Thursday, 21 February 2013

A central bank crisis

Vox has an excellent article by the LSE's De Grauwe about the austerity measures in the Eurozone periphery that were imposed by policymakers in response to a buyer's strike among sovereign bond investors. As yields soared, particularly in Greece, there was a growing belief that the cause was high levels of public debt and structural inefficiencies, and that to bring yields down it was necessary to slash public borrowing and make structural reforms. There was also concern about the lack of competitiveness of periphery economies and their high unit labour costs: had they had their own currencies, devaluation would have been the corrective for this problem, but because of the Euro this was not possible and the only solution was to force down wages. The measures adopted in a number of countries to reduce public deficits and force down wages caused GDP to collapse across the Eurozone. And they are still causing it. The Eurozone is formally in recession and shows no real sign of recovery despite the upbeat commentary from the Eurogroup. PMI figures today were ugly.

De Grauwe and his colleague show that the soaring yields were not directly to do with economic fundamentals in the periphery countries. They were a market panic. And unfortunately, the panic in the markets infected policy-makers too, who inflicted harsher and harsher austerity measures on the countries concerned in an attempt to break the spiral of rising yields and growing fears of Euro collapse. De Grauwe argues that correct response would have been for the central bank to provide unlimited liquidity - in this case, by buying bonds as required. Now, the ECB did buy bonds to some extent under the securities market programme (SMP). But it was hardly an "unlimited" response: it was small-scale, grudging and constantly attacked by Bundesbank hard men and German politicians angry about bailouts for what they perceived as "profligate" periphery states. No wonder investors didn't believe it. There was constant discussion about the possibility of various countries, not just Greece, leaving the Eurozone: there were theories about downsizing the Eurozone to a convergent core, or splitting it in two: there were fears that it would collapse completely as its predecessor the Exchange Rate Mechanism (ERM) had done. EU politicians reiterated that the Euro would survive, but analysts examining the market were divided. And throughout all this, the ECB did virtually nothing, despite the clear evidence of very tight monetary conditions in the periphery and runs on banks in crisis-hit countries. It stepped in to rescue the banking system when liquidity all but dried up in December 2011, and it bought a few bonds. That's all.

I have argued for a long time now that the problem in the Eurozone is not the fundamentals in the individual countries, it is the design and construction of the Euro. The Euro is a fiat currency disconnected from a sovereign - and that is a very strange beast indeed. To a considerable extent, the European policy makers are making things up as they go along, and therefore making considerable mistakes. Belatedly, they are now trying to fix the errors in the original construction of the Euro - the lack of a common banking system, the lack of coordination of fiscal policy, the inadequacy of the institutions created to manage it. The last of these in my view is particularly critical. The Eurosystem of central banks (ECB and national CBs) together create and manage the Euro, and there are strict limits on what unilateral actions a national CB can take: they can provide the domestic banking system with liquidity provided that the ECB gives permission, but they can't do much more than that. They have no control of interest rates and cannot use unconventional monetary policy tools such as QE. So effectively the countries that use the Euro have no control of monetary policy: their central banks can do little to protect their economies from exogenous shocks, and their governments can't do much either since EU rules prevent them using unconventional measures such as capital controls.

I first became aware of just how vulnerable Eurozone countries are, and how little power national CBs have, in a recent conversation with two Irish central bankers who were worried about the stresses in the UK economy. If the UK went into a tailspin, they could do nothing to prevent the Irish economy going down with it because of its extensive trade links and borrowings, and they know that the ECB would do nothing. There is no institutional device in place for protecting individual parts of the Eurozone from local shocks. In real currency unions such as the United States and the UK, that device is fiscal support*. That is absent in the Eurozone.

The ECB, as the senior bank in the Eurosystem, is responsible for ensuring that the money supply in all parts of the Eurozone is sufficient to meet economic needs. De Grauwe says that it failed to do this. I agree. And it is still failing to do this. Inflation is down to the target 2% and falling, and the entire Eurozone is in recession - but has the ECB done anything to ease monetary conditions? No. It is holding the policy rate at 0.75% and the deposit rate at zero, and appears to have no plans to change this even though the Euro is soaring against other currencies as other central banks do all manner of unconventional things to improve liquidity in their own economies. The ECB simply is not acting as a central bank should.

