“Now the enriched country merely declares it is insolvent and spits on Its victims.”

I can’t help of thinking of events in the 1930s when I see the headlines in the financial media these days. One thing is the geopolitical situation – another thing is the new Greek government’s attempt to negotiate a new debt deal with the EU.

To me it is striking to what extent the economic and political situation in Greece resembles that of Germany in the early 1930s. And similar the position of Germany today – both that of the German media and of the German government is very similar to the French position in the early 1930s.

In 1931 the German economy was in a deep crisis with deflation and ever mounting debt – both public and private. A rigid monetary regime – the gold standard – was strangulating the German economy – while extremist parties on the left and right became increasingly popular among voters. At the same time the position of French government was uncompromising – Germany’s problems is of her own making. The answer was more austerity and there could be no talk of a new debt deal for Germany. Nobody seemed to think there was a monetary solution.

I therefore think we can learn a lot from studying events in the early 1930s if we want to find solutions for the euro zone crisis and it might be particularly suiting for the German newspapers to take a look at what they themselves were writing in early 1930s about the French position and then compare that with what today is written in Greek newspapers about the German position today.

Or compare what the French media was saying about Germany in 1931. Just take a look at this quote:

(The French newspaper) L’Intransigeant describes Germany‘s financial methods as frankly dishonest bankruptcy. “In 1923,” it states, “Germany reduced the national debt to nothing, then borrowed abroad on short terms credit which was invested on long terms, and is thus unable to repay her creditors. Now the enriched country merely declares it is insolvent and spits on Its victims.”

I am pretty sure I could find a similar quote in the Bild Zeitung today about Greece.

I encourage my readers to have a look at the newspaper achieves from 1931 to find similarities with the situation today in regard to the relationship between France and German in 1931 and Germany and Greece today. I will be happy to publish your findings (drop me a mail at lacsen@gmail.com).

Jens Weidmann should be promoting (some of) Varoufakis’ ideas

The new Greek Finance Minister Yanis Varoufakis is all over the international media these day and surprise, surprise he is making a lot more sense than a lot of people (including myself) had feared.

I have certainly not been optimistic about what the new hardcore leftist Greek government would come up with. However, I most admit that I have some (considerable) sympathy for the fact that Greek public finance problems are not entirely a result of Greek economic-political mismanagement (even though there has been a lot of that).

Hence, the sharp rise in Greek public debt to GDP since 2008 to large extent is a result of the collapse of Greek nominal GDP and I have often been arguing that we do not (primarily) have a debt crisis in the euro zone. We have a nominal GDP crisis and the euro crisis is primarily a result of overly tight monetary policy.

While Varoufakis certainly is not a monetarist he fully well understands that at the core of the Greek crisis is the collapse in NGDP and I was very pleasantly surprised to see his proposal for a new Greek debt deal with the EU.

This is what Financial Times writes about Varoufakis’ new proposals:

Attempting to sound an emollient note, Mr Varoufakis told the Financial Times the government would no longer call for a headline write-off of Greece’s €315bn foreign debt. Rather it would request a “menu of debt swaps” to ease the burden, including two types of new bonds.

The first type, indexed to nominal economic growth, would replace European rescue loans, and the second, which he termed “perpetual bonds”, would replace European Central Bank-owned Greek bonds.

He said his proposal for a debt swap would be a form of “smart debt engineering” that would avoid the need to use a term such as a debt “haircut”, politically unacceptable in Germany and other creditor countries because it sounds to taxpayers like an outright loss.

So Varoufakis is suggesting is to swap the Greek debt to the EU (and ECB) with nominal GDP linked bonds. What can I say? Great idea Yanis!

I have of course for years be arguing that governments should issue debt linked to nominal GDP – not only because NGDP linked bonds would provide a very good measure of the monetary policy stance, but also because it would be good from a public finance perspective (and from a general macroeconomic stability perspective).

