"Our Mandate Is Not Full Employment"

ECB press conference, Jan. 10th, 2013:

Question: The fragmentation in the labour markets seems to be getting even more pronounced, especially in youth unemployment, which is almost 60% in Spain and 8% in Germany. Overall unemployment is over 25% in Spain and a little over 5% in Germany. At what point does this become an issue for monetary policy?

Draghi: Our mandate is not full employment. Our mandate, and our statutory objective, is to maintain price stability.

Question: Jean-Claude Juncker has said that too much fiscal consolidation could have a negative effect on countries like Spain, because unemployment is so high. What can you say about that?

Draghi: This fiscal consolidation is unavoidable, and we are aware that it has short-term contractionary effects. But now that so much has been done, I do not think it is right to go back.

There was a self-congratulatory air at the ECB press conference last week. Draghi took credit for declining bond yields and for “positive contagion” in the financial markets. He acknowledged that unemployment was high, but said that it was inevitable, and would only subside when structural reforms are completed and budgets are balanced. He reminded his audience that “our mandate is not full employment”.

The poor man must be suffering a considerable amount of cognitive dissonance, since the dials on the ECB’s dashboard tell a different story than the happy talk that he is providing:

Economic growth: continuing decline

Unemployment: 12% and rising

Industrial production: continuing decline

Peripheral government fiscal balance: large, persistent deficits

Private sector loan growth: negative

The eurozone is in a persistent recession with high and rising unemployment, large fiscal imbalances, declining industrial production and ongoing credit contraction. The ship is sinking, but “flotation is not our mandate”.

The ECB thinks that its monetary policy has been successful because “inflation expectations for the euro area remain firmly anchored”. This is analogous to the Fed’s satisfaction with its performance during the Depression because the dollar maintained its gold price, and employment was “not its mandate”. The world maybe plunging into catastrophe, but that is beyond our mandate.

In peripheral Europe today, an irresistible force is colliding with an immovable object: voter dissatisfaction continues to build as unemployment rises, while the message from Europe is that the pain must continue into the indefinite future. Stuck between these forces is the political class, which cannot ignore the will of the people but which lacks the intellectual capacity to challenge Europe’s ruinous orthodoxy. Just as the only people who held the key to recovery in the Depression were the “prairie radicals”, so today anyone who would challenge the ECB’s deflationary prescriptions is a left wing radical or, even worse, an inflationist!

The European Right sees the euro and its accompanying depression as a means to “reform” southern Europe and make it more like Germany, while the European Left thought that they were successfully building “socialism in one monetary zone” until things went a bit haywire. There is no one in the eurozone who appears capable of explaining that the cost of “structural reform” is extremely high and in fact counterproductive.

What makes the Germans think that a starving person is more likely to reject unions and the welfare state than one with a full belly? The Germans think that the lesson of their history is that inflation leads to political chaos. It isn’t. The lesson of German history is that deflation leads to political chaos. They have somehow forgotten that 1929-33 was a period of deflation, depression and unemployment.

Europe as a bastion of liberal democracy is imperiled by incompetent monetary policy based upon a willful misreading of economic history. I find it frustrating that a lesson so well understood in the anglosaxon world has been forgotten or was never learned on the Continent. This is at root a cultural problem. Right now, every anglosaxon central bank is either experimenting with reflationary policies or is at least actively debating them. Somebody needs to start translating these websites into European so that these ideas can start percolating.

To give you a flavor of where the ECB stands on the matter of unemployment and unconventional policies, this is what Draghi said last week:

Each central bank has its own institutional set-up, has its own statutory objectives and its mandate. Within this institutional set-up, within the statutory objectives, each central bank tries to steer private sector expectations. As far as our mandate goes, namely maintaining price stability, I think we’ve shown how to do it.

Translation: “Employment is not our mandate”. It would be one thing if Draghi were asking for an expanded mandate. But he isn’t, because he evidently believes, with Andrew Mellon, that unemployment is a way to purge the rottenness out of the system, and that people will work harder and live a more moral life. Mellon quit before he was impeached.

I cannot blame Draghi for complying with his insane mandate, but I can blame him for embracing it without a struggle. His leadership is catastrophic.

Confronting Monetary Ignorance At The Wall Street Journal

Once in a while, an op-ed will be so offensive in its obtuseness that it raises my hackles. In this case, the offending column was not written by Thomas Friedman, despite his tireless efforts to make sentient readers pop a gasket. 

Today’s column was written by the esteemed George Melloan, the Wall Street Journal’s patriarch of solid conservative thinking, and of the sound dollar, the bedrock of American prosperity. 

Below is what this confused man wrote, and my parenthetic commentary in italics. Note the nature of his lapidary prose: he speaks in unanswerable platitudes, as if there could be no possible disagreement. Melloan is a theologian, not an economist. He exemplifies the Journal’s inexplicable embrace of austerity, deflation and depression.

Deficits, Debt and the Fate of the Dollar

By George Melloan

January 9, 2013

The year-end "fiscal cliff" tax deal sent shivers through the bond market, driving the price of 10-year Treasurys to the lowest level since April.

So...bond yields rose because of the cliff deal, and not because of the publication of the FOMC minutes which suggested that QE3 could be ended prematurely? Both events happened simultaneously.

There was a good reason. The stubborn resistance by President Barack Obama and Senate Majority Leader Harry Reid to spending cuts left no further doubts about their lack of interest in the nation's No. 1 economic problem, massive federal deficits.

Is the #1 problem overspending, or inadequate nominal growth?

The bond-market decline came despite the Federal Reserve's renewed program to gobble up yet more government debt.

So far, the Fed has bought nothing for the past 20 months. The monetary base hasn’t budged since June of 2011.

Presidents of some regional Federal Reserve Banks are growing nervous about this program, judging from the December minutes of the Federal Open Market Committee, which guides Fed policy. Jeffrey Lacker of the Richmond Fed, Richard Fisher of Dallas and Esther George of Kansas City have been among the most outspoken in voicing fears that continuation of the Fed's manic buying—now running at $85 billion a month in Treasury and agency paper—will ultimately destroy the dollar.

So far the Fed’s balance sheet has been flat, and the dollar has been rising since mid-2011.

The concerns expressed in the FOMC minutes didn't cheer the bond market either.

So which was it: the cliff deal or the minutes?

These are signals of dangerous times. Forget about the next Washington dog-and-pony show on the debt ceiling. The bond market will ultimately dictate the future of U.S. monetary and budgetary policy. Bond markets only obey the law of supply and demand. When the flooding of markets with American debt causes the world to lose confidence in dollar-denominated securities, the nation will be in deep trouble.

Right now, the world is happy with exceptionally low interest rates on dollar securities, so we are not in any kind of trouble. We were in trouble back in 1981  when rates were very high, but that was thirty-two years ago.

The only force standing in the way of that now is the Fed's support of bond prices.

The Fed hasn’t started buying bonds. When it does, hopefully bond prices will fall as inflation expectations rise.

But regional Fed presidents are prudently asking how long that can be sustained.

Which is ironic since the Fed’s balance sheet hasn’t grown since June, 2011. There is nothing to sustain.

Mr. Obama currently is riding high, pumped up by his success in resisting Republican budget-cutting demands during the "cliff" talks. But the deal he muscled through Congress is a hollow victory. His so-called tax on the wealthy will produce scant revenues. The money sucked out of American pocketbooks by higher payroll taxes will curb consumer demand, further slowing already weak economic growth. Only entitlement reforms, which the president refuses to consider, can shrink the deficit enough to reduce the danger it poses.

Wouldn’t faster nominal growth caused by higher inflation also shrink the deficit, and in a less painful fashion? Or is austerity good for its own sake?