There has been some discussion of whether the market panic that De Grauwe alludes to was irrational. I don't think it was irrational at all. Investors were given no reason to believe that the ECB would act to prevent Euro collapse in the event of a country leaving, and they had the precedent of the ERM, which collapsed after the exit of the UK in 1992. It is no accident that the countries that experienced the steepest rises in yields (and the sharpest falls after OMT) were those where fundamentals differed the most from Germany: after all, it was economic divergence with Germany that drove the UK out of the ERM. Until OMT, it all looked very much like a repeat performance, with Greece as the focal point instead of the UK.

In my view the reason why the OMT worked is that for the first time investors were given a clear statement that the ECB would not allow the Euro to collapse, even if that meant buying every sovereign bond in Europe. Admittedly even that clear policy statement was criticised by the Bundesbank, which claimed that bond-buying would break the Lisbon treaty preventing monetary financing of governments. But what right does the Bundesbank - a national CB - have to criticise the ECB and threaten it with legal action over what was very clearly MONETARY policy designed to protect the Euro, and therefore well within the ECB's remit? The Bundesbank would prefer a strong Euro and tight monetary policy because of its ridiculous fear of inflation. The Weimar hyperinflation scars run deep. But that doesn't give it the right to dictate policy to the ECB. Anyway, there is ZERO prospect of hyperinflation, or even ordinary inflation, in the Eurozone. The problem in the Eurozone is deflation, not inflation - and that has been the case for the last 5 years. The ECB should be cutting rates and looking at other ways of easing monetary conditions across the Eurozone, particularly in the countries such as Spain and Portugal where GDP is falling disastrously. That it has not done so, and shows no sign of doing so, is a measure of its inadequacy.

This is not a crisis of public profligacy, nor even of a poorly-constructed political experiment, grim though the consequences of that are. It is first and foremost a crisis created and orchestrated by an inept and politically captive central bank. The ECB is a disaster.

* I know there are debates about whether various US states will be allowed to go bankrupt, but we all know they will be bailed out in the end, don't we....a municipal Lehman would be the last thing the US government would want.

Related links:

Panic-driven austerity in the Eurozone and its implications - Paul De Grauwe and Yuimei Ji
Markit Flash Eurozone PMI - Markit
Draghi's Debt Trap - Coppola Comment
It's the currency, stupid - Coppola Comment
The failure of austerity in Europe - Touchstone Blog


  1. From someone who lives in EU, I can confirm that inflation is an issue.
    Debasing currency does not work specially when there is so much corruption and a legacy of strong unions with ridiculous high benefits.

    1. The figures do not support you. Across the Eurozone as a whole at the moment, inflation is at 1.4% and falling. It is not an issue. There may be places where locally inflation is higher, and you may be fortunate enough to live in one of them (since those are the places that are NOT experiencing austerity). But across the Eurozone as a whole the issue is deflation.

      I am not arguing for debasing the currency. But the Euro is actually rising against other currencies. That is simply crazy.

      I too live in the EU, and where I live inflation IS an issue. But I'm not in the Eurozone. I'm in the UK.

      On a point of order: I accept anonymous comments on this blog because the captcha is difficult for many people. But I ask you please to identify yourself in the comment itself. If you are not willing to do so then I regret I cannot accept your comment.


    2. Why are economists so afraid of deflation? Right now, for many people in EU/UK deflation would be very welcome and would allow stagnant wages to have more purschasing power.

      In Greece for example, deflation will allow for people in lower wages/unemployed benefit to have more purchasing power or to be able to afford to live without going into debt.

      Please do remove my comments. Thank you for replying and I do appreciate that you allow anonymous comments.

    3. The money printers like getting stuff for free. That causes inflation and other things. If every one was against inflation and for deflation it wouldn't go over well. Come on, you knew that.

      They might like a temporary reduction in price, but inflation comes from printing. And bank money is expanded by loans originating and reduced by loan principle payments..

  2. "The problem in the Eurozone is deflation, not inflation - and that has been the case for the last 5 years. The ECB should be cutting rates and looking at other ways of easing monetary conditions across the Eurozone, particularly in the countries such as Spain and Portugal where GDP is falling disastrously."

