Mussolini’s great monetary policy failure

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

—-

Related blog posts:

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

And posts on the early 1930s:

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

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

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

 

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

This is from the Telegraph:

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

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

Eggs and fire crackers were hurled at the economy ministry.

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

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

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

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

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

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

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

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

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

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

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

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

crisis Italy

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

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

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

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

 

Turning the Russian petro-monetary transmission mechanism upside-down

Big news out of Moscow today – not about the renewed escalation of military fighting in Eastern Ukraine, but rather about Russian monetary policy. Hence, today the Russian central bank (CBR) under the leadership of  Elvira Nabiullina effectively let the ruble float freely.

The CBR has increasing allowed the ruble to float more and more freely since 2008-9 within a bigger and bigger trading range. The Ukrainian crisis, negative Emerging Markets sentiments and falling oil prices have put the ruble under significant weakening pressures most of the year and even though the CBR generally has allowed for a significant weakening of the Russian currency it has also tried to slow the ruble’s slide by hiking interest rates and by intervening in the FX market. However, it has increasingly become clear that cost of the “defense” of the ruble was not worth the fight. So today the CBR finally announced that it would effectively float the ruble.

It should be no surprise to anybody who is reading my blog that I generally think that freely floating exchange rates is preferable to fixed exchange rate regimes and I therefore certainly also welcome CBR’s decision to finally float the ruble and I think CBR governor Elvira Nabiullina deserves a lot of praise for having push this decision through (whether or not her hand was forced by market pressures or not). Anybody familiar with Russian economic-policy decision making will know that this decision has not been a straightforward decision to make.

Elvira has turned the petro-monetary transmission mechanism upside-down

The purpose of this blog post is not necessarily to specifically discuss the change in the monetary policy set-up, but rather to use these changes to discuss how such changes impact the monetary transmission mechanism and how it changes the causality between money, markets and the economy in general.

Lets first start out with how the transmission mechanism looks like in a commodity exporting economy like Russia with a fixed (or quasi fixed) exchange rate like in Russia prior to 2008-9.

When the Russian ruble was fixed against the US dollar changes in the oil price was completely central to the monetary transmission – and that is why I have earlier called it the petro-monetary transmission mechanism. I have earlier explained how this works:

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

This effectively means that in such a set-up the CBR will have given up monetary sovereignty and instead will “import” monetary policy via the oil price and the exchange rate. In reality this also means that the global monetary superpower (the Fed and PBoC) – which to a large extent determines the global demand for oil indirectly will determine Russian monetary conditions.

Lets take the case of the People’s Bank of China (PBoC). If the PBoC ease monetary policy – increase monetary supply growth – then it will increase Chinese demand for oil and push up oil prices. Higher oil prices will push up currency inflows into Russia and will cause appreciation pressure on the ruble. If the ruble is pegged then the CBR will have to intervene to keep the ruble from strengthening. Currency intervention of course is the same as sell ruble and buying foreign currency, which equals an increase in the Russian money base/supply. This will push up Russian nominal GDP growth.

Hence, causality runs from the monetary policy of the monetary superpowers – Fed and the PBoC – to Russian monetary policy as long as the CBR pegs or even quasi-peg the ruble. However, the story changes completely when the ruble is floated.

I have also discussed this before:

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

If today’s announced change in monetary policy set-up in Russia is taken to be credible (it is not necessary) then it would mean the completion of the transformation of the monetary transmission which essentially was started in 2008 – moving from a pegged exchange/manage float regime to a floating exchange rate.

This will also means that the CBR governor Elvira Nabiullina will have ensured full monetary sovereignty – so it will be her rather than the Federal Reserve and the People’s Bank of China, who determines monetary conditions in Russia.

Whether this will be good or bad of course fully dependent on whether Yellen or Nabiullina will conduct the best monetary policy for Russia.

One can of course be highly skeptical about the Russian central bank’s ability to conduct monetary policy in a way to ensure nominal stability – there is certainly not good track record, but given the volatility in oil prices it is in my view also hard believe that a fully pegged exchange rate would bring more nominal stability to the Russian economy than a floating exchange rate combined with a proper nominal target – either an inflation target or better a NGDP level target.

Today Elvira Nabiullina has (hopefully) finalized the gradual transformation from a pegged exchange to a floating exchange rate. It is good news for the Russian economy. It will not save the Russia from a lot of other economic headaches (and there are many!), but it will at least reduce the risk of monetary policy failure.

PS I still believe that the Russian economy is already in recession and will likely fall even deeper into recession in the coming quarters.

 

 

The fall of the Berlin Wall and the end of global extreme poverty

Today it is 25 years ago the Berlin Wall came down. It has become the symbol of the end of communism and is surely something which should be celebrated.

