The Euro – Monetary Strangulation continues (one year on)

Exactly one year ago today I was with the family in the Christensen vacation home in Skåne (Southern Sweden) and posted a blog post titled The Euro – A Monetary Strangulation Mechanism. I wrote that post partly out of frustration that the crisis in the euro once again had re-escalated as Greece fell deeply into political crisis.

One year on the euro zone is once again in crisis – this time the focal point it the Italian banking sector.

So it seems like little has changed over the past year. After nearly eight years of crisis the euro zone has still not really recovered.

In my post a year ago I showed a graph with the growth of real GDP from 2007 to 2015 in 31 different European countries – both countries with floating exchange rates and countries within the euro areas and countries pegged to the euro (Bulgaria and Denmark).

I have updated the graph to include 2016 (IMF forecast).

Monetary Strangulation Summer 2016.jpg

The picture is little changed. In general the floaters (the ‘green’ countries) have done significantly better than the peggers/euro countries (the ‘red’ countries).

That said, I am happy to admit that it looks like we have had some pick-up in growth in the euro zone in the past year – ECB’s quantitative easing has had some positive effect on growth.

However, the ECB is still not doing enough as new headwinds are facing the European economy. Here I particularly want to highlight the fact that the Federal Reserve – wrongly in my view – has moved to tighten monetary conditions over the past year, which in turn is causing a tightening of global monetary conditions.

Second, if we look at the money-multiplier in the euro zone it is clear that it over the past nearly two years have been declining somewhat due in my view to the draconian liquidity (LCR) and capital rules in Basel III, which the EU has pushed to implement fast.

Furthermore, given the increase in banking sector distress in the euro zone recently the euro zone money-multiplier is likely to drop further, which effective will constitute a tightening of monetary conditions. If the ECB does not offset these shocks the euro zone could fall even deeper into a deflationary crisis.  If you are interested in what I think should be done about it have a look here and here.

Concluding, the monetary strangulation in the euro zone continues. Luckily, again this year at this time it is vacation time for the Christensen family so I will try to enjoy life after all.

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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

A gameplan for the ECB – it is not complicated

A very good friend of mine asked me what the ECB should do in the present situation where inflation and inflation expectations continues to run well-below the ECB’s inflation target.

Here is my answer – it is what we could call a gameplan for the ECB (it could easily be used by other central banks as well):

1) Stop communicating in the terms of interest rates. Announce a PERMANENT growth rate for the money base. Announce that the growth rate will be stepped up every month or quarter until inflation expectations are at 2% at all relevant time horizons – for example 2y2y swap inflation expectations. At every ECB meeting the permanent money base rate is announced.

2) Control the money base by buying a basket of global AAA-rated govies.

3) Announce a NGDP LEVEL target consistent with the 2% inflation target and announce that the ECB will not let bygones be bygones – meaning if you undershoot the target one year then you should overshoot the following year.

4) Internal forecasting should be given up. Instead only surveys of professional forecasters and market forecasts should be used for policy input. In the reasoning for the money base growth target there should be given only a reference to these forecasts and the ECB should commit itself to set money base targets based on these forecasts and nothing else.

And what could the of EU do?

1) Suspend the implementation of Basell III and other banking regulation that depress the money multiplier and increase demand for safe assets until nominal GDP has grown for at least 4% for 8 quarters in a row.

And maybe also…

2) Suspend the growth and stability pact for now.

I think it is very easy to create inflation and nominal demand. It is all about commitment. Unfortunately the ECB does not have such commitment.

PS this is essentially what I earlier have called a forward-looking McCallum rule – see also a similar suggestion for the Fed here.

When effort and outcome is not the same thing – the case of Greece

Greece has made yet another other deal with the EU and IMF on its debt situation. Or rather as one EU official described it to the Financial Times “If it looks like we are kicking the can down the road that is because we are”.

Said in another way, this is not really a deal to solve the fundamental problem, but rather a deal to avoid dealing with the fundamental problem.