    Good diagnosis but rather lame prescription. Cutting rates from an already very low 0.75% wouldn't do much to stimulate economies undergoing a free fall.

    Only active fiscal policy (increasing public expenditures and/or cutting taxes) could do the trick. That is, the very opposite of the disastrous "fiscal consolidation" measures that "core Europe" is imposing on the periphery countries.

    It's really sad that those countries, being monetarily non sovereign, are more or less condemned to implement the austerity so cherished by the ECB, the EC and the IMF. Greece's GDP has already fallen around 20% from its previous peak. If we compare this figure with the "mere" 17% decline undergone by Germany in the early 1930s we'll grasp the full meaning of the economic disaster facing periphery Europe - essentially, as a result of austerity.

    Paul Krugman was right on the mark when he said recently that austerity is "an unethical experimentation on human beings going on across the world".

  3. "There is no institutional device in place for protecting individual parts of the Eurozone from local shocks. In real currency unions such as the United States and the UK, that device is fiscal support*."


    Wynne Godley wrote this in 1991 in an newspaper article titled "Commonsense Route To A Common Europe"

    "the existence or a common currency makes a country more directly dependent on its ability to sell exports and import substitutes than it was before, particularly as it will then possess no means whereby it can (in the broadest sense) protect itself against failure."

    and that:

    "If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area."


    1. Mainstream economists from the U.S. (though not their colleagues from the Eurpean continent) were also severely critical of the EMU.

      Here is Martin Feldstein writing in the Economist on June 13, 1992:

      "A currency union means…that nominal exchange rates cannot adjust to achieve a needed change in the real exchange rate. The local price level must, therefore, adjust to bring about the change in the real exchange rate…but a decline in domestic prices is likely to require a period of increased unemployment. It would therefore certainly be better to have a decline in the nominal exchange rate. The shift to a single currency in Europe would preclude such nominal exchange-rate adjustments and force real exchange-rate reductions to be achieved through lower local wages and prices


      "the American fiscal system provides an alternative source of regional stabilisation, making regional monetary policy less important. Each dollar decline in America's real GNP reduces taxes by about 30 cents and increases transfer payments by about 5 cents. These national fiscal responses are paralleled at the state and regional levels. When the Massachusetts economy turns down, the residents of Massachusetts send fewer tax dollars to Washington and receive more in transfers from the federal government. To the extent that the Massachusetts downturn is greater than the downturn in the nation as a whole, the result of this fiscal structure is a permanent transfer to Massachusetts. ..a decline in the state's economy automatically triggers a stabilising shift in fiscal policy. Nothing comparable to America's fiscal system exists in Europe, where virtually all taxes are paid to national and local governments. There is no fiscal transfer from the EC as a whole to countries that experience a relative cyclical decline. Without such a centralised fiscal system, shocks to aggregate demand that are geographically focused, or shifts in the real equilibrium values of national exchange rates, have a bigger impact on regional income and employment".

      And the conclusion was:

      "I cannot understand...those who advocate monetary union but reject any movement towards a federalist political structure for Europe. That is a formula for economic costs without any of the supposed political benefits".

      Prescient words, indeed!

    2. Roger, curious German, (no banker but engineer)

      Frances Coppola wrote in the end: "* I know there are debates about whether various US states will be allowed to go bankrupt"

      and Jose Guilherme qouted an old economic-article: "the American fiscal system provides an alternative source of regional stabilisation, making regional monetary policy less important. Each dollar decline in America's real GNP reduces taxes by about 30 cents and increases transfer payments by about 5 cents. These national fiscal responses are paralleled at the state and regional levels."

      Since quite some time I ask myself and brood:

      Do we actually (1) see the outcome of bad government of southern countries (Neither them nor the markets understood the cultural requirements of a hard currency) or (2) do we see the outcome of constructional defects in the monetary union?

      If it is (1), we may have the labor pains and can learn the lectures out of it, so afterwords it will work.
      If it is (2), I follow with the question: (2.1) Why can an economic union in such a huge and economcally diverse state like USA work and should not be able to do in Europe? And (2.2) what would be nessecary to make the euro currency living and working? (2.3)Would it be worth implementing that tools in Europe too, and (2.4) would it be politically and culturally be possible?

