IS/LM in the Eurozone and Germany´s surplus

The title is a reference to Lance Taylor´s seminal “IS/LM in the Tropics”[1] , the diagrammatic tool stems from Jeffrey Frankel´s paper on optimal sterilization policies in emerging countries, a debate to which I contributed almost a quarter of a century ago[2]. However, quite exceptionally for this blog, this entry is neither on the tropics nor on emerging countries. It is on the dismal zone, better known as Eurozone. The model will illustrate Bundesbank boss Jens Weidmann´s cynical statement about the Euro borrowed from Fisherman´s Friends drops and applied to the Euro: “Ist er zu stark, bist Du zu schwach”[3].


Germany has maintained a large surplus on the current account of its balance of payments – oscillating between six and eight percent of GDP in recent years - although the Eurozone outside Germany weakened, China´s merchandise imports stagnated and other large emerging markets (Russia, Brazil) were in trouble. As demonstrated by Patrick Artus´ team at Natixis Economic Research, the German surplus can be explained neither by a drop in its domestic demand (as is often done) nor by improved terms of trade. It is largely due to improved market shares and trade balances with the United States, Japan, non-euro-zone Europe and China, which has offset the deterioration in its trade position in the euro zone. As will be shown below, Germany´s hyper competitiveness slows down the depreciation of the Euro, required by the rest of the Eurozone to make it a bit less dismal.

IS/LM in the Eurozone

The Eurozone is illustrated by the familiar textbook macroeconomic general-equilibrium model, with the IS, LM, and BP curves denoting goods market, money market and balance of payments equilibrium, respectively. Demand for output Y is shown on the horizontal axis, with the price level predetermined in the short run. A move to the right on the y-axis thus denotes only employment gains (and no inflationary pressure), a move to the left employment losses. Y is the sum of domestic aggregate demand and the trade balance (net foreign demand for domestic output). The interest rate i is presented on the vertical axis; as the Eurozone has open capital markets, the interest rate i is equal to i*, the international rate. The overall balance of payments, BP, the sum of the trade balance and the capital account, is horizontal: the capital account rules, the current account follows, and a rise in i above i* sucks in infinite capital inflows (as long as the Eurozone is still ´investible´).

Germany´s surplus is so huge that it translates into a surplus of the Eurozone. The IS curve shifts to the right as the trade balance improves, putting upward pressure on the interest rate and therefore on the capital account. As the Euro is a flexible currency (outside the Eurozone), money inflows (not trade) will appreciate the Euro. In the model, the currency will appreciate far enough to return the trade balance, the IS curve, and domestic aggregate demand back to point A. In plain words, Germany´s improved trade balance has to be ´paid´ by even more depressed demand in the rest of the Eurozone. Maybe, Jens Weidmann should have said: “Is Germany too strong, it should abstain from using the Euro”?

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[1] Lance Taylor (1981), „IS/LM in the Tropics: Diagrammatics of the New Structuralist Macro Critique”, Economic Stabilization in Developing Countries, Vol 502, Brookings Institution, Washington DC.

[2] Jeffrey Frankel (1997), „Sterilization of Money Inflows: Difficult (Calvo) or Easy (Reisen)?“, Estudios de Economía, Vol. 24.2, December, pp. 263-285.

[3] Interview Jens Weidmann „Ist er zu stark, bist Du zu schwach“,  in Süddeutsche Zeitung, 22.5.2014; see http://www.bundesbank.de/Redaktion/DE/Interviews/2014_05_22_weidmann_sz.html

The Virus of Multilateral Trust Funds

Would a stronger core budget funding of the World Health Organisation and less dominance of earmarked funding of global health spending have prevented the current rapid spread of Ebola? This daring thesis was expressed last week at a fascinating workshop, sponsored by the Swiss Network for International Studies (SNIS), at Zurich University, on the “Proliferation of Multilateral Funds”. WHO Director Dr. Margaret Chan recently complained: “My budget [is] highly earmarked, so it is driven by what I call donor interests”.

