The continued embarrassment that is European monetary policy … economists?

In the summer 2008, when concerns were growing that a weaker economy was approaching, the ECB raised its rates – a step that had to be reversed pretty quickly as we know. Quite embarrassing.

And what happened this time? Another commodity boom “tricked” the ECB into raising rates at the worst possible time, even though there were no signs of a pass-through of the currently higher headline inflation to core inflation, and thus, to medium term headline inflation. Now, this step will probably be reversed quickly, too. Why? Because even Germany might be heading for a recession.

As Henry Kaspar has pointed out repeatedly on my (other) blog, I shouldn’t criticise the ECB for following its mandate. Even though we all know that the ECB broke its own rules in the past when there was a need to do so, there certainly is some truth to that. (Update: Karl Whelan points out in an email that the mandate of the ECB is “price stability”, so the ECB might actually have more discretion than is commonly assumed). So let me instead address those European economists that keep missing that monetary policy is a huge part of the problem, and potentially a big part of a shorter and longer term fix for the Eurozone.

First of all, what is monetary policy supposed to accomplish? Very broadly speaking: macroeconomic stability. An important aspect is to keep aggregate demand (AD) on a stable and predictable path. The reason is simple: prices and wages don’t adjust quickly enough to accommodate nominal changes that are caused by changes in the demand for the medium of exchange (aka money). So better keep the nominal values on a predictable and stable path, so that there is no need for across-the-board adjustments.

Usually, an inflation-based approach is sufficient, and it has stabilized inflation throughout a large part of the world, which is historically a big achievement. Whether it has contributed to the build-up of the current crisis is still an open question. In times of a severe crisis, however, this approach has clearly proved inadequate, as the focus on inflation has allowed AD to plummet 10% (!) below trend:

Such a drop in AD would be devastating for any economy, not only a currency union. It is time to realize that the policy of the ECB has been extremely tight since 2008, measured by the concept of macroeconomic stability and is therefore an important cause of the current mess.

Second, countries in a currency union experience asynchronous business cycles. This is a problem because monetary policy cannot be tailored to all different cycles. So even though there is some differentiation that the central bank can impose, a large part of the adjustment has to come through changes in prices and wages – a painful process as Germany learned during the first decade of the Euro. And as for anything else that is painful, there is one rule: get it over with quickly.

How can you overcome nominal rigidities quickly? Wages rarely decline nominally (see this Krugman post for some nice graphs), which means there is a(nother) zero lower bound. When some countries need to adjust wages and prices downwards, it is best to be further away from this threshold. The reason is simple: if the best you can do is to keep wages constant, the higher the general price increase, the more the decline in real wages. A higher nominal growth during normal times increases your room for manoeuvre during adjustment periods.

The essence of this: choose a higher inflation, or even better, nominal spending target the more diverse (read: suboptimal) your currency union is. For the Euro area, an inflation target of below 2% is inadequate. This seems so painstakingly obvious, and yet you will have a hard time finding European, let alone German!, economists who share this view – even though the evidence from the Gold standard era supports this argument, too.

Finally, economic historians like Kenneth Rogoff point out that we are currently in a situation of high debt and over-leverage that happens only rarely. When it does, the decline and adjustment usually takes many years – unless the central bank takes decisive action to prevent a severe drop in AD. This may entail temporarily higher inflation, as a period of deleveraging may hurt growth. But it is worth it, as Kenneth writes:

[In 2008] I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Of course, inflation is an unfair and arbitrary transfer of income from savers to debtors. But, at the end of the day, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning. … Some observers regard any suggestion of even modestly elevated inflation as a form of heresy. But Great Contractions, as opposed to recessions, are very infrequent events, occurring perhaps once every 70 or 80 years. These are times when central banks need to spend some of the credibility that they accumulate in normal times.

Higher nominal spending growth (or inflation) is therefore an important building block to solve the current, short term European crisis – even if you disagree with my argument above that monetary policy since 2008 is one of the major culprits for leading us into this mess. The ECB’s achievement to keep inflation at 2% is a Pyrrhic victory, as Ryan Avent ironically describes:

If the euro zone does fall apart, a fitting epitaph might read, “The ECB feared 3% inflation”.

I sincerely do hope that I read the wrong newspapers and missed all those European economists and commentators screaming all these things (or even better: that I am wrong). But whenever I try to hear something, there is just silence – or Axel Weber lashing out at Olivier Blanchard. Meanwhile, European policy makers and central bankers are wrecking one of the most fascinating projects in human history, the unity and friendship among the countries of Europe. This is beyond depressing. Way beyond.

Germany is not turning on itself

I’ve recently read some interesting but somewhat shocking article, recommended by FT alphaville, in The Globe and Mail (Canada): “Germany’s season of angst: why a prosperous nation is turning on itself”. Fortunately, the author Doug Saunders is wrong.