So what is the fundamental problem? Well, at the core of this is that the Greek government simply is insolvent and can’t pay its debts, but at the same time the EU is refusing to accept this fact.

The IMF seems to understand this and probably so do the eurocrats, but politically it seems impossible to accept because that would mean the EU would have to accept that the strategy to deal with Greece’s problems has been wrong and it would mean accepting a major debt write-down on Greece sovereign debt something with likely would not be popular with voters in for example Germany or the Netherlands.

Some are arguing that Greece haven’t done enough to solve its own problems and that letting Greece off the hook with a major debt write-down would just encourage even more bad habits and that is probably right, but it does change the fact that it is very hard to see how Greece will be able to pay of the debt.

Furthermore, it is wrong when some are arguing that Greece hasn’t done anything. In fact, Greece has done more fiscal austerity than any other nation in Europe. So if we for example look at the accumulative tightening of fiscal policy in Greece since 2009 then we will see that Greece in this period has tightened by 18-20% of GDP (measured as the accumulative change in IMF’s measure of Greece’s structural budget deficit). By any measure, this a massive fiscal tightening.

However, one thing is the effort another thing is the outcome and here the story is quite different. Hence, since 2009 Greek public debt has grown from 108% of GDP in 2008 to more 180% of GDP this year. Hence, despite of massive fiscal austerity public debt has continued to grow every single year since 2008.

Greece debt and fiscal policy

The reason for this depressing development is the fact that Greece has seen a massive collapse in economic activity. Hence, since 2008 nominal GDP in Greece has dropped by nearly 30%. A true economic disaster. No matter how fiscally conservative a country is it is impossible to stabilize the debt ratios with such an economic contraction.

Therefore, to fundamentally solve Greece’s debt problem it is needed to solve Greece’s growth problem and that is not easy. Fiscal stimulus could of course be a solution, but Greece don’t have the money for that and the markets will not be willing to finance a fiscal stimulus package.

Another solution is massive structural reforms and that is somewhat more promising that fiscal stimulus, but given the depth of the crisis even the most comprehensive reform package is not likely to be enough and that leaves on one solution – monetary easing.

But since Greece is not in control of its own monetary policy because the country is a member of the euro zone that is not really possible either. Or rather it is – if Greece decides to leave the euro area. That seems like a very risky strategy, but it is blatantly obvious that this is really the only solution that would work.

Therefore, it is not a question whether we will get a ‘Grexit’, but rather when it will happen. The German taxpayers will not forever be willing to pay the price for kicking the can down the road.

PS Marcus Nunes also comments on Greece.

PPS The IMF has a new paper, which once again shows that Greece is insolvent and urgently needs a debt write-down.

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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

 

 

 

Are we about to get a new ”euro spasm”?

 

I hate to say it, but I fear that we are in for a new round of euro zone troubles.

My key concern is that monetary conditions in the euro zone remains far to tight, which among other things is reflected in the continued very low level of inflation expectations in the euro zone. Hence, it is clear that the markets do not expect the ECB to deliver 2% inflation any time soon. As a consequence, nominal GDP growth also remains very weak across the euro zone.

And with weak nominal GDP growth public finance concerns are again returning to the euro zone. This is from Reuters:

Spain plans to ask the European Commission for an extra year to meet its public deficit targets, El Pais reported on Sunday, after missing the mark with its 2015 deficit and raising the prospect of further spending cuts to narrow the budget gap.

The country last month reported a 2015 deficit of 5 percent of economic output, one of the largest in Europe and above the EU-agreed target of 4.2 percent. To reduce that to the 2016 target of 2.8 percent of gross domestic product (GDP), the Spanish government will need to find about 23 billion euros ($25 billion) through tax increases or spending cuts.

The economy ministry declined to comment on the newspaper report, which cited government sources as saying that acting Economy Minister Luis de Guindos would include revised economic projections in the stability program to be presented to Parliament on April 19.

And Spain is not the only euro zone country with renewed budget concerns. Hence, on Friday Italy’s government cut it growth forecast for 2017 and increased it deficit forecast. Portugal is facing a similar problem – and things surely do not look well in Greece either.

