Bring On The Quantitative Easing, And Bring It On Now (Wonkish)!

by Claus Vistesen and Edward Hugh

Most sports coaches – irrespective of whether they work in soccer, baseball, rugby or even American football – have playbooks; small books or pads filled with notes, decision rules and strategies for each and every possible situation they can envision. Of course, in some cases the playbooks are mental rather than physical, but every good coach lives and dies by his ability to adapt and react to new and changing situations and in order to do this effectively what he needs above all is a good playbook.

So what has all this waffle about football, baseball and whatever got to do with the ECB and how it should respond to the Eurozone’s “fluid and evolving” economic and financial crisis? Well, the point surely would be that whatever playbook the ECB works with (and it is sometimes pretty hard to see clearly which one it actually is) they do not seem to have included a section on what to do when interest rates finally hit the zero bound (not this month evidently, but maybe, or possibly the one after….as Bank President Trichet said after today’s decision to reduce the rate to 1.5%: “We didn’t decide ex-ante that this was the lowest point that we could attain” ). Nor do the ECB seem to have a page which explicitly handles the currently fashionable state of the art set of tools known collectively as quantitative easing. And this omission may, as the zero bound looms and outright deflation threatens, turn out to be a rather large and unfortunate one. The question is, what exactly are we going to do if (or even when) the Eurozone as a whole enters a deflationary rather than a disinflationary dynamic, and even more importantly, what happens if price movements fall into deflation mode and stay there?

The Kaiserstrasse View

But before we get ahead of ourselves, let’s go straight to the horses mouth (as it were), and take a brief look at what it is exactly the ECB has been doing all this time in order to alleviate the credit crunch and reverse that depressing cycle of decline and deterioration which currently seems to hold the Eurozone economies so tightly in its grip. Speaking at the European American Press Club on the 20th of February ECB President Jean Claude Trichet laid out in some detail the considerable variety of measures the bank has been taking since the crisis broke out in August 2007. Reading through the text of the speech, one major detail immediately strikes the eye, and depending on your point of view the omission is a more or less disturbing one.

The fact of the matter is that at no point in his entire speech does the Central Bank President get to mention (not even once) the effects the crisis has been having on the real economy. His entire attention is focused on measures that the bank has been taking in order to ease the crunch by improving funding conditions in the interbank market, and in particular he enumerates in some considerable detail all the various classes of credit the ECB has been making available to Europe’s banks. Now, you could argue that this absence is hardly surprising given that Trichet was not invited to give a talk about the state of the European economy, but rather about the steps the bank was taking to address the impact of the financial crisis and the credit crunch. But this would be precisely the point, since at the present moment in time the two are inextricably intertwined, with the credit crunch driving the real economy down, even as the rising unemployment this produces sends risk sentiment in the banking sector to ever lower levels.

This being said, the more disturbing part of the whole speech is the sense of complacency it conveys, with the impression being given that Trichet by and large believes the ECB has things nicely under control with a nominal interest rate (then) running at 2% and that despite the awkward hurdles which may still lie out there in front of us, no extraordinary measures are needed. If this is the case, maybe someone needs to pick up the phone and give the gentlemen in Frnakfurt Ivory Tower a call suggesting they take a long hard look out of their window to see just what is happening in the world that lies beyond.

Possibly some may feel that the dichotomy being made here is a false one since the ECB always held that the measures it was taking to normalize conditions in the interbank market were also de-facto intended to cushion the effects of the credit crunch on the real economy. However, using this argument in the current situation is not only misleading, it is also dangerously complacent. Put in more prosaic fashion; this is all soo pre H2 2008.

It’s The Real Economy, Stupid!

The facts of the matter are all now pretty much unequivocal, and really speak for themselves (or at least they should do).

  • In the first place the problem in the banking sector and the wholesale money markets was never really the main issue. This, undoubtedly real, problem was merely the outward and evident symptom of a much deeper structural problem concerning how the whole (global) economy needed to deleverage, and how the systemic character of the money market breakdown would ultimately require government and institutional intervention on a large scale.

    Secondly the crisis has now very much become an economic and not simply a financial one. We won’t belabour the reader here with all the gory economic details which you are all already so familiar with, but we would like to stress that it is now pretty evident that the global economy is taking a hit on the scale that has not been seen since the first half of the last century, and most specifically, since the years of The Great Depression. So this is not a matter to take lightly, even if some economies are hit worse than others. We should also not fail to take notice of the fact that, despite many early assurances to the contrary, while the United States is certainly busily fighting its own private economic demons, the locus of the crisis has now slowly but surely moved in Europe’s direction, first via the Southern and Eastern periphery and then entering into that very bastion of the Eurozone itself – the German economy.

    This is not either the time or the place to examine all the chain-links and mechanisms through which crisis transmission operates, but we should all be aware that the force of the blast we are taking at the present time is such that the very foundations of our common economic edifice – of the Eurozone and even the European Union – are now at risk. When the simple act of transferring deposits from bank accounts in one member state to those in another (in order to speculate on the future stability of a currency) becomes (and by some multiples) a potentially more profitable investment opportunity than building a factory and creating employment then the seeds of financial crisis are well and truly sown, and action needs to be taken to prevent the implicit peril coming to fruition. We simply don’t understand how anyone can deny that this problem exists at the present juncture, and that something needs to be badly and urgently done to secure the foundations of our edifice before the worst is, by omission, allowed to happen. The economies of the EU and, in particular of the eurozone, need to see the return of profitable investment opportunities as an alternative to idle speculation, and the ECB has a key role to play in this process, by returning price stability, by stimulating growth possibilities, and above all by encouraging a return of confidence to our somewhat battered and beaten economic system.

