It’s the economy stupid – this is why Le Pen won

I have argued it again and again – the continued crisis in the European economy is the primary source of political radicalisation, populism, extremism and outright fascism.

The French regional elections provided yet another sad testimony to that thesis. Here is the one-graph version of that idea.

Le Pen

The graph shows the support for the extremist/populist anti-immigration party Front National (FN) against the unemployment rate across different regions in France. Each dot represents a region.

The simple regression ‘model’ shows that a 1%-point increase in unemployment increases support for FN by nearly 5%-point.

So it might be that FN is helped by the recent terror attacks in Paris and by the ‘refugee crisis’, but this is mostly about a weak French economy.

So if you want to blame anybody for the electoral success of Front National you should point the fingers at Jean Claude Trichet who as ECB-chief in 2011 hiked interest rates twice and at president Holland who has done everything to worsen the already bad competitive position of the French economy since he became president in 2012.

HT: This post have been inspired by a post on the same topic on Bloombergviews by .


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The Euro – A Monetary Strangulation Mechanism

In my previous post I claimed that the ‘Greek crisis’ essentially is not about Greece, but rather that the crisis is a symptom of a bigger problem namely the euro itself.

Furthermore, I claimed that had it not been for the euro we would not have had to have massive bailouts of countries and we would not have been in a seven years of recession in the euro zone and unemployment would have been (much) lower if we had had floating exchange rates in across Europe instead of what we could call the Monetary Strangulation Mechanism (MSM).

It is of course impossible to say how the world would have looked had we had floating exchange rates instead of the MSM. However, luckily not all countries in Europe have joined the euro and the economic performance of these countries might give us a hint about how things could have been if we had never introduced the euro.

So I have looked at the growth performance of the euro countries as well as on the European countries, which have had floating (or quasi-floating) exchange rates to compare ‘peggers’ with ‘floaters’.

My sample is the euro countries and the countries with fixed exchange rates against the euro (Bulgaria and Denmark) and countries with floating exchange rates in the EU – the UK, Sweden, Poland, Hungary, the Czech Republic and Romania. Furthermore, I have included Switzerland as well as the EEA countriesNorway and Iceland (all with floating exchange rates). Finally I have included Greece’s neighbour Turkey, which also has a floating exchange rate.

In all 31 European countries – all very different. Some countries are political dysfunctional and struggling with corruption (for example Romania or Turkey), while others are normally seen as relatively efficient economies with well-functioning labour and product markets and strong external balance and sound public finances like Denmark, Finland and the Netherland.

Overall we can differentiate between two groups of countries – euro countries and euro peggers (the ‘red countries’) and the countries with more or less floating exchange rates (the ‘green countries’).

The graph below shows the growth performance for these two groups of European countries in the period from 2007 (the year prior to the crisis hit) to 2015.

floaters peggers RGDP20072015 A

The difference is striking – among the 21 euro countries (including the two euro peggers) nearly half (10) of the countries today have lower real GDP levels than in 2007, while all of the floaters today have higher real GDP levels than in 2007.

Even Iceland, which had a major banking collapse in 2008 and the always politically dysfunctionally and highly indebted Hungary (both with floating exchange rates) have outgrown the majority of euro countries (and euro peggers).

In fact these two countries – the two slowest growing floaters – have outgrown the Netherlands, Denmark and Finland – countries which are always seen as examples of reform-oriented countries with über prudent policies and strong external balances and healthy public finances.

If we look at a simple median of the growth rates of real GDP from 2007 until 2015 the floaters have significantly outgrown the euro countries by a factor of five (7.9% versus 1.5%). Even if we disregard the three fastest floaters (Turkey, Romania and Poland) the floaters still massively outperform the euro countries (6.5% versus 1.5%).

The crisis would have long been over had the euro not been introduced  

To me there can be no doubt – the massive growth outperformance for floaters relative to the euro countries is no coincidence. The euro has been a Monetary Strangulation Mechanism and had we not had the euro the crisis in Europe would likely long ago have been over. In fact the crisis is essentially over for most of the ‘floaters’.

We can debate why the euro has been such a growth killing machine – and I will look closer into that in coming posts – but there is no doubt that the crisis in Europe today has been caused by the euro itself rather than the mismanagement of individual economies.

PS I am not claiming the structural factors are not important and I do not claim that all of the floaters have had great monetary policies. The only thing I claim is the the main factor for the underperformance of the euro countries is the euro itself.

PPS one could argue that the German ‘D-mark’ is freely floating and all other euro countries essentially are pegged to the ‘D-mark’ and that this is the reason for Germany’s significant growth outperformance relative to most of the other euro countries.

Update: With this post I have tried to demonstrate that the euro does not allow nominal adjustments for individual euro countries and asymmetrical shocks therefore will have negative effects. I am not making an argument about the long-term growth outlook for individual euro countries and I am not arguing that the euro zone forever will be doomed to low growth. The focus is on how the euro area has coped with the 2008 shock and the the aftermath. However, some have asked how my graph would look if you go back to 2000. Tim Lee has done the work for me – and you will see it doesn’t make much of a difference to the overall results. See here.

