The Financial Times highlights one of the most striking conclusions of the latest ECB Financial Stability Report (full document here). The ECB, using FT’s words, “issued a stark warning over the threat posed by the scaling back of US monetary stimulus, calling on eurozone policy makers to do more to prepare for the market shocks from Federal Reserve tapering.“
There are of course many reasons why a change of policy of the largest world economy is closely monitored because of its potential impact. The ECB statements nevertheless are striking to me, because they are further confirmation of the small country syndrome that I pointed out in the past.
Quantitative Easing has been pivotal in ensuring that the hasty reversal of the fiscal stance in the United States did not dip their economy into a new recession. One may argue that today’s US economy is not sufficiently robust for exiting monetary stimulus. But it is sooner or later going to happen. The rest of the world has been free riding on Fed’s policies. In particular, the eurozone has benefited from QE in a context of sharp and pro-cyclical austerity, and very timid monetary policy.
Here is the statement I would have expected from the ECB: “The eurozone, the second largest economy of the world, has benefited from exceptional measures implemented by the Fed. This helped our economies and our financial markets in the context of a difficult consolidation process. Domestic factors in the United States will most likely cause a reversal of these policies. It is time European policy makers stand on their legs. As our economies persist in a state of chronic weakness, the ECB will consider its own quantitative easing program, to compensate for tapering in the United States, and provide to the European economy the environment it needs to rebound“
Such a statement, that I would find reasonable and balanced (maybe even too prudent), is nevertheless revolutionary nonsense in European policy circles. Instead we had the same old “copy-and-paste” demand to EMU countries of structural reforms and stable macroeconomic policies (read austerity). Not a single hint of even remotely possible non orthodox policies here at home. The sad truth is that we are structurally incapable of finding within our economy and our institutions the instruments to ensure growth and prosperity. We are structurally free riders. We siphon aggregate demand from the rest of the world running increasing current account balances, and we are not capable of implementing an autonomous monetary policy.
The world’s second largest economic area remains a parasite of the global economy, and it is incapable of living up to its responsibilities. Nothing good can come out of this.
Last Thursday the ECB cut rates, somewhat unexpectedly. This shows that it takes the risk of deflation very seriously. Good news, I’d say. But unfortunately, press conferences follow ECB Council meetings. And I say unfortunately, because Mr Draghi words often fail to match his actions. Here is what he said on Thursday (I could not resist adding some bold here and there):
If you look at the euro area from a distance, you see that the fundamentals in this area are probably the strongest in the world. This is the area that has the lowest budget deficit in the world. Our aggregate public deficit is actually a small surplus. We have a small primary surplus of 0.7%, compared with, I think, a deficit of 6 or 7% deficit in US, – 6 I think – and 8 % in Japan. This is the area with the highest current account surplus. And it is also the area, as we said before, with one of the lowest – if not the lowest – inflation rate.
Fascinating. Truly fascinating. I will pass on the fact that one of the strong “fundamentals” Mr Draghi quotes, low inflation, is actually the main source of worry for economists and policymakers worldwide, including the ECB, that had to rush into a rate cut that was not planned at least until December! I will also pass on his praise of high current account surpluses while the Commission itself is considering opening an infraction procedure against Germany, for perpetuating an important source of imbalances within the eurozone and worldwide.
No, what I find more shocking is the list of fundamentals Draghi gives: public debt and deficit; inflation; current account balance. Now, it dates back a little, but I remember all of those, in Econ 101, to be defined as instruments of economic policy, supposed to serve the final objectives of growth and employment. It is true that we do rather well in what Draghi calls fundamentals, but I continue preferring to call instruments. Look at this table:
I have reported, for ease of comparison, data from the IMF World Economic Outlook (October 2013), therefore they are not the latest (quarterly or monthly) data. Also, I have highlighted in red the worst performer, and in green the best. And boy, Draghi is right! (Notice incidentally that eurozone inflation was 2.5 percent on average in 2012. With the latest data at 0.7 percent, this suggests that we are running, not walking, towards deflation.)