    Those Unconventional Tools Again

    In order to adress the rather urgent task which now faces us we should not, in principal, exclude the use of extraordinary action and recourse to what have come to be known as “unconventional tools” on the part of the ECB. Indeed in the difficult battle which now confronts us, no door should be closed, and no stone left unturned. Yet, all of this still remains on the level of “in principle” and in theory. Since despite all the evidence, indeed the facts on the ground speak for themselves, which strongly suggests that the Eurozone now faces not only a strong disinflation process but the advent of outright deflation (as defined by a sustained period of price declines in the core HICP index, see here and again here) we are still wallowing around in hypothetical discussions with no one actually prepared to strongly push for a very rapid biting of the most badly needed bullet. Furthermore, a new problem now presents itself, since the wreckage which is rapidly piling up in Eastern Europe risks destabilizing the whole system through the deep financial linkages which exist between the banking system in the Eastern countries and those very Western banks which have already been beaten to pulp by equity losses and debt defaults in one corner of the globe after another.

    Indeed, some of us would claim that once the wheels of the present train crash were set in motion a year or so ago it was not particularly difficult to see that the lions share of the problem would end up in Southern and Eastern Europe, and in this fashion would arrive beating and hammering at the doors of the ECB in the form of both a severe Eurozone recession and a near-systemic collapse in the economies of Eastern Europe. If there was a danger of a repeat of the 1990s Asian style contagion anywhere it was always going to be in Emerging Europe, as the Bank for International Settlements and those much maligned ratings agencies never ceased to point out.

    However, if we come to look at the responses to date from the ECB, we find that these have in no way been either as drastic or as urgent as those initiated by counterparts like the Bank of Japan and the US Federal Reserve (or even, come to that, by the Bank of England and the Swedish Riksbank). In fact, far from reacting rapidly and vigorously, ECB council members have repeatedly voiced concerns about the dangers of letting interest rates drop too low too quickly, and even warned of the dangers of reproducing yet more bubbles. This “conjuring of demons” seems to us to be soo terribly Japan in the 1990s-ish.

    Atonal Cachophony Of Views From The ECB

    In fact the whole crisis reponse and reaction process seems to have revealed more a feeling of confusion and disarray, than one of order and “everything under control”. Back in December 2008, the councils self-proclaimed hawk, Axel Weber, was busy worrying us all with his discovery of the “horrifying fact” that lowering interest rates below 2% would have implied the application of negative real interest rates (citing the fact that inflation expectations at that point for the medium-to-short term were themselves hovering at around 2%. He seemed to be blissfully unaware that with economies like the German and Spanish ones registering annual contraction rates in the 5% region, negative interest rates might be just the recipe the doctor was ordering. Just over a month ago Greek council member George Provopoulos added his voice to the chorus, cautioning that there was only limited scope for further rate cuts (towards 1%), citing among other reasons his expectation that the Eurozone economy would begin to recover by the time we reached 2010. Specifically, he noted that while there was room for interest rates to go lower if the economy and inflation expectations were to deteriorate further, this would in no case imply a move towards 0%.

    This view was reiterated some weeks later by Luxembourg’s representative on the Council, Yves Mersch, when he stated that he was completely opposed to the idea of the ECB adopting a Japanese (or US) type policy of ZIRP (zero interest rates). The reasons normally cited for such continued caution were what one might call the “usual suspects” – namely that while inflation was expected to reach very low levels due to the drop in energy prices it would subsequently rebound in late 2009 (due to the so-called base effects), or that the economic outlook in the Eurozone was fundamentally different that in Japan and the US where the respective central banks had gone much further in the direction of aggresive monetary policy.

    Most ECB watchers view the continuing cautious stance over on Kaiserstrasse with a growing sense of unease and bewilderment. In light of the daily slew of incoming bad news it has seemed pretty odd (to say the least) for the ECB to maintain its focus on measures which were clearly lagging the pace of economic development rather than trying to get out in front of the problem and head it off. In fairness, it does now seem that some members at least of the Governing Council may belatedly be moving closer to a recognition of the full scale of what we are up against. Recently, council member Guy Quaden pointed out that it was perfectly possible for the ECB to lower rates well beyond 2% and that, in his view, there were no taboos whatsover. Such statements certainly constitute a starting point, but still perpetually create the feeling of “too little too late”, and in fact have done little to persuade financial markets that the ECB is actually in control of the situation.

    This problem was further highlighted at the February meeting when rates were kept on hold and where Trichet, in his usual charming manner, simply noted that ZIRP (and thus QE) had several inappropriate drawbacks, although he did not see fit (at that point) to go further, and elaborate on what he thought these were. The markets responded as might have been expected to such obfuscation, and the yield on two year German bunds was pushed to its lowest level since 1997. Symptomatic of the then prevailing “zeitgeist” was the statement of Austrian council member Ewald Nowotny to the FT that the ECB would not move into ZIRP as this would imply negative real interest rates, apparently not understanding that this may well be precisely what we needed given the strength of the contraction.

    As BNP Paribas’s senior economist in London, Ken Wattret, said at the time:

    “We’re desperately spinning around to get a proper handle on the issue,” (…) “The worst-case scenario is that the ECB is hoping they don’t need to do things like this because the economy will pick up again. If that’s plan A, then that’s rather disturbing.”

    Part of the problem here, now and and as ever, is that the ECB Governing Council itself is far from having a uniform view. And looking at the stream of council members lining up to give their own personal views to Bloomberg in recent weeks, one might easily have been lead to utter the infamous “would the real spokesperson for the ECB now stand up” line! The latest “dissenter” in the long list who have been queing up one after the other to expound on their own “nuanced view” of the situation was Athanasios Orphanides, Governor of the Bank of Cyprus, who in a speech the 28th of January made it that, in his opinion:

    The suggestion that monetary policy becomes ineffective when rates are close to zero is a “dangerous” fallacy.

    That this should sound vaguely reminiscent of a message which has long been coming across from the other side of the pond should not surprise us that much, since as Bloomberg reporter Ben Sils has pointed out, Orphanides is in fact a former Federal Reserve economist (who made a name for himself, apparently, by telling his superiors they were wrong, go to it Athanasios). Sils suggests that events are now moving rapidly on the Council (although not that rapidly, judging by this week’s outcome), and that Orphanides might actually be the one emerging with the upper hand in the near term. In fact what ECB President Jean-Claude Trichet said to journalists after the rate setting meeting is that he wasn’t yet prepared to expand the ECB arsenal to include unorthodox policy tools, not that he wouldn’t get round to doing so eventually. The sticking point at this stage would seem to be inflation expectations (see below).