Update II: The euro is not only a Monetary Strangulation Mechanism, but also a Fiscal Strangulation Mechanism.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

“Whatever it takes to get deflation” (Stealing two graphs from Marcus Nunes)

Marcus Nunes has two extremely illustratative graphs in his latest blog post. Just take a look here:


 I don’t think any other comments are needed…

Policy coordination, game theory and the Sumner Critique

Here is Alan Blinder in a paper – “Issues in the Coordination of Monetary and Fiscal Policy” – from 1982:

“Consider the problem of designing a car in which student drivers will be taught to drive. The car will have two steering wheels and two sets of brakes. One way to achieve “coordination” is to design the car so that one set of controls – the teacher’s – can always override the other. And it may seem obvious that this is the correct thing to do in this case.”

The student driver obviously is fiscal policy, while the teacher is monetary policy. If the student (fiscal policy) try to take the car (the economy) in one direction the teacher (monetary policy) can always step in and overrule him. This is of course the Sumner Critique – monetary policy will always have the final say on the level of aggregate demand/nominal GDP and hence the fiscal multiplier is zero if the central bank for example targets the nominal GDP level or inflation and that is even the case if the world is assumed to be Keynesian in nature.

However, even though monetary policy has the final say that does not mean that monetary policy will conducted in the right fashion or as Blinder express it:

“But now suppose that we do not know in advance who will sit in which seat. Or what if the teacher, while a superior driver, has terrible eyesight? Under these conditions it is no longer obvious that we want one set of controls to be able to ovemde the other. Reasoning that a stalemate may be better than a violent collision, we may decide that it is best to design the car with two sets of competing controls which can partially offset one another.”

Blinder here raises an interesting question – what if the central bank does not conduct monetary policy in a proper fashion wouldn’t it then be better to give the fiscal authority the possibility to try it’s luck. Blinder is of course right there is no guarantee that the central bank will do a good job – if that was the case then we would not be in this crisis. However, does that mean that fiscal policy can “take over”? Obviously not – even a bad central bank can overrule the fiscal authority when it comes to aggregate demand. The ECB is doing that on a daily basis.

Anyway, I really just wanted to remind my readers of Blinder’s paper. It is really not directly about the Sumner Critique, but rather Alan Blinder is discussing coordination between monetary policy and fiscal policy from a game theoretical perspective. Even though Blinder obviously as a lot more faith in “government design” than I have the paper is quite interesting in terms of the games central banks an governments play against (and sometimes with) each other. I find Blinder’s discussion highly relevant for particularly the game being played in the euro zone today between the ECB and European governments about monetary easing versus fiscal consolidation.

William Nordhaus in 1994 wrote a similar paper to Blinder’s about “Policy Games: Coordination and Independence in Monetary and Fiscal Policies”Nordhaus’ paper is equally relevant to today’s discussion.

It seems like the game theoretical literature about monetary-fiscal policy coordination has somewhat disappeared today, but to me these topics are more relevant that ever. If my readers are aware of any newer literature on this topic I would be very happy to hear about it.

PS the literature apparently not completely dead – here is a 2010 dissertation on the same topic by Helton Saulo B. Dos Santos. I have not read it, but it looks quite interesting.

Update: Nick Rowe has kindly reminded me that he and Simon Power actually have written a paper on the same topic back in 1998. Nick recently did a blog post about his paper. Nick interesting enough reaches the same conclusion as I do that in a Stackelberg setting where the government sets the budget deficit first and the central bank follows and determine NGDP we get a outcome similar to the Sumner Critique. Again this is not due to monetarist assumptions about the structure the economy (the LM curve does not have to be vertical), but rather due to the game theoretical setting.

Monetary disorder – not animal spirits – caused the Great Recession

If one follows the financial media on a daily basis as I do there is ample room to get both depressed and frustrated over the coverage of the financial markets. Often market movements are described as being very irrational and the description of what is happening in the markets is often based on an “understanding” of economic agents as somebody who have huge mood swings due to what Keynes termed animal spirits.

Swings in the financial markets created by these animal spirits then apparently impact the macroeconomy through the impact on investment and private consumption. In this understanding markets move up and down based on rather irrational mood swings among investors. This is what Robert Hetzel has called the “market disorder”-view. It is market imperfections and particularly the animal spirits of investors which created swings not only in the markets, but also in the financial markets. Bob obviously in his new book convincingly demonstrates that this “theory” is grossly flawed and that animal spirits is not the cause of neither the volatility in the markets nor did animal spirits cause the present crisis.

The Great Recession is a result of numerous monetary policy mistakes – this is the “monetary disorder”-view – rather than a result of irrational investors behaving as drunken fools. This is very easy to illustrate. Just have a look first at S&P500 during the Great Recession.

The 6-7 phases of the Great Recession – so far

We can basically spot six or seven overall phases in S&P500 since the onset of the crisis. In my view all of these phases or shifts in “market sentiment” can easy be shown to coincide with monetary policy changes from either the Federal Reserve or the ECB (or to some extent also the PBoC).

We can start out with the very unfortunate decision by the ECB to hike interest rates in July 2008. Shortly after the ECB hike the S&P500 plummeted (and yes, yes Lehman Brother collapses in the process). The free fall in S&P500 was to some extent curbed by relatively steep interest rate reductions in the Autumn of 2008 from all of the major central banks in the world. However, the drop in the US stock markets did not come to an end before March 2009.

March-April 2009: TAF and dollar swap lines

However, from March-April 2009 the US stock markets recovered strongly and the recovery continued all through 2009. So what happened in March-April 2009? Did all investors suddenly out of the blue become optimists? Nope. From early March the Federal Reserve stepped up its efforts to improve its role as lender-of-last resort. The de facto collapse of the Fed primary dealer system in the Autumn of 2008 had effective made it very hard for the Fed to function as a lender-of-last-resort and effectively the Fed could not provide sufficient dollar liquidity to the market. See more on this topic in George Selgin’s excellent paper  “L Street: Bagehotian Prescriptions for a 21st-Century Money Market”.

Here especially the two things are important. First, the so-called Term Auction Facility (TAF). TAF was first introduced in 2007, but was expanded considerably on March 9 2009. This is also the day the S&P500 bottomed out! That is certainly no coincidence.

Second, on April 9 when the Fed announced that it had opened dollar swap lines with a number of central banks around the world. Both measures significantly reduced the lack of dollar liquidity. As a result the supply of dollars effectively was increased sharply relatively to the demand for dollars. This effectively ended the first monetary contraction during the early stage of the Great Recession and the results are very visible in S&P500.

This as it very clear from the graph above the Fed’s effects to increase the supply of dollar liquidity in March-April 2009 completely coincides with the beginning of the up-leg in the S&P500. It was not animal spirits that triggered the recovery in S&P500, but rather easier monetary conditions.

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

The dollar swap lines expired February 1 2010. That could hardly be a surprise to the markets, but nonetheless this seem to have coincided with the S&P500 beginning to loose steam in the early part of 2010. However, it was probably more important that speculation grew in the markets that global central banks could move to tighten monetary conditions in respond to the continued recovery in the global economy at that time.

On January 12 2010 the People’s Bank of China increased reserve requirements for the Chinese banks. In the following months the PBoC moved to tighten monetary conditions further. Other central banks also started to signal future monetary tightening.

Even the Federal Reserve signaled that it might be reversing it’s monetary stance. Hence, on February 18 2010 the Fed increased the discount rate by 25bp. The Fed insisted that it was not monetary tightening, but judging from the market reaction it could hardly be seen by investors as anything else.

Overall the impression investors most have got from the actions from PBoC, the Fed and other central banks in early 2010 was that the central banks now was moving closer to initiating monetary tightening. Not surprisingly this coincides with the S&P500 starting to move sideways in the first half of 2010. This also coincides with the “Greek crisis” becoming a market theme for the first time.

August 27 2010: Ben Bernanke announces QE2 and stock market takes off again

By mid-2010 it had become very clear that talk of monetary tightening had bene premature and the Federal Reserve started to signal that a new round of monetary easing might be forthcoming and on August 27 at his now famous Jackson Hole speech Ben Bernanke basically announced a new round quantitative easing – the so-called QE2. The actual policy was not implemented before November, but as any Market Monetarist would tell you – it is the Chuck Norris effect of monetary policy: Monetary policy mainly works through expectations.

The quasi-announcement of QE2 on August 27 is pretty closely connected with another up-leg in S&P500 starting in August 2010. The actual upturn in the market, however, started slightly before Bernanke’s speech. This is probably a reflection that the markets started to anticipate that Bernanke was inching closer to introducing QE2. See for example this news article from early August 2010. This obviously is an example of Scott Sumner’s point that monetary policy works with long and variable leads. Hence, monetary policy might be working before it is actually announced if the market start to price in the action beforehand.

April and July 2011: The ECB’s catastrophic rate hikes

The upturn in the S&P500 lasted the reminder of 2010 and continued into 2011, but commodity prices also inched up and when two major negative supply shocks (revolutions in Northern Africa and the Japanese Tsunami) hit in early 2011 headline inflation increased in the euro zone. This triggered the ECB to take the near catastrophic decision to increase interest rates twice – once in April and then again in July. At the same time the ECB also started to scale back liquidity programs.

The market movements in the S&P500 to a very large extent coincide with the ECB’s rate hikes. The ECB hiked the first time on April 7. Shortly there after – on April 29 – the S&P500 reached it’s 2011 peak. The ECB hiked for the second time on July 7 and even signaled more rate hikes! Shortly thereafter S&P500 slumped. This obviously also coincided with the “euro crisis” flaring up once again.

September-December 2011: “Low for longer”, Operation twist and LTRO – cleaning up your own mess

The re-escalation of the European crisis got the Federal Reserve into action. On September 9 2011 the FOMC announced that it would keep interest rates low at least until 2013. Not exactly a policy that is in the spirit of Market Monetarism, but nonetheless a signal that the Fed acknowledged the need for monetary easing. Interestingly enough September 9 2011 was also the date where the three-month centered moving average of S&P500 bottomed out.

