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Monetary policy still works at the ZLB

In case anybody was wondering, monetary policy definitely still has an effect at the zero lower bound.  In the UK, the banks have unwittingly (and certainly unwillingly) been part of a demonstration of a so-called helicopter-drop of money.  In a country of 60 million people, by mid 2008 there were over 20 million Payment Production Insurance (PPI) policies in effect and that number was growing fast.  In early 2011, they were ruled to have been mis-sold (customers were deemed, in general, to have been pressured or deceived into buying insurance they didn’t need) and banks were ordered to offer compensation.  Wikipedia has a summary here. From a pair of articles in the FT ([1], [2]):

[Article 1] About £4.8bn had already been paid out by the end of May – effectively acting as “helicopter money” dropped into the hands of those people who may be among the most likely to spend it.

[Article 2] The independent Office for Budget Responsibility, relying on estimates that PPI refunds would deliver £6bn over the year, revised up its estimate of the growth rate of real disposable household income by 0.5 percentage points in March from its November figure … the amounts set aside for PPI redress by the five biggest banks have now soared to almost £9bn.

[Article 2] The FSA said it does not know the average payout per claimant. But some of the “complaints management” companies, which have been making aggressive pitches to help consumers get their money back, say these average £2,000 to £3,000 per applicant.

[Article 1] “When I heard I was going to get over £2,000 in compensation I hired builders to fix a long-overdue problem with the eaves in my roof and put the rest of the money towards a holiday to Greece in September,” said Elaine Overten, a retired nurse from Derbyshire, who received compensation for PPI payments made on her NatWest mortgage over 10 years.

I just love the little (and not remotely subtle) hint from the FT that monetary stimulus would help Greece out of their hole.

Anyway, the point is simple.  If you put money in people’s hands, especially if those people are “credit constrained,” they will spend it.  That was the point of my “Monetary policy for 10 year olds” post a while ago.  It remains the point today.  It will always be the point.

The problem, of course, is that while PPI compensation payouts are acting as a positive stimulus, the corresponding hit to the banks will be causing them to hold back in their lending and so provide a negative stimulus at the same time.  If I had to guess, I’d say that the net effect of PPI compensation is to provide a positive stimulus because of the broad distribution and, I assume, the fact that a large fraction of the recipients really are currently credit constrained.

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Policy options for the Euro area [Updated]

I here list a few policy options for the Euro area that I support, broadly in descending order of my perception of their importance.  Everything here is predicated on an assumption that the Euro itself is to survive and that no member nation of the Euro area is to exit the union.  I don’t claim that this would solve the crisis — who would make such a claim? — but they would all be positive steps that increase the probability of an ultimate solution being found.

  • Immediately establish a single, Euro area-wide bank deposit guarantee scheme.  A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany.  That means that retail and commercial deposits in each should be backed by the same guarantee.  I have no firm opinion on how it should be funded.  The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them.  Just get the thing up and running.  Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing.  There are many and varied forms that fiscal union can take; this is the most urgent of them all.  I am shocked that this does not already exist.
  • The ECB should switch from targetting current inflation to expected future inflation.  The Bank of England already does this.  Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years.  This is important.  Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%.  On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany.  They will be much lower for the rest of the Euro area.  Monetary policy in the Euro area is much, much too tight at the moment.  At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.
  • The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation.  This follows on from my previous point, but is still logically distinct.  The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements.  I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP.  I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.
  • The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough.  The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this.  I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral.  I certainly believe (see my second point above) that interest rates should be lowered.  The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.
  • A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first).  The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability.  When banks are instead deleveraging, the problem is made worse by waiting.
  • Credit Default Swaps must be permitted to trigger.  The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky.  By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better.  Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.
  • Every member of the Euro periphery should be in an IMF programme.  Yes, I’m looking at you, Italy.  If the IMF does not have sufficient funds to work with, the ECB should lend to it.  All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity.  These things cannot be fixed in two or three years.  They can, at best, be put on the right path.
  • For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it.   If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%.  The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis.  Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere.  Note, too, that a central bank is only meant to be a lender of last resort to banks.  The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation:  Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT.  Any member country would retain the ability to provide benefits above and beyond the minimum.  This will have several benefits:

  • Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
  • It will help provide pan-European automatic stabilisers in fiscal policy;
  • It will provide crucial intra-European stabilisation;
  • It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
  • It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

———————-

Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks.  This is a good thing. Press releases:

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The ECB starts raising interest rates (updated)

[Updated to include labour cost inflation too]

Here are the stories at the FT, the WSJ, the Economist (in their blogs) and for a won’t-somebody-think-of-the-children perspective, the Guardian [1].