I therefore wholeheartedly support Varoufakis’ proposal – as a general principle to debt restructuring. Obviously to make a deal it should be in the common interest of both the EU and Greece and there are certainly very good arguments against just sending another big cheque to Athens. But this is exactly the point – this would (in general) be in the interest of both Greek and German taxpayers.

What we want to see is a situation where Greek government continues to service its debt. But we also want a situation where this doesn’t push Greece to a disorderly default and a disorderly exit, which would jeopardize economic and financial stability in Europe. I believe that a new debt deal that to a larger extent links Greek public debt to the future developments in nominal GDP would make it easier for Greece to service the debt, but also make it less likely that we get a disorderly collapse.

How would it work?

The general idea with NGDP linked bonds is that the servicing of the public debt is linked to the performance of Greek NGDP. This would mean that if growth picked up in Greece then the Greek government would pay of more debt, while is NGDP growth slows then Greece will pay of less debt.

This of course would make Greek public finances much less sensitive to shocks to NGDP and therefore reduce the likelihood that the Greek government would be forced to defaults if growth fails to pick-up. On the other hand German taxpayers should welcome that if there I a pick-up in NGDP growth in Greece then the Greek government would actually pay back its debt faster than under the present debt agreement.

Furthermore, more if public debt servicing is linked to the development in NGDP growth then Greek public finances would become significantly more counter-cyclical rather than pro-cyclical.

Jens Weidmann should be Varoufakis’ best friend

Hence, there are some very clear advantages with NGDP linked bonds. The most important, however, might be that if Greek public debt is linked to NGDP then it would significantly ease the pressure on the ECB to do things that fundamentally has nothing to do with monetary policy.

The ECB’s job odd to be to ensure nominal stability in the euro zone economy. It is not and should not be the job of ECB to bail out governments and banks. Unfortunately again and again over the past six years the ECB has been forced to bailout euro zone countries for example through the so-called OMT programme. Hence, ECB has again and again conducted credit policy (rather than monetary policy) to avoid euro zone countries defaulting.

The ECB is largely to blame for this itself because it has kept monetary conditions far too tight. However, it does not change the fact that the ECB has been under tremendous pressure to bailout nations and banks rather than conduct sound monetary policies.

By linking Greek public debt to NGDP (in Greece) Greek public finances would be more immune to monetary policy failure in the euro zone.

And this is why the hawkish Bundesbank chief Jens Weidmann should be an enthusiastical support for Varoufakis’ debt plan as the “cost” of tight monetary policies in the euro zone would be smaller.

Just imagine that all public debt in the euro zone had been linked one-to-one to euro zone NGDP. The ECB might have failed in 2008 to keep NGDP “on track”, but there would not have been any public finances crisis in the euro zone as public debt to (N)GDP ratios would have remained fairly stable and it would have been very unlikely that Greece would have needed an bailout. In such a situation the pressure to the ECB to support government lending would have been much smaller.

The graph below illustrates the very close correlation between NGDP growth and public debt developments in the euro zone. Greek debt ratio spiked primarily because Greek NGDP growth collapsed.

I have a lot of sympathy for the “German view” that the ECB should not bailout banks and countries, but if the ECB fails to deliver nominal stability it is unavoidable that there will be pressure on the ECB to do things it shouldn’t be doing.

Therefore, Jens Weidmann should not only endorse the general principle that Greek public debt to a larger extent should be linked to NGDP growth, but he should also advocate that public debt across the euro zone should be NGDP linked as it would significantly reduce the pressures the ECB to conduct problematic credit policies, which increases moral hazard problems.

Varoufakis should pay tribute to David Eagle

Yanis Varoufakis probably never heard of David Eagle. In fact economists never heard of David Eagle. However, I believe that David is the economist in the world who has done the most interesting academic work on what he has termed quasi-real indexing. David’s work centres on both the principle of making debt linked to the development in nominal GDP and on the advantages of NGDP targeting.