But if we look at the supposed objectives of economic policy (how would Draghi call these?), the picture changes, quite a bit:
No other major advanced economy is doing nearly as badly as the eurozone in terms of unemployment and GDP. But according to the ECB President we have “the strongest fundamentals in the world”. Does this means that Draghi did not take Econ 101? No, I know for sure that he did take it, and he actually had excellent mentors. To understand Draghi’s claim, it may be useful to read his whole sentence. After arguing that the eurozone has strong fundamentals he goes on:
This does not translate automatically into a galloping recovery. But, actually, it gives you the fundamentals upon which you can pursue the right economic policies. Structural reforms are the necessary and sufficient condition for this to happen. In the absence of that, unfortunately, we are going to stay here for quite a long time.
Here is the answer. The only and one answer. Focusing on instruments instead of targets is the strategy of those who do not believe that a role exists for active economic policies. It is a pity that one of these guys is heading the second most important central bank of the world. And it is paradoxically reassuring that the situation is currently so bad that he is forced to abandon his creed and implement active monetary policies.
Advice for the next episodes: praise Mario Draghi actions, and avoid reading the transcripts of his press conferences.
George Soros writes a piece on Project Syndicate, that is both pedagogical and very clear in outlining a possible answer to the current EMU crisis. He starts with a diagnosis of the EMU imbalances that rejects the “Berlin View”, and argues for the existence of structural imbalances
Normally, developed countries never default, because they can always print money. But, by ceding that authority to an independent central bank, the eurozone’s members put themselves in the position of a developing country that has borrowed in foreign currency. Neither the authorities nor the markets recognized this prior to the crisis, attesting to the fallibility of both. Read more
Bundesbank President Jens Weidmann strikes again. In a tribune on today’s Financial Times he argues that to break the sovereign-bank nexus, the only solution is to impose, through regulation, an extra burden on sovereign debt holdings (he is gracious enough to concede that a transition period could be accorded).
I find this fascinating. Germany is the country that most opposes a fully fledged banking Union, that to be effective would require common deposit insurance, a crisis resolution mechanism, and I would add, an enhanced role of the ECB as a lender of last resort.
This would break the vicious circle between sovereigns and the financial sector, without denying the special role of banks and credit in a modern economy; nor, also relevant in today’s situation, their capacity to finance governments. Weidmann stubbornly refuses to see any specificity to banks, and has nothing else to propose than imposing by regulation what de facto is a downgrading by default of sovereign debt.
Mr Weidmann is a talented economist. He should maybe go back to Bagehot’s Lombard Street
Dani Rodrik has an excellent piece on Project Syndicate. I strongly advise reading and sharing it. Rodrik points out that structural reforms (if well designed, I’d add) tend to destroy jobs in low productivity sectors, and to create them in high productivity ones. He then argues that for the second effect to happen, the high productivity sectors need to face strong demand. This is not happening right now, so that structural reforms, where implemented, are only contributing to depressing employment and growth. He concludes that the very success of structural reforms depends on fixing the short run aggregate demand deficiency problem, through standard Keynesian policies. The zest of the paper is in the last two paragraphs:
Ultimately, a workable European economic union does require greater structural homogeneity and institutional convergence (especially in labor markets) among its members. So the German argument contains a kernel of validity: In the long run, EU countries need to look more like one another if they want to inhabit the same house.
But the eurozone faces a short-term problem that is much more Keynesian in nature, and for which longer-term structural remedies are ineffective at best and harmful at worst. Too much focus on structural problems, at the expense of Keynesian policies, will make the long run unachievable – and hence irrelevant.
Rodrik states something rather obvious: Read more
I must say I am puzzled by today’s decision of the ECB to leave rates unchanged. It simply does not fit with what Mario Draghi said during the press conference. Let me quote him.
Inflation expectations for the euro area continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. At the same time, weak economic activity has extended into the early part of the year and a gradual recovery is projected for the second half of this year, subject to downside risks. Against this overall background our monetary policy stance will remain accommodative for as long as needed.
If words actually mean what they mean, Draghi informed us that (a) inflation, and inflation expectations, are in line with forecasts and objectives; (b) at the same time, economic activity is weaker than expected, and the future recovery is at risk; (c) the ECB is willing to have an accommodative monetary stance.
Two considerations: first, the king is naked; it was obvious from the very beginning that the recovery in the second half of the year was not in the cards. I already discussed the systematic bias in official forecasts. It turns out that simply saying to markets that things will go well, is not sufficient to make them act accordingly. The confidence fairy, as Krugman calls it, is nowhere to be seen. I would add that this systematic bias risks making EMU institutions less credible, and hence further weaken their capacity to anchor private sectors’ expectations…
And then the puzzle: if inflation is under control, and if economic activity is weak, and if the ECB deems accommodation to be needed, why, why on earth are rates kept constant? Should we remind to Mario Draghi what is written in article 127 of the Lisbon Treaty?
The primary objective of the European System of Central Banks, hereinafter referred to as “ESCB”, shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union.
Among the general policies that the ECB should support there is growth and employment. And lowering the rates today would certainly not lead to “prejudice to the objective of price stability”
Why is the ECB so frightened to send the signal to markets that it is ready to boost economic activity? Is there an hidden agenda we are unaware of?
There are signs of optimism around. Cautiously, policy makers and commentators start discussing the shape (and the fragility) of the future recovery. Martin Wolf on the Financial Times already speculates on the timing of reversal to a normal state of affairs. Wolf is rightly worried by the temptation to reverse policies too fast, a mistake we made already at the end of 2009, when stimulus plans were reversed into consolidation far too soon.
As a rule of thumb, I’d argue that exceptional involvement of governments in the economy should stop when the private sector is ready to take the witness. Stimulus plans and monetary easing should be rolled back once private spending resumes (or is ready to resume), and when the credit market is sufficiently loose. So the question is, how does private sector behaviour fit, within this moderate optimistic mood? Not too well I am afraid… Read More
Two articles on today’s Financial Times puzzle me. The first (Weidmann warns of currency war risk) offers yet another example of how economic analysis sometimes leaves the way to ideological beliefs. The Bundesbank’s president argues (as he already did in the past) that giving up inflation targeting hampers central bank independence. How? Why? He does not bother explaining.
What I think he has in mind is that once the objective of the central bank goes beyond strict inflation targeting, monetary policy needs an arbitrage between often conflicting objectives (typically unemployment and inflation). It is the essence of the dual mandate. This of course moves monetary policy out of the realm of technocratic choice, and makes it a political institution (Stephen King explains it nicely). I would argue that this is normal once we abandon the ideal-type of frictionless neoclassical economics, and we accept that we may have a tradeoff between inflation and unemployment. But this is not the issue here. The issue, and the puzzle, is why transforming the choice from technocratic to political, should necessarily lead to giving up independence. Read more
I have read an interesting article by Wolfgang Münchau, on the Financial Times. To summarize, Münchau argues that because of politician’s complacency, there is a chance that the new OMTs program launched by the ECB will never be used, and hence prove ineffective in boosting the economy. He therefore argues that the ECB should have done like the Fed, and announce an unconditional bond purchase program (private and public alike).
The piece is interesting because Münchau is at the same time right, and off the target. It is worth trying to clarify.
What to do of yesterday’s decision of the ECB? The tree looks
very rather nice, the forest much less. First, a look at what Mario Draghi announced:
- “[...] the Governing Council today decided on the modalities for undertaking Outright Monetary Transactions (OMTs) in secondary markets for sovereign bonds in the euro area. [...] We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance to the real economy throughout the area. OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro. [...] we act strictly within our mandate to maintain price stability over the medium term.” The technical note accompanying the decision explicitly states what markets wanted to know: “No ex ante quantitative limits are set on the size of Outright Monetary Transactions” In other words, bond purchases will be unlimited.The technical note also specifies the conditionality, the fact that the purchases will be on short maturities, and that they will be fully sterilized.
- Let’s go back to Draghi: “we decided to keep the key ECB interest rates unchanged. [...] inflation rates are expected to remain above 2% throughout 2012, to fall below that level again in the course of next year and to remain in line with price stability over the policy-relevant horizon.“
To summarize, the ECB will try to bring down the spreads, acting within its mandate, because speculation is perturbing the transmission mechanism of monetary policy and threatening stability. This can also help explain the decision to keep the rates unchanged: there is no point in using that lever, unless it is sure it works.
Why is the tree rather good? And what makes the forest more worrisome? The tree first.