Describing Germany’s booming economy, he writes:

These are, by several measures, the most successful people in the world. Yet it is very hard to find anyone here who is happy about this state of affairs.

And from my personal anecdotal evidence, he is right. When I talk to my fellow Germans about the economic situation, I have the same impression. But why is that? Doug’s interpretation, that Germany is afraid of change, involvement with the outside world, immigration or technological progress may be fitting with an earlier image of Germany. But I find other explanation much more plausible.

For starters, Germans fear the consequences of the Euro crisis in part because some politicians, academics and the media deliberately nurture fear. From “defending the Euro” to Prof Sinn’s exaggerated Target-2 arguments, from claims of high inflation to a Lehman-moment, the Germans are being told that the economic risks for them are huge and imminent, which is only partly correct (if at all). Interesting enough, the political risks – that the German taxpayers will become the major creditors of the periphery thanks to fear-induced bailouts (money and friendship…) – is discussed much less often.

But more importantly, Germans have lived through 15 years (!) of near-stagnation or mind-bogglingly high unemployment or both. That shapes your expectations in two important ways.

First, Germany knows how difficult it is to integrate and reform an economically (much more) devastated country of roughly the size of Greece. In fact, they have just been through it. So not only are they jolly well fed up with paying for something like that: after cumulated net public transfers of €1400bn (it’s not a typo), there are still €6bn in net transfers going to Eastern Germany. Per month. (The brain drain from former Eastern Germany was heavy, so how much “Western” Germany really payed is debatable.) At the same time, many Germans feel obliged to help European friends according to a recent poll:

A new survey finds that 60 percent of Germans believe their country has to help Greece in the eurozone debt crisis — like it or not.

Anyone caught in this tension will stray to extremes at times (like the person that Doug interviewed). The trigger may be when the Greek press retaliates with Nazi-jargon to German tabloids’ disgraceful headlines. Or when German politicians – supported by part of the German press – keep talking about “rescuing Greece” instead of being honest about what is actually being rescued: German investors and banks.

Second, after a decade-and-a-half-long economic struggle, Germans simply cannot believe that those times have finally passed for good, which is fully understandable for a country in whose national psyche security comes first. And no, Doug, the German boom is neither built on the birth of the Euro nor on “a deliberate strategy to keep labour costs low and productivity high”. It is built on Germany having re(!)-gained its competitiveness (warning: shameless cross-linking) and an ECB that will have to conduct too loose monetary policy for Germany in the years to come.

Doug’s other examples, immigration and a new protest movement, as well as nuclear power and the Libya war, have multiple roots that are too complex to discuss in a single post. He might have a point here, but there are more sympathetic and equally plausible explanations. For instance, the success of a populist and alarmist book by Thilo Sarrazin about the alleged decline of Germany is a late response of the German public to problems that have been piling up largely unaddressed over the last 30 years. In this context, Doug much too easily dismisses the internationally underappreciated contrast to Italy, Netherlands, France or even Sweden (!), not to mention Austria, that no right-wing populist party has made it into the federal parliament during the last 20 years, despite an unmatched economic malaise and a proportional election system.

Germany is not turning on itself. Germans just have a hard time dealing with and making sense of the current economic situation – and who could blame them? But if you give it some time, you will see that the 2006 & 2010 World Cup euphoria was not just a break from a national state of angst.

What the hell is an economic government?

So, somebody has a brilliant idea to solve all Europe’s problems. What is it? It’s to set up a European economic government for the EU. It’s not exactly new – several people in the Jospin government thought so, including Dominique Strauss-Kahn. It might have something going for it.

But what is it? The EU already has – already is – an economic government, in that it handles trade negotiations, operates a single set of product standards, interworking arrangements between big networked systems, some social and environmental regulations, and even operates some fiscal rules. If you include the European Central Bank, and why not, it conducts monetary policy.
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Eurozone Watch Blog

Well I have just noticed a new new Eurozone blog: Daniela Schwarzer and Sebastian Dullien who have been blogging at Eurozone Watch Blog for a few months now. Daniela has a post today about Mr Euro, Jean-Claude Juncker. But see this George Parker piece in the FT:

Jean-Claude Trichet, European Central Bank president, on Friday delivered a stiff warning to eurozone finance ministers to back off in an escalating dispute over the bank’s independence.

Mr Trichet pointed out that it was his signature on euro banknotes and that it was unlawful under the EU treaty for finance ministers to give instructions or try to influence the bank.

His comments came at a strained news conference in Helsinki with Jean-Claude Juncker, Luxembourg prime minister, who was on Friday given a second two-year term as political head of the eurozone.