On September 21 2011 the Federal Reserve launched what has come to be known as Operation Twist. Once again this is certainly not a kind of monetary operation which is loved by Market Monetarists, but again at least it was an signal that the Fed acknowledged the need for monetary easing.

The Fed’s actions in September pretty much coincided with S&P500 starting a new up-leg. The recovery in S&P500 got further imputes after the ECB finally acknowledged a responsibility for cleaning up the mess after the two rate hikes earlier in 2011 and on December 8 the ECB introduced the so-called 3-year longer-term refinancing operations (LTRO).

The rally in S&P500 hence got more momentum after the introduction of the 3-year LTRO in December 2011 and the rally lasted until March-April 2012.

The present downturn: Have a look at ECB’s new collateral rules

We are presently in the midst of a new crisis and the media attention is on the Greek political situation and while the need for monetary policy easing in the euro zone finally seem to be moving up on the agenda there is still very little acknowledgement in the general debate about the monetary causes of this crisis. But again we can explain the last downturn in S&P500 by looking at monetary policy.

On March 23 the ECB moved to tighten the rules for banks’ use of assets as collateral. This basically coincided with the S&P500 reaching its peak for the year so far on March 19 and in the period that has followed numerous European central bankers have ruled out that there is a need for monetary easing (who are they kidding?)

Conclusion: its monetary disorder and not animal spirits

Above I have tried to show that the major ups and downs in the US stock markets since 2008 can be explained by changes monetary policy by the major central banks in the world. Hence, the volatility in the markets is a direct consequence of monetary policy failure rather than irrational investor behavior. Therefore, the best way to ensure stability in the financial markets is to ensure nominal stability through a rule based monetary policy. It is time for central banks to do some soul searching rather than blaming animal spirits.

This in no way is a full account of the causes of the Great Recession, but rather meant to show that changes in monetary policy – rather than animal spirits – are at the centre of market movements over the past four years. I have used the S&P500 to illustrate this, but a similar picture would emerge if the story was told with US or German bond yields, inflation expectations, commodity prices or exchange rates.

Appendix: Some Key monetary changes during the Great Recession

July 2008: ECB hikes interest rates

March-April 2009: Fed expand TAF and introduces dollar swap lines

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

August 27 2010: Bernanke announces QE2

April and July 2011: The ECB hike interest rates twice

September-December 2011: Fed announces policy to keep rate very low until the end of 2013 and introduces “operation twist”. The ECB introduces the 3-year LTRO

March 2012: ECB tightens collateral rules

Maybe Jens Weidmann and Francios Hollande should switch jobs

There seem to be two main positions on how to solve the European crisis. One represented by Bundesbank chief Jens Weidmann and that is that monetary policy should not be eased anymore and fiscal policy needs to be tightened (this is the Calvinist position). The other position is held by the new French president Francios Hollande who wants to spur European growth by easing fiscal policy (this is the keynesian position)

I would claim that both positions are wrong. At the core of the European crisis is rising public debt ratios in Europe. The public debt ration (d) is defined in the following way:

(1) d=D/NGDP

Where D is public debt in euros and NGDP is nominal GDP.

Anybody with rudimentary monetarist insights would inform you that D is determined by the fiscal authorities, while NGDP is determined by monetary policy (remember MV=PY).

If you want to stabilize or reduce d then you have to either decrease D and/or increase NGDP. So what you basically need is fiscal tightening and monetary easing.

Unfortunately Weidmann is basically arguing for reducing NGDP and Hollande is arguing in favour of increasing D. Both positons will lead to an increase in d and hence worsen the crisis. Hence, it would be better if the two gentleman switched jobs  – at least mentally. It would be a lot more productivity if Weidmann argued for monetary easing and Hollande argued for fiscal consolidation. That would do the job and the crisis would come to an end fairly fast.

Between the need for fiscal tightening and the need for increasing NGDP I have no doubt that it is much more important to increase NGDP. The public debt ratios in Europe has not primarily increased because fiscal policy has been eased, but because NGDP has collapsed. In that sense the crisis is not a debt crisis, but a monetary crisis.


Note to the two gentlemen:

To President Hollande (The keynesian): Fiscal policy cannot increase NGDP. Recommend reading: There is no such thing as fiscal policy

To Bundesbank chief Weidmann (The Calvinist): Monetary policy is a panache and it can increase NGDP as much as you like it to be increased. Recommend reading: “Ben Volcker” and the monetary transmission mechanism

International monetary disorder – how policy mistakes turned the crisis into a global crisis

Most Market Monetarist bloggers have a fairly US centric perspective (and from time to time a euro zone focus). I have however from I started blogging promised to cover non-US monetary issues. It is also in the light of this that I have been giving attention to the conduct of monetary policy in open economies – both developed and emerging markets. In the discussion about the present crisis there has been extremely little focus on the international transmission of monetary shocks. As a consequences policy makers also seem to misread the crisis and why and how it spread globally. I hope to help broaden the discussion and give a Market Monetarist perspective on why the crisis spread globally and why some countries “miraculously” avoided the crisis or at least was much less hit than other countries.

