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.

Yellen’s recession and that horrible Phillips Curve

The global stock markets are taking yet another beating today and as I am writing this S&P500 is down nearly 3.5% and the latest round of US macroeconomic data shows relatively sharp slowdown in the US economic activity and more and more commentators and market participants are now openly taking about the risk of a US recession in the coming quarters.

Obviously part of the story is China, but at the core of this is also is the fact that Fed chair Janet Yellen has been overly eager to interest rates despite the fact that monetary and market indicators have not indicated any need to monetary tightening. It is only the defunct Phillips Curve that could led Yellen to draw the conclusion that monetary tightening is needed in the US.

Back in August I wrote:

To Janet Yellen changes in inflation seems to be determined by the amount of slack in the US labour market and if labour market conditions tighten then inflation will rise. This of course is essentially an old-school Phillips curve relationship and a relationship where causality runs from labour market conditions to wage growth and on to inflation.

This means that for the Yellen-fed labour market indicators essentially are as important as they were for former Fed chairman Arthur Burns in the 1970s and that could turn into a real problem for US monetary policy going forward.

…Central banks temporary can impact real variables such as unemployment or real GDP, but it cannot permanently impact these variables. Similarly there might be a short-term correlation between real variables and nominal variables such as a correlation between nominal wage growth (or inflation) and unemployment (or the output gap).

However, inflation or the growth of nominal income is not determined by real factors in the longer-term (and maybe not even in the short-term), but rather than by monetary factors – the balance between demand and supply of money.

The Yellen-fed seems to be questioning Friedman’s fundamental insight. Instead the Yellen-Fed seems to think of inflation/deflation as a result of the amount of “slack” in the economy and the Yellen-fed is therefore preoccupied with measuring this “slack” and this is what now seems to be leading Yellen & Co. to conclude it is time to tighten US monetary conditions.

This is of course the Phillips curve interpretation of the US economy – there has been steady job growth and unemployment is low so inflation most be set to rise no matter what nominal variables are indicating and not matter what market expectations are. Therefore, Yellen (likely) has concluded that a rate hike soon is warranted in the US.

This certainly is unfortunately. Instead of focusing on the labour market Janet Yellen should instead pay a lot more attention to the development in nominal variables and to the expectations about these variables.

…If we look at nominal variables – the price level, NGDP, the money supply and nominal wages – the conclusion is rather clear. The Fed has actually since 2009 delivered a remarkable level of nominal stability in terms of keeping nominal variables very close to the post-2009 trend.

If we want to think about the Bernanke-Fed the Fed had one of the following targets: 1.5% core PCE level targeting, 4% NGDP level targeting, 7% M2-level targeting or 2% wage level targeting at least after the summer of 2009.

However, the Yellen-Fed seems to be focusing on real variables – and particularly labour market variables – instead. This is apparently leading Janet Yellen to conclude that monetary conditions should be tightened.

However, nominal variables are telling a different story – it seems like monetary conditions have become slightly too tight within the past 6-12 months and therefore the Fed needs to communicate that it will not hike interest rates in September if it wants to keep nominal variables on their post-2009 path.

Obviously the Fed cannot necessarily hit more than one nominal variable at the time so the fact that it has kept at least four nominal variables on track in the past 5-6 years is quite remarkable. However, the Fed needs to chose one nominal target and particularly needs to give up the foolish focus on labour market conditions and instead fully commit to a nominal target. My preferred target would certainly be a 4% (or 5%) Nominal GDP level target.

And Chair Yellen, please lay the Phillips curve to rest if you want to avoid sending the US economy into recession in 2016!

Obviously Yellen did not get the memo and now we are exactly risking that recession that I warned about in August.

And no I am not bragging about my ability to forecast. In fact I am doing the exact opposite. In August the markets were telling us that there was no inflationary pressures (and I was only repeating that), but Yellen has all along insisted that the market expectations about inflation were wrong and that the Phillips Curve was right. That might turn out to be a costly mistake.

Talking to Ambrose about the Fed

I have been talking to The Telegraph’s  about the Fed’s decision to hike interest rates (see here):

“All it will take is one shock,” said Lars Christensen, from Markets and Money Advisory. “It is really weird that they are raising rates at all. Capacity utilization in industry has been falling for five months.”

Mr Christensen said the rate rise in itself is relatively harmless. The real tightening kicked off two years ago when the Fed began to slow its $85bn of bond purchases each month. This squeezed liquidity through the classic quantity of money effect.

Fed tapering slowly turned off the spigot for a global financial system running on a “dollar standard”, with an estimated $9 trillion of foreign debt in US currency. China imported US tightening through its dollar-peg, compounding the slowdown already under way.

It was the delayed effect of this crunch that has caused the “broad” dollar index to rocket by 19pc since July 2014, the steepest dollar rise in modern times. It is a key cause of the bloodbath for commodities and emerging markets.

Mr Christensen said the saving grace this time is that Fed has given clear assurances – like the Bank of England – that it will roll over its $4.5 trillion balance sheet for a long time to come, rather than winding back quantitative easing and risking monetary contraction.

This pledge more than offsets the rate rise itself, which was priced into the market long ago. Chairman Janet Yellen softened the blow further with dovish guidance, repeating the word “gradual” a dozen times.

So no I don’t think the hike is a disaster, but I don’t understand the Fed’s rational for doing this – nominal spending growth is slightly soft, inflation is way below the target, money supply and money base growth is moderate, the dollar is strong and getting stronger and inflation expectations are low and have been coming down.

So if anything across the board monetary indicators are pointing towards the need for easing of monetary conditions – at least if you want to maintain some credibility about the 2% inflation target and or keep nominal GDP growth on the post-2009 4% path.

But I guess this is because Janet Yellen fundamentally has the same model in her head as Arthur Burns had in the 1970s – its is all about a old-style Phillips Curve and I predict that Yellen is making a policy mistake in the same way Burns did in the 1970s – just in the opposite direction and (much) less extreme.

PS some Fed officials are obviously also concerned with the risk of asset market bubbles, but the Fed shouldn’t concern itself with such things (and by the way I don’t think there is any bubbles other than in the market for people concerning themselves with bubbles.)

 

The very unpleasant echo from the 1930s

I am trying very hard not to become alarmist, but I must admit that I see very little positive news at the moment and I continue to see three elements – monetary policy failure/weak growth, the rise of extremist politics (Trump, Orban, Erdogan, Putin, ISIS etc) and sharply rising geopolitical tensions coming together to a very unpleasant cocktail that brings back memories of the 1930s and the run up to the second World War.

It has long been my hypothesis that the contraction in the global economy on the back of the Great Recession – which in my view mostly is a result of monetary policy failure – is causing a rise in political extremism both in Europe (Syriza, Golden Dawn, Orban etc) and the US (Trump) and also to a fractionalization and polarization of politics in normally democratic nations.

That is leading to the appeal of right-wing populists like Donald Trump, but equally to the appeal of islamist groups like ISIS among immigrant youth in for example France and Belgium. Once the democratic alternative loses its appeal extremists and populists will gain ground.

The geopolitical version of this is Ukraine and Syria (and to some extent the South China Sea). With no growth the appeal of protectionism and ultimately of war increases.

Unfortunately the parallels to the 1930s are very clear – without overstating it try to look at this:

  • Syrian war vs Spanish civil war: Direct and indirect involvement of authoritarian foreign regimes (Stalin/Hitler vs Erdogan/Putin)
  • Euro  zone vs the gold standard
  • The rise of populists and extremists: Communists, Nazis and Fascists vs Syriza, Golden Dawn, Jobbik, Orban, regional separatism in Europe, anti-immigrant sentiment, Trump and ISIS (in Europe) etc.
  • The weakening (failure?) of democratic institution: Weimar Republic vs the total polarization of politics across Europe – weak and unpopular minority governments with no “political muscle” for true economic reforms across Europe.