    And don’t for a minute believe Orphanides is merely doing a bit of headline grabbing here. There is a real theoretical argument behind his position, one which he, himself, elaborated in this paper which discusses how, in a deflationary situation, the central bank should attempt to steer expectations back up into price increase territory by credibly “promising” to maintain very low interest rates for an extended period of time. (This was effectively the BoJ stance between 2002 and 2006. For some pretty wonkish material on all this, try the Lars E. O. Svensson paper from 2001 or Gauti Eggertsson and Jonathan D. Ostry’s IMF paper on the importance of communicating clearly when you want to make a “credible threat of irresponsibility”).

    OK, So Far I’m With You, You Want QE, But What The Hell Is QE?

    With the ECB being so cautious and unsure about whether or not to engage in some sort of Quantitative Easing (QE to its friends, for a pretty detailed discussion of QE in Japan and the US try this post here) maybe it would be worth taking a look to see just what the rest of them are doing.

    Morgan Stanley’s Stephen Jen has a very useful piece here on the Federal Reserves’ entry into QE in late November 2008. In the first place it is important to note that QE comes in two stages (although these really need to be collapsed into one here in Europe given the looming deflation threat).

    The first stage is to attack the credit crunch. If and when that attack fails (as it evidently has done, virtually everywhere) the second stage is to try to halt the slide into outright price (and then debt) deflation. In fact, for some time we have been operating a kind of modified version of QE in the Eurozone (without, of course, the presence of the “lower bound”) based on a division of labour between the bank (which has balooned its balance sheet in order to provide short term liquidity to the banking sector) and the national governments who (following the Paris meeting of October 12) have worked on the fiscal side with initiatives to try and move credit by guaranteeing bank loans or buying commercial paper. Now we are about to move into the second stage, which involves first and foremost trying to “steer” inflation expectations. According to Jen there are three key elements in any comprehensive system of QE.

    • Communication policy is vital, in order to steer expectations and in particular in convincing market participants that short term interest rates will be held low for a prolonged period of time, even as governments print money on the fiscal side, and even at the risk of “monetising” the growing debt. The point here, naturally, is to try to thrust rather than jolt inflation expectations strongly into positive territory. Judging by all the yelps of pain we are hearing from US market participants about looming inflation Bernanke seems to be having some success here (at least for the moment), and it is a pity we are not able to say the same thing about their European equivalents, who, it seems to us, are gradually (by omission) being steered towards reluctantly accepting either deflation, or at the least very low inflation, as now more or less inevitable.
    • The central bank can also increase the size of its balance sheet, and this is a tool that the Fed has been using extensively in an attempt to increase the money supply. For a visual illustration of the process, check out this graph . As for the mechanics, this piece by John Kemp is a good starting point.
    • A central bank can also alter the composition of its balance sheet by directly purchasing securities in an attempt to influence the prices of financial assets. This measure is of course intimately connected with the previous point, since without the former there is no great likelihood that the latter will work. We need to distinguish here between direct asset purchases in primary markets, and secondary market purchases. In fact, the ECB has already been effectively intervening in secondary markets for some for some time now. In a general sense, have also seen some pretty radical changes in the kind of assets is willing to accept as collateral for liquidity. What we have yet to see is the ECB intervening in the primary market, or, if you prefer, directly printing money. It is this move that the Bank of England have finally embarked on this week, and when the ECB also move in this direction, then we will be sure we really are in throes of QE in the Eurozone

    One of the cornerstones of QE as it has so far been implemented both at the Federal Reserve and at the BOJ has been the aggressive expansion in the purchase of unconventional securities. This could for example be corporate debt as well as, in the US case, agency and mortgage-backed securities (together with a veritable myriad of other assets). All of this marks a considerable evolution of the “traditional” QE measures (as practised during an earlier period in Japan) whereby the central bank engages in heavy purchasing of t-bills in order to “manage” the yield curve on the short end and thus allowing the government to conduct fiscal expansion at lower cost. Effectively, what we have at the Fed and the BoJ is both an asset and a liability approach where the former takes the form of the central bank accepting the purchase of an ever broader range of assets while the latter takes the form of expanding excess reserves held by banks.

    So, What should and could the ECB do?

    Well the answer to this question clearly depends on where you think the Eurozone’s real economy is at right now. In particular, if you are willing to entertain the idea that the bank needs to bring interest rates near to zero and start operating a more aggresive version of QE then you also need to buy the idea that there is a significant and impending risk of deflation in the Eurozone. Basically, M. Trichet’s recent comments to the effect that there is no present danger of deflation in the Eurozone seem to fly in the face of much of what we presently have on the table in terms of economic data, and suggest that we are still a long way from being willing to start doing the necessary.

    However, and in fairness to the opposing point of view, we might start by taking a look at the various reasons which have been offered in support of the idea that it would be inappropriate fat the present time for the ECB to engage in QE, examining in the process why it is that some still continue to argue that we are not facing a deflation problem.

    The best way to get to grips with such arguments is, of course, to listen to the arguments coming from the ECB itself, but since we have no access to the minutes of ECB Council meetings, and since council members all too often simply offer us their own highly ideosyncratic views, we need to cast our net rather wider, and look at the sorts of argument that may be influencing ECB thinking at this point. We are thus singling out two among many. The first comes from Robert Ophèle Deputy Director at La Banque de France, and the other from Sylvester Eijffinger, professor at Tilburg University.

    Now Opèle rightly tries to highlight the distinction between deflation and disinflation, pointing to the fact that what we are currently experiencing is the latter and not the former. Judging by the recent data it is not certain that this view is entirely correct, but he does highlight an important issue in the sense that the key question here is the extent to which one expects rapid disinflation to turn into deflation.