The Fed's worst fear is that despite its long-term commitment to buying up government debt, it will lose control of interest rates.

The purpose of QE, if it ever starts, is to raise inflation expectations and, by extension, long-term interest rates. So far the Fed hasn’t been able to do this because its expansionary efforts have lacked scale and credibility. It doesn’t yet have control of interest rates because it hasn’t inflated enough.

That's why the early-January upward blip in bond yields was a yellow warning light. If Treasury bond prices decline significantly from the artificial levels that massive Fed purchases have supported, several things will happen, none of them good.

If bond prices fall, it will signal that the Fed’s reflationary efforts are gaining credibility. This should spur investment and economic activity.


First of all, government borrowing costs will rise, making it even more difficult to control the deficit.

Lower bond prices will affect bondholders, not the Treasury. However, higher inflation will increase government revenue while shrinking the real value of the national debt. Wouldn’t that be a good thing?

Second, the value of the Fed's gargantuan and growing $2.6 trillion portfolio of Treasury and government-agency mortgage bonds will decline. It won't take much of a portfolio loss to wipe out the Fed's capital base.

The Fed does not mark to market, so there would be no portfolio loss, just as there has been no portfolio windfall as rates have fallen from 15% to 1.5% over the past thirty years.

Without capital of its own, it would become a ward of the Treasury, costing the Fed what little independence it has left to defend the dollar.

Central bank solvency is meaningless in a fiat currency economy, since money is a Fed liability which can be costlessly created. If you were to book the Fed’s money monopoly as an intangible, its value would be infinite. The Fed has plenty of independence and has no responsibility for the dollar’s foreign exchange value, only its purchasing power. You may want the Fed to support the dollar, but it has no such mandate.

Even now, the Fed faces a cruel dilemma. It can let bond prices fall and suffer the unhappy consequences. Or it can keep on its present course of buying up more hundreds of billions of Treasury paper. That course inevitably leads to inflation.

Which is the whole point of the exercise, except that the Fed isn’t buying enough to move the needle on inflation. Were it to ever start buying up “hundreds of billions of Treasury paper”, you might see the needle start to move.

Over the past four years, the damage to the dollar has been partly ameliorated by global investors fleeing weak currencies elsewhere for the relative safety of the dollar. But there has to be a limit to how long that will be true. We already are seeing signs of renewed asset inflation not unlike the run-up that occurred in the first half of last decade. Stocks and farmland are up and housing prices are recovering from their slump.

Are asset prices an element of the price level? If so, we experienced pretty horrible deflation during the crash.

Brendan Brown, London-based economist for Mitsubishi UFJ Securities, reminds us that asset inflation is usually followed by asset deflation, and that's no fun, as the events of 2007 and 2008 testified. More seriously, a rise in the price of assets often presages a general rise in the prices of goods and services.

Which is what Bernanke is praying for, so far to no avail.

Inflation can ultimately destroy the bond market, as it did in 1960s Britain during the government of the socialist Labour Party. No one wants to commit to an investment that might be worthless in 10 years, never mind 30 years.

Right now, the market is demanding the lowest dollar interest rates since WW2, right across the yield curve.

Throughout history, governments have inflated away their debts by cheapening the currency. That process is well under way through the Fed's abdication to irresponsible government.

The Fed is trying (unsuccessfully) to create higher inflation so as to increase nominal growth, grow government revenue, reduce the deficit, and shrink the real size of the national debt. Is that an abdication to irresponsible government? Would you prefer zero nominal growth, such as the BoJ and the ECB have been delivering? Would zero growth help balance the budget?

If Fed policies continue, another huge tax—inflation—will weigh down the American people. The politicians will try to escape public censure, as they always do, by blaming it all on "price gouging" by producers, retailers and landlords. A substantial cohort of the press will buy into that phony rationale and spread it as gospel.