The euro zone-US connection

– why the dollar’ status as reserve currency is important

In 2008 when crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused to drop by both a contraction in velocity and in the money supply. Reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss franc – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss franc will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over.

Why was the contraction so extreme in for example the PIIGS countries and Russia?

While the Fed failed to increase the money supply enough to counteract the increase in dollar demand it nonetheless acted through a number of measures. Most notably two (and a half) rounds of quantitative easing and the opening of dollar swap lines with other central banks in the world. Other central banks faced bigger challenges in terms of the possibility – or rather the willingness – to respond to the increase in dollar demand. This was especially the case for countries with fixed exchanges regimes – for example Denmark, Bulgaria and the Baltic States – and countries in currencies unions – most notably the so-called PIIGS countries.

I have earlier showed that when oil prices dropped in 2008 the Russian ruble started depreciated (the demand for ruble dropped). However, the Russian central bank would not accept the drop in the ruble and was therefore heavily intervening in the currency market to curb the ruble depreciation. The result was a 20% contraction in the Russian money supply in a few months during the autumn of 2008. As a consequence Russia saw the biggest real GDP contraction in 2009 among the G20 countries and rather unnecessary banking crisis! Hence, it was not a drop in velocity that caused the Russian crisis but the Russian central bank lack of willingness to allow the ruble to depreciate. The CBR suffers from a distinct degree of fear-of-floating and that is what triggered it’s unfortunate policy response.

The ultimate fear-of-floating is of course a pegged exchange rate regime. A good example is Latvia. When the crisis hit the Latvian economy was already in the process of a rather sharp slowdown as the bursting of the Latvian housing bubble was unfolding. However, in 2008 the demand for Latvian lat collapsed, but due to the country’s quasi-currency board the lat was not allowed to depreciate. As a result the Latvian money supply contracted sharply and send the economy into a near-Great Depression style collapse and real GDP dropped nearly 30%. Again it was primarily the contraction in the money supply rather and a velocity collapse that caused the crisis.

The story was – and still is – the same for the so-called PIIGS countries in the euro zone. Take for example the Greek central bank. It is not able to on it’s own to increase the money supply as it is part of the euro area. As the crisis hit (and later escalated strongly) banking distress escalated and this lead to a marked drop in the money multiplier and drop in bank deposits. This is what caused a very sharp drop in the Greek board money supply. This of course is at the core of the Greek crisis and this has massively worsened Greece’s debt woes.

Therefore, in my view there is a very close connection between the international spreading of the crisis and the currency regime in different countries. In general countries with floating exchange rates have managed the crisis much better than countries with countries with pegged or quasi-pegged exchange rates. Obviously other factors have also played a role, but at the key of the spreading of the crisis was the monetary policy and exchange rate regime in different countries.

Why did Sweden, Poland and Turkey manage the crisis so well?

While some countries like the Baltic States or the PIIGS have been extremely hard hit by the crisis others have come out of the crisis much better. For countries like Poland, Turkey and Sweden nominal GDP has returned more or less to the pre-crisis trend and banking distress has been much more limited than in other countries.

What do Poland, Turkey and Sweden have in common? Two things.

First of all, their currencies are not traditional reserve currencies. So when the crisis hit money demand actually dropped rather increased in these countries. For an unchanged supply of zloty, lira or krona a drop in demand for (local) money would actually be a passive or automatic easing of monetary condition. A drop in money demand would also lead these currencies to depreciate. That is exactly what we saw in late 2008 and early 2009. Contrary to what we saw in for example the Baltic States, Russia or in the PIIGS the money supply did not contract in Poland, Sweden and Turkey. It expanded!

And second all three countries operate floating exchange rate regimes and as a consequence the central banks in these countries could act relatively decisively in 2008-9 and they made it clear that they indeed would ease monetary policy to counter the crisis. Avoiding crisis was clearly much more important than maintaining some arbitrary level of their currencies. In the case of Sweden and Turkey growth rebound strongly after the initial shock and in the case of Poland we did not even have negative growth in 2009. All three central banks have since moved to tighten monetary policy – as growth has remained robust. The Swedish Riksbank is, however, now on the way back to monetary easing (and rightly so…)

I could also have mentioned the Canada, Australia and New Zealand as cases where the extent of the crisis was significantly reduced due to floating exchange rates regimes and a (more or less) proper policy response from the local central banks.

Fear-of-floating via inflation targeting

Some countries fall in the category between the PIIGS et al and Sweden-like countries. That is countries that suffer from an indirect form of fear-of-floating as a result of inflation targeting. The most obvious case is the ECB. Unlike for example the Swedish Riksbank or the Turkish central bank (TCMB) the ECB is a strict inflation targeter. The ECB does target headline inflation. So if inflation increases due to a negative supply shock the ECB will move to tighten monetary policy. It did so in 2008 and again in 2011. On both occasions with near-catastrophic results. As I have earlier demonstrated this kind of inflation targeting will ensure that the currency will tend to strengthen (or weaken less) when import prices increases. This will lead to an “automatic” fear-of-floating effect. It is obviously less damaging than a strict currency peg or Russian style intervention, but still can be harmful enough – as it clear has been in the case of the euro zone.

