All posts tagged Euro crisis

Spanish and Italian political news slipped into the financial section

One of my favourite Scott Sumner blog posts is on the connection been monetary policy failure and the impact of political news on the financial markets. I have quoted Scott many times on this issue, but let me do it again:

I once read all the New York Times from the 1930s (on microfilm.)  You can’t even imagine how frustrating it was.  They knew they had a big problem.  Then knew that deflation had badly hurt the economy (including the capitalists.)  They knew that monetary policy could reflate.  And yet . . .

Weeks went by, then months, then years.  Somehow they never connected the dots.

“Monetary policy is already highly stimulative.”

“There’s a danger we’d overshoot toward too much inflation.”

“Maybe the problems are structural.”

“There are green shoots, things are getting worse at a slower pace.  The economy needs to heal itself.”

“Consumer demand is saturated.  Even workingmen can now afford iceboxes and automobiles.  We produced too much stuff in the 1920s.”

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

It has been a long time since political headlines really have been able to move the global financial markets (remember the fiscal cliff story never really did it). However, just take a look at these two stories from today:

 Ten-year Spanish government bond yields rose on Monday as the country’s opposition party called for the resignation of Prime Minister Mariano Rajoy over a corruption scandal.

…and here:

Ten-year Italian government bond yields also rose on concerns that a scandal involving Monte Paschi bank could see a rise in the popularity of the centre-right party in the polls, whose election charge is being led by former prime minister Silvio Berlusconi.

Since August-September the Federal Reserve and the Bank of Japan the have moved in the direction of easing monetary policy and a significantly more ruled basked monetary policy and even the ECB has eased up with ECB chief Draghi’s promising to do “whatever it takes” to save the euro. And Mark Carney has given investors hope that the Bank of England will move towards some form of NGDP level targeting. As a result the “euro crisis” has more or less disappeared from the headlines in the newspapers’ “financial section” (just take a look at what Google trends has to say).

Hence, it seems pretty clear that the markets’ “responsiveness” to political worries is a function of the tightness of global monetary conditions with tighter monetary conditions leading to a bigger impact of political jitters.

So where are we now? It to me all dependent on the ECB. If the ECB move towards a clearly rule based regime – in a similar fashion as the Fed and the BoE (and likely soon also the Bank of England) then we are likely to see markets becoming more immune to political jitters. On the other hand if the ECB moves back to the bad habit of conditioning monetary policy on political outcome then once again the markets will start worrying about the finer details of Italian and Spanish politics.

PS Some would argue that European monetary conditions have become tighter recently as a result of higher money market rates and yields. However, I don’t think that is the case. Higher yields and rates reflect growth optimism – just look at European stock markets and implied inflation expectations in the European fixed income markets. Market Monetarists don’t run for the door in panic when yields rise – rather we argue that you should not make the interest rate fallacy and confuse higher (lower) rates/yields with tighter (easier) monetary policy. As Milton Friedman reminds us rates and yields are high (low) when monetary policy has been easy (tight).

8 Comments
by Lars Christensen on February 4, 2013  •  Permalink
Posted in ECB, euro crisis, Italy, Spain
Tagged , , , ,

Posted by Lars Christensen on February 4, 2013

https://marketmonetarist.com/2013/02/04/spanish-and-italian-political-news-slipped-into-the-financial-section/

The ECB is turning into the BoJ

This is ECB Chief Mario Draghi:

“Well, let me first just point out that I never mentioned deflation. Deflation is a generalised fall in the price level across sectors and it is self-sustaining. And so far we have not seen signs of deflation, neither at the euro area level nor at country level. We should also be very careful about not mixing up what is a normal price readjustment due to the restoration of competitiveness in some of these countries. They will necessarily have to go through a re-adjustment of prices. We should not confuse this readjustment of prices, which is actually welcome, with deflation. Basically, we see price behaviour in line with our medium-term objectives. So, we see price stability over the medium term. Also consider that monetary policy is already very accommodative, consider the very low level of interest rates and that real interest rates are negative in a large part of the euro area…”

When I read Draghi’s comments the first thing I came to think of was how much this sounds like comments from Bank of Japan officials over the last 15 years.

