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.
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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: