Remember the “Corralito”? Lessons on Greece and Argentina from the New York Times

This is from the New York Times today:

Greece will keep its banks closed on Monday and place restrictions on the withdrawal and transfer of money, Prime Minister Alexis Tsipras said in a televised address on Sunday night, as Athens tries to avert a financial collapse.

The government’s decision to close banks temporarily and impose other so-called capital controls — and to keep the stock market closed on Monday — came hours after the European Central Bank said it would not expand an emergency loan program that has been propping up Greek banks in recent weeks while the government was trying to reach a new debt deal with international creditors.

The debt negotiations broke down over the weekend after Mr. Tsipras said he would let the Greek people decide whether to accept the creditors’ latest offer. That referendum vote is to be held next Sunday, after the current bailout program will have expired.

And this is from the New York Times on December 2 2001:

The government (of Argentina) has limited cash withdrawals from banks and taken a step toward adopting the dollar as Argentina’s currency, as part of a desperate effort to avert a run on banks and a chaotic devaluation.

The measures, announced late Saturday, were another sign that Argentina is on the brink of a default on its $132 billion in public sector debt. It has already cut the interest payments it makes on $45 billion in bonds in recent days.

A month later we had street rioting, banking sector collapse, a sovereign default and a major devaluation – not to mention the collapse of government and a very busy rotating door at the presidential palace!

Will Greece be luckier in the coming month? Let’s hope so.

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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: daniel@specialistspeakers.com or roz@specialistspeakers.com.

How the RECOVERY will look like when Greece leaves the euro

Most indications are that Greece this weekend effectively has been pushed over edge by the collective failures of Greek and European policy makers. The combined forces of an European monetary straitjacket, the lack of a coherent European sovereign debt crisis resolution mechanism and weak Greek institutional structures and a lot of badwill on both sides of the issue in the end did it.

And we are now facing bank run, possible banking sector collapse, the likely introduction of capital controls, a Greek sovereign default and potentially also a Greek exit from the euro area.

So there is no doubt that the future looks very bleak for the Greek economy, but there are also good arguments that all this actually might mark the beginning of a Greek economic recovery in the same way the Argentine default and devaluation in January 2002 was the beginning of a sharp recovery in Argentine growth in from 2002 to 2007.

Argentina in 2001-2, Greece today 

it is no coincidence that I mention the example of Argentine. Hence, I have long argued that the present Greek crisis is very similar to the Argentine crisis of the late 1990s and early 2000s. Both countries have been suffering under the combined pressures of a monetary regime that creates strong deflationary pressures and a weak domestic political system.

We can essentially think of this as both a demand and a supply problem. With the monetary system causing a collapse in aggregate demand and weak institutional structures at the same time causing a negative supply shock as well as creating downward rigidities to wages and prices.

In the late 1990s the Argentine’s currency board set-up created serious deflationary pressures and a drop in nominal GDP, which caused a rise in Argentine debt ratios. There was a simple “solution” to this problem – Argentina should give up the currency board and devalue. That happened in early 2002.

Even though the contraction in the Argentine economy continued in the first couple of quarters after the devaluation growth soon picked up and in fact Argentine real GDP growth in the period 2003-2007 averaging nearly 8.5% per year. Obviously we should not forget that GDP dropped 10% in 2002, but that was essentially the impact of the banking crisis that played out ahead of the devaluation rather than a result of the devaluation.

I think that we very well could be in for a very similar development in Greece if the country indeed leaves the euro area. Obviously we are now in the midst of an extremely chaotic political and economic situation and what could become a full scale banking crisis and a disorderly sovereign default. The bank run we effective already have seen on its own constitutes a massive monetary tightening – due to the drop in the money-multiplier – and that on its own is going to have a strongly negative impact on the Greek economy in the coming quarters.

However, Grexit will also remove the monetary straitjacket, which has had caused an enormous amount of economic hardship in Greece since 2008. The removal of this straitjacket will cause a significant easing of Greek monetary conditions, which in my view very likely will cause a sharp rise in nominal GDP in Greece in the coming years. The graph below shows the development in Argentine M2 and nominal GDP on the back of the Argentine devaluation in 2002.

I think we might very well see a similar development in Greece on the back of Grexit and given the price and wage rigidities in the Greek economy we are likely to see a sharp recovery in Greek real GDP growth – after the initial deep recession, but my guess is that Grexit will be the beginning of the end of this recession.