Maybe Mario Draghi would be interested in this graph. It show the growth of broad money in the euro zone and Japan. I have constructed the graph so the growth of money peaks more or less at the same time in the graph for Japan and the euro zone. M2 growth peaked around 1990 in Japan and 2008 in the euro zone. The graph clearly shows both the boom and the bust and for Japan a very long period – more than a decade – of very low money supply growth.

I basically hate this kind of graph but the similarity is hard to miss. If Mario Draghi thinks euro zone monetary policy is “accommodative” today then he would also have to think Japanese monetary policy was accommodative in 1994-94.

BUT worse if the ECB continues on it’s present path it will likely repeat the mistakes of the BoJ and then we might be in for years of deflation. I know that this is not what Draghi wants, but the ECB’s present policy is unfortunately not giving much hope that a Japanese scenario can be avoided.

By the way that is the real reason for the slump we are seeing in global stock markets these days and it likely has very little to do with Obama’s reelection and the fear of the “fiscal cliff”. It is mostly about the escalation of bad news out of Europe. I hope Draghi will soon realize that unless he shows some Rooseveltian Resolve then the bad news will continue for another decade.

3 Comments
by Lars Christensen on November 9, 2012  •  Permalink
Posted in ECB, euro crisis, Japan
Tagged , , ,

Posted by Lars Christensen on November 9, 2012

https://marketmonetarist.com/2012/11/09/the-ecb-is-turning-into-the-boj/

“Conditionality” is ECB’s term for the Sumner Critique

Some time ago Scott Sumner did a number of blog posts on fiscal policy and why he believes that the budget multiplier is zero. At the time I was somewhat frustrated that the amount of time Scott was using to focus on an issue that I found quite obvious. However, I now found myself doing exactly the same thing – I can’t let go of the game played by central banks against governments and impact this has on the economic policy mix. This is maybe because I find empirical evidence for the so-called Sumner Critique popping up everywhere.

The Sumner Critique basically says that the central bank can always overrule any impact of expansionary fiscal policy on aggregate demand by tightening monetary policy and if the central bank is targeting for example inflation or nominal GDP then it will do so. Therefore, under inflation targeting or NGDP targeting the budget multiplier will always be zero even if the world is Keynesian.

Last week’s policy announcement from the ECB gives further (quasi) empirical support for the Sumner Critique. Hence, the ECB announced that it would conduct what it calls “Outright Monetary Transactions” (OMT) – that is it would (or rather could) buy euro government bonds.

But see here what the ECB said about the conditions for OMT:

“A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.

The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.

Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.”

The important term here is “conditionality”. The ECB’s condition for buying government bonds is that the individual euro zone country has a EFSF/ESM macroeconomic adjustment programme. Such a programme is basically a pledge of a given government to tighten fiscal policy. In other words – the ECB could buy for example Spanish government bonds, but the condition would be that the Spanish government should tighten fiscal policy.

Therefore, what the ECB is doing is basically asking the Spanish government and other euro zone governments to be the “Stackelberg leader”: First you tighten fiscal policy and then we will ease monetary policy.

As a consequence the ECB has basically said that the fiscal multiplier should be zero – the ECB will “neutralize” any impact on aggregate demand of changes in fiscal policy. This is better news than it might sound. Obviously European monetary policy is much too tight in the euro zone and I would have liked to see a lot more action from the ECB. However, one could understand “conditionality” to mean that the ECB will fill the possible hole in aggregate demand from fiscal consolidation in euro zone – monetary policy will be eased in response to fiscal tightening. That is good news.

However, the crucial problem of course is that the euro zone needs higher aggregate demand and therefore I would have been much happier if the ECB had announced a clear plan to increase aggregate demand (or rather nominal GDP) – it did not do that. However, if the ECB at least will try to counteract the possible negative impact on aggregate demand from fiscal consolidation then that is good news. One could of course say that this is a completely natural consequence of the ECB’s inflation targeting regime – if fiscal tightening reduces aggregate demand then the ECB should ease monetary policy to avoid inflation undershooting the inflation targeting.

Concluding, “conditionality” is another term for the Sumner Critique and it is in my view yet another illustration that expansionary fiscal policy is unlikely to bring us out of this crisis if central banks is not playing along.