So soon public finances problem with be back on the agenda for the European markets, but it is important to realize that this to a very large extent is a result of overly tighten monetary conditions. As I have said over and over again – Europe’s “debt” crisis is really a nominal GDP crisis. With no nominal GDP growth there is no public revenue growth and public debt ratios will continue to increase.

ngdp-debt

So why are we not seeing any NGDP growth in the euro zone?

Overall I see four reasons:

  1. Global monetary conditions are tightening on the back of tightening of monetary conditions from the Fed and the PBoC.
  2. Regulatory overkill in the European banking sector – particularly the implementation of the Liquidity Coverage Ratio (LCR), which since mid-2014 has caused a sharp drop in the euro zone money multiplier, which effectively is a major tightening of monetary conditions in the euro zone.
  3. Continued fiscal austerity measures to meet EU demand is also adding to the negative aggregate demand pressure.
  4. And finally, the three factor above would not be important had the ECB been credibly committed to its 2% inflation target. However, has increasingly become clear that the ECB is very, very reluctant in implemented the needed massive quantitative easing warranted to offset the three negative factors described above (tighter global monetary conditions, regulatory overkill and fiscal austerity). Instead the ECB continues to fool around with odd credit policies and negative interest rates.

Therefore, urgent action seems needed to avoid a new “euro spasm” in the near-future and I would focus on two factors:

  1. Suspend the implementation across of the new Liquidity Coverage Ratio until we have seen at least 24 months of consecutive 4% nominal GDP growth in the euro zone. Presently the implementation of the LCR is killing the European money market, which eventually will be draining the overall European economy for liquidity.
  2. The ECB needs a firm commitment to increasing nominal GDP growth and to bring inflation expectations back to at least 2% on all relevant time horizons. Furthermore, the ECB need to strongly signal that the central bank will increase the euro zone money base to fully offset any negative impact on overall broad money growth from the massive tightening of banking regulation in Europe.

So will we get that? Very likely not and the signs that we are moving toward renewed euro troubles are increasing. A good example is the re-escalation of currency inflows in to the Danish krone. Hence, the krone, which is pegged to the euro, has been under increasing appreciation pressures in recent weeks and Danish bond yields have as a consequence come down significantly.

This at least partly is a reflection of “safe haven” flows and fears regarding the future of the euro zone. These concerns are probably further exacerbated by Brexit concerns.

Finally, there has been signs of renewed banking distress in Europe with particularly concerns over Deutsche Bank increasing.

So be careful out there – soon with my might be in for euro troubles again.

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

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

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

Le Pen

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

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

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

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

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

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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.

Horror graph of the week – Greek PMI collapses

If you ever read Friedman and Schwartz’s “A Monetary History of the United States” you know what happens when a central bank fails to act as a lender-of-last resort in the event of a bank run and/or at the same time fails to offset the impact on broad money growth of such bank run.

It of course happened in the US in 1930-31 and again in Europe after the collapse of Credit-Anstalt in Austria also in 1931. In both cases the result was a deep depression. Now it has happened again in Greece, but Greece is already in a deep economic depression.

Just have a look at this shocking graph from Macropolis.gr.

Greek PMI

There is no great reason to trust eyeball-econometrics, but judging from the sharp drop in Greek July PMI (released today) then we should expect another 10-15% drop in Greek real GDP in the next couple of quarters. That would mean that we soon will have seen Greek real GDP being halved since the start of this crisis.

I think it will be very hard to find any other example of a (peacetime) collapse of real GDP of this magnitude in any other country in the world in the past 200 years and there is nothing positive to say about this. It is the terrible consequence of massive policy failures in Brussels, Frankfurt, Berlin and Athens.

A truly Greek tragedy.

HT Joe Wiesenthal.

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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: roz@specialistspeakers.com.

Also note that I am on a Speaking Tour in the US in October. See more here.

