Bloomberg repeats the bond yield fallacy (Milton Friedman is spinning in his grave)

This is from Bloomberg:

A series of unprecedented stimulus measures by the ECB to stave off deflation in the 18-nation currency bloc have sent bond yields to record lows and pushed stock valuations higher. “

Unprecedented stimulus measures? Say what? Since ECB chief Mario Draghi promised to save the euro at any cost in 2012 monetary policy has been tightened and not eased.

Take any measure you can think of – the money base have dropped 30-40%, there is basically no growth in M3, the same can be said for nominal GDP growth, we soon will have deflation in most euro zone countries, the euro is 10-15% stronger in effective terms, inflation expectations have dropped to all time lows (in the period of the euro) and real interest rates are significantly higher.

That is not monetary easing – it is significant monetary tightening and this is exactly what the European bond market is telling us. Bond yields are low because monetary policy is tight (and growth and inflation expectations therefore are very low) not because it is easy – Milton Friedman taught us that long ago. Too bad so few economists – and even fewer economic reporters – understand this simple fact.

If you think that bond yields are low because of monetary easing why is it that US bond yields are higher than in the euro zone? Has the Fed done less easing than the ECB?

The bond yield fallacy unfortunately is widespread not only among Bloomberg reporter, but also among European policy makers. But let me say it again – European monetary policy is extremely tight – it is not easy and I would hope that financial reporter would report that rather than continuing to report fallacies.

HT Petar Sisko

PS If you want to use nominal interest rates as a measure of monetary policy tightness then you at least should compare it to a policy rule like the Taylor rule or any other measure of the a neutral nominal interest rate. I am not sure what the Talyor rule would say about level of nominal interest rates we should have in Europe, but -3-4% would probably be a good guess. So interest rates are probably 300-400bp too higher in the euro zone. That is insanely tight monetary policy.

PPS I am writing this without consulting the data so everything is from the top of my head. And now I really need to take care of the kids…sorry for the typos.

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Great, Greater, Greatest – Three Finnish Depressions

Brad DeLong has suggested that we rename the Great Recession the GreatER Depression in Europe as the crisis in terms of real GDP lose now is bigger in Europe than it was it during the Great Depression.

Surely it is a very simplified measure just to look at the development in the level of real GDP and surely the present socio-economic situation in Europe cannot be compared directly to the economic hardship during the 1930s. That said, I do believe that there are important lessons to be learned by comparing the two periods.

In my post from Friday – Italy’s Greater Depression – Eerie memories of the 1930s – I inspired by the recent political unrest in Italy compared the development in real GDP in Italy during the recent crisis with the development in the 1920s and 1930s.

The graph in that blog post showed two things. First, Italy’s real GDP lose in the recent crisis has been bigger than during 1930s and second that monetary easing (a 41% devaluation) brought Italy out of the crisis in 1936.

I have been asked if I could do a similar graph on Finland. I have done so – but I have also added the a third Finnish “Depression” and that is the crisis in the early 1990s related to the collapse of the Soviet Union and the Nordic banking crisis. The graph below shows the three periods.

Three Finnish Depressions

(Sources: Angus Maddison’s “Dynamic Forces in Capitalist Development” and IMF, 2014 is IMF forecast)

The difference between monetary tightening and monetary easing

The most interesting story in the graph undoubtedly is the difference in the monetary response during the 1930s and during the present crisis.

In October 1931 the Finnish government decided to follow the example of the other Nordic countries and the UK and give up (or officially suspend) the gold standard.

The economic impact was significant and is very clearly illustrate in the graph (look at the blue line from year 2-3).

We have nearly imitate take off. I am not claiming the devaluation was the only driver of this economic recovery, but it surely looks like monetary easing played a very significant part in the Finnish economic recovery from 1931-32.

Contrary to this during the recent crisis we obviously saw a monetary policy response in 2009 from the ECB – remember Finland is now a euro zone country – which helped start a moderate recovery. However, that recovery really never took off and was ended abruptly in 2011 (year 3 in the graph) when the ECB decided to hike interest rate twice.

So here is the paradox – in 1931 two years into the crisis and with a real GDP lose of around 5% compared to 1929 the Finnish government decided to implement significant monetary easing by devaluing the Markka.

In 2011 three  years into the present crisis and a similar output lose as in 1931 the ECB decided to hike interest rates! Hence, the policy response was exactly the opposite of what the Nordic countries (and Britain) did in 1931.

The difference between monetary easing and monetary tightening is very clear in the graph. After 1931 the Finnish economy recovered nicely, while the Finnish economy has fallen deeper into crisis after the ECB’s rate hikes in 2011 (lately “helped” by the Ukrainian-Russian crisis).