    Ophèle uses two arguments in defence of the idea that what we currently have on our hands is a disinflation process and not a deflationary one. The first of these is that the current sharp drop in price levels is laregly driven by a fall in energy and food prices. What is happening is that we are simply giving back the price gains that were so instrumental in driving global inflation and monetary policy as recently as just a year ago (the year here is important, since this is what drives the annual inflation numbers) . The second argument is a much subtler one, and concerns the degree to which nominal wage rigidity may actually be a virtue in the context of disinflation since it acts as a structural hedge against a collapse into deflation.

    This is an extraordinarily powerful and, as it were, convenient argument for those who seek to defend the current posture of the ECB. In this context it is perhaps worth going back to all those endless disquisitions we were subjected to about the potential for those horrid second round effects on wages and prices as energy prices shot up ever higher, and one might thus assume the argument to be a symmetrical one now that energy prices are dropping sharply. That is, the presence of nominal wage and general core price ridigity might mean that wages and prices are not sent on a downward spiral by the negative energy proce shock and if one expects the downtrend in energy prices to be merely temporary then, arguably, the monetary stance should not be changed on this account alone.

    However this seemingly plausible argument may not be entirely valid in the current context. Firstly, it should by now be pretty obvious to everyone that the current correction will have to be deflationary in its consequences those economies in the Eurozone who have accumulated sizeable imbalances over the last seven or eight years. This would then exactly suggest that whatever the trend in energy prices it is the forward looking trend in the core price index we should be looking at. However, Ophèle has an argument ready to hand even in this case:

    We should recall that deflation is not possible while households and enterprises continue to expect price rises. This is incontrovertibly the case at the moment. Business surveys, measures derived from market rates, and forecasting experts surveyed by the ECB all point to five-year inflation expectations remaining anchored around 2% for the euro area as a whole.

    Shall we run that one by again: deflation is not possible as long as inflation expectations remain positive? This is evidently wrong, since it is basically circular (since prices can’t deflate because households don’t expect them to, and households don’t expect them to because they are currently running at an x% rate of annual increase), and it does serve to highlight the care one needs to take when interpreting those dreaded (rational?) expectations models. Basically, just because you expect inflation does not mean that you are going to get it, and furthermore, expectations are dynamic and change over time. It is a question here of which is the leading indicator and which the lagging one. There is much more evidence to support the idea that strong inflation expectations may, in some circumstances, be self fulfilling and fuel future price increases, than there is to support the idea that people always and everywhere don’t get deflation because they are expecting inflation. That is, there is a certain asymmetry in the situation. During rapid economic contractions, where excess capacity tends to lead to sharp and unanticipated price reductions, it is far more plausible that expectations follow prices downwards, and this is what we suspect is happening now.

    As ever when we have this discussion of expectations the time horizon is the key issue. Ophèle is talking about 5 years horizons, and these implicitly embody a high level of uncertainty, especially in an environment like the current one. Quite simply, the key problem for the Eurozone is to keep the edifice together over the next 6 months, not to quibble over some kind of perceived steady state five years from now, and it is this much shorter time perspective which should be in the forefront of ECB thinking right now.

    Turning to the case made by Sylvester Eijffinger, a potentially far stronger argument is fielded against deflation risk in the Eurozone since he not only believes the risk of deflation is slight, he actually thinks the risk of inflation is much higher than that of deflation. Like Ophèle, Eijffinger initially points towards the structural aspects of wage rigidity, citing as authority European Union Economy and Finance Commissioner Joaquim Almunia (dangerous as an authority this one) who has also advanced the idea that nominal downward wage and price rigidity constitutes a strong line of defense against deflation. This argument, if it were valid, would seem to us to be a self defeating one, since if it is valid then the most reasonable conclusion to draw would be that the future of countries like Spain, Ireland and Greece as Eurozone members should come under an immediate question mark, since without such downward relative price corrections it is impossible to see how they can ever hope to achieve the competitiveness their economies need in order to grow again. That is the Almunia/Eijffinger argument would seem to carry with it the dangerous corrolary that were it true, it would constitution strong justification for the idea that the future of the Eurozone were in doubt. So we’d just better hope they are wrong, hadn’t we?

    Further, it sees to us to be much more plausible that downward wage rigidity may be much more an issue than downward price rigidity, which means quite simply that as prices fall unemployment simply rises and rises as the recession deepens. In other words the difficulty people have in reducing wages simply means those very same people get sent home rather than working, and the consequent drop in demand only serves accelerate deflation rather than avoid it. That it, the kind of argument being advanced by Eijffinger and others is , in a major recession like the one we have now, totally and utterly false.

    Basically, the whole problem here boils down to the tricky question of implementing a common monetary policy in the absence of a coordinated fiscal one, not to mention the absence a unified treasury “piggy bank”. In this sense and while it is straightforward to see that the Fed should buy US treasuries to conduct QE it is not entirely clear what exactly the ECB either can or should do. For one thing, it seems to be strictly forbidden according to the ECB’s own founding rules for the bank to enter the primary market to directly purchase securities (read print money) in order to finance fiscal deficits in any member country. Moreover, and if we assume that this small niggle could be dealt with; whose bonds should the ECB buy and how many from each country?

    But what if, instead of directly purchasing individual country bonds the bank were to purchase EU bonds explicitly created for the purpose, and what if the produce ofthe same of those bonds were to be deployed by the commission across the Union to fulfil pre-agreed objectives. But wouldn’t those bonds be inflationary in their consequence? Of course, we would answer, that is precisely the objective.

    Time to Add More Pages to the Playbook?

    We realize that this has been somewhat of a whopper of a blog post and if you have made it this far then congratulations, since you obviously have a good deal more stamina than most. Our argument is fairly modest in its aims, since we are absolutely clear at this point that we do not have all the answers. What we have tried to do here is simply draw an intial tentative sketch of why it is that the ECB should be considering implementing Quantitative Easing at this point, and what the bank might do, once it has taken the decision, to implement such a policy. Clearly, not everyone will be ready to agree with our initial premise that the ECB should consider QE at all. Looking at the incoming data however this move does seem to be increasingly becoming a foregone conclusion even if the ECB itself is not ready yet to entertain the idea. As such we hope that what we have to say here may contribute to a wider ongoing debate about what to do about Europe’s present economic and financial crisis, and what kind of measures and tools we have available to deal with it.