      I got the impression you may have already thought in that directions.
      Do you have some ideas, hints or reading references for me?
      (And perhaps in a kind of language a non-banker can understand? :-)

      Thank you a lot,

      PS: I admit to be a typical German in the way that I kind of romantically loved and love the idea of an European Integration an hence supported and still support the implementation of the euro.
      (You know, like the Germans united in 19th century from Prussians, Bavarians, Saxonians and so on and never again wanted to disintegrate or be divided in two or more states - wouldn't it be nice to unite French, Germans, Italians, Poles, Spaniard, Scots and so on in the same way toward Europeans, and never ever having a war and hate again? Wouldn't it be worth offering a lot to work for such a European Integration in Cultural Diversity? Yeah, just a typical German romantic dream.) :-)

      So I am not asking for cheap Euro-bashing but for ideas to understand the mechanisms behind currency unions, how to make it work better (for what price) or alternativly why it should Europe be impossible to work like the Dollar-currency.

  4. No doubt De Grauwe is right to say that panic has more to do with soaring yields in periphery countries than fundamentals. However, he is wrong to write off fundamentals altogether: unit labour labour costs in periphery countries HAVE RISEN relative to Germany haven’t they?

    1. He didn't write off fundamentals altogether. He said they did matter. However, the rise in yields was out of all proportion.

  5. I agree with most of what you said but think the last comment about the crisis being primarily due to the ECB is too strong. Even with the ECB buying sovereign debt, fiscal restraint would have led to unemployment and contraction.

    On a different tangent, I don't think the risks of proposed ECB action are sufficiently recognized. Here is a non-exhaustive list:
    What prevents individual countries from bailing out their banks if the ECB will buy all sovereign debt? What then prevents the banks from ignoring risks of lending? What does the ECB do with profits? How does the ECB decide on individual sovereign yields?

  6. but has the ECB done anything to ease monetary conditions? No. It is holding the policy rate at 0.75% and the deposit rate at zero, and appears to have no plans to change this even though the Euro is soaring against other currencies

    The ECB is maintaining a corridor between the deposit rate a 0% and the refi rate at 0.75%. Interbanks rates are trading well towards the lower end of this corridor , so a cut in the refi rate (as JPMs David Mackie suggests could happen in march) would not really achieve anything. Cutting the deposit rate to negative could even be counter-productive, as it could prompt banks to return the roughly €500bn worth of excess liquidity, which would then drive interbank rates higher.

  7. I gave several carefully referenced points,
    where the claims of De Grauwe are just plain wrong

    and related there.

    I dont think there is a point I spam this here with copy/paste.

    I am deeply disappointed that De Grauwe and friends again demand crimes against the treaties of Europe. More and more people here see him as just an agent of Soros.

    I had hoped, that they learned last year, that there is "no pasaran" for that. Apparently not.

    I also reject, that the Weimar 1923 inflation scares the people in Germany. This was willfully done by the german government at this time, wiping out "old wealth" in a desperate national situation. The 3rd Reich was 10 years later. total causal disconnnect.

    What folks like me have in mind, is this typical Italian inflation from 5.6 deutschmark (DM) to 1000 lira in 1972 to just 1 at the end. I learned as a kid, that you can keep the shillings (with a 7:1 peg to the DM) but have to get rid of the lira at the end of each Italy vacation.

    The ESM is now the ones, who decide, at what conditions credits are shelled out.

  8. Thanks interesting. I must say I wouldnt have started from where de Grauwe starts from. It seems to me that the starting point was that the politicians/ECB imposed austerity in anticipation of what the markets might do otherwise. Then the politicians/ECB and the markets wound each other up in a sort of spiral. And they are still at it.

    In some cases, eg the German domestic politicians, they seemed to be cross about the markets and about lack of tax paying disciplines in Club Med to provide a route out. In other cases, eg the UK, the politicians seemed to be irrationally fearful of markets and confident in tax compliance as offering a route out.

    The linear cause and effect de Grauwe puts forward seems a bit simplistic to me, although it does make a good article. Ths applies also to the ECB points you make. They are just caught up in the general spiral. Or is it a spider's web? At any rate, this could all be clarified by some decent research and we really need someone to write a decent history of the post 2007 era, but that wont be possible for another 30 years.