Just to make it clear – I am not claiming that the only thing import here is monetary policy (even though I think it nearly is) and surely structural factors (for example the “disappearance” of Nokia in recent years and serious labour market problems) and maybe also fiscal policy (for example higher defense spending in the late-1930s) played role, but I think it is hard to get around the fact that the devaluation of 1931 did a lot of good for the Finnish economy, while the ECB 2011’s rate hikes have hit the Finnish economy harder than is normally acknowledged (particularly in Finland).

Finland: The present crisis is The Greatest Depression

Concluding, in terms of real GDP lose the present crisis is a GreatER Depression than the Great Depression of the 1930s. However, it is not just greater – in fact it is the GreatEST Depression and the output lose now is bigger than during the otherwise very long and deep crisis of the 1990s.

The policy conclusions should be clear…

PS this is what the New York Times wrote on October 13 1931) about the Finnish decision to suspend the gold standard:

“The decision of taken under dramatic circumstances…foreign rates of exchange immediately soared about 25 per cent”

And the impact on the Finnish economy was correctly “forecasted” in the article:

“In commercial circles it is expected that the suspension (of the gold standard) will greatly stimulate industries and exports.”

HT Vladimir

Related post:
Currency union and asymmetrical supply shocks – the case of Finland

Mussolini’s great monetary policy failure

Benito Mussolini is known for having been a horrible warmongering fascist dictator. However, he was also responsible for a major failed monetary experiment – the so-called Battle of the Lira.

Hence, in 1926 Mussolini announced a major revaluation of the Italian Lira as part of his general plan to revive the greatness of Italy.

This is how the Battle of the Lira was described in the New York Times in August 1927:

“It is just one year since Premier Mussolini, speaking at Pesaro, delivered that oration, destined to remain famous in the annals of modern Italian history, in which he announced his intention to revalue the lira.

‘We shall never inflict upon our wonderful Italian people, which for four years has been working with ascetic discipline and is ready for even greater sacrifieces, the moral shame and economic catastrophe of failure of the lira,’ he declared.

Looking back upon the last year, one must admit that Primier Mussolini has more than kept his word. In August 1926, the average exchange rate was 30 1/2 lira to the dollar. By October it had already dropped to 27 …the lira steadily continued its descent till in May (1927) it reached 18 to the the dollar, where it has remained ever since”

Hence, Mussolini engineered a nearly 70% revaluation of the lira in less than one year. Not surprisingly the economic impact was not positive. This how that is described in the same New York Times article:

“But the result has not been obtained without servere…jolts affecting all classes of citizens.

…Revaluation has led to a period of general stagnation and lack of enterprise in industry, for the gold value of money has increased automatically while the revaluation process was in progress and people preferred to leave their money in banks to rising it in ventures of any kind.

Unemployment is twice as high as it was in this month last year and greater than it has been at any time since 1924. Average quotations on stock exchanges have fallen 40 per cent. Wholesale prices have fallen about 30 per cent, but retail prices lag far behind and show a decrease of less than 15 per cent…

…Despite these somewhat depressing indications, the Government is convinced that the benefits of revaluation will ultimately far outweigh the drawbacks. The official opinion, indeed, is that now that the whole country has become adjusted to the new value of the lira, a rapid improvement will be expirienced.”

That of course never happened. Instead the Italian economy was hit by yet another shock in 1929 when the global crisis hit.

Finally in 1934 Mussolini decided to give up the gold standard and in October 1936 the lira was devalued by 41%.

What role Mussolini’s failed monetary policy played in his domestic policies and particularly in the foreign policy “adventures” – his war against Abyssinia in 1935-36 and his decision to ally himself with Hitler and Nazi-Germany in WWII – I don’t know, but there is nothing like war to take away the attention from failed economic policies.

Or as it was expressed in an article in New York Times in April 1935 at the start on Mussolini war against Abyssinia (but before the 1936 devaluation):

Behind each new political move in Europe, which expresses itself in the mobilization of larger armies, may generally be found an economic cause.

The article also touches on another key issue – the fact that (über) tight monetary policy historically has led to protectionist measures and that the logical consequence of such protectionist measures often is war:

The foreign trade of Italy is, figuratively, “shot to pieces.” The decrees against imports , the unwillingness to do business except where equal valued are exchanged by a foreign nation and the high rate of the lira have produced an alarming situation for a country that today under unobstructed movements of goods, would have an unfavorable trade balance.

One of the major efforts of Mussolini has been to place Italy on a self-supporting basis. Much has been done in this direction. As Italy is poor in natural resources that enter into processes of manufacture, the handicaps to attaining self-sufficiency are not easy to surmount.”

It is too bad today’s European policy makers didn’t study any economic history.