Conclusion: The (international) monetary disorder view explains the global crisis

I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also lead to a monetary contraction in especially Europe. Not because of an increase demand for euro, lats or rubles, but because central banks tighten monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as member of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

The international transmission was not caused by “market disorder”, but by monetary policy failure. In a world of freely floating exchange rates (or PEP – currencies pegged to export prices) and/or NGDP level targeting the crisis would never have become a global crisis and I certainly would have no reason to write about it four-five years after the whole thing started.

Obviously, the “local” problems would never have become any large problem had the Fed and the ECB got it right. However, the both the Fed and the ECB failed – and so did monetary policy in a number of other countries.

DISCLAIMER: I have discussed different countries in this post. I would however, stress that the different countries are used as examples. Other countries – both the good, the bad and the ugly – could also have been used. Just because I for example highlight Poland, Turkey and Sweden as good examples does not mean that these countries did everything right. Far from it. The Polish central bank had horrible communication in early 2009 and was overly preoccupied the weakening of the zloty. The Turkish central bank’s communication was horrific last year and the Sweden bank has recently been far too reluctant to move towards monetary easing. And I might even have something positive to say about the ECB, but let me come back on that one when I figure out what that is (it could take a while…) Furthermore, remember I often quote Milton Friedman for saying you never should underestimate the importance of luck of nations. The same goes for central banks.

PS You are probably wondering, “Why did Lars not mention Asia?” Well, that is easy – the Asian economies in general did not have a major funding problem in US dollar (remember the Asian countries’ general large FX reserve) so dollar demand did not increase out of Asia and as a consequence Asia did not have the same problems as Europe. Long story, but just show that Asia was not key in the global transmission of the crisis and the same goes for Latin America.

PPS For more on the distinction between the ‘monetary disorder view’ and the ‘market disorder view’ in Hetzel (2012).

Hjalmar Schacht’s echo – it all feels a lot more like 1932 than 1923

The weekend’s Greek elections brought a neo-nazi party (“Golden Dawn”) into the Greek parliament. The outcome of the Greek elections made me think about the German parliament elections in July 1932 which gave a stunning victory to Hitler’s nazi party. The Communist Party and other extreme leftist also did well in the Greek elections as they did in Germany in 1932. I am tempted to say that fascism is always and everywhere a monetary phenomenon. At least that was the case in Germany in 1932 as it is today in Greece. And as in 1932 central bankers does not seem to realise the connection between monetary strangulation and the rise of extremist political forces.

The rise of Hitler in 1932 was to a large extent a result of the deflationary policies of the German Reichbank under the leadership of the notorious Hjalmar Schacht who later served in Hitler’s government as Economics Ministers.

Schacht was both a hero and a villain. He successfully ended the 1923 German hyperinflation, but he also was a staunch supporter of the gold standard which lead to massive German deflation that laid the foundation for Hitler’s rise to power. After Hitler’s rise to power Schacht helped implement draconian policies, which effectively turned Germany into a planned economy that lead to the suffering of millions of Germans and he was instrumental in bringing in policies to support Hitler’s rearmament policies. However, he also played a (minor) role in the German resistance movement to Hitler.

The good and bad legacy of Hjalmar Schacht is a reminder that central bankers can do good and bad, but also that central bankers very seldom will admit when they make mistakes. This is what Matthew Yglesias in a blog post from last year called the Perverse Reputational Incentives In Central Banking.

Here is Matt:

I was reading recently in Hjalmar Schacht’s biography Confessions of the Old Wizard … and part of what’s so incredible about it are that Schacht’s two great achievements—the Weimar-era whipping of hyperinflation and the Nazi-era whipping of deflation—were both so easy. The both involved, in essence, simply deciding that the central bank actually wanted to solve the problem.

To step back to the hyperinflation. You might ask yourself how things could possibly have gotten that bad. And the answer really just comes down to refusal to admit that a mistake had been made. To halt the inflation, the Reichsbank would have to stop printing money. But once the inflation had gotten too high for Reichsbank President Rudolf Havenstein to stop printing money and stop the inflation would be an implicit admission that the whole thing had been his fault in the first place and he should have done it earlier…

…So things continued for several years until a new government brought Schacht on as a sort of currency czar. Schacht stopped the private issuance of money, launched a new land-backed currency and simply . . . refused to print too much of it. The problem was solved both very quickly and very easily…

…The institutional and psychological problem here turns out to be really severe. If the Federal Reserve Open Market Committee were to take strong action at its next meeting and put the United States on a path to rapid catch-up growth, all that would do is serve to vindicate the position of the Fed’s critics that it’s been screwing up for years now. Rather than looking like geniuses for solving the problem, they would look like idiots for having let it fester so long. By contrast, if you were to appoint an entirely new team then their reputational incentives would point in the direction of fixing the problem as soon as possible.