Related posts:

In New Zealand the Sumner Critique is official policy
Policy coordination, game theory and the Sumner Critique
The fiscal cliff and why fiscal conservatives should endorse NGDP targeting
The Bundesbank demonstrated the Sumner critique in 1991-92
“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy

5 Comments
by Lars Christensen on September 11, 2012  •  Permalink
Posted in ECB, euro crisis, Fiscal policy, Scott Sumner, Sumner Critique
Tagged , , , , ,

Posted by Lars Christensen on September 11, 2012

https://marketmonetarist.com/2012/09/11/conditionality-is-ecbs-term-for-the-sumner-critique/

Greece is not really worse than Germany (if you adjust for lack of growth)

Market Monetarists have stressed it again and again – the European crisis is primarily a monetary crisis rather than a financial crisis and a debt crisis. Tight monetary conditions is reason for the so-called debt crisis. Said in another way it is the collapse in nominal GDP relative to the pre-crisis trend that have caused European debt ratios to skyrocket in the last four years.

That is easily illustrated – just see the graph below:

I have simply plotted the change in public debt to GDP from 2007 to 2012 (2012 are European Commission forecasts) against the percentage change in nominal GDP since 2007.

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.

There are two outliers in the graph – Ireland and Estonia. The increase in Irish debt is much larger than one should have expected judging from the size of the change in NGDP in Ireland. This can easily be explained – it is simply the cost of the Irish banking rescues. The other outlier is Estonia where the increase in public debt has been much smaller than one should have expected given the development in nominal GDP. In that sense Estonia is really the only country in the euro zone, which have improved its public finances in any substantial fashion compared to what would have been the case if fiscal austerity had not been undertaken. The tightening of fiscal policy measured in this way is 20-25% of GDP. This is a truly remarkable tightening of fiscal policy.

Imagine, however, for one minute that Greece had undertaken a fiscal tightening of a similar magnitude as Estonia and assume at the same time that it would have had no impact on NGDP (the keynesians are now screaming) then the Greek budget situation would still have been horrendous – public debt would have not increase by 50% %-point of GDP but “only” by 30%-point. Greece would still be in deep trouble. This I think demonstrates that it is near impossible to undertake any meaningful fiscal consolidation when you see the kind of collapse in NGDP that you have seen in Greece.

Concluding, the European debt crisis is not really a debt crisis. It is a monetary crisis. The ECB has allowed euro zone nominal GDP to drop well-below its pre-crisis trend and that is the key reason for the sharp rise in public debt ratios. I am not saying that Europe do not have other problems. In fact I think Europe has serious structural problems – too much regulation, too high taxes, rigid labour markets, underfunded pension systems etc. However, these problems did not cause the present crisis and even though I think these issues need to be addressed I doubt that reforms in these areas will be enough to drag us out of the crisis. We need higher nominal GDP growth. That will be the best cure. Now we are only waiting on Draghi to deliver.

PS The graph above also illustrate how badly wrong Arthur Laffer got it on fiscal policy in his recent Wall Street Journal article – particular in his claim that Estonia had been got conducting keynesian fiscal stimulus. See here, here and here.

17 Comments
by Lars Christensen on August 28, 2012  •  Permalink
Posted in ECB, Estonia, euro crisis, Fiscal policy, Germany, Greece, Ireland
Tagged , , , , , , ,

Posted by Lars Christensen on August 28, 2012

https://marketmonetarist.com/2012/08/28/greece-is-not-really-worse-than-germany-if-you-adjust-for-lack-of-growth/

Policy coordination, game theory and the Sumner Critique

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

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

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

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

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

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

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

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

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

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

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

12 Comments
by Lars Christensen on August 25, 2012  •  Permalink
Posted in Alan Blinder, euro crisis, Reading recommendations, Scott Sumner, Sumner Critique, The euro, William Nordhaus
Tagged , , , , ,

Posted by Lars Christensen on August 25, 2012

https://marketmonetarist.com/2012/08/25/policy-coordination-game-theory-and-the-sumner-critique/

Friedman’s Japanese lessons for the ECB

I often ask myself what Milton Friedman would have said about the present crisis and what he would have recommended. I know what the Friedmanite model in my head is telling me, but I don’t know what Milton Friedman actually would have said had he been alive today.

I might confess that when I hear (former?) monetarists like Allan Meltzer argue that Friedman would have said that we were facing huge inflationary risks then I get some doubts about my convictions – not about whether Meltzer is right or not about the perceived inflationary risks (he is of course very wrong), but about whether Milton Friedman would have been on the side of the Market Monetarists and called for monetary easing in the euro zone and the US.