—-

Related blog posts:

“If goods don’t cross borders, armies will” – the case of Russia
Denmark and Norway were the PIIGS of the Scandinavian Currency Union

And posts on the early 1930s:

1931:
The Tragic year: 1931
Germany 1931, Argentina 2001 – Greece 2011?
Brüning (1931) and Papandreou (2011)
Lorenzo on Tooze – and a bit on 1931
“Meantime people wrangle about fiscal remedies”
“Incredible Europeans” have learned nothing from history
The Hoover (Merkel/Sarkozy) Moratorium
80 years on – here we go again…
“Our Monetary ills Laid to Puritanism”
Monetary policy and banking crisis – lessons from the Great Depression

1932:
“The gold standard remains the best available monetary mechanism”
Hjalmar Schacht’s echo – it all feels a lot more like 1932 than 1923
Greek and French political news slipped into the financial section
Political news kept slipping into the financial section – European style
November 1932: Hitler, FDR and European central bankers
Please listen to Nicholas Craft!
Needed: Rooseveltian Resolve
Gold, France and book recommendations
“…political news kept slipping into the financial section”
Gideon Gono, a time machine and the liquidity trap
France caused the Great Depression – who caused the Great Recession?

1933:
Who did most for the US stock market? FDR or Bernanke?
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
Remember the mistakes of 1937? A lesson for today’s policy makers
I am blaming Murray Rothbard for my writer’s block
Irving Fisher and the New Normal

 

Italy’s Greater Depression – Eerie memories of the 1930s

This is from the Telegraph:

Italy was hit by strikes, violent demonstrations and protests against refugees on Friday as anger and frustration towards soaring unemployment and the enduring economic crisis exploded onto the streets.

Riot police clashed with protesters, students and unionists in Milan and Padua, in the north of the country, while in Rome a group of demonstrators scaled the Colosseum to protest against the labour reforms proposed by the government of Matteo Renzi, the 39-year-old prime minister.

Eggs and fire crackers were hurled at the economy ministry.

On the gritty, long-neglected outskirts of Rome there was continuing tension outside a centre for refugees, which was repeatedly attacked by local residents during the week.

Locals had hurled stones, flares and other missiles at the migrant centre, smashing windows, setting fire to dumpster rubbish bins and fighting running battles with riot police during several nights of violence.

They demanded that the facility be closed down and claimed that the refugees from Africa and Asia were dirty, anti-social and violent.

Some protesters, with suspected links to the extreme Right, yelled “Viva Il Duce” or Long Live Mussolini, calling the migrants “b*******”, “animals” and “filthy Arabs”.

…A group of 36 teenage migrants had to be evacuated from the centre in Tor Sapienza, a working-class suburb, on Thursday night after the authorities said the area was no longer safe for them.

The sense of chaos in the country was heightened by transport strikes, which disrupted buses, trams, trains and even flights at Rome’s Fiumicino airport. Demonstrations also took place in Turin, Naples and Genoa.

Unemployment among young people in Italy is around 42 per cent, prompting tens of thousands to emigrate in search of better opportunities, with Britain the top destination. The overall jobless rate is 12 per cent.

Mr Renzi’s attempts to reform the country’s labour laws, making it easier for firms to dismiss lazy or inefficient employees, are bitterly opposed by the unions.

The ongoing recession has also exacerbated racial tensions, with some Italians blaming refugees and immigrants for their economic woes.

It is hard not to be reminded of the kind of political and social chaos that we saw in Europe in the 1930s and it is hard not to think that the extremely weak Italian economy is the key catalyst for Italy’s political and social unrest.

By many measures the Italian economy of today is worse than the Italian economy of the 1930s. One can say – as Brad DeLong has suggested – that this is a Greater Depression than the Great Depression.

Just take a look at the development in real GDP over the past 10 years and during the 1925-1936-period.

crisis Italy

If you wonder why Italian GDP took a large jump in 1936 (year +6) it should be enough to be reminded that that was the year that the Italian lira was sharply devalued.

Today Italy don’t have the lira and everybody knows who I blame for the deep crisis in the Italian economy.

It is sad that so few European policy makers understand the monetary causes of this crisis and it is tragic that the longer the ECB takes to act the more political and social unrest we will face in Europe.

PS I do not mean to suggest that Italy do not have structural problems. Italy has massive structural problems, but the core reason for the Greater Depression is monetary policy failure. Don’t blame Renzi or the immigrants – blame the Italian in Frankfurt.

 

The massively negative euro zone ‘Divisia Money Gap’

This will not be a long post – I have had a busy week with a three-day roadshow in Poland and it is after all Saturday night – but it will be long enough to yet again point the fingers at the ECB for its deflationary policies.

Earlier this week the Brussels’ based think tank Bruegel published a new data series for the Divisia money supply for the euro zone. I very much welcome Bruegel’s initiative to publish the Divisia numbers as it makes it possible to get an even better understanding of “tightness” of monetary conditions in the euro zone.

Bruegel’s Zsolt Darvas has written an excellent paper – “Does Money Matter in the Euro area? Evidence from a new Divisia Index” - on the data. Here is the abstract:

Standard simple-sum monetary aggregates, like M3, sum up monetary assets that are imperfect substitutes and provide different transaction and investment services. Divisia monetary aggregates, originated from Barnett (1980), are derived from economic aggregation and index number theory and aim to aggregate the money components by considering their transaction service.

No Divisia monetary aggregates are published for the euro area,in contrast to the United Kingdom and United States. We derive and make available a dataset on euro-area Divisia money aggregates for January 2001 – September 2014 using monthly data. We plan to update the dataset in the future.

Using structural vector-auto-regressions (SVAR) we find that Divisia aggregates have a significant impact on output about 1.5 years after a shock and tend also to have an impact on prices and interest rates. The latter result suggests that the European Central Bank reacted to developments in monetary aggregates. Divisia aggregates reacted negatively to unexpected increases in the interest rates. None of these results are significant when we use simple-sum measures of money.

Our findings complement the evidence from US data that Divisia monetary aggregates are useful in assessing the impacts of monetary policy and that they work better in SVAR models than simple-sum measures of money.

The deflationary ‘Divisia Money Gap’

I have used Darvas’ data to calculate a simple ‘Money Gap’ to assess the “tightness” of monetary conditions in the euro zone.

My assumption is that prior to 2008 monetary conditions in the euro zone were “well-calibrated” in the sense that nominal GDP grew at a steady stable rate and inflation was well-anchored around 2%. I have therefore assumed the pre-crisis trend in Bruegel’s Divisia money supply ensures “nominal stability”.

In the pre-crisis years the euro zone Divisia money supply grew by on average just below 8% per year. The ‘Divisia Money Gap’ is the percentage difference between the actual level of the Divisia money supply and the pre-crisis trend in the Divisia money supply.

Divisia Money Gap

The graph above tells two stories.

First, prior to 2008 the ECB kept Divisia money growth ‘on track’. In fact at no time during the pre-crisis years was the Divisia money gap more than +/- 1%. Obviously the ECB was not targeting the Divisia money supply, but nonetheless conducted monetary policy as if it did. This I believe was the reason for the relative success of the euro zone in the first years of the euro’s existence.

Second, starting in Mid-2007 Divisia money supply growth started to slow dramatically and ever since the growth rate of Divisia money has been significantly below the pre-crisis trend leading to “Divisia Money Gap” becoming ever more negative. This of course is a very clear indication of what we already know – since 2007-8 monetary conditions in the euro zone has become increasingly deflationary.

Concluding, this is just more confirmation that monetary policy is far too tight in the euro zone and bold action is needed to ease monetary conditions to pull the euro zone economy out of the present deflationary state.

HT William Barnett

Related posts:
The (Divisia) money trail – a very bullish UK story
 
Divisia Money and “A Subjectivist Approach to the Demand for Money”
 

Orphanides also wonders what happened to the ECB’s monetary pillar

Yesterday the Shadow Open Market Committee (SOMC) held its regular semi-annual meeting in New York.

It is no secret that many of the members of the SOMC have had a large influence on my monetary thinking – just to mention some of them Bennett McCallum, Michael Bordo, Peter Ireland, Marvin Goodfriend and Charles Calomiris all have greatly impacted my thinking.

That said, despite of the fact that the SOMC comes from the same monetarist tradition as myself I must admit I often has a very hard time agreeing with the overall message from the present-day SOMC.

In general I think that the hawkish bias of the SOMC members (and that is a clearly an unjust generalization) is somewhat misguided and seems to me to be overly politicized. I think that is unfortunate because I think that it to some extent overshadows the general message from the SOMC that monetary policy should be rule-based. A view I wholeheartedly agrees with.

That is, however, not really what I want to talk about in this post. Rather I like to highlight a very good paper published in connect yesterday’s SOMC meeting.

The paper – European Headwind: ECB Policy and Fed Normalization - by Athanasios Orphanides in my view is a very good discussion of the monetary causes of the euro crisis. Orphanides of course used to be an ECB insider as Cypriot central bank governor and a member of the ECB’s Governing Council (2008-2012).

What happened to the ECB’s monetary pillar 

At the core of Orphanides’ discussion of the ECB’s failures is a question I often have asked – what have happened to the ECB’s two-pillar strategy and particularly what happened to the the ECB’s M3 target? (See for example here and here).

The entire paper is very good – but I have done a bit of cut-and-paste:

In pursuing its mandate, the ECB adopted a numerical definition of price stability and a two-pillar strategy to guide its monetary policy to attain it. Since May 2003, the ECB has interpreted its primary objective as maintaining inflation rates close to but below 2% per year over the medium term.

This clarified earlier language that had suggested lower inflation levels, explicitly acknowledging the “need for a safety margin to guard against risks of deflation” … Recognition that the operational definition of price stability should be well above zero measured inflation and closer to 2%, in order to account for the zero lower bound on nominal interest rates and provide added room for conventional policy easing, has been a common principle across numerous central banks, including the Fed and the ECB.

The ECB’s two-pillar strategy, as developed under the direction of Otmar Issing who served on the Executive Board of the ECB from the founding of the ECB in 1998 until 2006, provided a role for economic analysis in formulating an assessment of the inflation outlook as well as a prominent role for money and credit as a cross check (Issing, 2005).

