ECB: Plus ?a Change?

The ECB met earlier today to conduct the monthly review of interest rate policy. It came as a surprise to noone that the outcome was to leave everything just as it is. Surprisingly though the decision this month is surrounded by a little more controversy than has been the case of late since Italy’s Berlusconi and economic opinion in Germany have been suggesting that some reduction of rates might be no bad thing, whilst Spain’s economy minister (and former EU commisioner) Pedro Solbes is reported to have been pushing for an increase. Why the difference?

Well I think there are a number of good reasons why interest rate policy might be viewed differently depending on where you are sitting, but before going into any of these I could alert the economy freaks (and possibly also the masochists) among you the the ‘grey men’ of the ECB are actually going live with a video image webcast at 2:30 this afternoon where you can hear and see the statement read out and then follow the accompanying press conference.

(Short parenthesis, and following my post yesterday, it is immediately apparent to me that this ‘webcast development’ has a very interesting potential application in economics teaching).

Now for the nitty gritty.

The euro as a common currency has three known and clear problems: it is contingent on the evolution of a growing political union for its long term operability, it assumes that it is possible to evolve a single monetary policy for a diversity of economies, and it suffers from the difficulty of the well-known ‘free rider’ problem when it comes to fiscal policy and indebtedness.

I have drawn attention to the first of these – the political union dimension – in a post on the possible consequences of a (now apparently less likely but still possible) French ‘no’ to the constitution. Also Peter at EuroPolyphony linked earlier in the week to an FT editorial which gives a basic rundown on the issues, so I won’t comment further here.

The second question, the ‘one ring to fit them all’ interest rate quandry is no less problematic. Basically the problem relates to possible differences between the inflation rate and the interest rate in each of the member countries. Essentially under ‘normal’ conditions a central banker would probably consider it desireable to maintain interest some 2 or 3 percentage points above the rate of inflation.

Such a setting would normally be considered ‘neutral’ since it neither tended to inflate nor deflate the economy. This then opens an arm of monetary policy for a central bank which can either raise the rate in order to reduce inflationary pressure or reduce it to ease oncoming recession.

Thus the US Fed (which is steadily and systematically raising rates incrementally) is being actively scrutinised for signs of anti-inflation tightening, whilst Japan (which has been suffering from some sort of deflation for the best part of a decade) maintains rates close to zero in a to date unsuccessful campaign to *provoke* inflation.

The US Fed policy at present is a kind of long march to achieve this ‘normalisation’ of rates precisely in order to restore some strength to monetary policy. But the weaknesses in the global economy following the bursting of the internet inspired assett bubble have made this an extremely difficult thing to do.

The ECB finds itself in a somewhat similar situation, with one important added difficulty: the inflation rate across the euroland member states in not uniform, and consequently what is known as the real interest rate (which is the difference between the central bank interest rate and the inflation rate) varies across the zone.

Germany and Italy would currently tend to favour a reduction since their economies are stagnating and inflation is relatively low, which means they have a positive real rate where a negative real rate might be indicated. Spain is at the other end of the scale, with an inflation rate of around 3.5% they have a minus 1.5% real rate and this is driving a mini boom based on a huge expansion in consumer indebtedness and a long property boom.

The clearest case of where the application of a single uniform rate would be extraordinarily unsound is that of the UK where the BoE currently has rates up at 4.75% precisely to try and reign in some of the problems which currently beset Spain. (This, of course, is precisely the reason that the UK is not in the euro).

Originally I suspect it was hoped that this problem would reduce in importance as euroland economies converged. Currently there is little evidence of this happening and my own feeling is that the problem will grow worse as the ineffectiveness of monetary policy only serves to make the imbalances worse.

Finally, a brief comment on the ‘free rider’ problem. Essentially membership of the eurozone has lead to a significant reduction in interest rates in those member states with living standards below the EU average. Initially this was considered to be one of the advantages of the euro, but inititially there was also a fairly strong and rigourous growth and stability pact in place.

This pact has now been significantly loosened and it remains to be seen how (if at all) the new version of the pact will be applied. It is in this context that the ‘free rider’ issue comes to the fore. Conventional economic theory has it that any government which allows itself to systematically run up debt will later have to resolve this problem by fuelling inflation to burn down the value of the debt (whilst simultaneously allowing the currency to fall), either it does this or it will face a growing finance problem as debt servicing (fuelled by higher interest rates) eats into current spending.