David back in 2012 wrote a numbers of very insightful guess posts on this blog about these topics. Everybody interested in the theoretically foundation for Varoufakis’ ideas should read this guest post. Here is an overview:

Guest post: GDP-Linked Bonds (by David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

Guest post: Why I Support NGDP Targeting (by David Eagle)

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!” (by David Eagle)

Quasi-Real indexing – indexing for Market Monetarists

David Eagle’s framework and the micro-foundation of Market Monetarism

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

A simple housing rescue package – QRI Mortgages and NGDP targeting

Supporting NGDP-linked bonds, but not the entire “Syriza package”

I have in this blog post voiced my support for the Greek Finance Minister’s suggests for a debt swap based on NGDP bonds. I should stress that that does certainly not mean that I in any other way supports the Greek government’s economic proposals. In fact I am deeply concerned about some of the ideas, which has been floated by the Greek government. The governing Syriza party is an extreme leftist party, which is strongly opposed to the free markets ideals I hold dearly, but on the issue of the desirability of NGDP linked bonds the Greek government has my full support.

Draghi’s golden oppurtunity – building the perfect firewall

The ECB’s large scale quantitative easing programme already has had some success – initially inflation expectations increased, European stock markets performed nicely and the euro has continued to weaken. This overall means that this effectively is monetary easing and that we should expect it to help nominal spending growth in the euro zone accelerate and thereby also should be expected to curb deflationary pressures.

However, ECB Mario Draghi should certainly not declare victory already. Hence, inflation expectations on all relevant time horizons remains way below the ECB’s official 2% inflation target. In fact we are now again seeing inflation expectations declining on the back of renewed concerns over possible “Grexit” and renewed geopolitical tensions in Ukraine.

Draghi has – I believe rightly – been completely frank recently that the ECB has failed to ensure nominal stability and that policy action therefore is needed. However, Draghi needs to become even clearer on his and the ECB’s commitment to stabilise inflation expectations near 2%.

A golden opportunity

Obviously Mario Draghi cannot be happy that inflation expectations once again are on the decline, but he could and should also see this as an opportunity to tell the markets about his clear commitment to ensuring nominal stability.

I think the most straightforward way of doing this is directly targeting market inflation expectations. That would imply that the ECB would implement a Robert Hetzel style strategy (see here) where the ECB simply would buy inflation linked government bonds (linkers) until markets expectations are exactly 2% on all relevant time horizons.

The ECB has already announced that its new QE programme will include purchases of linkers so why not become even more clear how this actually will be done.

A simple strategy would simply be to announce that in the first month of QE the ECB would buy linkers worth EUR 5bn out of the total EUR 60bn monthly asset purchase, but also that this amount will be doubled every month as long as market inflation expectations are below 2% – to 10bn in month 2, to 20bn in month 3 and 40bn in month 4 and then thereafter every month the ECB would buy linkers worth EUR 60bn.

Given the European linkers market is fairly small I have no doubt that inflation expectations very fast would hit 2% – maybe already before the ECB would buy any linkers. In that regard it should be noted that in the same way as a central bank always weaken its currency it can also always hit a given inflation expectations target through purchases of linkers. Draghi needs to remind the markets about that by actually buying linkers.

That I believe would be a very effective way to demonstrate the ECB’s commitment to hitting its inflation target, but it would also be a very effective ‘firewall’ against potential shocks from shocks from for example the Russian crisis or a Grexit.

An very effective firewall   

I have in an earlier blog post suggested that the ECB should “build” such a firewall. Here is what I had to say on the issue back in May 2012:

A number of European countries issue inflation-linked bonds. From these bonds we can extract market expectations for inflation. These bonds provide the ECB with a potential very strong instrument to fight deflationary risks. My suggestion is simply that the ECB announces a minimum price for these bonds so the implicit inflation expectation extracted from the bonds would never drop below 1.95% (“close to 2%”) on all maturities. This would effectively be a put on inflation.