However, today I got an idea about how to “test” indirectly what Friedman would have said. My idea is that there are economies that in the past were similar to the euro zone and the US economies of today and Friedman of course had a view on these economies. Japan naturally comes to mind.

This is what Friedman said about Japan in December 1997:

“Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.”

So Friedman was basically telling the Bank of Japan to do quantitative easing – print money to buy government bonds (not to “bail out” the government, but to increase the money base).

What were the economic conditions of Japan at that time? The graph below illustrates this. I am looking at numbers for Q3 1997 (which would have been the data available when Friedman recommended QE to BoJ) and I am looking at things the central bank can influence (or rather can determine) according to traditional monetarist thinking: nominal GDP growth, inflation and money supply growth. The blue bars are the Japanese numbers.

Now compare the Japanese numbers with the similar data for the euro zone today (Q1 2012). The euro zone numbers are the red bars.

Isn’t striking how similar the numbers are? Inflation around 2-2.5%, nominal GDP growth of 1-1.5% and broad money growth around 3%. That was the story in Japan in 1997 and that is the story in the euro zone today.

Obviously there are many differences between Japan in 1997 and the euro zone today (unemployment is for example much higher in the euro zone today than it was in Japan in 1997), but judging alone from factors under the direct control of the central bank – NGDP, inflation and the money supply – Japan 1997 and the euro zone 2012 are very similar.

Therefore, I think it is pretty obvious. If Friedman had been alive today then his analysis would have been similar to his analysis of Japan in 1997 and his conclusion would have been the same: Monetary policy in the euro zone is far too tight and the ECB needs to do QE to “rejuvenate” the European economy. Any other view would have been terribly inconsistent and I would not like to think that Friedman could be so inconsistent. Allan Meltzer could be, but not Milton Friedman.

——-

* Broad money is M2 for Japan and M3 for the euro zone.

Related posts:

Meltzer’s transformation
Allan Meltzer’s great advice for the Federal Reserve
Failed monetary policy – (another) one graph version
Jens Weidmann, do you remember the second pillar?

16 Comments
by Lars Christensen on August 15, 2012  •  Permalink
Posted in Allan Meltzer, ECB, euro crisis, Japan, Milton Friedman, Monetary institutions, Monetary policy, MV=PY, QE
Tagged , , , , ,

Posted by Lars Christensen on August 15, 2012

https://marketmonetarist.com/2012/08/15/friedmans-japanese-lessons-for-the-ecb/

Draghi and European dollar demand – an answer to JP Irving’s puzzle

Yesterday, ECB chief Mario Draghi hinted quite clearly that monetary easing would be forthcoming in the euro zone. In fact he said the ECB would do everything to save the euro. However, something paradoxical happened on the back of Draghi’s comments. Here is JP Irving on his blog Economic Sophisms:

“Something interesting happened yesterday. The Euro strengthened  after Draghi hinted at easier policy. Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply.  I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.”

I can understand that JP is puzzled. Normally we would certainly expect monetary easing to mean that the currency should weaken. However, I think there is a pretty straightforward explanation to this and it has to do with the monetary linkages between the US and the euro zone. In my post Between the money supply and velocity – the euro zone vs the US from earlier in the week I described how I think the origin of the tightening of US monetary conditions in 2008 was a sharp rise in European dollar demand. When European investors in 2008 scrambled to increase their cash holdings they did not primarily demand euros, but US dollars. As a result US money-velocity dropped much more than European money-velocity, but at the same time the ECB failed to curb the drop in money supply growth. The sharp increase in dollar demand caused EUR/USD to plummet (the dollar strengthened).

What happened yesterday was exactly the opposite. Draghi effectively announced that he would increase the euro zone money supply and hence reduce the risk of crisis. With an escalation of the euro crisis less likely investors did move to reduce their demand for cash and since the dollar is the reserve currency of the world (and Europe) dollar demand dropped and as a result EUR/USD spiked. Hence, yesterday’s market action is fully in line with the mechanisms that came into play in 2008 and have been in play ever since. In that regard, it should be noted that Mario Draghi not only eased monetary policy in Europe yesterday, but also in the US as his comments led to a drop in dollar demand.