The ECB’s two-pillar strategy distilled the fundamental lessons of monetarist economics and combined it with business cycle analysis such as models that  draw on the Keynesian tradition that have generally downplayed the role of money and credit. In this sense, the two-pillar strategy, could deliver more robust policy advice.

…The dismal performance of the euro area coincides with the euro area crisis so it can be suggested that at least part of the responsibility for the outcome (and perhaps the largest part) can be attributed to the mismanagement of the crisis by euro area governments. Pertinent to the ECB, however, would be the question as to whether it has pursued the best possible independent policy action, within its mandate, and accounting for the dysfunction of the governments. And if the ECB has not pursued the best policy to fulfill its mandate, a question of interest is why not?

… according to the monetary pillar, the ECB has pursued consistently exceptionally tight monetary policy over the past few years. Could this be because the monetary pillar lacked information content?

… Before the crisis, real credit growth tracked real GDP growth in the euro area rather closely. And since the beginning of the crisis, fluctuations in real credit growth continue to track fluctuations in real GDP growth…

…The persistent and significant monetary policy tightness reflected in money and credit growth in the euro suggests that the ECB may have all but abandoned its monetary pillar. If it had not, the ECB would have pursued considerably easier monetary policy during this period, counteracting at least part of the dramatic fall in the growth of money and credit. If the ECB has abandoned the two-pillar strategy it had developed over a decade ago, as is strongly suggested by the data, this would represent a very unfortunate development.

…Faster money and credit growth over the past few years could have contributed to higher employment and greater economic growth and stability without compromising price stability. In this manner, faster money and credit growth would have led to better
fulfillment of the ECB’s mandate as specified in the Treaty.

As worrisome as the conclusions suggested by examining the ECB’s monetary pillar may seem, a fundamentally similar conclusion is suggested by examination of recent trends in inflation.

…Over the past six months, core inflation has consistently registered readings under 1%, the first time in the history of the euro with such persistently low core inflation readings. Consistent with the information suggested by the monetary pillar, these data suggest that the ECB has been persistently pursuing overly tight monetary policy. The inflation swap data further suggest that longer-term inflation expectations are becoming unanchored.

(On the ECB “miscalibration” of monetary policy)

…One possibility is a miscalibration of policy at the zero lower bound, perhaps resulting from the misleading notion that policy is already “as easy as can be” once short-term nominal interest rates are close to zero. Such confusion, often associated with the notion of the so called “liquidity trap,” has been noted in earlier historical episodes, for example at the Fed during the Great Depression and at the Bank of Japan in the late 1990s and 2000s.

…History repeated itself across the Pacific during the 1990s. The Bank of Japan was faced with the zero lower bound and stopped easing policy, focusing inappropriately on short-term rates. Economists such as Milton Friedman (1997) and Allan Meltzer (1998)warned that the Bank of Japan should engage in quantitative easing to avert continued stagnation. Friedman reminded policymakers: “There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow; and after another delay, inflation will increase moderately.” Unfortunately, Bank of Japan policymakers delayed the adoption of quantitative easing policies by many years. The result is what we now know as the Japanese “lost decade.”

…The simplest way to calibrate the proper stance of monetary accommodation at the zero lower bound is by adjusting the size of the balance sheet of the central bank through the accumulation of government debt. Once the zero lower bound looms near, policy needs
to shift from interest rates to monetary quantities. Adjusting the size of the balance sheet could replace the traditional movements in the policy rate as a guide to policy. Other options for providing policy accommodation are also available. Clouse et al
(2003) present a review of policy options in a study that was prepared for the FOMC on this issue. In the case of the Fed, the massive expansion of its balance sheet since the beginning of the crisis suggests that in the current episode, the Fed implemented monetary policy along the lines of the policy response suggested by Keynes, Friedman and Meltzer for earlier episodes. The policy response also included additional elements, such as forward guidance, consistent with the preparatory analysis done before the crisis for the
FOMC.

Sadly, in the case of the ECB, the data point to a different conclusion.

… In the summer of 2012, the two balance sheets (of the Fed and the ECB) were comparable, with the Fed’s balance sheet at about 3 trillion dollars and the ECB’s balance sheet at about 3 trillion euro. Since then, the Fed embarked on the quantitative easing policy that has just been concluded at the FOMC’s latest meeting, raising its balance sheet to about 4.5 trillion dollars, an increase of one half. By contrast, over the same time period, the ECB has engineered a massive tightening of policy by reducing its balance sheet to about 2 trillion euro, a reduction of one third.

The tightening of monetary policy that the ECB has engineered through the contraction of its balance sheet has been partly offset by other policy decisions, for example a small reduction in policy rates. Indeed, in response to negative economic developments, in
September 2014 the ECB has undertaken the unprecedented step of bringing the deposit facility rate to minus 0.2%. And the ECB has repeatedly communicated that it wishes to provide the appropriate policy stimulus to fulfill its mandate.