How would the inflation put work?

Imagine that we are in a situation where the implicit inflation expectation is exactly 1.95%. Now disaster strikes. Greece leaves the euro, a major Southern Europe bank collapses or a euro zone country defaults. As a consequence money demand spikes, people are redrawing money from the banks and are hoarding cash. The effect of course will be a sharp drop in money velocity. As velocity drops (for a given money supply) nominal (and real) GDP and prices will also drop sharply (remember MV=PY).

As velocity drops inflation expectations would drop and as consequence the price of the inflation-linked bond would drop below ECB’s minimum price. However, given the ECB’s commitment to keep inflation expectations above 1.95% it would have either directly to buy inflation linked bonds or by increasing inflation expectations by doing other forms of open market operations. The consequences would be that the ECB would increase the money base to counteract the drop in velocity. Hence, whatever “accident” would hit the euro zone a deflationary shock would be avoided as the money supply automatically would be increased in response to the drop in velocity. QE would be automatic – no reason for discretionary decisions. In fact the ECB would be able completely abandon ad hoc policies to counteract different kinds of financial distress.

This would mean that even if a major European bank where to collapse M*V would basically be kept constant as would inflation expectations and as a consequence this would seriously reduce the risk of spill-over from one “accident” to another. The same would of course be the case if Greece would leave the euro.

When I wrote all this in 2012 it seemed somewhat far-fetted that the ECB could implement such a policy. However, things have luckily changed. The ECB is now actually doing QE, Mario Draghi clearly seems to understand there needs to be a focus on market inflation expectations (rather than present inflation) and the ECB’s QE programme seems to be quasi-open-ended (but still not open-ended enough). Therefore, building a linkers-based ‘firewall’ would only be a natural part of what the ECB officially now has set out to do.

So now I am just waiting forward to the next positive surprise from Mario Draghi…

PS I would have been a lot more happy if the ECB would target 4% NGDP growth (level targeting) rather than 2% or at least make up for the failed policies over the past 6-7 years by overshooting the 2% inflation target for a couple of years, but a strict commitment to build a firewall against velocity-shocks and keeping inflation expectations close to 2% as suggested above would be much better than what we have had until recently.

PPS A firewall as suggested above should make a Grexit much less risky in terms of the risk of contagion and should hence be a good argument to gain the support from the Bundesbank for the idea (ok, that is just totally unrealistic…)

Related blog posts:

Bob Hetzel’s great idea
Kuroda still needs to work on communication
Mr. Kuroda please ‘peg’ inflation expectations to 2% now

‘Draghi’s framework’ – a step in the right direction

It is no secret that I for years have been very critical about the ECB’s conduct of monetary policy. In fact I strongly believe that the mess we in Europe still are in mostly is due to monetary policy failure (even though I certainly do not deny Europe’s massive structural problems).

However, I do think that the ECB – and particularly ECB chief Mario Draghi – deserves some credit for the policy measures introduced today.

It is certainly not perfect, but neither is Fed or Bank of Japan policy, but for the first time since the beginning of the Great Recession soon seven years ago the ECB is in my view taking a major step in the right direction. It will not solve all of Europe’s problems – far from it – but I believe this will be quite helpful in curbing the strong deflationary pressures in the European economy.

The glass is half-full rather than half-empty

Below I will highlight a number of the things that I think is positive about today’s policy announcement.

1) The ECB’s nominal target has been made more clear

One thing that the Market Monetarists again and again have stressed is that central banks should be clear about their nominal targets. Even though I like other Market Monetarists prefer NGDP targeting I think that it should be welcomed that Mario Draghi and the ECB today was a lot clearer on the inflation target than ever before.

Furthermore, Draghi for the first time clearly acknowledged that the ECB was not living up to its commitment to ensure price stability interpreted as close to 2% inflation. By doing so Draghi quite clearly signaled that future possible changes in the amount of QE will dependent on the outlook for hitting the inflation target.