Matt is of course very right. Central banks and central banks alone determines inflation, deflation, the price level and nominal GDP. Therefore central banks are responsible if we get hyperinflation, debt-deflation or a massive drop in nominal GDP. However, central bankers seem to think that they are only in control of these factors when they are “on track”, but once the nominal variables move “off track” then it is the mistake of speculators, labour unions or irresponsible politicians. Just think of how Fed chief Arthur Burns kept demanding wage and price controls in the early 1970s to curb inflationary pressures he created himself by excessive money issuance.  The credo seems to be that central bankers are never to blame.

Here is today’s German central bank governor Jens Weidmann in comment in today’s edition of the Financial Times:

Contrary to widespread belief, monetary policy is not a panacea and central banks’ firepower is not unlimited, especially not in the monetary union. First, to protect their independence central banks in the eurozone face clear constraints to the risks they are allowed to take.

…Second, unconditional further easing would ignore the lessons learned from the financial crisis.

This crisis is exceptional in scale and scope and extraordinary times do call for extraordinary measures. But we have to make sure that by putting out the fire now, we are not unwittingly preparing the ground for the next one. The medicine of a near-zero interest rate policy combined with large-scale intervention in financial markets does not come without side effects – which are all the more severe, the longer the drug is administered.

I don’t feel like commenting more on Weidmann’s comments (you can pretty well guess what I think…), but I do note that German long-term bond yields today have inch down further and is now at record low levels. Normally long-term bond yields and NGDP growth tend to move more or less in sync – so with German government 10-year bond yields at 1.5% we can safely say that the markets are not exactly afraid of inflation. Or said in another way, if ECB deliver 2% inflation in line with its inflation target over the coming decade then you will be loosing 1/2% every year by holding German government bonds. This is not exactly an indication that we are about to repeat the mistakes of the Reichbank in 1923, but rather an indication that we are in the process of repeating the mistakes of 1932. The Greek election is sad testimony to that.

PS David Glasner comments also comments on Jens Weidmann. He is not holding back…

PPS Scott Sumner today compares the newly elected French president Francois Hollande with Léon Blum. I have been having been thinking the same thing. Léon Blum served as French Prime Minister from June 1936 to June 1937. Blum of course gave up the gold standard in 1936 and allowed a 25% devaluation of the French franc. While most of Blum’s economic policies were grossly misguided the devaluation of the franc nonetheless did the job – the French economy started a gradual recovery. Unfortunately at that time the gold standard had already destroyed Europe’s economy and the next thing that followed was World War II. I wonder if central bankers ever study history…They might want to start with Adam Tooze’s Wages of Destruction.

Update: See Matt O’Brien’s story on “Europe’s FDR? How France’s New President Could Save Europe”. Matt is making the same point as me – just a lot more forcefully.

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…


PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

Guest post: Why we need the European Central Bank as Lender and Owner of Last Resort

THIS IS A GUEST POST By Arash Molavi Vasséi

Why we need the European Central Bank as Lender and Owner of Last Resort

This post summarizes a short policy note where I argue that the only feasible as well as incentive-compatible solution to the current sovereign debt crisis in the Eurozone involves the European Central Bank (ECB)

  • as a Lender of Last Resort to the Eurozone’s core countries like France, Austria, Finland, and The Netherlands, and
  • as the Owner of Last Resort to the European banking system, thereby setting the stage for haircuts on the debt of potentially insolvent peripheral Member States like Greece, Italy, Spain, and Portugal.

The arguments for a credible commitment of the ECB to an unlimited swap line, promising to swap central bank liabilities for sovereign bonds with the aim to reduce liquidity premia, are well-known. So I won’t repeat them here. I will rather focus on the second part of my argument, on the ECB as an Owner of Last Resort. As far as I am aware of, the idea is new. I guess the idea is fundamentally flawed in a way that I cannot see. This is the reason I wrote it down and why I thank Lars for making it available to a wider audience. Note, however, that I am full aware that the implementation of the idea is neither politically feasible, not is it legal (see the conclusion). My arguments are just concerned with economic admissibility.

The ECB as Owner of Last Resort

There are few economist who would deny that a haircut on sovereign debt is an incentive-compatible solution; the extremely serious downside is the risk of a breakdown of the European banking sector and global contagion.

But there is a solution. First, the European Banking Authority (EBA) should come up with serious stress tests, that is, predicting the impact of realistic haircuts on peripheral sovereign debt and of a Europe-wide recession on each Systemically Important Financial Institution (SIFI) in Europe. In a next step, the ECB should step in as the Owner of Last Resort and recapitalize each such SIFI according to the EBA’s projections. In contrast to its role as Lender of Last Resort, the ECB would swap central bank liabilities for preferred stocks, i.e., senior equity securities that carry no voting rights and, thus, prohibits the ECB from getting involved in the SIFI’s business models.