Mr Juncker said he had only agreed to carry on chairing the eurogroup – the political arm of the single currency – after finance ministers supported his plan to have an “intensified dialogue” with the ECB.

As I say in a comment on Daniela’s post. This is about the only topic I am currently in agreement with Trichet on: I simply don’t see what he and Trichet have to talk about.

Meantime over on Afoe Mark Thoma had a very interesting guest post last week on whether the eurozone will be affected by any possible downturn in the US, and this post has been picked up by both New Economist and Claus Vistesen at Alpha Sources.

Will They, Won’t They?

While Latvia is still arguing with the EU Commission over the spelling of eiro (or is it euro), the FT today asks the much more pertinent question: will the other baltic states even be able to join? On the backs of the energy hike Estonia and Lithuania are struggling to comply with the entry conditions, especially those on inflation. Slovenia is, however, expected to join on target on 1 January 2007.

Estonia, Lithuania and Slovenia set themselves the target of being in the first wave of new euro members next January and of complying with most of the rules, including public debt levels, interest rates and budget deficits.

Estonia, however, is struggling to meet the inflation criterion, which is likely to be set at about 3 per cent this year, 1.5 per cent above the average inflation rates of the three countries with the lowest inflation….. Like in other former Soviet-bloc countries, energy has a bigger weighting in Estonia’s consumer price index because the country uses power less efficiently than the EU’s older members.

“We feel that it’s a shame that just when we need to qualify for euro entry, the world oil prices go up,” said Kylike Sillaste, adviser to the prime minister….

Joaquin Almunia, the EU’s monetary affairs commissioner, has said he will apply strictly the entry standards for the candidate countries, although the ultimate decision on enlarging the eurozone lies with member states.

Has He Finally Gone Mad?

Really, when I saw this I had a hard time believing it.

The UK’s case for staying out of Europe’s single currency “is becoming weaker”, European Trade Commissioner Peter Mandelson has argued in a bid to reopen Britain’s euro debate……The British economy has prospered outside of the single currency but with increasing harmonisation in other areas of financial services, the long term case for staying outside is becoming weaker.

Which world is he living in?

The Political Fallout of Italy’s Growth Problem

Yesterday the news from Italy was the sudden drop in industrial output, today it is the fact that this makes Berlusconi’s re-election much more uphill work. In particular his coalition just lost a vote in Messina, Sicily, that they normally should have won.

This trend in indutrial output is important for what it implies about growth in Italy this year and next, and this is important for the knock-on implications for Italy’s deficit. This Italian government has incorporated an economic growth target of 1.5 per cent in its 2006 budget, and this target now seems improbable. This means the budget shortfall will be greater than agreed with Brussels, and that the deficit will rise more than anticipated. More problems.

The IMF is critical of the approach the Italian government is taking and has already expressed its fears that Italy will not meet its goal of reducing its budget deficit to 3.8 per cent of gross domestic product in 2006 from 4.3 per cent this year. The principal culprit for the IMF: Italy’s slow productivity growth.

“The nation’s economic problems are essentially ‘made in Italy’,” an IMF report said last month. “The fundamental factor accounting for weak competitiveness, and for a decade of disappointing economic performance, is slow productivity growth. Over 1996-2004, growth of output per hour worked was the lowest among all industrial countries and a cumulative 5.5 percentage points below the euro area average.”

Don’t Say I Didn’t Tell You!

Inflation in the eurozone is not about to spiral out of control. I have been arguing this for months now. The latest piece of evidence: French consumer prices fell 0.3 percent in November as compared with the previous month:

French consumer prices fell 0.3 percent in November on the previous month, national statistics office INSEE reported on Tuesday. That brought the annual rate of inflation down to 1.8 percent from 2.0 percent in October. The drop in consumer prices was largely driven by a 2.8 percent fall in energy prices, with petrol products down 5.1 percent.

Italian Industrial Output Falls Sharply

Well, this was really what I had been waiting for, not that I welcome the news, obviously, but simply that as far as I am concerned it is far from unexpected. People have been ‘writing off’ Italy’s grave structural problems far too easily IMHO:

Industrial production in Italy declined 0.9 percent month-on-month in October for an annual drop of 2.7 percent, national statistics agency ISTAT reported today.

The fall was driven by a 3.6 percent year-on-year drop in intermediate goods production and a 3.1 percent reduction in consumer goods output.

OTOH, the German Investor Confidence Index published by the ZEW Center for European Economic Research spiked dramtically upwards today showing how strong growth in China and the US and the falling euro is boosting expectations in Germany’s export sector. This is, I think, pretty much what we can expect to see from Germany in the months and years ahead: strong export growth when the global economy is booming, and weak domestic demand keeping overall growth tepid.