2) Draghi speaks in terms of market expectations

It was also notable that Draghi at the press conference following the monetary policy announcement again and again referred to the markets’ inflation expectations and he stressed that since market expectations for inflation are below 2% the ECB does not fulfil its target. That to me is quite a Market Monetarist – it is about ‘targeting the forecast’ more than anything else. At the time the ECB’s own forecasts played a much less prominent role in Draghi’s presentation. That I consider to be quite positive.

3) The ECB is using the right instrument

A major positive is that the ECB now finally seems to be focusing on the right instrument. The only mentioning of ‘interest rates’ was basically the announcement that the policy rates had been kept unchanged.

Furthermore, there was no talk about ‘credit policy’ and attempts to distort relative prices in the European fixed income markets.

Instead it was straight-forward about money base control. That I consider to be very positive. Now we have to hope that the ECB will continue to focus on money base growth rather than on interest rates. Furthermore, by focusing on money base growth (quantitative easing) the ECB signals clearly to the markets that there are no institutional or legal restrictions on the ECB’s ability/possibility to create money. That will make it significantly easier for the markets to trust the ECB to be committed to ensuring nominal stability.

4) The programme is fairly well ‘calibrated’

One can clearly debate what is the “right number” in terms of the necessary quantitative easing necessary to take the euro zone out of the deflationary mess. I have earlier argued that the ECB essentially should target 10% M3 growth in a number of years to undo past monetary policy sins (see here, here and here.)

The programme announced by the ECB – essentially 60bn euros QE per months until September 2016 is not in any way big enough to undo past sins, however, it is nonetheless sizable.

In fact if we assume that the trend in M3 growth we have seen during 2014 is maintained during 2015-16 and we add 60bn euros extra to that every single month until September 2016 then the pick-up in M3 growth will be substantial. In fact already by the end of this year M3 growth could hit 10% and remain at 8-9% all through 2016.

This is of course is under an assumption that there is no decline in the money-multiplier. I believe that is a fair assumption. In fact one can easily argue that it is likely that the money-multiplier will likely increase in response to the ECB money base expansion.

Hence, even though we will not close the ‘gap’ from past mistakes it looks likes ECB’s QE programme could provide quite substantial monetary stimulus and likely large enough to significantly lift nominal GDP growth during 2015 and 2016, which in turn likely will bring euro inflation back in line with the ECB’s 2% inflation target.

That said, the ECB has essentially failed to hit its inflation target since 2008 (leaving out negative supply shocks) and one can therefore argue that even 10% M3 growth will not be enough to lift inflation to 2% given the markets’ lack of trust in ECB’s willingness to do everything to provide nominal stability. Therefore, commitment on the ECB’s part to continue some form of QE also after September 2016 therefore might be necessary (more on that below.)

5) The programme is quasi-open-ended

Given the considerations above it is also very important that the ECB QE programme apparently is of a quasi-open-ended nature. So while the ECB plans for the program to end in September 2016 it should be noted that the ECB in its statements today said that the programme will run until “at least” September 2016. Hence, this is likely a signal that the programme could and will be extended if needed to meet the ECB’s 2% inflation target.

The quasi-open-ended nature of the programme opens the door for the ECB to communicate in terms of two dimensions – how long the programme will run and the monthly growth rate of the money base. That in turn could potentially – if we make a very optimistic assessment – bring us to a situation where the ECB becomes focused on money base control rather than interest rate targeting.

So overall the more I digest the details in the ECB new QE programme the more upbeat I have become about it. That is not to say that the program is perfect – far from it, but it is nonetheless in my view the biggest and most positive step undertaken by the ECB since crisis hit in 2008.