Now in the case of a currency union some of this no longer applies: weaker countries can continue to accrue debt almost without any financial constraint. This is what has been happening in some cases. The downside on this comes when there is some weakening in the guarantees and the financial markets start to sense this. Hence the jitters about the constitution votes.

Obviously the ‘free rider’ problem is a complex one. Two good background papers spell out in more detail some of the issues. The first from Marty Feldstein is a completely non-technical review from a long standing critic of the very idea of monetary union. The other from Barry Eichengreen is rather more technical (though it is possible simply to jump past the denser sections) and comes from an economist who is in general pro-euro.

18 thoughts on “ECB: Plus ?a Change?

  1. The free rider problem also raises the question of what level of analysis is the proper one and, accordingly, how the markets view the different debt issuers.

    That is, should we look at individual national economies? Or should we look at euroland as a whole?

    In the context of another reasonably successful monetary union, is it really important that, say, Wyoming is a free rider on the California economy? Does the Fed worry that a fed-funds rate that would be high enough to prick a housing bubble in California might choke off growth in Ohio? As some level (and I’m not a regular enough reader of the Beige Books to have a view on this) it probably does worry, but it is charged with its tasks relating to the overall dollarland economy. The politicians at the state level have to deal with it. Similarly, the ECB worries about the eurozone as a whole. This problem was still there when interest rates were set at the national level; what was right for Bavaria and Baden-Wuerttemberg probably was not right for Thueringen and Mecklenburg-Vorpommern. (For the rest of the now-eurozone states, the situation was actually worse, as their interest rates were set in Frankfurt anyway, just without any non-German input.)

    The free rider problem has additional complexity if all members are treated as equals, rather than weighted in some sense for the size of their economies. If Malta were a eurozone country, the amount of debt it could run up would probably be trivial. The problem arises when it is the large economies that are running up the debt. Italy is the largest problem, with Germany and France not too terribly far behind.

    Plus ?a la meme chose.

  2. “is it really important that, say, Wyoming is a free rider on the California economy?”….”the ECB worries about the eurozone as a whole.”

    I think the basic thing here Doug is that the US is an independent nation state, albeit a federal one (so the comparison could be made with eg Germany) whilst the eurozone is a monetary union of separate nation states. I mean what evidence is there of the business cycle in various US states being seriously out of phase, there’s plenty of evidence for that in euroland?

    The same kind of things apply to the consitution debate, very often we can’t usefully compare the two entities, and we mislead ourselves more than we help ourselves by carrying any comparisons too far.

    Indeed maybe many were convinced that monetary union had to work in Europe since it did in the US. This may have been the first mistake, they should have thought about what was always going to be different.

  3. Now I think about all this a bit more I want to tighten up something I am saying in the post.

    Classically it has been suggested that the problem with ‘one ring that fits them all’ is that each state loses its own independent monetary policy instrument.

    I want to go farther than that, I want to suggest that the whole zone as an entity is adrift without the capacity to arm itself with an effective monetary policy, simply because the idea of cutting the collective interest rate off an abstract average harmonised rate does just that, leave the whole entity adrift without a powerful monetary policy instrument.

    I am not a monetarist, so I don’t believe the control of broad monetary aggregates has anything like the impact that some claim for it. I do believe interest rate policy is important, and it’s a shame we can’t have an effective one.

  4. The politicians at the state level have to deal with it. Similarly, the ECB worries about the eurozone as a whole.

    The problem with that statement is that the politicans at the state level may analyze the situation and come to the conclusion that they’d be better off with their own currency.
    If I understand the economics involved correctly, there’s a level of differences in desirable interest rates at which changing money in international transactions is cheaper than having a bad interest rate.

  5. “at which changing money in international transactions is cheaper than having a bad interest rate.”

    Absolutely, that’s the only really important trade-off. Remember the recent accession countries are managing to attract significant investment, and they aren’t in (yet).

    Also of course there’s an ongoing cost. Imagine that in year ‘one’ the slightly inappropriate interest rate moves a national economy (in an idealised theoretical sense) off it’s ‘optimum’ growth path.

    Then in year ‘two’, another inappropriate rate may be applied to an economy which is already performing ‘inefficiently’ etc. Then of course in year ‘x’ you may have something of a big problem, and with no inbuilt correction mechanism I can see.