    Unfortunately, the most recent decision to cut interest rates by 50 basis points constitutes nothing more than the expected (not even surprising us with a bolder move down to 1%) and this on a day when the BoE seems to have accepted the severity of the UK situation as it bit the bullet and moved itself over to QE. We are not arguing here that the ECB should turn itself into some sort of a rubber stamping clone following blindly along a path laid down by it peers, but rather, that the ECB decision makers should reflect very carefully about the arguments which have lead others along the QE path, since quite frankly, at this point in time the ECBs “originality” is beginning to turn into a liability rather than an asset, and one really has to wonder just how much credbility the institution will have left as and when it really decides to jolt itself back into action. In particular, if it has through either inaction or negligence lead the countries placed in its charge into a hard to break negative deflation cycle, will it still have the credibility left to convince market participants that it has the ability to lead us back out of the mire, into the inflation and into the sun? Or whatever happened to the idea of asymmetric risk?

This entry was posted in A Fistful Of Euros, Economics and demography by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

22 thoughts on “Bring On The Quantitative Easing, And Bring It On Now (Wonkish)!

  1. I don’t get it.

    There is a given amount of wealth in the economy. This is the value of all things; pots and pans, houses, cars, baby food, commerical property, the national supply of bubblegum – you name it.

    There is also a given amount of currency in the economy. This is paper and coins and numbers in bank accounts, which in and of themselves are valueless, but are accepted by everyone as representing value.

    If you increase the amount of currency you do not actually increase the amount of wealth.

    Banks are currently are not lending because they don’t have enough wealth to do so – they have too many debts to worry about. Banks own a certain amount of wealth – mortgages, properties, investments, etc. Increasing the amount of currency makes absolutely no difference to the amount of wealth banks own. As such, it can have absolutely no influence whatsoever on lending.

  2. Also – with regard to inflation/deflation; I understand that creating currency leads to inflation. The value of a unit of currency is the total wealth in the economy divided by the total amount of currency, so increasing the amount of currency reduces the per unit wealth value of each unit of currency and since the face value is unchanged, this forces the currency prices of all goods and services to rise.

    But the *currency value* of goods and services is utterly, utterly meaingless. It’s the *real wealth value* of these things which matters.

    You could have real deflation – the real cost of goods and services falling – even while you have currency value inflation.

    Seeing the real wealth cost of goods and services fall is a good thing – competition causes it all the time. This is not a problem.

    Right now, currency value deflation is occuring because the amount of wealth in the economy is falling. This means each unit of currency is worth more.

    If you want to prevent currency value deflation when the amount of real wealth is falling, you need to reduce the amount of currency.

    Now, this ought to make absolutely no difference whatsoever to anything, because the amount of currency makes no difference to the amount of real wealth.

    However, it seems to me loans do not adjust their real wealth value as currency value changes occur. So although the prices of goods and services simply adjust themselves to the changes in real wealth value of a unit of currency, *loans do not*. So here, inflation and deflation act to transfer real wealth – inflation transfers wealth from the lender to the borrower, deflation acts to transfer wealth from the borrower to the lender.

    Again, though, no actual creation or destruction of real wealth has occurred.

    So all in all, I don’t get it. I can see no benefit of creating money. I can only see a harm, whereby it becomes harder to discern real price changes because inflation is putting noise into the picture.

  3. And something else – why printing money *anyway?*

    Interest rates go to zero – okay. Why not make them negative? when rates are positive, you reduce them to encourage lending by making it cheaper to borrow money.

    If you make rates negative, then you are *paying* people to borrow money, e.g. the amount they pay back is less than they borrow.

    That actually puts real wealth back into the economy, because I think the State will have to fund these rates – the private banks certainly won’t, but then again, maybe they will – I don’t understand why the State controls their rates at all anyway.

    Putting real wealth back into the economy could just as well be done by taxing less of course and then you wouldn’t have to mess around with interest rates, which are I think a bloody awful way of trying to manually control crucial economic functions.

  4. Hi Xavier,

    I think this is the problem:

    “There is a given amount of wealth in the economy.”

    There isn’t. You produce and destroy wealth. What all this is about is the level of output and employment. Inflation/deflation is a secondary issue, it is just that with deflation the level of output and employment in lower over time. Competitive devaluations via internal deflation are another thing altogether. We are talking about plain simple and old fashioned (Irving Fisher type) debt deflation here.

    Look. Suppose you are now 30, and have just spent 10 years doing super degree courses, on company internships etc and are ultra prepared and ready to go. You have 20 years of high earning potential in front of you (since after 50 you are already worth a lot less).

    Then some idiot comes and says, right you, were’re sending you home for five years while all this settles down. Then neither you, or society, ever recovers the wealth you would have created (you know, all that biotechnology you could have developed) etc etc.

    What we are fighting here is a pure and simple loss of wealth. In old fashioned terms we are talking about the level of output path, debt deflation sense us to a lower one.

    Of course, you could argue that WWII didn’t matter, since all the inventions the people who died would have made were made by others later, but personally I don’t buy this approach.

    Also, it cannot be sound policy to create an environment were it is more profitable to speculate against particular currencies or currency areas than it is to invest in building factories, providing jobs, and creating real weaalth, rather than simply moving from one persons hand to the next. That is what this whole debate is about, and that is what it was always about, even back in the time of Keynes. Big government is simply a red herring.

    “If you increase the amount of currency you do not actually increase the amount of wealth.”

    Of course not, you create inflation, monetise all that debt, and shift the wealth around from the hands of those who (right now) would only speculate with it (becuase there is nothing better to do, not because they are bad people) into the hands of those who will invest and will produce, via government as midwife and intermediary.

    Look at the difference between February car sales and employment in Spain and Germany if you don’t see this. Perhaps little new wealth was created in Germany, but a lot of people were kept in employment via their stimulus programme and a lot of people have cars at the end of the month who wouldn’t have had them otherwise. I fail to see how that can be bad.

  5. Incidentaly Krugman makes essentially the same point in the “Liquidity preference versus loanable funds” post on his NYT blog.