So far the Fed’s policy for the past 20 months has been to talk a lot and do nothing. If it ever takes up QE3 in earnest and starts growing its balance sheet, we will be lucky to see higher inflation and higher nominal growth.

The Fed's dilemma is in fact everyone's dilemma, given the universal stake in the value of the dollar. And all because an American president and a substantial number of senators and representatives don't understand one simple fact: In the end, the bond market rules.

We have no stake in the value of the dollar in foreign currency, other than making sure that it doesn’t get so high as to price us out of global markets (which it has). What we do have a stake in, is more rapid growth and higher government revenue. Cutting spending in order to cope with weak growth is a strategy for depression. Take a look at Europe.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is the author of "The Great Money Binge: Spending Our Way to Socialism", Simon & Schuster, 2009.

FOMC Minutes: Read 'Em And Weep

FOMC minutes, Dec. 11-12, 2012:
While almost all members thought that the asset purchase program begun in September had been effective and supportive of growth, they also generally saw that the benefits of ongoing purchases were uncertain and that the potential costs could rise as the size of the balance sheet increased. 
Various members stressed the importance of a continuing assessment of labor market developments and reviews of the program's efficacy and costs at upcoming FOMC meetings. 
In considering the outlook for the labor market and the broader economy, a few members expressed the view that ongoing asset purchases would likely be warranted until about the end of 2013, while a few others emphasized the need for considerable policy accommodation but did not state a specific time frame or total for purchases. Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.

As JFK said in slightly different words "Fooled again." So much for the triumph of monetarism at the Fed. It turns out that the College of Cardinals is not 100% behind the pope.

Bernanke is trying to drive down the real funds rate by raising inflation expectations. If he could get expectations up to say 3%, that would make the real rate -3%, which would be stimulative. The whole point of QE3 is to commit to print money until unemployment falls to 6.5% from its current level of 7.7%, and thus raise inflation expectations. They were supposed to add $1 trillion to the monetary base in 2013. Now they say that "the benefits of ongoing purchases are uncertain and the potential costs could rise as the size of the balance sheet increased." Is that so?

There is absolutely no point in making forward-looking statements unless they have credibility. How hard is that to understand? We should have learned this from twenty years of  “anti-deflationary” policies at the Bank of Japan.

We learned today that Bernanke is still not in charge, and that the cats he has been trying to herd are still running in different directions. It is not “his” FOMC. The committee seems to feel that it is committed to nothing other than to make “continuing assessments”. Don't go out on a limb.

The committee’s forward guidance now has almost no credibility. At any moment, some of the cats can stick their heads up  and say “We think that’s enough”. End of QE3!

There are two ways to conduct monetary policy: offer credible guidance which can by itself change market behavior; or failing that, just go ahead and follow through with whatever it is that you said you were going to do. To offer non-credible guidance while reserving the right to stop expansion at any time is the worst way to do it, as Bernanke knows very well.

I hate to say it, but Bernanke is giving monetarism a bad name. He isn’t doing it right. Now, with expectations up in the air and the monetary base stalled, people are going to start saying that QE3 hasn’t worked and that “monetary policy has lost its efficacy”. Actually, they are already saying that.

So let me remind you of one salient fact: the monetary base stands today at $2.6 trillion. Eighteen months ago, in June of 2011, the monetary base was $2.6 trillion. There has been no expansion of the Fed’s balance sheet since the announcement of QE3, none. And so you may well ask “Will there ever be an expansion of the monetary base?’ And I can only answer, “Definitely, unless the hawks stop it at the next meeting”. There may never be a QE3. It may all have been a dream.

So all of the hoopla about the intellectual sea-change at the Fed now looks misplaced. We don’t have a monetarist Federal Reserve; we have a monetarist Federal Reserve chairman. It’s like the Supreme Court: we don’t have an originalist court, we have an originalist chief justice. The other member get to vote however they please.

This is all very disappointing.