Things can still go badly wrong – and we are not out of the crisis yet

There is a lots of things that can go wrong – there is for example a clear risk that massive German resistance against the programme will undermine the credibility of the programme or that the ECB now thinks everything is fine and that no more work on the programme is needed. Therefore, to ensure success the ECB needs to work on the details of the QE programme in the coming weeks and months.

In the coming days I will try to write a couple of blog posts where I will try to come with recommendations on how to improve the ‘Draghi framework’. Particularly I will stress that the ECB needs to move closer to a purely rule-based framework rather than a discretionary framework. We are still someway away from that.

PS The markets’ judgement of the ECB’s new QE programme has been positive – European (and US) stocks are up, inflation expectations are up and the euro is weaker on the day. However, the markets’ reaction is significantly smaller than one could have hoped for given the scale of the programme. This illustrates just how big problems the ECB still has with its credibility. It will take time and hard work from the ECB to change that perception – seeing is believing.

PPS I was very happy today to see that the ECB did not just introduce yet another acronym for some new useless credit policies.

Grexit, Germany and Googlenomics

The talk of Greece leaving the euro area – Grexit – is back. Will Grexit actually happen? I don’t know, but I do know that more and more people worry that it will in fact happen.

This is what Google Trends is telling us about Google searches for “Grexit“:

Grexit

And guess what? While this is happening euro zone inflation expectations have collapsed. In fact this week 5-year German inflation expectations turned negative! This mean that the fixed income markets now expect German inflation to be negative for the next five years!

It is hard to find any better arguments for massive quantitative easing within a rule-based framework in the euro zone (with or without Greece). And this is how it should be done.

PS it has been argued recently that euro zone bond yields have declined because the markets are pricing in QE from the ECB. Well, if that is the case why is inflation expectations collapsing? After all investors should not expect monetary easing to led to lower inflation (in fact deflation) – should they?

PPS I do realise that the drop in oil prices play a role here, but the markets (forwards) do not forecast a drop in oil prices over the coming five years so oil prices cannot explain the deflationary expectations in Europe.

Yet another year of asymmetrical monetary policy – revisiting the Weidmann rule

Nearly a year ago – January 2 – I wrote a blog post on what I termed the Weidmann rule. In the blog post I argued that the ECB is basically following a rule – named after Bundesbank boss Jens Weidmann – which is asymmetrical. The ECB will tighten monetary conditions in the event of a positive aggregate demand (velocity) shock, but will not ease in the event of a negative demand (velocity) shock to the euro zone economy.

This means that the ECB monetary policy set-up basically ensures that we are in a classical world when demand is picking (the budget multiplier is zero), but is in a basically keynesian world when we have negative demand shocks (the budget multiplier is positive). The world is not “naturally” keynesian, but the ECB’s policy regime makes the euro zone economy is essentially 50% keynesian.

A year ago I argued that the Weidman rule would be deflationary. Hence, “if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).”

This is of course exactly what we have seen over the past year – US NGDP remains on its 4% path, while euro zone has averaged less than 1% over the past year and the gap between US and euro zone NGDP is therefore growing larger and larger.

Add to that that euro zone has seen as least two negative demand shocks in 2014. First of all and likely most important the Russian (Ukrainian) crisis, which is likely to lead to a double-digit contraction in Russian real GDP in 2015 and second renewed concerns over the political situation in Greece and other Southern European countries (particularly separatist worries in Spain). These shocks are so far not major shocks and with a proper monetary policy set-up would like have very limited impact on the European economy. However, we do not have a proper monetary policy set-up and therefore every even smaller negative demand shock will just push Europe deeper and deeper into a deflationary spiral.

It is correct that the ECB has done a bit to offset these shocks – which in quantity theoretical context essentially are negative velocity shocks – by cutting interest rates and indicated that we will get some sort of quantitative easing in 2015.

However, with the euro zone money base basically still contracting, M3 growth being lacklustre, inflation expectations declining and NGDP growth being very weak it is hard to argue that the ECB has done a lot. In fact it has not really done anything to even offset the negative velocity/demand shocks we have seen in 2015.