    There is plenty of money washing about out there, it is just that it is finding better employment at the moment trying to strip the EU apart one country at a time.

  6. Hi,

    “It’s like, they are getting ready for Red Nose Day, but the joke is on us.”

    Who is the “us” here curly wurly, those who are in work, or those who are out of it. Of course printing money might lead to inflation (we hope it does, but it may not, that is the worry). We are aiming at 2% positive inflation, we are not talking about Zimbabwe, we never were, and that sort of thing has always been an irrelevance. Angela Merkel is not Robert Mugabe, and I think it will be very hard to convince marekt participants that she is.

    We need to monetise some of that debt, or we won’t see anything resembling normal growth in a decade. This was Keynes’s key argument in “How to pay for the war”.

  7. EH wrote:
    > I wrote:

    > I think this is the problem:

    > > “There is a given amount of wealth in the economy.”

    > There isn’t. You produce and destroy wealth.

    Yes. I didn’t mean over a period of time – I meant at any one *instant*. It’s just a convenient way to assert that wealth divided by currency equals value per unit of currency. Of course, wealth is constantly changing and so as such value per unit of currency is constantly changing.

    > What all this is about is the level of output and employment. Inflation/deflation is a
    > secondary issue, it is just that with deflation the level of output and employment in lower
    > over time.

    Hang on. Nominal face value devaluation (currency worth less, face value prices rise) or real wealth value deflation (goods and services really actually cost less)?

    > Look. Suppose you are now 30, and have just spent 10 years doing super degree courses, on
    > company internships etc and are ultra prepared and ready to go. You have 20 years of high
    > earning potential in front of you (since after 50 you are already worth a lot less).

    > Then some idiot comes and says, right you, were’re sending you home for five years while
    > all this settles down. Then neither you, or society, ever recovers the wealth you would have
    > created (you know, all that biotechnology you could have developed) etc etc.

    Right. I concur.

    > What we are fighting here is a pure and simple loss of wealth.

    Yup. I concur. Real wealth is being/has been destroyed, face value deflation naturally occurs.

    > Of course, you could argue that WWII didn’t matter, since all the inventions the people
    > who died would have made were made by others later, but personally I don’t buy this
    > approach.

    Quite so. Crazy idea. The work that would have been done by the dead wasn’t done. That wealth was not generated.

    > Also, it cannot be sound policy to create an environment were it is more profitable to
    > speculate against particular currencies or currency areas than it is to invest in building
    > factories, providing jobs, and creating real weaalth, rather than simply moving from one
    > persons hand to the next.

    Meh. I think it’ll sort itself out naturally over time. The more people invest in speculating, the less is invested in producing goods and services, the less competition there is, the more profitable that will become. Eventually it becomes better to invest in factories and so on.

    > > “If you increase the amount of currency you do not actually increase the amount of
    > > wealth.”

    > Of course not, you create inflation, monetise all that debt, and shift the wealth around from
    > the hands of those who (right now) would only speculate with it (becuase there is nothing
    > better to do, not because they are bad people) into the hands of those who will invest and
    > will produce, via government as midwife and intermediary.

    Alarm bells going off at this point.

    First, this is unethical, no matter what. It is a violation of private property rights. This makes it absolutely unacceptable under any circumstances whatsoever.

    Secondly, I don’t buy it *anyway*. It seems like a stereotypical characterization as a means to justifying an end *and* it presumes we know best.

    > Look at the difference between February car sales and employment in Spain and Germany
    > if you don’t see this. Perhaps little new wealth was created in Germany, but a lot of people
    > were kept in employment via their stimulus programme and a lot of people have cars at the
    > end of the month who wouldn’t have had them otherwise. I fail to see how that can be bad.

    This assumes the analysis of events is correct.

    Furthermore, if I assume it is correct, this “good” was achieved by doing something entirely unethical – by the violation of private property rights. I could just as well shoot a few people and donate their organs to those who need an organ to live. Five people die, twenty-five live. It’s exactly the same. *We have no right to decide on the behalf of others who will give up what belongs to them for the sake of others*.

  8. Yesterday Trichet mentioned the phrase “unlimited liquidity” seven times, not once, SEVEN:

    What part of that phrase you don’t understand?

    This post is a waste of your time really, you tie yourself in knots in order to convince the ECB to do something that they have been doing since August 07: Unlimited liquidity to buy Spanish mortgages , any sort of ABS, Irish govt bonds, whatever.

  9. Blank Xavier wrote:
    “Furthermore, if I assume it is correct, this “good” was achieved by doing something entirely unethical – by the violation of private property rights. I could just as well shoot a few people and donate their organs to those who need an organ to live. Five people die, twenty-five live. It’s exactly the same. *We have no right to decide on the behalf of others who will give up what belongs to them for the sake of others*.”

    Huh?
    Part of the German stimulus package is a program that grants you Euro 2,500 if you scrap your old car (9 years or older) and buy a new one.
    http://www.dw-world.de/dw/article/0,,4070176,00.html

    In what way is that unethical or a violation of property rights? Nobody is forced to scrap his/her car.

  10. Detlef wrote:
    > Blank Xavier wrote:

    > > [snip private property rights]

    > Huh?

    Huh? 🙂

    > Part of the German stimulus package is a program that grants you Euro 2,500 if you scrap
    > your old car (9 years or older) and buy a new one.

    > In what way is that unethical or a violation of property rights? Nobody is forced to scrap
    > his/her car.

    Where does the 2,500 euro come from?

  11. “Where does the 2,500 euro come from?”

    Well it could come from issuing EU bonds, and these then being bought by the ECB. But I’m sure your not convinced.

    The thing is, individual rights are not the fundamental issue, but savers could launch a class action suit, since money is being transfered from them to debtors, all in the common good, of course.

    On the other hand, if you have no job, then you can’t save, so we just come round full circle.

    Do you have a health insurance, btw, since I am sure the same principle arises, the healthy people are violated to pay for the sick, and it doesn’t matter whether this is public or private.