Maybe this is too alarmist, but you would have to be blind to the lessons from history not to see this. However, that does not mean that history will repeat itself – I certain hope not – but if we ignore the similarities to the 1930s things will only get worse from here.

PS if you are looking for more empirical evidence on these issues then have a look at Manuel Funke, Moritz Schularick and Christoph Trebesch’s recent very good post on voxeu.org on The political aftermath of financial crises: Going to extremes.

HT Otto Brøns-Petersen.

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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.

What the SNB should have done

I have got a lot of questions about what I think about the Swiss central bank’s (SNB) decision last week to give up its ‘floor’ on EUR/CHF – effectively revaluing the franc by 20% – and I must admit it has been harder to answer than people would think. Not because I in anyway think it was a good decision – I as basically everybody else thinks it was a terrible decision – but because I so far has been unable to understand how what I used to think of as one of the most competent central banks in the world is able to make such an obviously terrible decision.

One thing is that the SNB might have been dissatisfies with how it’s policy was working – and I would agree that the policy in place until last week had some major problems and I will get back to that – but what worries me is that the SNB instead of replacing its 120-rule with something better seems simply to have given up having any monetary policy rule at all.

It is clear that the SNB’s official inflation target (0-2%) really isn’t too important to the SNB. Or at least it is a highly asymmetrical target where the SNB apparently have no problems if inflation (deflation!) undershoots the target on the downside. At least it is hard to think otherwise when the SNB last week effectively decided to revalue the Swiss franc by 20% in a situation where we have deflation in Switzerland.

Try to imagine how this decision was made. One day somebody shows up in the office and says “we are facing continued deflation. That is what the markets, professional forecasters and our own internal forecasts are telling us very clearly. So why not test economic theory – lets implement a massive tightening of monetary conditions and see what will happens”. And what happened? Everybody in the SNB management screamed “Great idea! Lets try it. What can go wrong?”

Yes, I am still deeply puzzled how this happened. Switzerland is not exactly facing hyperinflation – in fact it is not even facing inflation. Rather deflation will now likely to deepen significantly and Switzerland might even fall into recession.

What was wrong with the ‘old’ policy?

When the SNB implemented its policy to put a ‘floor’ under EUR/CHF back in 2011 I was extremely supportive about it because I thought it was a clever and straightforward way to curb deflationary pressures in the Swiss economy coming from the escalating demand for Swiss franc. That said over the past year or so I have become increasingly sceptical about the policy because I think it was only a partial solution and it has become clear to me that the SNB had failed to articulate what it really wanted to achieve with the policy. Unfortunately I didn’t put these concerns into writing – at least not publicly.

Therefore let me now try to explain what I think was wrong with the ‘old’ policy – the 120-floor on EUR/CHF.

At the core of the problem is that the SNB really never made it clear to itself or to the markets what ultimate nominal target it has. Was the SNB targeting the exchange rate, was it targeting a money market interest rate (the key policy rate) or was it targeting inflation? In fact it was trying to do it all.

And we all know that you cannot do that – it is the Tinbergen rule. You cannot have more targets than you have instruments. The SNB only has one instrument – the money base – so it will have to focusing on only one nominal target. The SNB never articulated clearly to the markets, which of the three targets – the exchange, the interest rate or inflation – had priority over the others.

This might work in short periods and it did. As long as the markets thought that the SNB would be willing to lift the EUR/CHF-floor even further (devalue) to hit its 2% inflation target there was no downward (appreciation) pressure on EUR/CHF and here the credibility of the policy clearly helped.

Hence, there is no doubt that the markets used to think that the floor could be moved up – the Swissy could be devalued further – to ensure that Switzerland would not fall into deflation. However, by its actions it has become increasingly clear to the markets that the SNB was not about to lift the floor to fight deflationary pressures. As a consequence the credibility of the floor-policy has increasingly been tested and the SNB has had to intervene heavily in the FX market to “defend” the 120-floor.