  6. Incidentally Doug I’m trying to get away from the whole US/EU way of looking at things, but if you insist………

    Feldstein does have some important arguments in the arsenal:

    “There is also a greater need in Europe than in the United States to use discretionary fiscal policy to respond to an economic downturn in a ?local? area ? i.e., in a European country or an American state. This reflects both fundamental labor market differences between Europe and the US and differences between the two fiscal systems. By fundamental labor market differences I mean the much greater geographic mobility and wage flexibility in the US than in Europe. A sharp decline in demand for the products of Massachusetts, my own state, some years ago led to a relative decline in the Massachusetts labor force (more out-migration and less in-migration) and to a decline in the relative wage of Massachusetts workers. The European labor force is much less mobile (because of differences in language and culture and a general reluctance to move even within countries) and wages are much less flexible.”

    “The contrast between the centralized fiscal system in the United States and the decentralized fiscal system in Europe is also very important in this context. A decline of economic activity in a single US state automatically causes a substantial decline in the flow of taxes to Washington from residents and businesses in that state and an increase in transfer payments from Washington. The magnitude is roughly equal to 40 percent of the local decline in GDP. This net fiscal swing constitutes a significant external fiscal stimulus to the local economy. In contrast, with the decentralized European fiscal system, a fall of GDP in any country causes a contraction in tax revenue in that country but very little net transfer from outside.”

    Nothing particularly new in either of these arguments, but that doesn’t make them any less important.

  7. Good post Edward. Very nice round up. I had coincidentally read Feldstein’s paper over the weekend. Very good assessment in my opinion.

  8. Edward,

    The Euro is undoubtedly on the verge of going through a very rocky patch if some of the investment baks are to be believed. Currency union without the political structure in place to back it up is always going to be risky.

    There is some good comment on the ?uro, Euroland, and the ECB at the following:

    Eric Chaney – Stag-disinflation – 2 May

    Joachim Fels ? Buy treasuries, sell bunds, wear diamonds ? 29 April

    Joachim Fels Euro at risk? ? 19 April

    Not to go overboard on Morgan Stanley, there is also some good comment from Norbert Walter and his crew at Deutsche Bank Research about the loosening, or should that be trashing!?, of the Growth & Stability Pact.

    As for accession states trying to qualify for membership of EMU I think it is madness at this stage. Not because the ?uro has some inherent risks, but because to meet the criteria of ERM2 on inflation, budget deficits etc. they will almost certainly have to go for austerity programmes which will not be popular.

  9. Yes Peter, I’d noted already from your blog that you were a keen MS GEF reader :).

    “on the verge of going through a very rocky patch”.

    This is hard to say at present. Remember the euro is high at the moment precisely because the dollar is weak. Since at the Federal Reserve they are unlikely to do anything to unduly strengthen the dollar (this is another issue) this seems to put a short term ‘cap’ on the upward movement of interest rates there.

    The Japanese – struggling away with deflation – would undoubtedly fiercely resist any strong rise in the yen, and the Chinese yuan, as I have been suggesting, just isn’t strong enough to plug the gap.

    So in the short term at least the euro is likely to remain strong by default.Of course all this is playing with fire, since the situation is far from stable.On the SGP I don’t know whether it’s ‘loosening’, ‘trashing’, or simply de-facto abandonment. We’ll have to wait and see, but my feeling is its a gonner.

    Listening to Trichet’s webcast yesterday was a rather depressing affair. I hadn’t really twigged how attached he still is to the old mantra of ‘providing a firm anchor for inflation expectations’. Of course inflation needs to be kept under control, but this shouldn’t become an obsession which blinds you to changing realities.

    The euro zone generally is in a strong cycle of disinflation. That this should be the case after what is probably the strongest year of global growth ever recorded is rather alarming. At some point global growth will slacken and then disinflation could become, in some cases, outright deflation: Germany would be the prime candidate here. This also seems to be Eric Chaney’s view in the piece you link to:

    “With real interest rates already at zero and fiscal policies more or less frozen, reflation is unlikely to come from policy makers. On the other hand, wage moderation has turned into wage deflation in several regions, starting with Germany, where this is a necessary but extremely painful adjustment. The conclusion: Europe is doomed to remain in this stag-disinflation world for a long period of time, the risk being that disinflation could turn into outright deflation if the risk scenario I alluded to earlier became a reality.”

    When Chaney refers to real rates at zero he is talking about a comparison between the *average* harmonised rate and the 2% ECB funds rate. I’ve already indicated my opinion of this specific comparison, but I agree with Chaney’s main point.

    On the euro and the accession states I am working on a post right now :).