    So lets put it this way, would you live in a country which made it obligatory for everyone who is working to pay health insurance, or do you think it would be more ethical for those who have paid to be treated, and those who didn’t bother to be left to bleed to death in the street. Or would that be bad taste.

    Look, Wittgenstein already had all these arguments with just about everyone. Check mate is easy here, you can do it cycling with no hands. He essentially tied Hayek up in knots five times over.

    He was able to do this simply becuase in the Tractatus he had already explored all the atomistic arguments, and “been there, done that”, as Aristotle already noticed, being human is always, already being social. There can only be private property because there is social property to contrast it with, you know, the village pond and all that.

    Forget ideology, be pragmatic, and lets get everyone back to work as soon as possible.

  12. Incidentally, just to be clear, and for future reference, I am not saying the German stimulus programme will work (in the sense of WORK), but simply it is better directed than all the public money that is being poured down the drain in Spain (you see Xavi, I am not in favour of spending money just for the sake of it),

    The reason is quite simple. The German labour market only “turned” in November, so the package was timely, and kept people in work and confidence up so people were still prepared to take the risk of buying cars. In Spain the labour market turned in July 2007, and has been headed downhill ever since. If a good intervention had been practised in Spain in, say, October 2007 (I was already pointing out the magnitude of the problem in Spain well before this, so personally I am on safe ground) then the situation might have been bad, but might not have become so rotten ripe as it is now. But Zapatero and company were busy saying there was no real problem at this point.

    Now it is impossible to get that many people to make large purchases, whatever the subsidy, since everyone is afraid for their jobs.

    The thing is, I think the situation in Germany is going to get worse, a lot worse, before it gets better, since I don’t think the economy is going to recover over the time horizon the German leaders are currently anticipating, which is basically what this post is about.

    “*and* it presumes we know best.”

    Here we go with another philosophical argument xavi 🙂

    Satre already got to the point than an omnipotent and omniscient deity was a contradiction in terms. The entity could be one thing or the other, but not both at one and the same time.

    But then, going from saying that we don’t know everything to saying we know nothing, and from saying we are not all powerful to saying we can do nothing is not legitimate. We are, as Nietzsche put it “humam all too human”, but we are human (still, and at the moment, anyway).

    “This assumes the analysis of events is correct.”

    You bet. Economics is an empirical science, even if I have to use a tautological argument – that only those who don’t understand it claim the contrary – to justify my suggestion. When you go to the dealer and by one of those subsidised cars and turn the key you do expect the engine to work don’t you, you aren’t worried that it won’t. So why the lack of confidence in the technicians here?

    I know, don’t answer that :).

  13. Edward is right with both statements about Germany.

    People here in Germany know (in their brain) that the economic outlook is bad and that the situation will get a lot worse.
    On the other hand their personal situation (on average) right now probably “feels” better than in years.

    Wages finally increased significantly in 2008.
    After stagnating since around 2000/2001. Coupled with lower gas prices that means people have more available income for the first time in several years. Some gets saved and some gets spent. Which might explain why retail sales stayed stagnant rather than fall. And it might explain why Germans actually used that car bonus to buy new cars. The money is there and that “gift” bonus finally was irresistible.

    Also, unemployment year over year in February 2009 was still lower than in February 2008. Helped by the government “short-time worker assistance”. If you have to work short-time you´ll get a government compensation to partly close the financial gap.
    That helps a bit to avoid job cuts now and helps a bit with domestic spending.
    Extending this program, by the way, is also part of the stimulus package.

    But I also agree with Edward that the situation will get a lot worse. And that it will last longer than the German government is currently officially expecting.

  14. But back to the topic of QE.

    Edward, I think the crux of the matter in your proposal is “the produce of the same of those bonds were to be deployed by the commission across the Union to fulfill pre-agreed objectives.”

    Which is actually my first concern with your proposal. As in, the “newly-printed” money from the EU bonds might be used for some bail-out, banks or countries. And will subsequently vanish into bank vaults. Never to be seen again 🙂 because banks are now hoarding money.

    Say, we help Eastern Europe with that “extra” money. Don´t you think that some / a lot of that money will or must be used to repay maturing loans? And I don´t think the Austrian, Italian or whatsoever banks will loan that money out again? And if that money doesn´t stay in circulation…

    And my second concern.
    If that money is used for some stimulus package, doesn´t that allow member states to borrow less money? As in, they use EU money where before they would have used national money for a stimulus package?

    I guess my question is how easy or hard is it to actually enlarge the money supply if the banks aren´t functioning?

    As an aside here is a Krugman post.
    (Assuming HTML code works.)

    Quote:
    “You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills — the two sides of the Fed’s balance sheet — become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent.”

    If I understand him right (and I´m not sure here) he seems to be saying that at close to zero interest rates quantitative easing doesn´t work?

  15. Detlef wrote:

    > People here in Germany know (in their brain) that the economic outlook is bad and that the
    > situation will get a lot worse.

    > On the other hand their personal situation (on average) right now probably “feels” better
    > than in years.

    Question : how did Germany end up in the state in the first place? rigid labour market, etc, no? too much Government regulation? basically, unethical and uneconomic behaviour. Which to some extent has been addressed, but now we have more on the way with this stimulus bill.

    > Wages finally increased significantly in 2008.

    > After stagnating since around 2000/2001. Coupled with lower gas prices that means people
    > have more available income for the first time in several years. Some gets saved and some
    > gets spent. Which might explain why retail sales stayed stagnant rather than fall. And it
    > might explain why Germans actually used that car bonus to buy new cars. The money is
    > there and that “gift” bonus finally was irresistible.

    My view in this is that trying to scrute the inscrutible is the profoundly unwise and doomed to failure.

    The economy, in its detail, is beyond human comprehension. It is orders of magnitude too complex even in its original form and then made massively, unpredictably, bizzarely perverse by the pervasive cancer of State regulation.

    Because of this whenever you try to manipulate the economy, it always fails. Even if you manage to have some effect in your intended direction – which is frankly improbable – you will certainly have unintended consequences of a far greater magnitude.