Therefore, we unfortunately have to conclude that the Weidmann rule still the name of the game in Frankfurt and all indications are that the Bundesbank remains strongly opposed to any quantitative easing.

What the ECB needs to do is of course to once and for all to demonstrate that it will indeed offset any shock to velocity – both negative and positive to ensure nominal stability. A 4% NGDP target rule would do the job (see here) and would be fully within ECB’s mandate.

PS These days Jens Weidmann is arguing that things will be a lot better in the euro zone because the drop in oil prices is a positive demand shock (yes, this is basically what he is saying) and that monetary easing therefore is not needed. In 2011 the Bundesbank of course was eager to see interest rate hikes in response to increased oil prices because the risk of “second-round effects” (horrible expression!). It is hard to get any better illustration of the just how asymmetrical the Bundesbank’s preferred monetary policy rule is.

PPS Tim Worstall has an excellent post on Jens Weidmann and the Bundesbank here.

Political unrest is always and everywhere a monetary phenomenon – also in Greece

This is Sara Sjolin at MarketWatch.com:

Greece’s Athex Composite tanked almost 13% Tuesday — the biggest drop for the index on record, according to FactSet. The renewed jitters came after the government, in a surprise move late Monday, said it would bring forward presidential elections to Dec. 17, potentially, setting the scene for snap elections in early 2015.

Here’s why that’s important: Far-left party Syriza currently is leading the early polls and it seems likely they would win a snap election. This is how to think about Syriza:

  • The party has been calling for an end to austerity in Greece
  • Has been campaigning for market-unfriendly measures
  • Is firmly against the international bailout program that helped the country avoid a default during the depths of its financial crisis.

How bad is Greece’s Tuesday collapse? It’s worse than the 9.7% drop the market saw Oct. 24, 2010, at the peak of Greek debt worries. The drop also eclipses the 10% fall Greek markets saw in 1989 during a bout of political turmoil.

…With Greece’s problems once again in the limelight, investors all across Europe. the Stoxx Europe 600 index slumped 2.3%, while Germany’s DAX 30 index fell 2.2% and France’s CAC 40 index  gave up 2.5%.

Greek government bond yields  jumped 75 basis point to 7.90%, according to electronic trading platform Tradeweb.

So once again political news slips in to the financial section of the news. As Scott Sumner once expressed it about his studies of the Great Depression:

“And the worst part was the way political news kept slipping into the financial section. Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc. In the 1930s the readers didn’t know what came next—but I did.”

I must admit that the similarities between the continued euro crisis and the situation during the 1930s worries me a great deal and my regular readers well-know that I to a large extent blame the deepening political troubles in Europe on the deep economic crisis caused mainly by extremely tight monetary conditions in the euro zone.

Just to remind everybody how bad it is in Greece. Take a look graph below comparing the real GDP lose in Austria during Great Depression and Greece during the present crisis (Year 0 is 1929 for Austria and 2008 for Greece.)

I used Austria as a comparison because the country had massive banking crisis (in 1931), had one of the deepest depressions of all of the European economies during the Great Depression and maintained the Gold Standard the longest.

Greece Austria

Given the scale of the crisis in Greece it is hardly surprising that extremist parties like Syriza and Golden Dawn are very popular parties. After all Austria disintegrated politically during the 1930s and eventually ceased to exist as an independent nation in 1938.

Monetary policy according to a German lawyer

This is from Bloomberg:

European Central Bank Executive Board member Sabine Lautenschlaeger said quantitative easing isn’t the right policy choice for the euro area currently, hardening a split among officials over the right response to slowing inflation.

“A consideration of the costs and benefits, and the opportunities and risks, of a broad purchase program of government bonds does not give a positive outcome,” Lautenschlaeger, a former Bundesbank vice president, said at an event in Berlin today. “There are very few shared competencies in fiscal policy. As long as this is the case, the ECB’s purchase of government securities is inevitably linked to a serious incentive problem.”

