Cockroach Ideas and Weak Arguments

Helene Mees in a Project Syndicate Comment weighs into the dispute between Paul Krugman and the Commission officials, siding with Rehn and his people.
Mees’ criticism of Krugman is two-sided. First, she argues, Krugman omits to say that the OMTs program is subject to heavy conditionality, and that the signature of the fiscal compact was a necessary precondition for the adoption of the program. I don’t get it. The ECB is very vocal on austerity and on structural reforms, and it is clear that the OMTs program was adopted only at the very last minute, facing the perspective of eurozone collapse. A number of economists, including myself, welcomed the OMTs while criticizing the heavy conditionality attached to it. The very fact that the OMTs was reluctantly adopted shows that even austerity partisans cannot deny the fact that the EMU is desperately lacking a proper lender of last resort, of which the OMT is a pale surrogate. The more non-Keynesian institutions are forced to adopt Keynesian solutions, the more Krugman’s point is vindicated. I fail to see how the opposite could be true.

Fear and Confusion in Frankfurt

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?

Leaks in the Dam?

Interesting things happened this morning. I assisted to one of the presentations of the OECD interim assessment. There is nothing very new in the assessment, that concerning the eurozone, can be summarized as follows

• The outlook remains negative (while the rest of the OECD countries are doing better)
• There is still room for monetary accommodation
• This monetary accommodation may not benefit the countries that need it more, because the transmission mechanism of monetary policy is still not fully working
• The Cyprus incident shows that there is a desperate (this I added) need of a fully fledged banking union
• EMU countries need to continue on the path of fiscal stabilization, even if automatic stabilizers should be allowed to fully play their role, even at the price of missing nominal targets

End of The Tunnel?

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…

Does Central Bank Independence Need Inflation Targeting?

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.

Economic Theories and Technocratic Governments

The upcoming Italian elections triggered an interesting debate on the choices ahead, and on the role of technocratic governments. A few days ago the Italian journalist Barbara Spinelli published on the daily La Repubblica a masterly analysis (in Italian) of the difficulties faced by a political sphere that seems incapable, or unwilling, to reclaim from technocrats the task of governing, by which I mean the right/duty to choose between policies with different economic and social consequences.

To an economist, Spinelli’s analysis is a source of further thoughts on the role of choice in economic theory and policy, with important consequences not only for Italy but also for the path that the European construction will walk in the coming years.

The Ancient Roots of EU Problems

Il Sole 24 Ore just published an editorial I wrote with Jean-Luc Gaffard, on the structural problems facing the EU. Here is an English (slightly longer and different) version of the piece:

It is hard not to rejoice at the ECB announcement that it would buy, if necessary, an unlimited amount of government bonds. The Outright Monetary Transactions (OMT) program is meant to protect from speculation countries that would otherwise have no choice but to abandon the euro zone, causing the implosion of the single currency. As had to be expected, the mere announcement that the ECB was willing to act (at least partially) as a lender of last resort calmed speculation and spreads came down to more reasonable levels.

The Tree and the Forest

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.

(Bad) Arguments Against Debt Monetization

I think it is useful to list, and assess, the main arguments advanced against an enhanced role of the ECB as a lender/buyer of last resort. I can think of four of them: credibility, inflation, irrelevance, ineffectiveness.