  10. There’s actually a good case for having a decentralised fiscal structure with a single monetary policy – in the US, as mentioned upthread, a state feeling the effects of an asymmetric shock receives fiscal transfers from the federal government fairly automatically.

    But a similar, if not better, solution would be to devolve fiscal control. This is roughly the ?-solution, with the important proviso that there are only minor transfers from/to the centre and also that significant restrictions are placed on the member-states’ discretion.

    Now, consider the following: the ECB has its inflation target as a guarantee to the markets, but the Stability and No Growth Pact goes. Instead all members are required to maintain a balanced budget over the economic cycle. If Ireland (say) is booming and testing the inflation target, it can apply the fiscal brakes – if state X is recessing, it can Keynes away.

    Alternatively you could perhaps have a pan-European budget target; deficits in one to be balanced by surpluses elsewhere. But this would be problematic in the event of a continent-wide recession (or boom), and would be politically difficult as the surplus state would no doubt be infuriated at effectively subsidising the deficit state.

  11. Alex, your suggestion would undoubtedly be fine in the best of all possible worlds, in which all the different components of the euro zone were more or less homogeneous. But this is obviously not what we are dealing with.

    It is also, btw, the more or less pragmatic conclusion of Eichengreen in the linked paper.

    My opinion however differs from this. In a modern nation state – US, France, Germany eg – there are a series of policies which operate to guarantee what is called ‘territorial integrity’. Roughly speaking this normal means less populated areas have per capita more political clout, and that richer areas subsidise poorer ones in the name of ‘national solidarity’.

    In principle this is fine, but there are limits to how far this can go. I think I am right in saying that the German constitution places limits on redistribution between the various Lander (please correct me someone if I am wrong here).

    In Spain at the present time there is a furious row going on about this since Catalunya – one of the richer regions – pays a disproportionate price, and is finding that its growth capacity is falling behind other regions (which are benefiting from the transfers) in part due to the fiscal burden.

    Now my point here is that if these problems require a *delicate* balancing act within any given nation state, how much more difficult would this be to apply across states, especially were there is no inbuilt correction pressure on the net-recipient (the free rider problem).

    Just imagine the row there would be in the UK if it were to join the euro and then find that as a high growth country it was to be required to fund a growing deficit in relatively low growth Greece and Italy.

    Of course it is intelligent to have a general policy to assist the relatively poorer EU economies catch up with the relatively richer ones: but the structural funds already exist to do this, and the objective here is different.

    “Instead all members are required to maintain a balanced budget over the economic cycle.”

    This is actually the current obligation, but as we can see it isn’t working out. As I keep flagging last year was a record global growth year, that may be the best it’s going to get. We may now be near the top of the cycle, and most euroland economies (and of course the US, the UK and Japan) are heavily in deficit. So what exactly is going to happen when we enter the bad times?

    The central problem for several euro zone economies is that the trend growth line my have sunk so low that it is virtually impossible to distinguish boom from recession.

  12. Just a couple of points, as I’m not sure that we disagree all that fundamentally.

    First, from Mitterrand’s endorsement of the franc fort policy forward, monetary policy for what will become euroland is effectively made in Frankfurt. The Bundesbank sets its rate, and very shortly after, the other central banks follow it up, down or sideways. (The Bank of England is the exception, as it is today.) At that point, the other states have the market risk of a nominally independent monetary policy, i.e., the markets are not 100% certain they will follow Frankfurt and thus charge a bit more. But the other states have very little practical benefit in practice, as they cannot move separately from Frankfurt without paying even higher risk premiums.

    That might be different today, though I’d be hard pressed to think the markets would price French or Italian debt lower than German debt, despite all of Germany’s problems.

    Compared with following Frankfurt with no voice in policy and continuing to pay a risk premium, the maintenance of the eurozone is almost by definition a good deal for all of the non-German members.

    My argument here is analogous to my argument with the folks who say an orderly delay would have been better in 98-99. Maybe, but the situation in the market was such that you could have had either order or delay, but not both. Here, euroland without the euro would still have interest rates set in Frankfurt but without any of the positive offsetting effects discussed above. They may be smaller than the transfers in the US, but they are more explicit than they would be without the euro.

    On another track, growth really does seem to be the problem in some large euroland economies. If I knew for sure what was keeping down German growth, I’d be raking it in as a consultant, or lobbying like hell in Berlin. For example, I talk to a reasonably large number of entrepreneurs in biotech, and I have almost never had someone tell me the much-maligned labor laws are a significant problem. And I ask quite explicitly on a regular basis. I dunno.