The graph below shows the development in real GDP in Argentina eight years ahead of the default and the devaluation in 2002 and in eight years following the initial collapse. The graph also includes Greek real GDP. “Year zero” is 2001 for Argentina and 2014 for Greece.

Argentina Greece RGDP

The recovery will not primarily be about exports

Hence, I believe there is good reason to think that a potential Grexit will be the beginning of a sharp recovery in Greek growth – following the initial sharp contraction. However, I would like to stress that contrary to the common-held view such recovery will not be about Greece becoming more “competitive” due to the drop in value of the “New Drachma” (I easily see a 70-80% devaluation following Grexit).

Rather we are likely to see a sharp recovery in domestic demand as a likely sharp rise in inflation expectations will cause a sharp increase in money velocity. This combined with the expected increase in the money supply will cause a significant easing of Greek monetary conditions, which likely will spur a strong recovery in Greek growth.

This is exactly what happened in Argentina. This is from Mark Weisbrot and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

So you better get ready for the stories in the media following a potential Grexit that this will be “good for Greek tourism” and “feta exports”, but if you study monetary history you will know that this will only be part of a the story and looking ahead over the coming five years it is much more likely that the story will be a sharp recovery in Greek domestic demand.

But don’t forget Greece’s quasi-Constitutional problems

Concluding, I am probably more optimistic that a potential Grexit will cause a recovery (after the initial contraction) in the Greek economy than most economists who tend to stress Greece’s structural problems. That, however, does not mean that I don’t think Greece has structural problems. In fact I believe the Greece has very serious structural problems and I will even go so far as to say that Greece’s deep structural problems are a result of fundamental constitutional problems.

Hence, at the core of the problems that have dominated the Greek economic development for decades (if not centuries!) is a flawed political system. Therefore, if Greece wants to avoid ending up as present-day Argentina – where the initial positive effects of monetary easing has been “replaced” by overly easy monetary policy and large political uncertainties – then there is a need for fundamental constitutional reform to reduce the role of government in the Greek economy and constrain the unhealthy relationship between economic and political interests.

So yes, monetary easing can solve the demand problems in the Greek economy (I think that actually was under way prior to Syriza winning the parliament elections), but monetary easing will not do anything about Greece’s structural and constitutional problems.

Finally, on a personal note I must say I have a very deep sympathy for the economic and social suffering of the Greek population and I full well understand their justified frustration they have with European and Greek policy makers who so utterly have failed in the past seven years. I equally understand the frustration of German, Danish and Slovak tax payers who directly or indirectly over the past seven years have been asked to pick up the bill for numerous badly designed bailout packages. They have done very little good to Europe or Greece.

But I mostly hope that we would give up the national stereotyping and instead study the fundamental economic and monetary issues. The Greek crisis is not about the Greeks being “lazy” (in fact Greeks work a lot more than the Germans…) or corrupt, but it is about the serious monetary policy failures of the ECB and a generally badly designed monetary policy framework in Europe combined with the failures of the Greek political establishment.

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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: daniel@specialistspeakers.com or roz@specialistspeakers.com.

Guest post: Europe’s problem is not a Greek drama but a medieval Calvinist morality play (by Mikio Kumada)

I have asked my friend Mikio Kumada to write a guest post on blog on a topic he knows very well – the Greek crisis. While I do not agree with everything Mikio writes (I do agree with most of it) I think it is extremely important to get a broader and more insightful perspective on the Greek crisis (and the euro crisis) than the standard “Calvinist” version.

Good luck.

Lars Christensen

Guest post: Europe’s problem is not a Greek drama but a medieval Calvinist morality play

by Mikio Kumada

The crisis that Greece has found itself in over the past five years has been invariably labelled as a “Greek tragedy” by the media around the world – which is both wrong and misleading. More importantly, it is very unhelpful when it comes to finding a way out for Greece and for Europe as a whole.

The reality is that, if one wishes to use catchy cultural labels, it would be more appropriate to call it a medieval European morality play of the Calvinist sort – and a rather bad one at that, too. Bad, because it harks back to notions of good and evil that perpetuate mistakes and delay a solution to the actual problem.

In this “Calvinist” play, the Europeans are telling Greece:

“We understand that your house is on fire, but you cannot use our stand-by fire extinguishers and fire engines, because you’ve been a bad boy/bad girl, and you have to repent for your sins first. You can use the extinguishers in the rooms in which our property is stored, but for the rest, use this bucket of water instead, which we so generously provide to you.”

What you say if your house was on fire, and your “friends” gave the above “advice” and “help”?