    Where I wear my Adam Smith tie and see the world in that way, the only game in town for me is to abide by sound macro-economic principles (which inherently implies ethically, where all contracts are voluntary and well-informed), because I *know* they work, and let the rest take care of itself – because it is impossible for humans to care of it.

    I believe in individual freedom as an economic policy.

    Current Governments do not.

    > Also, unemployment year over year in February 2009 was still lower than in February 2008.
    > Helped by the government “short-time worker assistance”. If you have to work short-time
    > you´ll get a government compensation to partly close the financial gap.

    Was it helped? Maybe companies were doing that anyway. Employement depends on the amount of capital in the economy and companies use that money in the best way they can to generate more capital. The Government has taken that capital from these companies, who earned it and to whom it properly belongs and who could have done with it as they please, and as such has reduced employment. The Government then spends it, giving it to people who are now working part-time.

    Great. What about those people who don’t *have* a job any more, because of this tax?

    What about the fact this money *belonged to someone else?*

    > That helps a bit to avoid job cuts now and helps a bit with domestic spending.

    No. It increased job cuts, but gave more money to those who are working short-time.

    Also, I’ll just go shoot a few people and share out their organs.

    > Extending this program, by the way, is also part of the stimulus package.

    As you can imagine, for me, this is bad news. More job losses.

  16. Question : how did Germany end up in the state in the first place? rigid labour market, etc, no? too much Government regulation? basically, unethical and uneconomic behaviour.

    Er, no. Germany is the world’s biggest exporter; your argument is the classic The Economist one of wearing a Swiss watch and a (German) Hugo Boss suit, driving a BMW to the airport to catch an Airbus with one eye on your Nokia mobile phone (with its Infineon RF chip and Balda AG touchscreen, talking to a Nokia-Siemens Networks base station), using electricity generated by a Siemens turbine to bother the Germans about their supposed inefficiency.

    Further, Germany spent the 2000s having a fairly tough wage squeeze in order to boost export competitiveness. It had both a trade and a budget surplus as recently as 2007. Germany’s problems now are driven by the fact that world trade is in the crapper, and if your economy is specialised in global industrial exports, you’re operationally geared to world trade.

  17. “If I understand him (Krugman) right (and I´m not sure here) he seems to be saying that at close to zero interest rates quantitative easing doesn´t work?”

    Krugman clears this up in his quick response to Scott Sumner.

    “My view, which I thought was pretty clear, is that the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another. If the Fed could credibly commit to inflation at rates higher than the 2-ish percent target it’s already believed to have, that would be effective. But right now I don’t see that as a realistic option, hence the emphasis on fiscal policy and bank recapitalization.”

  18. Hi,

    “If I understand him right (and I´m not sure here) he seems to be saying that at close to zero interest rates quantitative easing doesn´t work?”

    Well this is a very complex problem. I think familybusiness brings out some of the question. Basically, the evidence from Japan is that quantitative didn’t have a very substantial effect on the price level, although it did stabilise the situation. But this was in part because they focused on maintaining the quantity of liquidity in the bank balances with the BoJ. In fact the ECB has been practicing this kind of operation, especially after last September.

    We need to think it terms of two stages here – bashing the credit crunch and changing price expectations. Expanding the balance sheet can do quite a lot in the mid term to ease a credit crunch, but it can’t change patterns of consumer behaviour once negative price expectations set in. To do that you need to convince people that you are really serious about fuelling up inflation.

    Then you need to print money and buy government bonds to finance fiscal spending in sufficient quantity that everyone starts to worry that inflation is coming. This is known as “committing to being irresponsible” This is what Kugman seems to think isn’t practical at the moment. I would be interested in why he thinks it isn’t practical. I had an exchange of opinion with him last time round, since I was taking the somewhat obtuse view that GWB might have been a more effective person at convincing people that he was going to be irresponsible that (say) Obama would be now. Unsurprisingly K didn’t seem to see the funny side of that at the time.

  19. “Those Unconventional Tools Again”

    Well extraordinary measures must be taken indeed, not only by the ECB, but also by governments. In this perspective I support the idea proposed by Kees de Kort, to force bondholders from banks that are in deep trouble, to exchange their bonds for shares. And only if there is no other way, to support those banks with tax money.
    I shall explain. Lets look at the current situation with relation to the positions of the bank’s shareholders and bondholders, and the taxpayers. When there is a threat that a bank goes bankrupt, the owners of this bank (the shareholders) are taking a great loss because their shares will lose a lot of their value. The one’s who were taking the risk of lending money to this bank (the bondholders) are nowadays fully protected by the money of the taxpayers. The taxpayers who have no responsibility for this bank’s bad financial position, have to pay for the bailout. There is something amoral about this situation. Why should people who have wilfully decided to loan this bank money (the bondholders) be fully protected for the risk the have taken, with the taxpayer money? The taxpayers have not taken this risk, but nevertheless the are forced to pay for it.
    Now lets look to the situation when under a threat of bankruptcy, the government forces the bondholders to exchange their bonds for shares. In this situation, the Bank will get rid of a lot of debts (the bond loans), and those debts will be replaced with a increase of property (the shares). With this new much better balance account, this bank probably will be financial healthy enough to survive without much tax money. Due to this much better financial position the financial-market will have more trust in this banks future, and the value of the shares will increase. This will be of course good news for the shareholders and the former bondholders. Also, everybody happy.
    Ron.

  20. Hello Ron,

    I appreciate your frustration, and I read you suggestion with interest. Can I own up to something here, I haven’t a clue what will work, and worse, I haven’t the time to go into all the arguments – since they truly are myriad.

    I am not saying that this is all not very important, just that it is beyond my expertise, and at the end of the day I think we all need to recognise our limitations.

    I am focused on some of the macro economic implications of the financial crisis (like deflation) and what we can do about them, hence this post. What to do about the banks? I wish I knew. I just hope that amid all the arguing that is currently going on someone will come up with something that will work, and they can finally restore some sort of order to the whole system, since we badly need it.

    Meantime, people are being sent home one (or ten) at a time, and asked to wait and twiddle their thumbs.

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