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  10. I think in the US that states and local governments would be allowed (and have been allowed) to go bankrupt, because it isn't that big a problem. The debt is restructured and life goes on. Largely because the Federal government continues to distribute money throughout the nation via social insurance, defense spending, etc.

    I agree that the Euro is fundamentally flawed, but the problem runs much deeper than the ECB. Europe is not a nation. If one member bleeds, the others have little empathy because the citizens don't share a common language or experience. People consider themselves Greeks and Germans, not Europeans.

    For example, if a foreign power attacked any part of the US or UK then the entire nation would rush to comfort the wounded and seek bloody revenge. If southern Europe were attacked then northern Europe would issue a press release with its sympathies and file a strongly worded diplomatic complaint.

    The ECB reflect its members. They should have never given up their sovereign right to their own currency in order to borrow cheaply.

    1. The point is just, that

      the southern Euro countries were NOT able to "borrow cheaply",

      before they pledged to adhere to the strict ECB standards. Only after that and the pretty detailed rules effectively force them to do so, their interest spreads relative to german interest rates came down.

    2. The Euro is a Faustian bargain for southern Europe. You can borrow cheaply, but once you enter a recession you can never escape. What good is a low interest rate when your nation is unemployed and unproductive?

  11. To make this more clear to the author and the commenters here:

    VoxEU is just an outlet to folks, who make wild, unsubstantiated allegations, they can not stand to be refuted by facts / comments.

    Publishing there now counts as NEGATIVE on my trust scale. As a long term reader, it makes me sad to say that.

  12. Hello; I followed the link from FTAlphaville.

    I would not take De Grauwe seriously if I were you - he is a perma-easist:

    I don't know where you get the idea that eurozone inflation is 1.4% from. The latest flash estimate of HICP is 2.0%:

    In general, I disagree with the often uncritically repeated idea that there was something wrong with the conception of the euro because it did not include fiscal transfers etc. In a national monetary area, large companies, like say, Tesco and Sainsbury operate alongside each other quite successfully without transfers between them. The key point is that they do not expect fiscal transfers or bailouts from each other, so they endeavour to operate their businesses to avoid reaching a point where they would need a transfer to survive. The real problem with the eurozone has been the politicians, who, despite all the warnings of Article 123, the stability pact etc, declined to change their ways to steer clear of the hard constraints of the euro, although they were quite happy to take advantage of the lower debt costs that the end of the devaluation option brought them.

    1. Apologies, that inflation figure was indeed wrong. I have corrected it in the post.

      Apart from that, I don't agree with you. Countries are not supermarkets.

  13. Yields down, unemployment and debt to GDP up. Time to call it a failed experiment, start over, Italy and others print, devalue instead of allowing their citizens to suffer at the hands of the troika.

    1. getting back to the Lira or other local currency, would not make the debt in Euro go away.

      The interesting thing about specifically Italy is actually that they have net assets in Germany, I am just rowing through account numbers at the BIS via queries like that:

  14. @Kent, "if a foreign power attacked any part of the US or UK". I'm not sure for the US, but I think most mainland Brits would be relieved if a good samaritan had the kindness to get them rid of the Northern Irish crackpots. Nor would I think many Scots would be that keen to die for the Isles of Scilly (or even London).

  15. I know we like to be backward looking in those parts, but lately the labour costs differences have shrunk (wage inflation in the north vs. nominal flat or slightly down in the periphery). At this speed the differential will be fully gone in a few years.

    The markets' inaccuracy goes both ways, yields were too low for the fundamentals for long (nobody should have been lending to Greece at those levels to start with).

    1. Hi cig,

      Yes, I agree. De Grauwe's analysis doesn't start early enough. Yields were too low in the periphery for much of the 2000s - hence the hot money inflows. I would criticise the ECB for doing nothing about that, too. Inactivity has been the hallmark of the Eurosystem from the start.

    2. Yields are not defined by Gods though, the presence of hot money is what made the yields what they were, so I think the causality is the other way.

      What could the ECB have done though? Short Greek bonds? Announce they wouldn't support a defaulting member state? That would have been obviously suicidal, and was already written down in their statutes anyway. They didn't have a particularly accommodative interest rate etc policy either.