A proposal for a credible, rule-based policy that would work

My proposal for a policy that would work for the SNB would be the following:

First, the SNB should make it completely clear what its money policy instrument is and what intermediate and ultimate monetary policy target it has. It is obvious that the core monetary policy instrument is the money base – the SNB’s ability to print money. Second, in a small-open economy particularly when interest rates are at the Zero Lower Bound (ZLB) it can be useful to use the exchange rate as an intermediate target – a target the central bank uses to hit its ultimate target. This ultimate target could be a NGDP level target, a price level target or an inflation target.

Second, when choosing its intermediate target it better rely on the support of the markets – so the SNB should announce that it will adjust its intermediate target to always hit its ultimate target (for example the inflation target.)

In this regard I think it would make a lot of sense using the exchange rate – for example EUR/CHF or a basket of currencies – as an intermediate and adjustable target. By quasi-pegging EUR/CHF to 120 the SNB left the impression that the FX ‘target’ was the ultimate rather than an intermediate target of monetary policy.

By stating clearly that the exchange rate ‘target’ is only a target implemented to hit the ultimate target – for example 2% inflation – then there would never be any doubt about what the SNB would trying to do with monetary policy.

I think the best way to introduce such an intermediate target would have been to announced that for example the EUR/CHF floor had been increased to for example 130 – to signal monetary policy was too tight at 120 – but also that the SNB would allow EUR/CHF to fluctuate around a +/-10% fluctuation band.

At the same time the SNB should announce that it in the future would use the ‘mid-point’ of the fluctuation band as the de facto ‘instrument’ for implementing monetary policy so to signal that the mid-point could be changed always to hit the ultimate monetary policy target – for example 2% (expected) inflation.

That would mean that if inflation expectations were below 2% then the Swiss franc would tend to depreciate within the fluctuation band as the market (rightly) would expect the SNB to move the mid-point of the band to ensure that it would hit the inflation target.

This would also mean that there would be a perfect ‘ordering’ of targets and instruments. The expectations for inflation relative to the inflation target would both determine the expectations for the development in the exchange and what intermediate target SNB would set for EUR/CHF. This would mean that under normal circumstances where SNB’s regime is credible the market would effectively implement SNB policy through movements in the exchange rate within the fluctuation band.

As a consequence the SNB would rarely have to do anything with the money base. Of course one can of course think of periods where the SNB’s credibility is tested – for example if a spike global risk aversion causes massive inflows into CHF and push the CHF stronger even if inflation expectations are below the inflation target. That said the SNB would never have to give up “defending” CHF against strengthening as the SNB after all has the ability to print all the money it needs to defend the peg.

Of course this is the ability that has been tested recently, but I believe that the appreciation pressure on CHF has been greatly increased by the SNB failure to move up the target in response to the clear undershooting of he inflation target. Hence, the reluctance to respond to deflationary pressures really has undermined the peg.

Had the SNB moved up the EUR/CHF peg to 130 or 140 six months ago then there would not have been the appreciation pressures on the CHF we have seen and the SNB would not have had to expand its balance sheet as much as have been the case.

The ‘regime’ I have outlined above is any many ways similar to Singapore’s monetary regime where the monetary authorities use the exchange rate rather than interest rates to implement monetary policy. In such a regime the central bank allows interest rates to be completely market determined and the central bank would have no policy interest rate.

This would have that clear advantage that there would never be any doubt what target the SNB would be trying to hit and how to hit it. This of course is contrary to the ‘old’ regime where the SNB effectively tried to have both an exchange rate target, an interest rate target and the inflation target. This inherent internal contradiction in the system I believe is the fundamental reason why SNB’s management felt it had to give it up.

Unfortunately the SNB so far has failed to put something else instead of the old regime and we now seem to be in a state of complete monetary policy discretion.

I hope that the SNB soon will realise that monetary policy should be rule-based and transparent. My suggestion above would be such a regime.