  13. The EU structural funds and cohesion fund together account for about only 0,4 % of EU GDP.

    This is not a big transfer in global terms, though as its distribution is weighted towards poorer regions (structural funds) and States (cohesion fund) it can be significant to them in terms of % of their local GDP. (The new member states for example, will get roughly 4% of GDP in transfers).

    But – in a nutshell – it is hardly on the scale of transfers within member states, where the automatic stabilisers of unemployment benefits, regional policies and the like, are much more significant.

    I fully agree that it is just not reasonable (or desirable) to envisage much bigger transfers at the EU level. This would be a political nightmare. The squabbling is bad enough as it is.

    But how big a constraint is the loss of a national monetary policy? This is where the pro-euro argument can be refined: There are two points related sometimes made:

    1. If a member state is regionally diverse then a national monetary policy does not necessarily help much as shocks will tend to have regional, not country sized effects, and a national monetary problem does not get round this. So the empirical issue is: how much more homogenous are member states than the euro zone as a whole?

    2. If the real problem is one of slow and fast growing regions rather than fast and slow growing member states, then tranfers within member states may be an adequate adjustment mechanism, so the lack of an EU wide instrument may not be a real problem.

    Although I see the point in these arguments, I am sceptical, and tend to buy into your concerns about the problems the euro zone faces.

  14. oops – I meant national monetary “policy” , not “problem”, of course !

  15. Cohesion and structure fonds are based on GDP numbers. The relation to growth is long term only. You might argue that in terms of growth at present they make matters worse.
    The US, if we stay with the example, has a national income tax, which instantely will react to unemployment and wages.

  16. yes – income taxes and benefits are much more important as stabilisers – no quibble. A the pro-euro camp might point though to the argument that shocks are regional, not national, and so stabilisers acting within member states are adequate

  17. “yes – income taxes and benefits are much more important as stabilisers – no quibble”.

    I think we all agree on this, the question is that in the nation state the tax benefits from the faster growing regions are distributed to those who grow more slowly. But again I think we are all agreed that tax revenue going to Brussels and then being shared out would be a political ‘no-no’.

    Here in Spain Catalonia wants the right to raise the revenue and then pass an agreed portion of it on, and you should see the row that this is causing.

    “I’d be hard pressed to think the markets would price French or Italian debt lower than German debt, despite all of Germany’s problems.”

    This is the whole point, this would be the automatic stabiliser: those countries would have to pay more for their debt so there would be less temptation to get into systematic debt. Lets be clear here: we are not talking about cyclical fluctuations, we are talking about a long term tendency to endebtment. As I am flagging, for some of the countries running high deficits we are as near to an economic boom as we are going to be in the foreseeable future.

    “Compared with following Frankfurt with no voice in policy and continuing to pay a risk premium, the maintenance of the eurozone is almost by definition a good deal for all of the non-German members.”

    OK this is certainly true, so we could add it to Oliver’s earlier point, which was:

    “there’s a level of differences in desirable interest rates at which changing money in international transactions is cheaper than having a bad interest rate.”

    Oliver II, courtesy of Doug, could be the idea that you can offset the disadvantage of losing your monetary policy with the fact that you can get yourselves into debt very cheaply. (Incidentally this has also happened to individual Spanish consumers, but that’s coming in another post).

    The point is that the plus signs on both these values – savings in currency transaction costs, and interest savings on debt – could be fairly small compared with the loss of GDP produced by being away from your optimum output operating level. And remember, as I tried to indicate this is a kind of ‘compound interest’ problem as the years go by.

    I don’t think it can be long before someone does a modeling exercise (maybe they already have, let me know if you see one) comparing achieved GDP with the GDP which would have been accumulated by running a national monetary policy with (say) a 2% inflation target. My guess the resulting difference would be big and important.

    “I talk to a reasonably large number of entrepreneurs in biotech”

    It’s just a guess, but I can imagine a reason for this. Biotech start-ups contract labour. Most of the reforms are directed to those who want to shed labour, and want to do it more cheaply. It’s about time scales. Shedding labour has a high initial cost. Maintaining the person in employment is cheaper in the short run, but may be grossly inefficient over time.

  18. yes -the point on the loss of market discipline is really key – this is why the Commission is still struggling to keep some credibility in the excessive deficit process, despite the changed terms of the stability pact. But I’m not at all optimistic. The pact seems totally bust.

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