There are plenty of arguments against the increase.  You could argue that there’s a sizeable output gap, so any inflation now is unlikely to be persistent.  You could argue that core inflation is low and that it’s only the headline rate that’s high.  You could argue that with the periphery countries facing fiscal crises, they need desperately to grow in order to avoid a default or, worse, a breakup of the Euro area.  You could argue that a period of above-average inflation in Europe’s core economies and below-average inflation in the periphery would allow the latter to (slowly) achieve what a currency devaluation would normally do:  make them more competitive, attract business and allow them to grow in the long run (above and beyond the short-run stimulus of low interest rates).

On that last point, though, it’s worth looking at the data.  It’s a great idea, in principle, but unfortunately and despite all the austerity packages, the data show exactly the opposite picture at present.  Here’s the current year-over-year inflation rate broken down by country, from Eurostat (HICP and Labour Costs):

 

 

Economy HICP Labour Cost Index
Euro area as a whole 2.4% 2.0%
Germany 2.2% 0.1%
France 1.8% 1.5%
Greece 4.2% 11.7%
Ireland 0.9% n/a
Portugal 3.5% 1.0%
Spain 3.4% 4.1%

 

 

For some reason Ireland doesn’t seem to be included in the Labour Cost data.  Look at Greece and Spain.  They’re getting more expensive to do business in relative to Germany and France.  Portugal is in the right area, but with Germany’s growth rate in Labour Costs so low, they’re still coming out worse.  The same story is painted in consumer inflation.  It looks like Ireland is doing what it needs to, but Greece, Portugal and Spain are all getting even less competitive.

Here’s my theory:  The ECB hates the fact that they’re temporarily funding these governments, but can’t avoid that fact.  Furthermore, they reckon that Greece, Ireland and Portugal are eventually going to restructure their debt.  Given that they cannot shove the temporary funding off onto some other European institution, the ECB either doesn’t care whether it’s in 2013 or today (they’ve already got the emergency liquidity out there and it can just stay there until the mess is cleaned up) or quietly wants them to do it now and get it over with.  Either way, the ECB is going to conduct policy conditional on the assumption that it’s as good as done.

 

[1]  Just kidding, Guardian readers.  You know I love you.  Mind you, the writing in that article could have been better — it says that inflation has gone above the ECB’s target of 2% and never mentions what it actually is, but later mentions the current British inflation rate (4.4%) without explaining that it is for Britain and not the Euro area.

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Improving the Euro

On BBC Radio 4, Jonathan Charles — the BBC’s European correspondent in the 1990s — has done a special on the Euro and the trouble it’s experiencing.  It’s well worth a listen if you have 40 minutes to spare.

It reminded me that I’d meant to write a post on two things I think ought to be done in improving the long-term outlook for the single currency.  None of this is particularly innovative, but I needed to put it down somewhere, so here it is.

First, a European Fiscal Institution (EFI)

At the start of February, when Greece and her public debt was dominating the news, I wrote:

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment. Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment. The latter is difficult in Europe with it’s multitude of languages, but not impossible.

Let me hang some meat on those not-even-bones.  I like the idea of a partially shared, European Fiscal Institution (EFI) that can conduct counter-cyclical spending, subject to strict limits on its mandate.  I am deliberately avoiding calling it an “authority” because that implies a certain freedom of action, which I oppose.  Instead, I think that an EFI should:

  • be limited to implementing commonly-agreed automatic stabilisers (in particular, a universally-agreed-upon minimum level of unemployment benefits);
  • be able to issue its own “Euro bonds”;
  • have a mandate to retain the very highest regard for the safety of its borrowing; and
  • be funded (and its bonds be guaranteed) by member countries in a manner part way between proportionate to population and proportionate to GDP.

I do not think that membership of such an institution should be required of any European country.  If a non-Euro country wants to be in it, fine.  If a Euro country wants to not be in it, fine.