The Euro – A Fiscal Strangulation Mechanism (but mostly for monetary reasons)

In my earlier post The Euro – A Fatal Conceit I argued that had the euro not be introduced and had we instead had freely floating exchange rates then “European taxpayers would (not) have had to pour billions of euros into bailing out Southern European and Eastern European government”. Said in another way had we not had the euro then there would not have been a European “debt crisis” or at least it would have been significantly smaller.

A simple way of illustrating this is to have a look at the debt development in the euro countries (and the countries pegged to the euro) and comparing that with the debt development in the European countries with floating exchange rates.

I use the same countries as in my previous post – The Euro – A Monetary Strangulation Mechanism. 21 euro countries (and countries pegged to the euro) and 10 countries with more or less floating exchange rates.

The graph below shows the development in (median) gross public debt (% of GDP) in the two groups of countries. (All countries are hence equally weighted).

debt change 2007 20014 floaters peggers

The picture is very clear – while both the floaters and the euro countries saw their public debt ratios increase sharply on the back of the 2008 shock (albeit less extremely for the floaters than for the euro countries) – from 2011 there is a very clear difference in the debt development.

Hence, from 2011 the floaters have seen as seen a gradual decline in gross public debt (as share of GDP), while the euro countries (and the peggers) have seen a steep increase in public indebtedness.

So while the floaters have seen their public debt increase by just above 10% of GDP from 2007 to 2014 the euro countries have seen a rise in public debt of more than 25% of GDP!

The graph below shows the individual breakdown of the data.

Publ debt green red

Again the picture is very clear – the euro countries (and the euro peggers) have had significantly more negative debt dynamics than the European floaters. Even if we disregard the PIIGS countries then the euro countries are on average doing a lot worse than the floaters in terms of public debt dynamics .

The euro countries are trying harder, but are succeeding less

One could of course argue that the difference in debt development simply reflects that some countries are just less prudent than other. However, the graph below shows that this is not a very good explanation.

Fiscal tightening

The graph shows the annual change in the fiscal stance (measured as the annual change in IMF’s estimate for the structural public balance as share of GDP). Positive (negative) values are a fiscal easing (tightening).

A few interesting conclusions emerge. First of all overall both euro countries and floaters seem to have had rather pro-cyclical fiscal policies – hence, both groups of countries eased fiscal policy in the ‘good years’ (2005-2009), but tightened the fiscal stance in the ‘bad years’ (2010-14.)

Second, it is notable that the fiscal stance of the euro countries and the floaters is highly correlated and is of a similar magnitude.

So even if the fiscal stance has an impact on growth in both groups of countries it seems a bit far-fetched to in general attribute the difference in real GDP growth between the two groups of countries to difference in the fiscal stance. That said, it seems like overall the euro countries and peggers have had a slightly more austere fiscal stance than the floaters after 2010. (Some – like Greece of course have seen a massive tightening of fiscal policy.)

This of course makes it even more paradoxical that the euro countries have had a significantly more negative debt dynamics than the floaters.

It is not a debt crisis – it is an NGDP crisis  

So we can conclude that the reason that the euro countries’ debt dynamics are a lot worse than the floaters is not because of less fiscal austerity, but rather the problem seems to be one of lacking growth in the euro countries. The graph below illustrates that.

NGDP debt

The graph plots the debt dynamics against the growth of nominal GDP from 2007 to 2014 for all 31 countries (both euro countries and the floaters).

The graph clearly shows that the countries, which have seen a sharp drop in nominal GDP such as Ireland and Greece have also seen the steepest increasing the public debt ratios. In fact Greece is nearly exactly on the estimated regression line, which implies that Greece has done exactly as good or bad as would be expected given the steep drop in Greek NGDP. This leaves basically no room for a ‘fiscal irresponsibility’ explanation for the rise in Greek public debt after 2007.

This of course nearly follows by definition – as we define the debt ratio as nominal public debt divided by nominal GDP. So when the denominator (nominal GDP) drops it follows by definition that the (debt) ratio increases. Furthermore, we also know that public sector expenditure (such as unemployment benefits) and tax revenues tend to be rather sensitive to changes in nominal GDP growth.