Lautenschlaeger’s comments signal she’s become ECB President Mario Draghi’s highest-ranking opponent in the debate over introducing QE to the euro area. They echo the position of Bundesbank President Jens Weidmann, who has said QE diverts attention from the need for governments to make structural adjustments to their economies.

“Long-term interest rates on Spanish and Italian (GBTPGR10) government bonds, for example, are already lower than those from the U.S. or the U.K.,” Lautenschlaeger said. “It is therefore questionable whether we should ‘depress’ interest rates for the securities class even further.”

First of all, it is very clear that Frau Lautenschlaeger thinks that quantitative easing – an expansion of the money base – is some kind of credit policy. It is not. Let me quote myself:

I have noticed that there generally is a problem for a lot of people to differentiate between monetary easing and bailouts. Often when one argues for monetary easing the reply is “we should stop bailing out banks and countries and if we do it we will just create an even bigger bubble”. The problem here is that Market Monetarists certainly do not favour bailouts – we favour nominal stability.

I think that at the core of the problem is that people have a very hard time figuring out what monetary policy is. Most people – including I believe most central bankers – think that credit policy is monetary policy. Just take the Federal Reserve’s attempt to distort relative prices in the financial markets in connection with QE2 or the ECB’s OMT program where the purpose is to support the price of government bonds in certain South European countries without increasing the euro zone money base. Hence, the primary purpose of these policies is not to increase nominal GDP or stabilise NGDP growth, but rather to change market prices. That is not monetary policy. That is credit policy and worse – it is in fact bailouts.

As the ECB’s OMT and Fed’s QE2 to a large extent have been focused on changing relative prices in the financial markets they can rightly be – and should be – criticized for leading to moral hazard. When the ECB artificially keeps for example Spanish government bond yields from increasing above a certain level then the ECB clearly is encouraging excessive risk taking. Spanish bond yields have been rising during theGreat Recession because investors rightly have been fearing a Spanish government default. This is an entirely rational reaction by investors to a sharp deterioration of the outlook for the Spanish economy. Obviously if the ECB curb the rise in Spanish bond yields the ECB are telling investors to disregard these credit risks. This clearly is moral hazard.

The problem here is that a monetary authority – the ECB – is engaged in something that is not monetary policy, but people will not surprisingly think of what a central bank do as monetary policy, but the ECB’s attempts to distort relative prices in the financial markets have very little to do with monetary policy as it do not lead to a change in the money base or to a change in the expectation for future changes in the money base.

That is not to say that the ECB’s credit policies do not have monetary impact. They likely have. Hence, it is clear that the so-called OMT has reduced financial distress in the euro zone, which likely have increased the money-multiplier and money-velocity in the euro zone, but it has also (significantly?) increased moral hazard problems. So the paradox here is that the ECB really has done very little to ease monetary policy, but a lot to increase moral hazard problems.

I can hence certainly understand if Frau Lautenschlaeger would object to credit policies to bailout nations or banks, but an expansion of the money base to curb deflationary pressures and to stabilise nominal spending growth has nothing to do with bailouts. It is just the proper policy response to a deflationary crisis – by the way caused by the ECB itself.

Second, Frau Lautenschlaeger is clearly making the common bond yield fallacy when you claim monetary policy already is easy because nominal bond yields are low. She of course should know that rates and yields are low in the euro exactly because monetary policy is extremely tight and there market expectations are for continued very low growth and inflation.

Furthermore, I am puzzled why she would make a reference to bond yields in specific countries. Monetary policy certainly is not about targeting bond yields and certainly not about targeting bond yields in individual countries in a monetary union.

Listening to some ECB official brings memories of French central bankers in the 1930s or Japanese central bankers in the 1990s. The outcome unfortunately is the same deflationary mess – and as a consequence rising debt problems.

 

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.

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

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