The unemployment benefits provided would be the absolute minimum that everyone could agree on.  I want to emphasise that this should be extremely conservative.  If it ends up being just €100/week for the first month of unemployment, so be it; so long as it is something.  Member countries would provide additional support above the minimum as they see fit.

This will have several benefits:

  • It will help provide pan-European automatic stabilisation in fiscal policy.
  • It will provide crucial intra-European stabilisation.
  • It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high.
  • It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

Second, country-specific lending standards

A crucial problem with a single currency is that it imposes a one-size-fits-all monetary policy on all member states, even when those states’ economies are not perfectly synchronised.  Synchronisation was, and is, one of the requirements for accession to the Euro, but perfect synchronisation is impossible.  In particular, inflation rates have varied significantly across the Euro-area, meaning that the common-to-all interest rates set by the ECB have been, by necessity, too low for those economies with the highest rates of inflation (e.g. Spain) and too high for those with the lowest rates of inflation (e.g. Germany).

But the (causal) link from interest rates to inflation travels via the extension of credit to the private sector, and the level of credit is determined not just from the demand side (with agents responding to changes in interest rates), but also from the supply side (with banks deciding to whom and under what conditions they will grant credit).  Monetary authorities in individual member countries therefore retain the ability to influence the level of credit through regulatory influence on the supply of the same.

Altering reserve requirements for banks operating in one’s country would be the crudest version of this mechanism. A more modern equivalent would be changes to the minimum level for banks’ capital adequacy ratios.  Imagine if the Spanish banking regulators had imposed a requirement of 10% deposits on all mortgages from 2005.

I suspect that the new “macro-prudential” role of the Bank of England, in addition to its role of more conventional — and, with Q.E., unconventional — monetary policy will grant them the ability to engage this sort of control.  I think it will become more important over time, too, as the British economy continues its (to my mind inevitable) decline relative to the Euro-area, the UK moves closer to the textbook definition of a “small, open economy” and the BoE thus finds itself more constricted in their choice of interest rates.

Update 13 September 2010:

The new Basel III capital adequacy requirements are out and they appear to enable exactly this second idea.  Good!

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Note to self: holidaying in Greece will soon be cheap

Megan McArdle directs the world to this piece in the FT.  From the FT article:

The European Commission said on Tuesday it would endorse Athens’ plan to bring back under control the public sector deficit, which last year reached almost 13 per cent of gross domestic product.
…
Under a three-year plan, the Greek government seeks to cut the national budget deficit to less than 3 per cent of GDP by the end of 2012.

and:

In response to criticism that earlier plans had not included sufficient spending cuts, Mr Papandreou also announced an across-the-board freeze in public sector wages which, together with cuts in allowances, would reduce the public sector wage bill by 4 per cent. The government has also pledged to raise the retirement age.

If the Greek government can achieve this without massive, nation-wide strikes, I’ll be terrifically impressed.  Megan’s comments:

Everyone is expressing optimism. But while this sort of belt-tightening is necessary for Greece to stay in the EU, it’s going to come at a huge cost. Greece is already in recession–that’s why its budget problems loom so large–and the fiscal contraction will only make them deeper. Meanwhile, the EU will be setting its interest rates to meet the needs of larger, healthier members (and inflation-hawk bondholders). Tight fiscal and monetary policy means a long, painful period ahead for the Greeks.

This is the dilemma that faced Argentina with its monetary peg to the dollar; ultimately, it led to devaluation and default. We will see if Greece can whether [sic] it better.

I don’t think that this sort of belt-tightening is strictly necessary in the near term.  Germany will, again, fund a bail-out if it really comes down to it because, if nothing else, the loss to Germany of a member of the EU dropping the currency is greater than the loss to Germany of paying for Greece’s debt.

It’s clearly necessary in the long term that Greece get it’s fiscal house in order, but since they’re in such a severe recession, this isn’t really the time to do it (financial market pressure aside).  This is, in essence, the same debate that is gripping America, although there the pressure to address the deficit is coming from a successful political strategy of the opposition rather than, much as that same opposition might like, pressure from the markets.

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment.  Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment.  The latter is difficult in Europe with it’s multitude of languages, but not impossible.

In a perfect world where all regions of the EU currency zone were equally developed, this would simply replace the EU development grants.  But this isn’t a perfectly world …