As a consequence we can conclude that the so-called ‘Europe debt crisis’ really is not about lack of fiscal austerity, but rather a result of too little nominal GDP growth.

And who controls NGDP growth? Well, overall NGDP growth in the euro zone is essentially under the full control of the ECB (remember MV=PY). This means that too tight monetary policy will lead to too weak NGDP growth, which in turn will cause an increase in public debt ratios.

In that regard it is worth noticing that it is hardly a coincidence that the ECB’s two unfortunate rate hikes in 2011 also caused a sharp slowdown in NGDP growth in certain euro zone countries, which in turn caused a sharp rise in public debt ratios as the first graph of this post clearly shows.

Consequently it would not be totally incorrect to claim that Jean-Claude Trichet as ECB-chief in 2011 played a major role in dramatically escalating the European debt crisis.

Had he not hiked interest rates in 2011 and instead pursued a policy of quantitative easing to get NGDP growth back on track then it seems a lot less likely that we would have seen the sharp increase in public debt ratios we have seen since 2011.

Of course that is not the whole story as the ECB does only control overall euro zone NGDP growth, but not the NGDP growth of individual euro zone countries. Rather the relative NGDP growth performance within the euro is determined by other factors such as particularly the initial external imbalances (the current account situation) when the shocks hit in 2008 (Lehman Brothers’ collapse) and 2011 (Trichet’s hikes.)

Hence, if a country like Greece with a large current account deficit is hit by a “funding shock” as in 2008 and 2011 then the country will have to have an internal devaluation (lower prices and lower wage growth) and the only way to achieve that is essentially through a deep recession.

However, that is not the case for countries with a floating exchange rate as a floating exchange country with a large current account deficit does not have to go through a recession to restore competitiveness – it just has to see a depreciation of its currency as Turkey as seen since 2008-9.

Concluding, the negative debt dynamics in the euro zone since 2008 are essentially the result of two things. 1) The misguided rate hikes in 2011 and 2) the lack of ability for countries with large current account deficits to see a nominal exchange rate depreciation.

The Euro is Fiscal Strangulation Mechanism, but for monetary reasons 

We can therefore conclude that the euro indeed has been a Fiscal Strangulation Mechanism as fiscal austerity has not been enough to stabilize the overall debt dynamics in a numbers of euro zone countries.

However, this is only the case because the ECB has first of all failed to offset the fiscal austerity by maintaining nominal stability (hitting its own inflation target) and second because countries, which initially had large current account deficits like Greece and Spain have not – contrary to the floaters – been able to restore competitiveness (and domestic demand) through a depreciation of their currencies as they essentially are “pegged” within the euro zone.

PS I have excluded Croatia from the data set as it is unclear whether to describe the Croatian kuna as a dirty float or a dirty peg. Whether or not Croatia is included in the sample does not change the conclusions.

Update: My friend Nicolas Goetzmann pointed out the Trichet ECB also hiked interest rates in 2008 and hence dramatically misjudged the situation. I fully agree with that, but my point in this post is not necessarily to discuss that episode, but rather to discuss the fiscal implications of the ECB’s failures and the problem of the euro itself.

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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.

The Euro – A Monetary Strangulation Mechanism

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

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

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

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

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

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

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

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

floaters peggers RGDP20072015 A

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

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

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

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

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

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

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

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

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

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

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

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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.

Mario, stay on track and avoid the mistakes of 1937 and 2011

The global stock markets have been facing some headwinds recently, and there may be numerous reasons for this. One obvious one is the recent rebound in oil prices, which I believe is essentially driven by markets’ expectation that the Saudi-led global oil price war is now ending.

If that is indeed the case then we are seeing a (minor) negative supply shock, particularly to the European and U.S. economies. Such supply shocks often get central banks into trouble. Just think of the ECB’s massive policy blunder(s) in 2011, when it reacted to a negative shock (higher oil prices on the back of the Arab spring) by hiking interest rates twice, or the Federal Reserve’s (or rather the Roosevelt Administration’s) premature monetary tightening in 1937 – also on the back of high global commodity prices.