But the very focus on short term interest rates, coupled with the unwillingness to engage in quantitative easing, suggests deep problems with the policy strategy pursued by the ECB in the recent past.

…A central bank claiming that it will do “whatever it takes” while not delivering with actions eventually loses its credibility. Quantitative easing—the expansion of the central bank’s balance sheet through the purchase of government debt—or even the undertaking of open positions in derivatives contracts, allow the central bank to demonstrate with its actions that it means what it says. By “putting its money where its mouth is,” the central bank vastly improves the odds of success in providing policy accommodation.

I find it very hard to disagree with anything in Orphanides’ analysis. In fact it is very similar to my own take on the euro crisis – the ECB consistently has continued to argue that monetary policy is easy in the euro zone, while monetary analysis clearly shows that monetary conditions actually has remained very tight since 2008 and this is the core reason for the crisis and the reason why we are heading for Japanese style deflationary scenario for the euro zone.

But what should the ECB do? Orphanides has a clear policy recommendation:

The most straightforward and time-tested course of action is for the ECB to announce and start the implementation of a quantitative easing program with no further delay. Purchases of euro area sovereign debt should be apportioned according to the ECB’s capital key, to account for the relative sizes of the member states whose sovereign debt would be purchased in the secondary market. How large the purchases should be to restore growth and stability in the euro area, and in full respect of the ECB’s primary mandate, cannot the determined in advance. Judging from the experience of the Federal Reserve, the ECB could announce an initial plan of purchases aiming to double its balance sheet in coming quarters, with a target of reaching at least 4 trillion euro.

This expansion would be proportionally smaller that the expansion of the Fed’s balance sheet relative to size of the balance sheets of the two central banks in the summer of 2012. Nonetheless, a plan to expand the ECB’s balance sheet to 4 trillion euro could serve as a starting point and could be subsequently adjusted, depending on the success of the policy.

One could further hope that the ECB will return to its pre-crisis roots and re-focus on its two-pillar strategy ensuring that money and credit growth in the euro area economy is commensurate with sustainable growth and price stability, in accordance to the ECB’s mandate.

I certainly would fully endorse a programme of quantitative easing with-in a clearly defined rule-based framework and Orphanides suggestion is similar to my own suggestion that the ECB should re-state its M3-target – targeting 10% M3 growth until “money-gap” is closed (See here.) Needless to say I would like to see much more radical reform than that – a full-blown NGDP level targeting regime – but a re-statement of ECB’s monetary pillar and a M3 target would at least provide a much higher degree of nominal stability than is the case today.

However, the sad fact is that it still seems like we are very far away from seeing anything similar to what Orphanides suggests and as a consequence we are still far away to being able to declare an end to the euro crisis. As Orphanides warns:

Europe is not out of the woods and a severe deterioration of the crisis cannot be ruled out, both because of the ECB’s inappropriately tight monetary policy and because of continued political fragility and dysfunction. Turning to this side of the Atlantic, the Fed needs to remain vigilant to headwind from Europe. At the same time, it should be recognized that if the ECB reverses course and adopts the warranted monetary policy for the euro area, global growth prospects would improve notably and the Fed would need to be ready to unwind the accumulated policy accommodation on this side of the Atlantic at a much faster clip than is currently anticipated.

Is anybody in Frankfurt listening? I hope so…

PS see the other SOMC papers here.

Mike Darda tells it as it is – The ECB’s deflationary failure

This is my good friend Michael Darda speaking on Bloomberg TV about the ECB – needless to say I agree with everything he says.

PS this is Mike talking about commodity prices – is it a demand or a supply story?Again I agree with Mike – it is both.

PPS This is myself on FOX Business’ Opening Bell with Maria Bartiromo last week commenting on the Bank of Japan’s latest action.

End Europe’s deflationary mess with a 4% nominal GDP (level) target

From the onset of the Great Recession in 2008 the ECB has been more afraid of doing “too much” rather than too little. The ECB has been obsessing about fiscal policy being too easy in the euro zone and about that too easy monetary policy would create bubbles. As a consequence the ECB was overly eager to hike interest rates in 2011 – way ahead of the Federal Reserve started to talk about monetary tightening.

The paradox is that the ECB now is in a situation where nobody can imagine that interest rates should be hiked anytime soon exactly because the ECB’s über tight monetary stance has created a deflationary situation in the euro zone. As a consequence the ECB under the leadership (to the extent the Bundesbank allows it…) of Mario Draghi is trying to come up with all kind of measures to fight the deflationary pressures. Unfortunately the ECB doesn’t seem to understand that what is needed is open-ended quantitative easing with proper targets to change the situation.

Contrary to the situation in Europe the financial markets are increasing pricing in that a rate hike from the Federal Reserve is moving closer and the Fed will be done doing quantitative easing soon. Hence, the paradox is that the Fed is “normalizing” monetary policy much before the ECB is expected to do so – exactly because the Fed has been much less reluctant expanding the money base than the ECB.