Do not get me wrong: Greece was predominantly responsible for the fact that its house was so easily inflammable, and that that it was ill-prepared to cope with the disaster. But it is only to a smaller part responsible that the fire is still raging.

Furthermore, over the past five years, Greece has done its best to put out the fire with the water bucket, and to “repent”, as recommended – i.e. it has implemented a wide range of difficult reforms and cuts (Prof. Karl Whelan of University College Dublin provides a good account here). Even Greece’s new government is willing to compromise to a considerable degree.

That said, let me move straight on to what I believe is the most likely scenario of how things will play out in the coming days or weeks – depending on the level of European intransigence ability to admit mistakes and lose a little bit of face, for the sake of avoiding an even greater calamity.

In spite of what I may have appeared to suggest above, I believe Europeans in general and Northern Europeans in particular are emotionally capable of soul-searching and intellectually perfectly endowed for reflection and pragmatism, to use a very Greek term. Thus, realistic, practical solutions will ultimately prevail in this whole affair.

Consequently, I still think there will not be a “Grexit” – not this week, not this quarter, not next year, or in any other year. What is most likely (though of course not certain) to happen, is the following:

  • There will be an extension of the current (revised and softened) program for something like 3 to 6 months.
  • In order to achieve this, the Europe will find a way to move Greece’s current liabilities versus the IMF and the ECB to the ESM, without actually having to spend a single “new” penny. The funds required for this purpose are available – in the form of the unused 10 billion euros from the Greek bank recapitalization fund, the roughly 2 billion euros in ECB profits from its older purchases of the Greek bonds, and by allowing Athens to borrow a couple of billion more from its own banks (the issuance limit of T-bills is subject to approval by the ECB). This will also allow the Europeans to get the IMF off their backs for now.
  • This, in turn, should eventually allow Greece to participate in what is the most important determinant factor for Europe’s economic recovery in the near future – the ECB’s first proper quantitative easing program that began in March – before it’s too late.
  • There will be a third financing program for Greece sometime early next year, which will be much smaller in size and more realistic by design than the previous ones. It will probably include a specific European commitment to provide debt relief – in order to get the IMF back on board. Or it will completely “Europeanize” the problem.
  • Under these conditions, it will be possible for Greece to produce nominal GDP growth – which is the mother of all debt sustainability miracles, as it is the basis of all household income, corporate profit, and tax revenue.

I should add that international political considerations regarding the IMF form an important part and driver of the above scenario. Point 2) would calm the US-led IMF, for now, as it would avoid a global loss of face for Europe, if an EU member is allowed to default vs. the fund.

Needless to say, such an event would weaken Europe’s global standing in the organization, and beyond. No matter how much Northern Europe would like to detach itself from it, Greece is a European affair.

Here, it is useful to remember that we live in an era in which the Bretton Woods organizations will soon be competing, to say the least, with similar international institutions-in-the-making, led by China and the BRICs. This is no small matter.

Europe’s huge combined share aside, the IMF’s two largest shareholders are the US and Japan, which, by the way, stands behind the Eurozone bailout loans with some 90 billion US dollars.

And while Germany, and others, could try to squarely place the blame on Athens, but hardly anyone would really buy that. The rest of the world would see this as a European failure, especially since the IMF was (reportedly) pressured by the Europeans to bend its rules to lend to Greece. Allies and friends such as the US/UK and Japan will have a harder time siding with Europe, and the emerging economies will see as proof that Europe’s role in the IMF is not just oversized, but also very costly, to say the least.

The problem of the “Calvinist” approach to the Greek crisis also plays a role on this level.

After all, practically all major countries outside Northern Europe are less moralistic and more pragmatic when it comes to debt problems. One example can be found in the fact that the US, UK and Japan were quicker in intellectually accepting QE, without concerning themselves too much about whether this represented inappropriate / immoral “stealth government financing” (I believe QE is simply a perfectly legitimate, useful and important tool of monetary policy). Another example can be found in a side-quip by a Chinese economist I overheard in Hong Kong, who described Beijing’s ongoing (vaguely veiled) bailout of its highly indebted provinces as being akin to Europe’s bailout of Greece – “just without the austerity”.

To make a long story short, I do believe that Europe will overcome the limitations imposed by the simplistic application of culture-specific morality in internationally relevant policy affairs – especially when the tools and means to overcome its problem are clearly available.

And if there is any “Greek drama” involved in this, it could very well prove useful for Europe as a whole, by confronting it with important policy questions – and thus ultimately help it move on to a more workable, and pragmatic, solutions to its problems.