The end of communism and the end of the Cold War sparked what has become one of the best periods in human history. As communism ended globalization or rather global capitalism took off. While communism stated goal was to eradicate poverty it never succeed in anything else than oppressing billions of people.

On the other hand globalisation has turned out to be a fantastic anti-poverty program as the always brilliant Doug Irwin explains in a new Wall Street Journal oped:

The World Bank reported on Oct. 9 that the share of the world population living in extreme poverty had fallen to 15% in 2011 from 36% in 1990. Earlier this year, the International Labor Office reported that the number of workers in the world earning less than $1.25 a day has fallen to 375 million 2013 from 811 million in 1991.

Such stunning news seems to have escaped public notice, but it means something extraordinary: The past 25 years have witnessed the greatest reduction in global poverty in the history of the world.

To what should this be attributed? Official organizations noting the trend have tended to waffle, but let’s be blunt: The credit goes to the spread of capitalism. Over the past few decades, developing countries have embraced economic-policy reforms that have cleared the way for private enterprise.

China and India are leading examples. In 1978 China began allowing private agricultural plots, permitted private businesses, and ended the state monopoly on foreign trade. The result has been phenomenal economic growth, higher wages for workers—and a big decline in poverty. For the most part all the government had to do was get out of the way. State-owned enterprises are still a large part of China’s economy, but the much more dynamic and productive private sector has been the driving force for change.

In 1991 India started dismantling the “license raj”—the need for government approval to start a business, expand capacity or even purchase foreign goods like computers and spare parts. Such policies strangled the Indian economy for decades and kept millions in poverty. When the government stopped suffocating business, the Indian economy began to flourish, with faster growth, higher wages and reduced poverty.

…The reduction in world poverty has attracted little attention because it runs against the narrative pushed by those hostile to capitalism…Yet thanks to growth in the developing world, world-wide income inequality—measured across countries and individual people—is falling, not rising, as Branko Milanovic of City University of New York and other researchers have shown.

…Some 260 years ago, (Adam) Smith noted that: “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things.” Very few countries fulfill these simple requirements, but the number has been growing. The result is a dramatic improvement in human well-being around the world, an outcome that is cause for celebration.

Today we celebrate the end of communism, but we also celebrate globalization, capitalism and the near eradication of extreme poverty over the past 25 years.

HT Steve Ambler

PS To me the beginning of the end of communism is not the fall of the Berlin Wall, but rather the so-called roundtable negotiations between the Polish communist government and the Solidarność movement and the first (quasi) free elections in Poland in 1989. This of course does not makes today’s celebrations less important.

 

The massively negative euro zone ‘Divisia Money Gap’

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

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

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

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

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

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

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

The deflationary ‘Divisia Money Gap’

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

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

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

Divisia Money Gap

The graph above tells two stories.

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

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

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

HT William Barnett

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

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

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

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

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

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

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

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

What happened to the ECB’s monetary pillar 

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

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

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

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

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

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

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

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

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

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

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

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

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

(On the ECB “miscalibration” of monetary policy)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is anybody in Frankfurt listening? I hope so…

PS see the other SOMC papers here.

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

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

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

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

Milton, Melamed and Me

Earlier this week Leo Melamed and myself spoke about Milton Friedman and markets at the Danish free market think thank CEPOS. See the show here

The Brilliant Nick Rowe

This is our own Nick Rowe on “Boom-Bust”.

Nick is a brilliant monetary thinker – and very entertaining. I would so hope that the likes of the ECB and the Riksbank would listen to people like Nick.

Time for the Fed to introduce a forward-looking McCallum rule

Earlier this week Boston Fed chief Eric Rosengreen in an interview on CNBC said that the Federal Reserve could introduce a forth round of quantitative easing – QE4 – since the beginning of the crisis in 2008 if the outlook for the US economy worsens.

I have quite mixed emotions about Rosengreen’s comments. I would of course welcome an increase in money base growth – what the Fed and others like to call quantitative easing – if it is necessary to ensure nominal stability in the US economy.

However, the way Rosengreen and the Fed in general is framing the use of quantitative easing in my view is highly problematic.

First of all when the fed is talking about quantitative easing it is speaking of it as something “unconventional”. However, there is nothing unconventional about using money base control to conduct monetary policy. What is unconventional is actually to use the language of interest rate targeting as the primary monetary policy “instrument”.

Second, the Fed continues to conduct monetary policy in a quasi-discretionary fashion – acting as a fire fighter putting out financial and economic fires it helped start itself.

The solution: Use the money base as an instrument to hit a 4% NGDP level target

I have praised the Fed for having moved closer to a rule based monetary policy in recent years, but the recent escalating distress in the US financial markets and particularly the marked drop in US inflation expectations show that the present monetary policy framework is far from optimal. I realize that the root of the recent distress likely is European and Chinese rather than American, but the fact that US inflation expectations also have dropped shows that the present monetary policy framework in the US is not functioning well-enough.