There are clear advantages of the ECB engaging as the Owner of Last Resort:

1. The most important reason why the ECB should engage in the recapitalization of the European banking sector is the same as usual: it can create unlimited amounts of central bank liabilities and, thus, unlimited amounts of premium-quality capital. The ECB as an Owner of Last Resort thereby avoids the vicious circle that any other realistic recapitalization scheme would trigger: if Member States like France and Germany are supposed to finance heavy haircuts on peripheral sovereign debt, their own solvency could be endangered, respectively; this would suggest even higher default probabilities and potentially higher haircuts on sovereign debt. In turn, Member States would have to get involved in a second recapitalization-scheme, which would endanger their solvency and credit ratings even further; the feedback loop would continue until the entire Eurozone eventually collapses.

The same is true for any other limited fund like the EFSF, which is eventually backed by France and Germany (IMF-financed recapitalization would in addition endanger U.S. ratings; neither the Obama administration, nor the Republican presidential candidates show any interest in increasing IMF-funds; also China refuses to support the EFSF). By contrast, the ECB cannot become insolvent. That such a situation is considered in its constitutions is only due to the fact that it is designed by lawyers, obviously unaware of the basics of central banking: what makes a central bank so special is that the unit of account in a at system is defined in terms of its liabilities, and that its liabilities are the used to redeem contracts. The monopoly producer of the means of final settlement just cannot get bankrupt, for bankruptcy happens if you lack the means to settle your obligations. Unconstrained by its constitution, any central bank can shield its equity capital against losses.

2. The approach is incentive compatible: it rescues banks, but punishes their owners. Given the increased quantity of SIFI-stocks, the share of profits generated by such financial entities that could be distributed to the private sector diminishes. In short, recapitalization is a blow to the return on capital invested, reducing the value of each stock in circulation as well as the value of newly issued stocks. This is why banks hate it, and why they negotiate insufficient haircuts. Thus, recapitalization by the ECB must be mandatory to avoid resistance by the SIFI’s managements – who are obliged by law to protect the interests of private shareholders.

3. The approach avoids deleveraging processes that otherwise will accompany the revision of the the EU’s Capital Requirement Directive (CRD IV), which implements Basel III (in fact, CRD IV goes beyond Basel III). By cutting well-established credit lines to profitable companies, banks increase their capital ratio, respectively, by reducing the denominator. By contrast, the ECB as Owner of Last Resort would increase the numerator, leaving no rationale to deleverage. The consolidated balance sheet of the European banking system would lengthen instead. This ensures that (1) bank lending to the so-called “real economy” and (2) the transmission mechanisms of monetary policy remain intact.

4. Finally, and closely related to point 3, the ECB as Owner of Last Resort would back the possibility to implement significantly higher capital requirement over a horizon of ten to fifteen years. Research shows that high capital requirements are not detrimental to economic growth (See for example here). Instead, they ensure that systemically relevant institutions climb down the “Efficient Frontier” such that a lower return on capital invested is compensated by reduced risk. Ask yourself: Of all possible investments possibilities, why should systemically relevant institutions be the hotbed of relatively less risk averse or even risk-loving investors? All it needs is that the ECB injects more capital than projected by the EBA such as to ensure capital ratios around twenty or even thirty percent. In the aftermath of the crisis, the ECB would sell its  preferred stocks during a period of ten to fifteen years, while commercial banks are prohibited to buy back these papers.


To contain the crisis, the ECB should act as a Lender of Last Resort, that is, it should credibly commit itself to an unlimited swap line as described above. However, to resolve the crisis the ECB should also act as an Owner of Last Resort with respect to the European banking sector and, thereby, set the stage for haircuts on the debt of potentially insolvent peripheral members of the Eurozone.

Of course, there is little hope that Germany will ever support such unconventional measures. It already brought France and Italy into line: they all announced not to seek for ECB intervention to rescue the Eurozone from a deepening sovereign debt crisis. But the problems with my proposal root deeper: it seems not only politically infeasible, but is clearly illegal. As an adherent to the Rule of Law, I feel highly uncomfortable with my own suggestions. Yet, I am not aware of an economically admissible solution to the sovereign debt crisis in the Eurozone that also conforms to law, including those measures I am opposed to. Given that the current legal framework does not support any feasible solution, and given that we do not have the time to adjust the legal framework, we will break the law anyway. Actually, we broke it already.

Perhaps is this the major lesson of the political project to impose a common currency on a non-optimal currency area: any attempt to implement a political vision in contradiction to economic regularities is not only doomed to fail, but also undermines the fundamental ingredient to a free and prosperous society: the Rule of Law.

I am grateful to Arash for this very insightful comment on crisis resolution for the euro zone. We are facing an extremely challenging situation in Europe at the moment and if we do not move swiftly to resolve the crisis we could be heading for a disastrous outcome. I therefore welcome any discussion of this is issue and I would happily accept guest posts from other economists with an input to how to solve the crisis (please mail me at

Finally I should say that I think that Arash’s ideas are very helpful in the terms of solving this crisis. That does not mean I agree with everything, but on the other hand there is certainly a lot of what Arash is saying that I agree 100% with. Furthermore, there is no doubt that the concept of Owner of Last Resort is theoretically very interesting and in my view the idea deserves more attention by other researchers.

Lars Christensen


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