      When the shit hit the fan, Trichet's response (full bail out/write off of Greece as soon as possible) was fairly sensible, but he wasn't as astute a politician as Draghi is, so they didn't listen to him.

      Really the government sector responsibility in this business is almost entirely with the eurozone's politicians, from the top onwards (eg France and Germany exempting themselves from Maastricht rules when it suited them).

    3. Sorry, had my implications the wrong way round....I meant that yields were pushed down by hot money inflows (high savings rate in Germany, particularly, and crowding-out of investment outside EU by Asian savings). The ECB did have a bit of a dilemma, since raising interest rates would have encouraged German saving even more. But the problem really is the dysfunctional institutional structure that I noted. The NCBs can do nothing to counter local stresses, including flows of hot money. Local real interest rates needed to be raised, but neither NCBs nor governments had any power to do this. I have to say that proposals for a banking union will do nothing whatsoever to address this problem and may even make it worse.

    4. In a single currency you cannot for most intent and purposes have "local" interest rates, this would be arbitraged double quick. Money is fungible!

      I would argue that even worldwide, in the absence of exchange control, the scope for local exchange rate setting is constrained: it seems that local central banks are in a channel of -2/+2 around the "world" rate before things start cocking up royally. If you look at interest rates since the floating rate system was introduced, things are broadly within the channel and the big moves are global. The constraint is of course much stronger in a single currency were there's no exchange rate risk to moderate the arbitrageurs.

      But interest rate is not the only tool available. I don't think there is anything in the structure of the eurozone that prevented the Irish Central Bank, or whichever agency of the Irish government is in charge of these matters, to prick the real estate bubble by simply declaring that any (new) mortgages above X% loan to value would not be enforceable in court. Property loans are entirely based on local law, so the local government has full control. If people in Ireland are blaming the Euro structure, it's really a case of a poor workman blaming their tools instead to hide their incompetence.

      That said, had I been Taoiseach, I may not have had the courage to murder AIB at point blank range by setting the LTV to 50% at the time most people were benefiting from the bubble (or thinking they were). Political courage is the hard problem, and there's no easy solution for it.

    5. This comment has been removed by the author.

    6. Real interest rates always reflect local conditions. The nominal interest rates created by the currency union (ECB monetary policy) were lower than real interest rates should have been. The money flows WERE arbitrage.

      The usual mechanism for equalising interest rates across a currency union is fiscal transfers. In the absence of such a mechanism, prior to 2010 inflows of money and credit did the same job. They adjusted local conditions to the fixed interest rate. But when the 2010 panic happened those inflows abruptly reversed. In effect, the interest rate equalisation mechanism broke and real interest rates in the periphery separated from nominal rates. Draghi's observation that ECB monetary policy transmission was failing was correct.

    7. I fear fiscal flows are given too much credit.

      They are *a* mechanism, which helps when it's there as usually the flows move in the opposite direction as the economic (mis)fortune of a region, but they are no panacea. It certainly would be nice to have more of it in the eurozone, but still they are very imprecise (they are not set by the central bank!) and kludgey, and do not fully prevent imbalances to happen or correct them smoothly. Detroit still had a tough time despite benefiting from Federal money, London is probably not enough of a net tax contributor given the ebullience of its property market (why no London-specific LTV limits?) and economy compared to other members of the pound zone, and I'm sure one can find many other examples.

      A robust system should have many tools in the toolbox and use each of them as convenient. No tool of its own will produce permanent miracles. Local politicians should not get away with blaming HQ when they fail to use the local tools they do have full control on (and conversely).

    8. The main advantage of fiscal flows as opposed to private sector flows is that they are much less likely to reverse in adverse conditions. It's similar to the idea that public sector safe assets are better than private sector ones - which I have discussed extensively elsewhere. Private sector safe assets are inevitably pro-cyclical. So is private sector money, and private sector credit.

      I agree with your point about local fiscal tools. As I've argued elsewhere, fiscal tools are not used enough to fine-tune policy settings. Local politicians do have fiscal tools and they could use them much more than they do. We have come to expect monetary policy to do everything - this attitude has rather been encouraged by the economics profession.

      I'd support London-specific LTV limits. In fact I would support LTV limits generally.