Finally this is a very good illustration of Scott Sumner’s point that monetary policy tends to work with long and variable leads. The expectational channel is extremely important in the monetary transmission mechanism, but so are – as I have often stressed – the international monetary linkages. In that regard it is paradoxical that University of Chicago (!!) economics professor Casey Mulligan exactly yesterday decided to publish a comment claiming that monetary policy does not have an impact on markets. Casey, did you see the reaction to Draghi’s comments? Or maybe it was just a technology shock?

—-
Related posts:

Between the money supply and velocity – the euro zone vs the US
International monetary disorder – how policy mistakes turned the crisis into a global crisis

6 Comments
by Lars Christensen on July 27, 2012  •  Permalink
Posted in ECB, euro crisis, Exchange rates, Mario Draghi, Reading recommendations, The Great Recession, Velocity
Tagged , , ,

Posted by Lars Christensen on July 27, 2012

https://marketmonetarist.com/2012/07/27/draghi-and-european-dollar-demand-an-answer-to-jp-irvings-puzzle/

Between the money supply and velocity – the euro zone vs the US

When crisis hit in 2008 it was mostly called the subprime crisis and it was normally assumed that the crisis had an US origin. I have always been skeptical about the US centric description of the crisis. As I see it the initial “impulse” to the crisis came from Europe rather than the US. However, the consequence of this impulse stemming from Europe led to a “passive” tightening of US monetary conditions as the Fed failed to meet the increased demand for dollars.

The collapse in both nominal (and real) GDP in the US and the euro zone in 2008-9 was very similar, but the “composition” of the shock was very different. In Europe the shock to NGDP came from a sharp drop in money supply growth, while the contraction in US NGDP was a result of a sharp contraction in money-velocity. The graphs below illustrate this.

The first graph is a graph with the broad money supply relative to the pre-crisis trend (2000-2007) in the euro zone and the US. The second graph is broad money velocity in the US and the euro zone relative to the pre-crisis trend (2000-2007).

The graphs very clearly illustrates that there has been a massive monetary contraction in the euro zone as a result of M3 significantly undershooting the pre-crisis trend. Had the ECB kept M3 growth on the pre-crisis trend then euro zone nominal GDP would long ago returned to the pre-crisis trend. On the other hand the Federal Reserve has actually been able to keep M2 on the pre-crisis path. However, that has not been enough to keep US NGDP on trend as M2-velocity has contracted sharply relative the pre-crisis trend.

Said in another way a M3 growth target of for example 6.5% would basically have been as good as an NGDP level target for the euro zone as velocity has returned to the pre-crisis trend. However, that would not have been the case in the US and that I my view illustrates why an NGDP level target is much preferable to a money supply target.

The European origin of the crisis – or how European banks caused a tightening of US monetary policy

Not surprisingly the focus of the discussion of the causes of the crisis often is on the US given both the subprime debacle and the collapse of Lehman Brothers. However, I believe that the shock actually (mostly) originated in Europe rather than the US. What happened in 2008 was that we saw a sharp rise in dollar demand coming from the European financial sector. This is best illustrated by the sharp drop in EUR/USD from close to 1.60 in July 2008 to 1.25 in early November 2008. The rise in dollar demand is obviously what caused the collapse in US money-velocity and in that regard it is notable that the rise in money demand in Europe primarily was an increase in demand for dollar rather than for euros.

This is why I stress the European origin of the crisis. However, the cause of the crisis nonetheless was a tightening of US monetary conditions as the Fed (initially) failed to appropriately respond to the increase in dollar demand – mostly because of the collapse of the US primary dealer system. Had the Fed had a more efficient system for open market operations in 2008 then I believe the crisis would have been much smaller and would have been over already in 2009. As the Fed got dollar-swap lines up and running and initiated quantitative easing the recovery got underway in 2009. This triggered a brisk recovery in both US and euro zone money-velocity. In that regard it is notable that the rebound in velocity actually was somewhat steeper in the euro zone than in the US.

The crisis might very well have ended in 2009, but new policy mistakes have prolonged the crisis and once again European problems are causing most headaches and the cause now clearly is that the ECB has allowed European monetary conditions to become excessively tight – just have a look at the money supply graph above. Euro zone M3 has now dropped more than 15% below the pre-crisis trend. This policy mistake has to some extent been counteracted by the Fed’s efforts to increase the US money supply, but the euro crisis have also led to another downleg in US money velocity. The Fed once again has failed to appropriately counteract this.