Update: I realise that I really should have dedicated this blog post to Irving Fischer, Lars E. O. Svensson, Bennett McCallum, Robert Hetzel and Michael Belongia. Their work on monetary and exchange policy greatly influenced the thinking in the post.

The high cost of currency (rouble) stability

This is from Reuters today:

“The Russian currency has opened higher Thursday, continuing its recovery from the biggest intraday drop since 1998 default on so-called ‘Black Tuesday’. The dollar was down 65 kopeks at the opening on the Moscow Exchange, while on the stock market, the dollar-denominated RTS index was up 6.5 percent. That’s was hours before President Vladimir Putin commenced his much-anticipated Q&A marathon, in which he’s expected to face tough economic questions about the ruble and turmoil in the financial markets. ….On Wednesday, the ruble jumped 6 percent against the US dollar to finish trading at 60.51 against the Greenback. On ‘Black Tuesday’ the ruble dipped to as low as 80 rubles against the US dollar and hit a threshold of 100 against the euro.”

So after a terrible start to the week the Russian rouble has stabilised over the past two days. However, the (temporary?) stabilisation of the rouble has not been for free. Far from it in fact. Just take a look at this story from ft.com also from today:

Russian banks are getting cautious about lending each other money, with the interest rate on three-month interbank loans hitting its highest since at least 2005. The three-month “mosprime” interbank lending rate has soared to 28.3 per cent, which is its highest since it hit its financial crisis peak of 27.6 in January 2009. The rate is also sharply higher than it reached on Wednesday – the day after the Central Bank of Russia hiked interest rates to 17 per cent to stem a plunge in the rouble – when it closed at 22.33. Stresses have been building in Russian economy because of Western sanctions and a sharp fall in the oil price But another reason for the mosprime spike is that Russian banks are unsure about the state of each other’s businesses. Russian bank customers have been rushing to withdraw their roubles out of their bank accounts and convert them to dollars or euros.

Hence, the rouble might have stabilised, but monetary conditions have been tightened dramatically. So the question is whether the benefits of a (more) stable rouble outweigh the costs of tighter monetary conditions?

We might get the answer by looking that the graph below. The consequence of higher interest rates in 2008-9 was a 10% contraction in real GDP. This week’s spike in money market rates is even bigger (and steeper) than the spike in rates in 2008-9. Is there any good reason why we should not expect a similar contraction in real GDP this time? I think not… MosPrime 3m RGDP

PS obviously I would be the first to acknowledge that money market rates is not the entire story about monetary contraction and money market rates are only used for illustrative purposes here. There are also some differences between 2008-9 and now, but it should nonetheless be noted that the recent drop in oil prices is similar to what we saw in 2008-9.

Tighter monetary conditions – not lower oil prices – are pushing down inflation expectations

Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong.

Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future.

2y2y BEI euro zone

But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward.

Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market.

brent 1-year foreard

Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year.

Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices – because the market actual expects higher oil prices – more than 2.5% higher oil prices over the coming year.

So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions.

Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow.

As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now.

Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down.

I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not.

Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening.

We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad.

PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future.

PPS This post was greatly inspired by clever young colleague Jens Pedersen.

Chinese monetary policy failure

“Fed tapering” seems to be repeated in every single story in the financial media over the last couple of days. However, I am afraid that the financial media – as often is the case – is overly US centric. We might want to look at another central bank than the Fed. We should instead pay some (a lot!) of attention to the People’s Bank of China (PBoC).

This is from CNBC:

“China’s central bank continued to test the resilience of local lenders to withstand a cash crunch on Thursday, as money market rates soared once again and short-term rates hit record highs.

The seven-day repo rate, which is seen as gauge of confidence to lend in the interbank market, rose to a record high above 10 percent. China’s overnight repo rate jumped to as high as 30 percent, analysts said.

Chinese money markets have suffered a severe liquidity strain in the past week, due to seasonal factors and a sharp slowdown in foreign exchange inflows, raising concerns about the financial risks facing the world’s second largest economy.

But to the surprise of many market participants, the central bank has held back from pumping cash into the market to ease the credit squeeze and analysts said a spike in the rates at which banks lend money to each other was also a concern. “

I can’t help thinking that we have seen this before. The fed and ECB actions in 2008 come to mind.

This is what I said in my post “Dangerous bubbles fears” in October last year:

“…the PBoC eased monetary policy aggressively in 2009 and that pulled the Chinese economy out of the crisis very fast, but since 2010 the PBoC obviously has become fearful that it had created a bubble – which is probably did. To me Chinese monetary policy probably became excessively easy in early 2010 so it was right to scale back on monetary easing, but money supply growth has slowed very dramatically in the last two years and monetary policy now seem to have become excessively tight.”

It seems to me that the PBoC is just continuing the excessive tightening and that seems to be the real culprit behind the stream of bad economic data we have got out of China recently. It looks like Chinese monetary policy failure.

So yes, Bernanke might have a communication problem, but at the moment it seems like the biggest monetary policy failure is Chinese rather than American.

PS it seems like the Bank of Japan is regaining some credibility – the Nikkei has been remarkably resilient in recent days.

Gustav Cassel on Hoover’s Mistake and monetary policy failure

While I was going through old Australian newspaper articles (don’t ask me why…) I came across a wonderful little article by Gustav Cassel published on February 17 1930. In the article Cassel spells out why fiscal policy would not be able to pull out the US of the Depression and why the Great Depression was caused by  monetary policy failure. The whole thing sounds very Market Monetarist.

I have reproduced the entire article below. Enjoy the wisdom of Gustav Cassel.

President Hoover’s Mistake

– By Professor Gustav Cassel, the Distinguished Swedish Economist

It has been an open question for many years as to what Governments can do to counteract an economic depression… It has above all been suggested that public works should be regulated according to the fluctuations caused from time to time by economic conditions. In other words, the Government should start comprehensive undertakings at the moment when private enterprise begins to lag. The United States are at present in such a condition. Under the energetic leadership of President Hoover it seems that the Government is to intervene promptly and effectively in order to prevent the Stock Exchange crisis from developing into an economic depression.

This case can provide a most useful lesson for the general treatment of this problem and deserves special attention because Europe is more or less bound to be affected by an American depression and will then have to face the same difficulties against which America is fighting today. President Hoover’s programme, which has been given the name of ‘Prosperity Maintenance’ mainly comprises the starting of big undertakings in order to prevent the threatened reduction of industrial employment. To this purpose the official departments are to co-operate with the private employers.

The President called together at the White House several groups representing the economic activity of the country, and the representatives of the railways at once assured him of their cooperation in the form of a comprehensive programme of extensions.

Apart from a certain psychological influence, the President’s programme, is, however, in every way a mistake. It rests not only on an incorrect conception of the actual conditions, but also on an over-estimate the Government’s power.

In the endeavours to create employment by extraordinary new enterprises, it must be remembered very clearly that the burden will fill on the nation’s savings and reduce the amount of money available for the increase of true capital. An intervention by the State in order to increase the existing works and their machinery equipment might possibly be a sensible policy if a surplus of savings were available. The Hoover programme seems to assume that it is the case. In his message to Congress the President has proclaimed to the whole world that hitherto American capital was invested to an extraordinarily large proportion in stock speculation. The crisis is now said to have set this capital free, and made it available for general economic enterprises.

The ‘Government therefore considered it to be their duty to find employment for the capital supply. Every link in this chain or argument is a fallacy. Speculation in stocks has never involved any capital and cannot involve any. Therefore no capital can flow back from the Stock Exchange to economic enterprise. After all, America has no more available capital requiring a special effort for its employment.

The American Stock Exchange crisis signifies no more than that exaggerated quotations have been reduced to their normal value. There is no crisis in the economic life, but only a certain reduction of capital available, mostly for the building of dwelling houses. This reduction is caused immediately by the fact that the current new savings were not sufficient to maintain the production of real capital in the enormous proportions of last year.