The tragic difference between monetary policy in the US and Europe is very visible when we look at the difference in the development in nominal GDP in the euro zone and the US as the graph below shows.

NGDP EZ US

The story is very simple – while both the euro zone and the US were equally hard hit in 2008 and the recovery was similar in 2009-10 everything went badly wrong when the ECB prematurely started to hike interest rates in 2011. As a result NGDP has more or less flat-lined since 2011. This is the reason we are now seeing outright deflation in more and more euro zone countries and inflation expectations have dropped below 2% on most relevant time horizons.

While the Fed certainly also have failed in many ways and monetary policy still is far from perfect in the US the Fed has at least been able to (re)create a considerable degree of nominal stability – best illustrated by the fact that US NGDP basically has followed a straight line since mid-2009 growing an average of 4% per year. This I believe effectively is the Fed’s new target – 4% NGDP level targeting starting in Q2 of 2009.

The ECB should undo the mistakes of 2011 and copy the Fed

I believe it is about time the ECB fully recognizes the mistakes of the past – particularly the two catastrophic “Trichet hikes” of 2011. A way forward could be for the ECB to use the performance of the Fed over the last couple of years as a benchmark. After all the Fed has re-created a considerable level of nominal stability and this with out in any having created the kind of runaway inflation so feared in Frankfurt (by both central banks in the city).

So here is my suggestion. The ECB’s major failure started in April 2011 –  so let that be our starting point. And now lets assume that we want a 4% NGDP path starting at that time. With 2% potential real GDP growth in the euro zone this should over the cycle give us 2% euro zone inflation.

The graph below illustrate the difference between this hypothetical 4% path and the actual level of euro zone NGDP.

EZ NGDP path 4pct

The difference between the 4% path and the actual NGDP level is presently around 7.5%. The only way to close this gap is by doing aggressive and open-ended quantitative easing.

My suggestion would be that the ECB tomorrow should announce the it will close ‘the gap’ as fast as possible by doing open-ended QE until the gap has been closed. Lets pick a number – lets say the ECB did EUR 200bn QE per month starting tomorrow and that the ECB at the same time would announce that it every month would monitor whether the gap was closing or not. This of course would necessitate more than 4% NGDP growth to close the gap – so if for example expected NGDP growth dropped below for example 6-8% then the ECB would further step up QE in steps of EUR 50bn per month. In this regard it is important to remember that it would take as much as 8% yearly NGDP growth to close the gap in two years.

Such policy would course be a very powerful signal to the markets and we would likely get the reaction very fast. First of all the euro would weaken sharply and euro equity prices would shoot up. Furthermore, inflation expectations – particularly near-term inflation expectations would shoot up. This in itself would have a dramatic impact on nominal demand in the European economy and it would in my opinion be possible to close the NGDP gap in two years. When the gap is closed the ECB would just continue to target 4% NGDP growth and start “tapering” and then gradual rate hikes in the exact same way the Fed has done. But first we need to see some action from the ECB.

So Draghi what are you waiting for? Just announce it!

PS some would argue that the ECB is not allowed to do QE at all. I believe that is nonsense. Of course the ECB is allowed to issue money – after all if a central bank cannot issue money what is it then doing? The ECB might of course not be allowed to buy government bonds, but then the ECB could just buy something else. Buy covered bonds, buy equities, buy commodities etc. It is not about what to buy – it is about increasing the money base permanently and stick to the plan.

PPS Yes, yes I fully realize that my suggestion is completely unrealistic in terms of the ECB actually doing it, but not doing something like what I have suggested will condemn the euro zone to Japan-style deflationary pressures and constantly returning banking and public finances problems. Not to mention the risk of nasty political forces becoming more and more popular in Europe.

Three terrible Italian ‘gaps’

Yesterday we got confirmation that Italy feel back to recession in the second quarter of the year (see more here). In this post I will take a look at three terrible ‘gaps’ – the NGDP gap, the output gap and the price gap –  which explains why the Italian economy is so deeply sick.

It is no secret that I believe that we can understand most of what is going on in any economy by looking at the equation of exchange:

(1) M*V=P*Y

Where M is the money supply, V is money-velocity, P is the price level and Y is real GDP.

We can – inspired by David Eagle – of course re-write (1):

(1)’ N=P*Y

Where N is nominal GDP.

From N, P and Y we can construct our gaps. Each gap is the percentage difference between the actual level of the variable – for example nominal GDP – and the ‘pre-crisis trend’ (2000-2007).

The NGDP gap – massive tightening of monetary conditions post-2008 

We start by having a look at nominal GDP.

NGDP gap Italy

We can make numerous observations based on this graph.

First of all, we can see the Italian euro membership provided considerable nominal stability from 2000 to 2008 – nominal GDP basically followed a straight line during this period and at no time from 2000 to 2008 was the NGDP gap more than +/- 2%. During the period 2000-2007 NGDP grew by an average of 3.8% y/y.