Both the Fed and the ECB have failed

In the discussion above I have tried to illustrate that we cannot fully understand the Great Recession without understanding the relationship between US and euro zone monetary policy and I believe that a full understanding of the crisis necessitates a discussion of European dollar demand.

Furthermore, the discussion shows that a credible money supply target would significantly have reduced the crisis in the euro zone. However, the shock to US money-velocity shows that an NGDP level target would “perform” much better than a simple money supply rule.

The conclusion is that both the Fed and the ECB have failed. The Fed failed to respond appropriately in 2008 to the increase in the dollar demand. On the other hand the ECB has nearly constantly since 2008/9 failed to increase the money supply and nominal GDP. Not to mention the numerous communication failures and the massively discretionary conduct of monetary policy.

Even though the challenges facing the Fed and ECB since 2008 have been somewhat different in nature I would argue that proper nominal targets (for example a NGDP level target or a price level target) and better operational procedures could have ended this crisis long ago.

—–

Related posts:

Failed monetary policy – (another) one graph version
International monetary disorder – how policy mistakes turned the crisis into a global crisis

37 Comments
by Lars Christensen on July 25, 2012  •  Permalink
Posted in ECB, Federal Reserve, Monetary institutions, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, The Great Depression, Velocity
Tagged , , , ,

Posted by Lars Christensen on July 25, 2012

https://marketmonetarist.com/2012/07/25/between-the-money-supply-and-velocity-the-euro-zone-vs-the-us/

Time to try WIR in Greece or Ireland? (I know you are puzzled)

The ECB so far has refused to sufficiently increase the money base to meet the increase in the demand of money and as a result euro zone money-velocity has contracted. We are basically in a monetary disequilibrium. Normally we would say an excess demand for money can be reduced in two ways. Either you can increase the money supply or the price of money can increase sufficiently to reduce the demand for money until it matches the supply of money. An increase in the price of money of course means a drop in all other prices – deflation.

However, there is a third option – we could also increase the supply of money substitutes. This could be in the form of free banking – privately issued money – or through different forms batter systems. I have also earlier examined the impact ofthe so-called M-Pesa system in Kenya and how M-Pesa likely has increased money-velocity (reduced money demand) dramatically in Kenya. I suggested that could offer a partial solution to the euro crisis. A similar idea could be to create a system similar to the Swiss Wirtschaftring system (WIR).

WIR is basically a barter club of corporations and households and in a sense WIR functions as a parallel currency in the Swiss economy. Here is a description from a paper by Wojtek Kalinowski:

“The Swiss currency known as the WIR is by far the oldest and most important complementary currency presently in circulation. It remains, however, largely unknown. Created in 1934, it is currently used by approximately 60,000 small and medium-sized businesses found in all economic sectors, but primarily building, commerce (wholesale and retail), and manufacturing … In 2008, the volume of WIR-denominated trade was 1.5 billion Swiss francs …a figure that makes it far superior to any other parallel currency but which is still only an insignificant portion of the global monetary mass (0.35% of M2 in 2003).”

What I find particularly interesting with the Swiss experience is the counter-cyclical nature of the use of WIR. In a 2009 paper by James Stodder “Complementary Credit Networks and Macro-Economic Stability: Switzerland’s Wirtschaftsring”  it is demonstrated that there is a clear negative (positive) correlation between GDP growth (unemployment) and the turnover of WIR. Hence, this indicates that WIR tends to help equate money supply and money demand (reduce monetary disequilibrium). If you have studied George Selgin’s theory of Free Banking then you should not be surprised by this result.

Time for WIR in Greee or Ireland?

The deflationary trends are very strong in some euro zone countries such as Ireland or Greece. So what is needed is an increase in the money supply, but as the national central banks do not determine the local money supply (that is firmly in the hands of the ECB) that option does not exist. However, a WIR style system could be a second or third best solution for doing something about the monetary disequilibrium in these countries.

Obviously, it will likely be far too little to end the crisis and the best solution obviously still would be for the ECB to significantly ease monetary conditions. However, that should not stop deflation and crisis hit euro zone countries from removing legal barriers to the introduction of WIR style systems. Furthermore, one could easily imagine that euro zone governments and central banks could move to facilitate the creation of WIR style systems in their countries.