Earmarked multilateral funding has spread like a virus in recent decades, with earmarking defined in thematic, geographic and/or institutional terms. Bilateral donors channel earmarked funds to multilateral development agencies that implement activities for them, but without allowing these agencies to use the funds at their own discretion. The hybrid funding mechanism is often dubbed multi-bi aid. The Figure[1] below shows that earmarked multilateral funding has really won traction, ironically, since the Paris Declaration 2005 that sought to turn aid delivery less burdensome for the recipients, including by simplifying delivery channels. It is based on 680 (!) distinct multilateral development organisations (much more than the 280 ODA eligible counted by the OECD Report on Multilateral Aid). With a volume of 19 billion USD in 2012, multi-bi aid today amounts to almost 60 percent of the volume of multilateral aid.

Figure: Multi-bi aid relative to multilateral contributions,

                                                        in percent, 1990 - 2012

Source: Reinsberg et al. (2014)

Viewed from a principal-agent perspective (with the donors as principals and the multilaterals as agents), the higher share of non-core budgets in multilateral organizations has gone along the move from collective principals to multiple principals, from member country groupings with largely homogenous preferences to groupings with heterogeneous policy goals. Applied to the UN system, the US called the shots after WWII based on its Western European and Latin American allies in what was then a much smaller country grouping. To the extent that the UN enlarged and raised its member base, the US, the UK and other leading countries lost the majority. This explains the start and rise of voluntary multilateral aid funding from the 1960s. Multiple principals have multiple interests that they see better implemented in earmarked rather than general policy programs.

The recent rapid rise of the share of earmarked contributions to multilateral aid over the past two decades, however, needs further explanation. The rise is closely correlated with the establishment of so-called trust funds, either umbrella funds with many donors or, somehow perversely, single-donor funds. Mid-2013, the overall number of active trust funds at the World Bank was more than 900(!).

So what makes trust funds attractive to donor governments? First, the voluntary nature of multi-bi contributions to trust funds provides more flexibility as they are typically independent of long-term agreements at the international level (such as the three-year IDA replenishment rounds). In contrast, they are released on a short-term basis.  Second, governance and management structures can be designed in ways that may also allow for leverage from private charities, foundations, firms, or charities. Third, and perhaps most importantly, trust funds (especially the rapidly rising single-donor funds) can be tailored to the (ever changing) policy priorities of donor governments. Arguably, the vehicle is well suited to mobilise resources to fund global public goods – under the condition that these resources are complementary (which seems largely the case).

What then has made multilateral trust funds so much more attractive? Two further papers presented at the SNIS workshop provide some convincing hints[2]. First, the simple existence of trust funds influences the aid allocation by donors across available channels: the possibility of earmarking multilateral aid decreases donors' contributions to the multilateral's discretionary core budget and the amount of bilateral aid. Second, the existence of earmarking may also stimulate some active agents (the boss or management team of an international organisation) to enlarge their fiefdoms; I for one have worked in such an organization. Third, policy priorities do change but multilaterals can be very slow to accommodate those changes, partly for bureaucratic inertia but also for perfectly justified governance rules; the more this results in incompatible goals between donors and agencies, the higher will be the incentive to create trust funds and earmark funds. Finally, the same impact will occur to the extent that policy priorities become more heterogeneous across donors.

The demise of the United States as the benevolent Kindleberger-type hegemon in a multipolar world  and the rise of the emerging donors such as China would lead to predict that there will be more, not less, earmarked multilateral funding in the future. The multilateral donor chaos is alive and kicking[3].

 

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[1] Modified from and based on a forthcoming article by Reinsberg, Michaleowa and Eichenbauer (2014), “The rise of multi-bi aid and the proliferation of trust funds”, Handbook of Development Economics 2014.

[2] Eichenbauer and Hug (2014), “The politics of special-purpose trust funds”, unpublished, Heidelberg University and Université de Génève; Reinsberg, Michaelowa, and Knack (2014), “Which donors, which funds? The choice of multilateral funds by bilateral donors at the World Bank”, unpublished, University of Zurich and World Bank.

[3] Reisen (2010), "The multilateral donor non-system: towards accountability and efficient role assignment," Economics - The Open-Access, Open-Assessment E-Journal, vol. 4(5), pages 1-22.