It may be that the ECB will not repeat the mistakes of 2011, but you can’t blame investors for thinking that there is a risk that this could happen – particularly because the ECB continues to communicate primarily in terms of headline inflation.

Therefore, even if the ECB isn’t contemplating a tightening of monetary conditions in response to a negative supply, the markets will effectively tighten monetary conditions if there is uncertainty about the ECB’s policy rule. I believe that is part of the reason for the market action we have seen lately.

The ECB needs to spell out the policy rule clearly

What the ECB therefore needs to do right now is to remind market participants that it is not reacting to a negative supply shock, and that it will ignore any rise in inflation caused by higher oil prices. There are numerous ways of doing this.

1) Spell out an NGDP target

In my view the best thing would essentially be for the ECB to make it clear that it is focusing on the development of expected nominal GDP growth. This does not necessarily have to be in conflict with the overall target of hitting 2% over the medium term. All the ECB needs to do is to say that it is targeting, for example, 4% NGDP growth on average over the coming 5 years, reflecting a 2% inflation target and 2% growth in potential real GDP in the euro zone. That would ensure that markets also ignore short-term fluctuations in headline inflation.

2) Target 2y/2y and 5y/5y inflation

Alternatively, the ECB should only communicate about inflation developments in terms of what is happening to market inflation expectations – for example 2y/2y and 5y/5y inflation expectations. Again, this would seriously reduce the risk of sending the signal that the bank is about to react to negative supply shocks.

3) Re-introduce the focus on M3

There are numerous reasons not to rely on money supply data as the only indicator of monetary conditions. However, I strongly believe that it is useful to still keep an eye on monetary aggregates such as M1 and M3. Both M1 and M3 show that monetary conditions have indeed gotten easier since the ECB introduced its QE programme. That said, the money supply data is also telling us that monetary conditions overall can hardly be described as excessively easy. Yes, money supply growth is still picking up, but M3 growth is still below the 6.5% y/y that it reached in 2000-2008, and significantly below the 10% “target” I earlier suggested would be needed to bring us back to 2% inflation over the medium term.

If the ECB re-introduces more focus on the money supply numbers – and monetary analysis in general – then it would also send a pretty clear signal that the bank is not about to change course on QE just because oil prices are rising.

4) Change the price index to the GDP deflator or core inflation

Another pretty straightforward way of trying to convince the markets that the ECB will not react to negative supply shocks is by changing the focus in terms of the inflation target. Today, the ECB is officially targeting HICP (headline) inflation. This measure is highly sensitive to swings in oil and food prices as well as changes in indirect taxes. These factors obviously are completely outside the direct control of the ECB, and it therefore makes very little sense that the ECB is focusing on this measure.

Recently, ECB chief Mario Draghi hinted that the ECB could start focusing on a core measure of inflation that excludes energy, food and taxes, and I certainly think that would be a step in the right direction if the bank does not want to introduce NGDP targeting. This would effectively mean that the ECB had a target similar to the Fed’s core PCE inflation measure. It would not be perfect, but certainly a lot better than the present headline inflation measure.

An alternative to a core inflation measure, which I believe is even better, would be to focus on the GDP deflator. The good thing about the GDP deflator (other than being the P in MV=PY) is that it measures the price of what is produced in the euro zone, and hence excludes imported inflation and indirect taxes.

Conclusion: It is still all about credibility – so more needs to be done

One can always discuss what is in fact going on in the markets at the moment – and I will deliberately avoid trying to explain why German government bond yields have spiked recently (it tells us very little about monetary conditions) – but I would focus instead on the markets’ serious nervousness about whether the ECB will prematurely end its QE programme.

There would be no reason for such nervousness if the ECB clearly spelled out that it does not intend to let a negative supply shock change its plans for quantitative easing, and that it is intent on ensuring nominal stability. I have given some suggestions on how the ECB could do that, and I fundamentally think that Mario Draghi understands that the ECB needs to move in this direction. Now he just needs to make it completely clear to the markets (and the Bundesbank?)

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If you want to hear me speak about this topic or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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

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