Second, there were no signs of excessive NGDP growth in the years just prior to 2008. If anything NGDP growth was fairly slow during 2005-7. Therefore, it is hard to argue that what followed in 2008 and onwards in anyway can be explained as a bubble bursting.

Third, even though Italy obviously has deep structural (supply side) problems there is no getting around that what we have seen is a very significant drop in nominal spending/aggregate demand in the Italian economy since 2008. This is a reflection of the significant tightening of Italian monetary conditions that we have seen since 2008. And this is the reason why the NGDP gap no is nearly -20%!

Given this massive deflationary shock it is in my view actually somewhat of a miracle that the political situation in Italy is not a lot worse than it is!

An ever widening price gap

The scale of the deflationary shock is also visible if we look at the development in the price level – here the GDP deflation – and the price gap.

Price gap Italy

The picture in terms of prices is very much the same as for NGDP. Prior to 2007/8 we had a considerable level of nominal stability. The actual price level (the GDP deflator) more or less grew at a steady pace close to the pre-crisis trend. GDP deflator-inflation averaged 2.5% from 2000 to 2008.

However, we also see that the massive deflationary trends in the Italian economy post-2008. Hence, the price gap has widened significantly and is now close to 7%.

It is also notable that we basically have three sub-periods in terms of the development in the price gap. First, the ‘Lehman shock’ in 2008-9 where the price gap widened from zero to 4-5%. Then a period of stabilisation in 2010 (a similar pattern is visible in the NGDP gap) – and then another shock caused by the ECB’s two catastrophic interest rate hikes in 2011. Since 2011 the price gap has just continued to widen and there are absolutely no signs that the widening of the price gap is coming to an end.

What should be noted, however, is that the price gap is considerably smaller than the NGDP gap (7% vs 20% in 2014). This is an indication of considerably downward rigidity in Italian prices. Hence, had there been full price flexibility the NGDP gap and the price gap would have been of a similar size. We can therefore conclude that the Italian Aggregate Supply (AS) curve is fairly flat (the short-run Phillips curve is not vertical).

The Great Recession has caused a massive output loss in Italy

In a world of full price flexibility the AS curve is vertical and as a result a drop in nominal GDP should be translated fully into a drop in prices, while the output should be unaffected. However, as the difference between the NGDP gap and the price indicates the Italian AS curve is far from vertical. Therefore we should expect a major negative demand shock to cause a drop in prices (relative to the pre-crisis trend), but also a a drop in output (real GDP). The graph below shows that certainly also has been the case.

Output gap Italy

 

The graph confirms the story from the two first graphs – from 2000 to 2007 there was considerably nominal stability and that led to real stability as well. Hence, during that period real GDP growth consistently was fairly close to potential growth. However, the development in real GDP since 2008 has been catastrophic. Hence, real GDP today is basically at the same level today as 15 years ago!

The extremely negative development in real GDP means that the output gap (based on this simple method) today is -14%! And worse – there don’t seems to be any sign of stabilisation (yesterday’s GDP numbers confirmed that).

And it should further be noted that even before the crisis Italian RGDP growth was quite weak. Hence, in the period 2000-2007 real GDP grew by an average of only 1.2% y/y – strongly indicating that Italy not only has to struggle with a massive negative demand problem, but also with serious structural problems.

Without monetary easing it could take a decade to close the output gap  

The message from the graphs above is clear – the Italian economy is suffering from a massive demand short-fall due to overly tight monetary conditions (a collapse in nominal GDP).

One can obviously imagine that the Italian output gap can be closed without monetary easing from the ECB. That would, however, necessitate a sharp drop in the Italian price level (basically 14% relative to the pre-crisis trend – the difference between the NGDP gap and the price gap).

A back of an envelop calculation illustrates how long this process would take. Over the last couple of years the GDP deflator has grown by 1-1.5% y/y compared a pre-crisis trend-growth rate around 2.5%. This means that the yearly widening of the price gap at the present pace is 1-1.5%. Hence, at that pace it would take 9-14 years to increase the price gap to 20%.

However, even if this was political and socially possible we should remember that such an “internal devaluation” would lead to a continued rise in both public and private debt ratios as it would means that nominal GDP growth would remain extremely low even if real GDP growth where to pick up a bit.

Concluding, without a monetary easing from the ECB Italy is likely to remain in a debt-deflation spiral within things that follows from that – banking distress, public finances troubles and political and social distress.

PS An Italian – Mario Draghi – told us today that the ECB does not think that there is a need for monetary easing right now. Looking at the “terrible gaps” it is pretty hard for me to agree with Mr. Draghi.

ECB’s failure in one graph

ECBs failure

…maybe it is about time the ECB actually tries to ease monetary policy. If you don’t know how here is a plan – and another plan and one more. It is not really very hard.

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