Obviously, this kind of discussion would not be necessary if the ECB moved to reduce monetary disequilibrium, but times are desperate – and that is why you for example see the reemergence of the old Irish punt certain places in Ireland (See here).

Finally I should add that some proponents of local currencies and WIR systems see them as a kind of “small is beautiful” system and a system to protect local producers. I strongly disagree with this kind of protectionist view and in that sense I completely agree with the views of George Selgin. See here.

——

Update: See also this paper by James Stodder.
Update 2: In the comments below James Stodder recommends Irving Fisher’s book on “Scrip Currencies” and Georgiana Gomez’s recent book (2009) “Argentina’s Parallel Currency: The Economy of the Poor”. I knew Fisher’s book before, but was unaware of Gomez’s book (so I ordered it…)

12 Comments
by Lars Christensen on June 23, 2012  •  Permalink
Posted in M-pesa, WIR
Tagged , , ,

Posted by Lars Christensen on June 23, 2012

https://marketmonetarist.com/2012/06/23/time-to-try-wir-in-the-greece-or-ireland-i-know-you-are-puzzled/

Liaquat Ahamed should write a book about Trichet, Draghi, Weidmann & Co.

The author of the great book  ‘Lords of Finance: The Bankers Who Broke the World’ Liaquat Ahamed has a comment on ft.com on the euro crisis and the parallels of the behavior of today’s European central bankers with that of the central bankers of the 1930s. I have been making the argument many times that we are in the process of making the same mistakes as we did in the 1930s – particularly in Europe. Ahamed agrees.

Here is Ahamed:

“The situation in Europe today bears an eerie similarity to that of Europe in the 1930s. Ironically, Germany was then in the position of the peripheral European countries today. It was weighed down with government debt because of reparations imposed at Versailles; its banking system was severely undercapitalised, the result of the hyperinflation of the early 1920s; and it had become dependent on foreign borrowing. It was locked into a rigid fixed exchange rate system, the gold standard, which it dared not tamper with for fear of provoking a gigantic crisis of confidence. And so when the Depression hit and international capital markets essentially closed down, Germany had no choice but to impose brutal austerity. Eventually, unemployment rose to 35 per cent.

Like today, in the 1930s there was one major economy in Europe doing well. It was France. While the rest of Europe was suffering, unemployment in France, as in Germany today, was in the low single figures. And France, again like Germany today, had large current-account surpluses and was in a financial position to act as the locomotive for the rest of Europe. But the French authorities of the 1930s, refusing to accept responsibility for what was happening elsewhere in Europe, would not adopt expansionary policies. Nor would they lend directly to Germany, fearing that they would be throwing good money after bad. The effect of French policy eventually brought down the whole financial system of western Europe”

I completely agree. The PIIGS are the Germany of the 1930s and Germany of today is France of the 1930s. In that regard it should be noted that despite France initially avoided being hard hit by the Great Depression, but the crisis eventually caught up with the French economy in 1931-32. Let that be a lesson for Merkel and Weidmann. Unfortunately today’s policy makers seem completely unaware of the parallels to the mistakes of the 1930s.

Maybe it is time for  Liaquat Ahamed to write a book on today’s Lords of Finance – the central bankers who are in the process of killing the European economy.

—-

For an overview of some of my posts on the 1930s see here.

Book recommendation of the week: I just received in the mail what seems to be a very interesting book on Exchange Rate Regimes of small states in twenties-century Europe. The book “Fixed Ideas of Money” by Tobias Straumann tells the story of why European small economies such as the Scandinavian countries, Belgium, the Netherlands and Switzerland have been so attracted to pegged exchange rate regimes. From what of the book I have read so far I must say it is very interesting and the book is full of interesting anecdotes from European monetary history. The book is extremely well-researched and it is clear that Straumann has had access to local sources for information about monetary policy in for example Denmark or Belgium in the 1930s.

3 Comments
by Lars Christensen on June 23, 2012  •  Permalink
Posted in ECB, euro crisis, Liaquat Ahamed, Tobias Straumann
Tagged , , ,

Posted by Lars Christensen on June 23, 2012

https://marketmonetarist.com/2012/06/23/liaquat-ahamed-should-write-a-book-about-trichet-draghi-weidmann-co/

« Older Posts
Newer Posts »