The outstanding feature of the present position is therefore undoubtedly a great scarcity of capital. This being the case, is it not foolish to undertake large new enterprises in the belief that they can be paid for with available capital? Any effort in this direction, especially if made by the Government, is bound to waste the already scarce reserves, and thus to weaken the entire political economy.

That scarcity of capital is the principal feature of the present situation is also shown by the fact that the export of American capital has decreased very considerably indeed. If more surplus money were offered America would increase its export of capital and thereby improve the purchasing power of the other countries for the American export products. This would free the Government from many cares concerning inner political economy and at the same time render superfluous its efforts to exert its political power in creating outlets for American exports.

Such a development would be most welcome to all the countries needing capital. Conditions, the whole world over have shaped themselves in such a way that the export of American capital is an indispensable condition for a prosperous world economy. The whole world must therefore view with grave concern a Government intervention which, on account of its uneconomic investments, is bound to render impossible the accumulation of American savings.

Government intervention is in this case obviously to the detriment of the economic organisation. It would be far better to leave that organisation to look after itself. If this were done, any available new surplus money would very quickly be put, to use, provided that no new hindering circumstances should arise. An important American journal has recently collected a number of views on this subject by industrial leaders.

The general impression to be gathered from this inquiry is that the industrialists intend to carry on, notwithstanding the Stock Exchange crisis. In most branches of industry there is an acute necessity to enlarge the buildings and to improve the equipment. On reading the inquiry made by this journal we certainly do not feel that there is any lack of opportunities to use any available American capital. In the present situation there is indeed only one single factor which can seriously hinder development and this one factor has its origin in a Government Department. I am referring to the bank rate policy or in a wider sense to the limitation of money supplies to the economic life by the Federal Reserve System. This limitation has of late been far too strict. The reason is the attempt to regulate the bank rate in such a way that it, would have a supreme influence on the Stock Exchange, limiting the speculative inflation of share prices.

There is no doubt that this attempt constitutes an improper transgression of the natural limits of the tasks evolving upon a central banking institution – an attempt which ultimately can be traced back to the ardent desire of the Government to usurp an ever growing share of influence upon the country’s political economy. It is true that after the Stock Exchange crisis the bank rate has been slightly reduced. But this measure was taken far too slowly and hesitatingly.

The Federal Reserve system has not kept pace with the development, but since the last summer has adhered to rates which were far too high, with the result of a collapse in prices which seriously endangered the whole political economy, and which, so long as it continues will naturally prevent any sensible persons from making new investments. If the fall in prices were to continue, this would unavoidably prevent American economy from continuing its recent wonderful developments.

The collapse in prices is bound to drag with it the whole of the rest of the world and to create a universal condition which must react on the economy of the United States. And all this entirely unnecessary collapse of prices is exclusively the result of the mishandling of the American dollar value which in its turn is the consequence of an uncalled for excursion of Government influence into the province of economic problems.

The whole matter is a blatant example of what happens if we yield to the modern tendency of permitting the Government to meddle unnecessarily with economics. The Government assumes a task which is not in its province; in consequence of this it is driven to mismanage one of its most pertinent tasks, i.e., the supervision of money resources, this causes a depression, which the same government seeks to remedy by measures which are again outside the sphere of its true activity and which can only make the whole position worse.

The particular case under review is really only an illustration of a phenomenon which at present is very general; while neglecting their proper functions, governments greedily seize every opportunity to usurp provinces which are not their concern, and by doing so place themselves – with or against their will – on a plane inclined towards a form of socialism, the aim of which is, in this respect, to risk everything to obtain the utmost.

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Other posts on Gustav Cassel:

Gustav Cassel foresaw the Great Depression
Hawtrey, Cassel and Glasner
“Our Monetary ills Laid to Puritanism”
Calvinist economics – the sin of our times
Gustav Cassel on recessions

And Steve Horwitz on why Hoover was an interventionist.

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