© Copyright (2015) Mikio Kumada

Yanis Varoufakis has a point – the Greek debt crisis is mostly about the collapse of NGDP

The Greek Finance Minister Yanis Varoufakis has a new article for Project Syndicate. He is making a point that Market Monetarists have been making since the outbreak of the euro crisis – it is not really a ‘debt crisis’, but rather a monetary crisis.

This is Varoufakis:

The view that Greece has not achieved sufficient fiscal consolidation is not just false; it is patently absurd. The accompanying figure not only illustrates this; it also succinctly addresses the question of why Greece has not done as well as, say, Spain, Portugal, Ireland, or Cyprus in the years since the 2008 financial crisis. Relative to the rest of the countries on the eurozone periphery, Greece was subjected to at least twice the austerity. There is nothing more to it than that.

Here is his graph:

Now compare that with a graph I had in one of my blog posts back in 2012:

And this is what I wrote then:

The conclusion is very clear. The change in public debt ratios across the euro zone is nearly entirely a result of the development in nominal GDP.

The “bad boys” the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain (and Slovenia) are those five (six) countries that have seen the most lackluster growth (in fact decline) in NGDP in the euro zone. These countries are obviously also the countries where debt has increased the most and government bond yields have skyrocketed.

This should really not be a surprise to anybody who have taken Macro 101 – public expenditures tend to increase and tax revenues drop in cyclical downturns. So higher budget deficits normally go hand in hand with weaker growth.

The graph interestingly enough also shows that the debt development in Greece really is no different from the debt development in Germany if we take the difference in NGDP growth into account. Greek nominal GDP has dropped by around 10% since 2007 and that pretty much explains the 50%-point increase in public debt since 2007. Greece is smack on the regression line in the graph – and so is Germany. The better debt performance in Germany does not reflect that the German government is more fiscally conservative than the Greek government. Rather it reflects a much better NGDP growth performance. So maybe we should ask the Bundesbank what would have happened to German public debt had NGDP dropped by 10% as in Greece. My guess is that the markets would not be too impressed with German fiscal policy in that scenario. It should of course also be noted that you can argue that the Greek government really has not anything to reduce the level of public debt – if it had than the Greece would be below to the regression line in the graph and it is not.

So yes I agree with Varoufakis that a lot of Greece’s fiscal troubles are a direct consequence of the collapse of Greek GDP. That, however, does not change the fact that Greece needs serious structural reforms – including pension reform, tax reform and privatisation – preferably also in my view serious constitutional reforms and I am not sure that the hard-leftist Syriza government is able or willing to deliver such reforms.

And I am not arguing that the EU and the IMF should let Greece off the hook, but on the other hand I do think that there are ways forward.

In my view the best solution – and there are no easy solutions at this point – is deep structural reforms in Greece combined with a refinancing of Greek government debt so the present debt to the European Stability Mechanism is replaced by newly issued bonds linked to Greek NGDP.

Interestingly enough Varoufakis has also suggested that Greek public debt should be linked to NGDP. This is how I explained the idea recently:

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

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

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

NGDP linked bonds is not a solution for all of Greece’s problems – far from it –  but it could help reduce the pain of necessary structural reforms.

So once again I have to say that I to a large extent agree with Varoufakis analysis and some of his policy proposals. That, however, does not mean that I think he has the backing in the Syriza government to implement the serious structural reforms in the Greece that I also think is badly needed.

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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: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

How would it work?

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

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

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

Jens Weidmann should be Varoufakis’ best friend

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

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

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

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

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

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

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

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

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

Varoufakis should pay tribute to David Eagle

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

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

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

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

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

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

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

Quasi-Real indexing – indexing for Market Monetarists

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

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

A simple housing rescue package – QRI Mortgages and NGDP targeting

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

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

Draghi’s golden oppurtunity – building the perfect firewall

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

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

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

A golden opportunity

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

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

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

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

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

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

An very effective firewall   

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

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

How would the inflation put work?

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

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

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

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

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

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

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

Related blog posts:

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

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

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

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

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

The glass is half-full rather than half-empty

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

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

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

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

2) Draghi speaks in terms of market expectations

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

3) The ECB is using the right instrument

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

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

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

4) The programme is fairly well ‘calibrated’

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

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

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

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

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

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

5) The programme is quasi-open-ended

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

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

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

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

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

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

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

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

Grexit, Germany and Googlenomics

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

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

Grexit

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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