commission maybe in parallel with a domestic fiscal council basically do this exercise do this as the essay exercise explain what assumptions they are using and so on and then come to a conclusion saying well yes maybe there is a risk and we would like the government to actually do something then the government would be asked if this was the case i mean in most cases i think you know they will get a pass at this point because the interest rates are so low and the uncertainty about interest rates is relatively limited over the next five years i think but if a government didn't pass then it would be asked to present measures that it intends to take in order to reduce the risk i'm going to increase the vat i'm going to do this i'm going to do that it's clear that the government will in general disagree with the work of a commission or even the work of its domestic fiscal council say well you haven't been optimistic enough you've been too pessimistic about growth you've been too pessimistic about interest rates there will be a discussion there could be agreement or there could be no agreement he raised this agreement then the decision would go to either the european council which is the way it has happened until now when there was a disagreement the european council was in charge of deciding or if you wanted to build some jurisprudence and some expertise you could basically extend the code of justice to have more economic knowledge at this stage it's not ready to do it but it could do it and it would take a decision it would be a judicial decision and that's probably an issue from the point of view of democracy but you know this happens in many cases for antitrust and many other dimensions of what brussels does so my sense is if i were a benevolent dictator and i was in brussels this is what i would try to do it's probably not what's going to happen and that's my last slide which is that what i have found is when when i push this idea of a fiscal standard rather than fiscal rules and the use of this tool uh yes gsa people say oh it's too fuzzy too many assumptions we're never going to converge and countries are basically going to cheat and we're not going to be uh able to to constrain them i'm not sure but i hear it and uh i'm not the policy maker and i suspect that at the end the uh the european union is going to go for modified wolves but wolves it's going to want to have something i suspect for example that a number which is now utterly relevant will stay the 60 dead ratio will remain it will be symbolic uh countries will not be asked to actually attain it at any point but it will remain there because symbolically it's very important so the challenge this year given that wool has to be basically ready in you know seven months is to hope for a wall which will do a decent job a decent job in the sense of in most cases basic doing the same thing as we as gsa which have presented on the previous slide would be i think at the minimum what they have to do is take into account the level of interest rate and we are in a world in which the interest rates are extremely low and that's not because of covet that's not because of a great financial crisis it's a long trend and they are going to remain very low when interest rates are low borrowing is much less dangerous and if 60 had at any point being the right number it is now a much higher number japan shows that you can go much higher because what really matters is that service right is the product of that times the interest rate so this has to be recognized a set of rules which did not recognize that i think would just be a non-starter the second is that it should give enough room for countries to use fiscal policy to stabilize output and the reason again is that we are going to be in an environment in which monetary policy is going to be constrained for quite a while this is the so-called zero lower bound constraint at this stage monetary policy cannot do a lot it can do something to tighten but it cannot be much to illusion and therefore fiscal policy has to stabilize output and if the rules prevent fiscal policy from doing this then you'll get high unemployment cyclical unemployment in various countries and i don't want to see this happen the last point i would make is that these rules have to allow for the right level of public investment because what happened in the past is that when a country had to consolidate to reduce spending what it did is the easiest thing to do which is to cut public investment because public investment you can cut and this year it doesn't look it's catastrophic it's catastrophic in many years but you're not going to be there anymore so it basically has to protect public investment now you know is there a way to write the rule which is going to be a half decent approximation to what should be done i think that's the challenge and if any of you are working on these issues i think that's a challenge that we all have find a new rule which is not going to be perfect but it's going to be much better than what we have flexible enough but tough enough and the stakes are very high if the european commission screws things again then the effects on output and unemployment on italy are going to be very substantial so let me stop here and take questions if i thank you very much professor blanchard for your lecture we'll see if there are questions for professor blanchard there's a mic available for you if you wish to ask a question to professor blanchard we still have 15 minutes to go so you can very well take advantage to take at least three four questions from the audience is there a request for the floor can you please come here and use the microphone possible there's a mic available for you i'm not an expert on economics i haven't studied economics but i would like to make a comment though anyway i have a question in that i understand that that has to be reduced but i think that money should be found where it is there are huge inequalities in our country i come from a village where the mr ferrero lives and i know it is um family business that was turned into a multinational so there's a lot of people that are very off ferrero became a multinational it piled up a lot of profits hence i believe that no redistribution of wealth has been achieved there was no redistribution among the workers at that factory i see them all certainly they enjoy job security according to the collective bargaining they work a lot and yet they do not get any of the profit that the company gets so the managers pile up huge gains and this leads to the increase in inequalities so i think that higher tax should be levied against those who gain more even at the time of crisis and people have piled up huge wealth and i think that they should be taxed they should pay higher taxes maybe we can take a couple of questions more and then give the flow back to professor professor blanchard any more questions mr blair and reading the lively conversation that you had on twitter um with reference to these statements by schwebler who said he was concerned about the potential deflation following suitor to the expansionary measures can you perhaps dwell on that tweet of yours so as to explain also to the lame and what are the different stances let's see if there's any more questions for the floor no more questions from the floor then perhaps we can invite professor blanchard to take these two questions actually that and the other day in a conversation with the commissioner gentiloni we raised this issue of a revision of the of the rules and uh i i i asked him about fiscal standards and your idea and it didn't seem to be against this oh you you can't hear me no should i repeat then from the start now first of all a wonderful lecture very clear and these are difficult issues so thank you so much the other day talking to commissioner gentiloni about the reform of the fiscal rules he acknowledged that this is badly needed and also we were mentioning the idea of a fiscal standards that you were supporting and the reaction he had was not negative in principle but simply thought that it's very difficult to go through a reform of the treaties so if you have to change the treaties that is going to be something that will prevent these changes to be done so i wonder whether there is any possibility to uh reform in the direction that you are proposing without having to change the treaties thank you sir to professor blue aries over to you professor bernal shaw you have the floor to take these three questions sure let me take them in in the order in which they came so i completely agree that there is a major issue of of inequality in in many countries and uh indeed it got worse during the covet crisis and still worse part of the reason is that the way we have fought the government crisis is by having very low interest rates and basically what low interest rates do is that they increase the price of assets i increase the price of stocks to increase the price of houses so people who have stocks the people in houses do much better than the poor people we don't have those those assets so i think of it as indeed increased inequality and i think uh that there is a reasonable argument uh for having a one-time uh covered levy if you want tax on the capital gains uh due to covet i would be in favor of it and many economists are in favor of it that's not going to solve the form of inequality in general there are you know issues long before covered and they will still be there after covered which is that we have a hard time taxing capital because capital is very mobile and capital is very smart and it goes to places where the rate of taxation is low and as a result it doesn't pay much in the way of taxes fortunately there there is actually progress as some of you may know there has been negotiations at the oecd which have been going on for a long time but the us has just indicated that it is quite eager to actually do something and the idea would be to tax multinationals uh in better ways in more efficient ways and basically eliminate the possibility that they create their headquarters in some tax haven so i completely agree now the point where we might disagree is that i'm not sure but we need to reduce the debt right now but whether or not we do i think the idea of having some redistribution from the people who have benefited from the crisis towards the people who have suffered from the correct crisis is something that government should indeed look at i completely agree now on my discussions on the second question my discussion with uh with mr charlie it's a long-running discussion uh mr xiaobi is very much in the old mode of that is bad and don't complicate my life in explaining that's more complicated like that that is bad and therefore we have to reduce that and i have a sense that there is no argument that could actually make him change his mind now the reason this came up is that he actually wrote an op-ed in the financial times in which he said that is bad and eli summers and olivia blanchard actually agree with me and i felt that i had to be clear about the fact that we did not agree i've disagreed with biden stimulus program which is this enormous program 1.9 trillion which is going to increase demand and i think it's going to overheat the us economy in ways which are not particularly desirable but i have objected to it because it's too big and because it's not needed i have not objected to it because it increases that i think that if it was smaller and financed by that i'd be completely happy and then i've indicated that i'm worried about inflation in the united states for the same reason because this enormous increase in demand facing limited supply is likely to lead to quite a bit of inflation and although i would like to have more inflation than what we have i don't want to have 10 percent inflation that would scare me mr chavre has said that i worried about inflation in europe but i want to reassure him i don't because in europe the plants are much smaller than the biden plans we're much further away from full employment so i think the risk of inflation in europe is very very small so i wanted to be clear on tito boeres remark yes first at some general level if you're going to get a terrible rule because you don't want to change a treaty then you actually have to think twice about whether this is the right thing to do but maybe more realistically it seems it seems to me and we have written this and i don't want to go into the legal details but we think that what we have proposed can actually be done without a treaty change it is for lawyers to decide but my sense is if the commission decided that this was the way to go they have good lawyers and they could make the case and there would not be a need for treaty charge but again the notion that the treaty is preventing you from doing something which is clearly better must lead you to say shouldn't we revisit the treaty i realize it's complicated thank you very much professor blanchard we hope that next year we'll meet in person yes this year uh it's uh 50 50 some of us are here some of uh us are um elsewhere so i think that we should put our hands together to thank you most warmly for your lecture thank you professor professor you