I, however, think that the Fed could improve the policy framework dramatically with a few adjustments to its present policy.

First of all the Fed needs to completely stop thinking about and communicating about its monetary stance in terms of setting an interest rate target. Instead the Fed should only communicate in terms of money base control.

The most straightforward way to do that is that at each FOMC meeting a monthly growth rate for the money base is announced. The announced monthly growth rate can be increased or decreased at every FOMC-meeting if needed to hit the Fed’s ultimate policy target.

Using “the” interest rate as a policy “instrument” is not necessarily a major problem when the “natural interest rate” for example is 4 or 5%, but if the natural interest rate is for example 1 or 2% and there is major slack in the economy and quasi-deflationary expectations then you again and again will run into a problem that the Fed hits the Zero Lower Bound everything even a small shock hits the economy. That creates an unnecessary degree of uncertainly about the outlook for monetary policy and a natural deflationary bias to monetary policy.

I frankly speaking have a hard time understanding why central bankers are so obsessed about communicating about monetary policy in terms of interest rate targeting rather than money base control, but I can only think it is because their favourite Keynesian models – both ‘old’ and ‘new’ – are “moneyless”.

I have earlier argued that the Fed since the summer of 2009 effectively has target 4% nominal GDP growth (level targeting). One can obviously argue that that has been too tight a monetary policy stance, but we have now seen considerable real adjustments in the US economy so even if the US economy likely could benefit from higher NGDP growth for a couple of year I would pragmatically suggest that the time has come to let bygones-be-bygones and make a 4% NGDP level target an official Fed target.

Alternatively the Fed could once every year announce its NGDP target for the coming five years based on an estimate for potential real GDP growth and the Fed’s 2% inflation target. So if the Fed thinks potential real GDP growth in the US in the coming five years is 2% then it would target 4% NGDP growth. If it thinks potential RGDP growth is 1.5% then it would target 3.5% growth.

However, it is important that the Fed targets a path level rather than the growth rate. Therefore, if the Fed undershoots the targeted level one year it would have to bring the NGDP level back to the targeted level as fast as possible.

Finally it is important to realize that the Fed should not be targeting the present level of NGDP, but rather the future level of NGDP. Therefore, when the FOMC sets the monthly growth rate of the money base it needs to know whether NGDP is ‘on track’ or not. Therefore a forecast for future NGDP is needed.

The way I – pragmatically – would suggest the FOMC handled this is that the FOMC should publish three forecasts based on three different methods for NGDP two years ahead.

The first forecast should be a forecast prepared by the Fed’s own economists.

The second forecast should be a survey of professional forecasts.

And finally the third forecast should be a ‘market forecast’. Scott Sumner has of course suggested creating a NGDP future, which the Fed could target or use as a forecasting tool. This I believe would be the proper ‘market forecast’. However, I also believe that a ‘synthetic’ NGDP future can relatively easily be created with a bit of econometric work and the input from market inflation expectations, the US stock market, a dollar index and commodity prices. In fact it is odd no Fed district has not already undertaken this task.

An idealised policy process

To sum up how could the Fed change the policy process to dramatically improve nominal stability and reduce monetary policy discretion?

It would be a two-step procedure at each FOMC meeting.

First, the FOMC would look at the three different forecasts for the NGDP level two-years ahead. These forecasts would then be compared to the targeted level of NGDP in two year.

The FOMC statement after the policy decision the three forecast should be presented and it should be made clear whether they are above or below the NGDP target level. This would greatly increase policy-making discipline. The FOMC members would be more or less forced to follow the “policy recommendation” implied by the forecasts for the NGDP level.

Second, the FOMC would decide on the monthly money base growth rate and it is clear that it follows logically that if the NGDP forecasts are below (above) the NGDP level target then the money base growth rate would have to be increased (decreased).

It think the advantages of this policy process would be enormous compared to the present quasi-discretionary and eclectic process and it would greatly move the Fed towards a truly rule-based monetary policy.

Furthermore, the process would be easily understood by the markets and by commentators alike and it would in no way be in conflict with the Fed’s official dual mandate as I strongly believe that such a set-up would both ensure price stability – defined as 2% inflation over the cycle – and “maximum employment”.

And finally back to the headline – “Time for the Fed to introduce a forward McCallum rule”. What I essentially have suggested above is that the Fed should introduce a forward-looking version of the McCallum rule. Bennett McCallum obviously originally formulated his rule in backward-looking terms (and in growth terms rather than in level terms), but I am sure that Bennett will forgive me for trying to formulate his rule in forward-looking terms.

PS if the ECB followed the exactly same rule as I have suggested above then the euro crisis would come to an end more or less immediately.

 

 

Follow

Get every new post delivered to your Inbox.

Join 4,129 other followers

%d bloggers like this: