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Monday, July 9, 2012

The ECB is guilty of malpractice

There is a theory (known as market monetarism) that central banks can control nominal growth. Predicated on the Quantity Theory of Money,  it asserts that the central bank, by controlling M (with V assumed to be within a bounded range) can control nominal GDP*.

Politicians can tune up the engine and improve efficiency (the supply side), but they do not control the throttle (aggregate demand); only the central bank does.

If one steps back and looks at the developed countries today, what is the #1 problem that they all have in common? Answer: low nominal growth, resulting in inadequate employment and tax revenue.

Global nominal growth levels have been falling for thirty years. During the non-recessionary years of the Clinton-Bush era, the US enjoyed nominal growth of >6%%. Today, post-crash, the US remains stuck in second gear at 4%, which had been considered recessionary.

Southern Europe, which used to enjoy modest nominal growth, now has zero nominal growth almost four years after the crash. To paraphrase a prominent market monetarist, you can’t have 5% real growth with 0% nominal growth.

I will now introduce a derivative thesis, which is that fiscal deficits are not primarily caused by the government’s failure to raise taxes and cut spending, but rather by inadequate nominal growth. This is certainly true of the world today. Nominal growth and nominal government revenue growth are historically quite low for a “recovery”, causing high unemployment and fiscal deficits. Higher nominal growth would automatically translate into lower deficits and lower unemployment.

Obviously, real growth is not a linear function of nominal growth, any more than agricultural output is a linear function of rainfall. There can be too little, just the right amount, or too much. It appears that, for modern economies with inflexible labor markets, low nominal growth is not enough, 5-7% is just right, and double-digits is inflationary. Right now, no major developed economies have nominal growth in the optimal range, and most are far below, especially in the eurozone.

The market monetarist theory is potentially Copernican in its implications. If accepted intellectually, it means that fiscal policy is much less important than previously believed, and that central bank policy alone can create or retard growth. It also means that the single central bank mandate of “price stability” is inadequate, since it can be satisfied with very low nominal growth.

We could profitably discuss the Fed and the BoJ in this context, but right now their economies are not on the verge of a collapse. That would be the eurozone, where monetary policy will make the difference between survival and depression.

Today, the ECB has one positive mandate (price stability) and one negative mandate: no fiscal monetization, even if governments cannot otherwise finance themselves.

The evidence suggests that the ECB’s governing council is not divided on this issue. They all would appear to agree that not only do they have only one mandate, but also that there should be only one mandate. Although the Fed has a growth mandate, the ECB doesn’t have one and doesn’t want one--not even now, with the eurozone in extremis.

Draghi told the European Parliament this morning (July 9th) that "I think to have one mandate is already so difficult that to have another would make our life even more impossible”. God forbid that one would want to make the ECB council’s job more difficult, what with all the other important things that they have to do, such as picking out the drapes for their new conference room.

If central banks control nominal growth, and weak nominal growth causes unemployment and fiscal deficits, then the ECB’s governing council and its chairman are guilty of monetary malpractice (which goes beyond nonfeasance since it is deliberate). This is not about arcane technical issues; it is about millions of lives and the futures of nations. The ECB council cannot shirk its moral duty because it is too busy, or because unorthodox monetary policies are “risky”. What we know for certain is that the ECB’s orthodox policies are not only risky, they are suicidal.

If the eurozone is to be saved, it will require a responsible central bank. To stay in the zone, Southern Europe will need at least 5% nominal growth as well as fiscal monetization (yield targeting). These goals are compatible. If fiscal monetization expands the monetary base too quickly, the ECB can mop up excess liquidity up by issuing its own bonds and thus limit the impact.

This would require a decision to amend or ignore the ECB's charter, just as the eurozone has ignored the fiscal and debt provisions of the Maastricht treaty. Such treaties were made to be ignored when necessary. The ECB can provide the eurozone with adequate nominal growth while limiting government bond yields, if it so chooses.

It would be one thing if the ECB council attributed its helplessness to its charter; it is quite another when it explicitly asks that its charter not be changed. That’s the criminal part.
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*The “market monetarist” thesis* is a derivative of the classical Fisherian quantity theory of money, which can be summarized as M x V = P x T, or (Money supply) x (money Velocity) = (Price level) x (real economic Transactions).

If V (velocity) is held within a bounded range, then changes in M can bring about changes in P x T, which is nominal GDP. Therefore, the central bank, by controlling the quantity of money in the economy, can control the level of nominal GDP (NGDP).

Scott Sumner’s seminal paper on market monetarism:
http://www.nationalaffairs.com/publications/detail/re-targeting-the-fed

Thursday, July 5, 2012

France deathwatch


There is a good bit of anticipatory gloating and schadenfreude about France in conservative anglosaxon circles.

We enjoy the spectacle of the French people electing a socialist government in the midst of a sovereign debt credit crisis. We are excited by the new government’s array of taxes which will throttle any prospect of animal spirits in that lovely country. We are amused by the government’s new law against plant closings. We await impatiently the inevitable “missed” fiscal targets, the “unexpected” decline in revenue and the “unexpected” rise in spending. We gnash our teeth at  the bond market’s dereliction, refusing to rise up and do to France what it is doing to Italy and Spain. But we know, in our heart of hearts, that France is going down.

No one wants to see Hollande fail more than I do. But I have to be honest: it isn’t really his fault. Yes, of course raising taxes and cutting spending may help to keep the bond market happy, but it will not succeed; France is going down.

Thanks to the wonderful folks at the St. Louis Fed, we can readily access French financial and economic data in God’s own language. The picture isn’t pretty. Yes, debt/GDP is headed in the wrong direction, and yes, the public sector is gigantic. But that’s not the problem. The problem is nominal growth (real growth plus inflation). Nominal money is the currency in which the world does business; “real” money isn’t real.

France’s nominal GDP growth is dangerously inadequate. Having fallen to -4% during the crisis, it crawled back to 2% and is now falling once again. Right now it’s at 1.5%, and falling. No country can prosper and maintain fiscal balance without better growth than that. Since EMU, NGDP growth has ranged from 3% to -4%, with an average that is way too low.

NGDP growth of 1.5% necessarily limits government revenue growth to ~1.5%, and it is not possible to run a socialist economy on that level of growth. Yes, Northern Europe has done so. But Northern Europe has already reformed itself, and shed an awful lot of socialist dead weight in the process.

France has not reformed itself, and just voted for more left-wing utopianism. To live in a world of very low nominal growth requires heroic budget discipline and flat real wage growth. It requires docile labor unions and public-sector layoffs. It requires an efficient private sector that can restructure itself to compete despite a strong currency. That France doesn’t have.

France needs at least 4% if not 5% NGDP growth to start digging out of its hole. Hollande could usher in his socialist paradise if he had that kind of growth. But he’s not going to get it, the way things are headed. France is going down, but he is too dumb to know it. (Has he ever bothered to read an American economics textbook?)

France needs inflation now. There are only two ways to get it: eurozone exit or a change in the ECB’s mandate. France is not going to leave the eurozone prior to its default, which leaves the ECB charter. The problem there is that the charter treaty can’t be changed without a unanimous vote of the 17 eurozone members, and the North isn’t buying it.

That means that France faces a future of anemic growth, continuing fiscal deficits, rising debt ratios, riots (of course) and, at some point, a bond market revolt. The ECB will do everything it can to prevent a sharp rise in French bond yields, but it is limited by its “no fiscal monetization” charter. That is why I expect France to go down, probably at the end of next year, when the fiscal targets are “missed”.

Wednesday, July 4, 2012

The Declaration of Independence: A conservative critique


Note: As stated in this blog's charter, I reserve the right to comment, from time to time, on political subjects. Below is my contribution for the Fourth of July.

For many years I have struggled with the language of America’s founding document. As a conservative, I have found it hard to justify revolution against one of the freest and best-governed countries on earth, and I have found it especially hard to buy the justification in the Declaration.

I am familiar with the colonists’ growing sense of identity and consciousness of nationhood, and with their endless complaints against the King and Parliament. But these grievances were minor (prior to the revolt), and nothing like the complaints of the preceding century when the British government really was a disaster.

The colonists could have simply said “we want to be our own country”. The world would have understood if not sympathized. But instead, the colonists cooked up an entirely new philosophy of government that was supposed to justify their actions. They wanted to be more moral than the British, to be the good guys.

I can understand the desire for moral justification (found in all revolutions, no matter how gruesome). But their arguments were specious, hypocritical and subversive of their true political goals. They invented universal rights that they had no intention of ever granting to most of their inhabitants or to any foreigners. They invoked abstract authorities (God and Nature) who had no ability to express differing views.

The founding fathers broke the first law of civilization (the surrender of the right of private violence) in the supposed pursuit of a higher level of civilization. In fact, the only relevant authority for their assertions was the majesty of English law, which they cast aside in favor of invented and abstract reasoning.

This is precisely the same Cartesian reasoning that led to the French Revolution, communism, fascism and the near destruction of Western civilization. The founders were intellectual dilletantes intoxicated by their own fancy words and imported philosophy. In the end, they established a remarkably well-conceived form of government, but that government is built on the seeds of its own demise: abstract rights.


IN CONGRESS, July 4, 1776.
The unanimous Declaration of the thirteen united States of America,

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature's God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

The revolutionaries assert that the “Laws of Nature and of Nature’s God” entitle them to revolt against Britain. There are no known laws of nature which speak to human political organization, and God has not taken a clear position on the right of revolution. What little we have is that the Biblical Jesus advised the Jewish people to “render unto Caesar that which is Caesar’s”, which is not a revolutionary sentiment.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

This iconic passage is another unsupported assertion, seeking abstract authority for a dubious political argument. Few truths are self-evident, and the “truths” asserted are patently false. It is was obvious in 1776 that “all men” are not created equal, to which the revolutionaries’ slaves would readily attest. It is a convenient sentiment that the revolutionaries’ slaves entered the world with inalienable rights, but one is hard pressed to say what they were, and certainly not those enumerated.

I am not referring to the hypocrisy of owning slaves while expressing libertarian sentiments; I am using the institution of slavery to disprove the notion that men have inalienable rights. One might argue that their slaves possessed some latent “human” rights, but clearly those rights had been alienated. Liberty and the pursuit of happiness were explicitly and lawfully denied to negro slaves.

It is reasonable to interpret this famous passage as referring not to all men, but rather to all enfranchised British subjects (male, free, adult and landed), with “all”  having a geographic character, as opposed to a class or racial meaning. It was an assertion that a British subject living abroad in a British colony does or should enjoy the same rights and an Englishman in England. This may be a reasonable argument, but it contravened British law at the time.


--That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed,

In non-utopian reality, governments are not established for the purpose of securing alleged rights. Governments are established by the powerful for the maintenance and preservation of the existing social order. They derive their power from the monopoly of violence, not from the consent of their subjects. Nothing prevents the powerful from organizing a political system on quasi-democratic lines, but nothing requires them to do so. The thirteen colonies were not notably more democratic after the Revolution than before. (In fact, the British Empire abolished slavery thirty years before the U.S. did.)

--That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.

The right of revolution may exist in philosophy, but not in law. The people in general, and British subjects in particular, have no right to abolish their government. No government on earth provides a legal means for its own dissolution. An attempt to overthrow an established government is, by definition, treason. The British Crown was not a temporary measure designed to be superseded at a later date, any more than was the United States (as demonstrated four score and seven years later).

Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed.

This is sound advice for would-be revolutionaries, advice that was successfully followed elsewhere in the self-governing parts of British Empire to no ill-effect. The reason that governments should not be overthrown for light and transient causes is that revolutions are bloody and destructive. The list of “rights” demanded by the American revolutionaries did not extend to those colonists who disagreed with them. They, their wives and children were driven from their lands and often murdered for daring to remain loyal to the government.

But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.

We have, I trust, already dispensed with the notion of imagined “rights” that apply only to those with whom one agrees and with whom one is a social equal. A British subject (unlike a French or Spanish subject) was indeed granted certain rights by the Crown, but such rights were forfeited when the subject made war upon the lawful authorities. Revolutions often provoke martial law (see Lincoln), but such a lawful response does not evince a design to impose “absolute Despotism”. It is exigent and temporary.

--Such has been the patient sufferance of these Colonies; and such is now the necessity which constrains them to alter their former Systems of Government. The history of the present King of Great Britain is a history of repeated injuries and usurpations, all having in direct object the establishment of an absolute Tyranny over these States.

Once again, the Crown should not be libelled as tyrannous for taking lawful actions to maintain civil order and suppress insurrection. Any subject people can make a list of grievances. But for such a list to rise to the level of justification for violent revolution, it should include more than a few trivialities. The colonists’ pre-revolutionary complaints were trivial in relation to their proposed remedy. Few people on earth were freer than British subjects at that time. The signers of the Declaration were not exactly down-trodden.

To prove this, let Facts be submitted to a candid world.

Examine below the revolutionaries’ catalog of grievances. Some of them are trivial, some are false, and the most egregious are the government’s lawful  response to insurrection. In fact, many of the abuses listed below (in bold) were subsequently inflicted by the federal government upon citizens resident in the states that sought to secede from the U.S. in 1861.

He has refused his Assent to Laws, the most wholesome and necessary for the public good.

He has forbidden his Governors to pass Laws of immediate and pressing importance, unless suspended in their operation till his Assent should be obtained; and when so suspended, he has utterly neglected to attend to them.

He has refused to pass other Laws for the accommodation of large districts of people, unless those people would relinquish the right of Representation in the Legislature, a right inestimable to them and formidable to tyrants only.

He has called together legislative bodies at places unusual, uncomfortable, and distant from the depository of their public Records, for the sole purpose of fatiguing them into compliance with his measures.

He has dissolved Representative Houses repeatedly, for opposing with manly firmness his invasions on the rights of the people.

He has refused for a long time, after such dissolutions, to cause others to be elected; whereby the Legislative powers, incapable of Annihilation, have returned to the People at large for their exercise; the State remaining in the mean time exposed to all the dangers of invasion from without, and convulsions within.

He has endeavoured to prevent the population of these States; for that purpose obstructing the Laws for Naturalization of Foreigners; refusing to pass others to encourage their migrations hither, and raising the conditions of new Appropriations of Lands.

He has obstructed the Administration of Justice, by refusing his Assent to Laws for establishing Judiciary powers.

He has made Judges dependent on his Will alone, for the tenure of their offices, and the amount and payment of their salaries.

He has erected a multitude of New Offices, and sent hither swarms of Officers to harrass our people, and eat out their substance.

He has kept among us, in times of peace, Standing Armies without the Consent of our legislatures.

He has affected to render the Military independent of and superior to the Civil power.

He has combined with others to subject us to a jurisdiction foreign to our constitution, and unacknowledged by our laws; giving his Assent to their Acts of pretended Legislation:

For Quartering large bodies of armed troops among us:

For protecting them, by a mock Trial, from punishment for any Murders which they should commit on the Inhabitants of these States:

For cutting off our Trade with all parts of the world:

For imposing Taxes on us without our Consent:

For depriving us in many cases, of the benefits of Trial by Jury:

For transporting us beyond Seas to be tried for pretended offences

For abolishing the free System of English Laws in a neighbouring Province, establishing therein an Arbitrary government, and enlarging its Boundaries so as to render it at once an example and fit instrument for introducing the same absolute rule into these Colonies:

For taking away our Charters, abolishing our most valuable Laws, and altering fundamentally the Forms of our Governments:

For suspending our own Legislatures, and declaring themselves invested with power to legislate for us in all cases whatsoever.

He has abdicated Government here, by declaring us out of his Protection and waging War against us.

He has plundered our seas, ravaged our Coasts, burnt our towns, and destroyed the lives of our people.

He is at this time transporting large Armies of foreign Mercenaries to compleat the works of death, desolation and tyranny, already begun with circumstances of Cruelty & perfidy scarcely paralleled in the most barbarous ages, and totally unworthy the Head of a civilized nation.

He has constrained our fellow Citizens taken Captive on the high Seas to bear Arms against their Country, to become the executioners of their friends and Brethren, or to fall themselves by their Hands.

He has excited domestic insurrections amongst us, and has endeavoured to bring on the inhabitants of our frontiers, the merciless Indian Savages, whose known rule of warfare, is an undistinguished destruction of all ages, sexes and conditions.

In every stage of these Oppressions We have Petitioned for Redress in the most humble terms: Our repeated Petitions have been answered only by repeated injury. A Prince whose character is thus marked by every act which may define a Tyrant, is unfit to be the ruler of a free people.

Nor have We been wanting in attentions to our Brittish brethren. We have warned them from time to time of attempts by their legislature to extend an unwarrantable jurisdiction over us.

We have reminded them of the circumstances of our emigration and settlement here.

We have appealed to their native justice and magnanimity, and we have conjured them by the ties of our common kindred to disavow these usurpations, which, would inevitably interrupt our connections and correspondence. They too have been deaf to the voice of justice and of consanguinity.

We must, therefore, acquiesce in the necessity, which denounces our Separation, and hold them, as we hold the rest of mankind, Enemies in War, in Peace Friends.

We, therefore, the Representatives of the united States of America, in General Congress, Assembled, appealing to the Supreme Judge of the world for the rectitude of our intentions, do, in the Name, and by Authority of the good People of these Colonies, solemnly publish and declare, That these United Colonies are, and of Right ought to be Free and Independent States; that they are Absolved from all Allegiance to the British Crown, and that all political connection between them and the State of Great Britain, is and ought to be totally dissolved; and that as Free and Independent States, they have full Power to levy War, conclude Peace, contract Alliances, establish Commerce, and to do all other Acts and Things which Independent States may of right do.

And for the support of this Declaration, with a firm reliance on the protection of divine Providence, we mutually pledge to each other our Lives, our Fortunes and our sacred Honor.

Tuesday, July 3, 2012

The eurozone's problems are monetary, not fiscal


Readers will recall that I recently published the blog, “The ECB can easily save the eurozone”. I elaborate on that theme in today’s posting.

Economic depression is always and everywhere a monetary phenomenon. That is the monetarist postion, which is shared all the way from Friedman on the the right to Krugman on the left, from Bernanke at the Fed to Eichengreen, Temin, Sumner and many others in academia. Monetarism has prevailed because it explains economic phenomena (such as depressions) better than any other theory.

So let us agree to the axiom: depressions are monetary phenomena. They are caused by inept central bankers who fail to maintain adequate growth in nominal GDP.

Depressions are not caused by droughts, floods, George Bush, over-indebtedness, war, budget deficits, stock market crashes, housing bubbles, banking crises, Barack Obama, overproduction, underconsumption, laziness, tax evasion, automation, cheap imports, high oil prices, poor-quality education, ATMs, over-regulation or “income inequality”.

Depressions are caused by inadequate money growth. Europe’s problems today are monetary in nature, not fiscal or financial.

Can we also agree that depressions are to be avoided? There is a school that argues that depressions can be prophylactic, and we will shortly hear from them. But let’s agree that an “eat your spinach” monetary policy that prescribes depression as a prohylaxis is probably a bad idea.

European monetary policy today has wickedly prescribed depression as the solution to the eurozone’s woes.

Most contemporary economists believe that a central object of policy should be the avoidance of massive economic contractions. There are three reasons for this: (1) depressions cause human misery, not a policy desideratum; (2) depressions cause fiscal crises; and (3) depressions can have destructive social and political consequences.

At present, the eurozone’s policy prescription for sinful Southern Europe is a depression that will force the South to (1) undergo internal devaluation in order to restore competitiveness; (2) break structural rigidities such as sticky wages and entrenched labor unions and professions; and (3) downsize the welfare state to a more affordable size. This is the classic gold standard deflationary policy which caused the Great Depression.

Depression and deflation, it is said, will increase competitiveness, balance budgets, and force the South to become more like the North and thus a better fit for continental monetary union. The problem is the sinful patient, not the poisonous prescription. The eurozone (or at least the northern part of it) truly believes that an imposed southern depression is appropriate public policy, and that there is no better alternative.

European monetary union was a political decision foisted on Europe by the French and against the opposition of the economics profession. Europe would emerge, Paris said,  as a world financial powerhouse (La Place Financiere). The transatlantic enemy and its almighty dollar would be cast down, and the euro would rightfully become the world’s reserve currency. Etcetera.

Thirteen years later, EMU has proven to be a fiasco, a world-historical mistake, a gigantic blunder on an unimaginable scale. But no one inside the eurozone’s cone of silence can say this. Too much has been invested in “Europe” in general and EMU in particular to admit error now.

This state of affairs is analogous to 1916, when it had become obvious to objective observers that a mechanized war of attrition was a disaster, but no one could admit it because so many had already died. And so the European powers persisted in the same blood-soaked strategy for two more years of death and destruction.

Right now, Europe faces a choice as critical as that in 1916. Will she admit error and turn back, or will she blunder forward into economic disaster?

As I have argued before, Europe faces three choices:
1. Fiscal union, with joint-and-several eurobonds and Berlin-imposed austerity;
2. An ECB monetary solution combining inflation and debt monetization; or
3. Deep depression followed by breakup, default, redenomination and inflation.

At present, Europe is on a very rocky and circuitous path towards fiscal union. Each time that Merkel gives ground, it is in the direction of fiscal union, not inflation.

Assuming that fiscal union were even possible, it would be an unmitigated  disaster. Fiscal union means that the South would become a colony of the North, with continuing deflation, fiscal austerity, and loss of sovereignty. Germany will bleed herself white as she pumps her tax revenues southward, while the South will seethe in hatred and resentment at German-imposed austerity and misery. Economic growth will stagnate, Japan-style.

Fiscal union is a debt solution to a monetary problem. It will pile debt upon debt, both in the South and in the North. The eurozone debt mountain will grow ever bigger, and wealth will dissipate.

I will reiterate that depressions are monetary phenomena, and the cure for depressions is sufficient money creation to produce a desired rate of nominal growth. The only way that this can be achieved in the eurozone is if the ECB’s mandate is changed to include financial stability and economic growth, with fiscal monetization explicitly permitted. This is the only way that budgets can be balanced, excessive austerity can be avoided, massive indebtedness can be averted, and prosperity can replace depression.

But this will require an entirely new definition of the EMU, the euro and the ECB. Instead of seeking to Germanize the Mediterranean, the EU must seek to Mediterraneanize the euro. (In philosophical terms, move the ECB from Frankfurt to Rome.)

From the perspective of ECB governance, this is almost conceivable, since the South and its allies can probably outvote the North on the governing council. But because the ECB charter does not permit inflation or monetization, there are limits to how far the Southern caucus can go without violating the ECB’s charter (which is a treaty).

If one reads the comments of the Bundesbank and its allies, their position is that Germany signed up for a common market and a common currency, but not for fiscal union or fiscal monetization, which is true. They point to the letter of the law, as does the Constitutional Court. As long as the Germans persist in this policy, the eurozone’s problems will only become more acute. And if Germany continues to give ground on the road to fiscal union, the fiasco will only be compounded and ramified northward.

We do not know how Germany will respond when the eurozone finds itself in extremis, nor do they. But at present, all signs point to disaster.

Saturday, June 30, 2012

What happened at the EU summit?



There’s an old saying that copper is the metal with a PhD in economics. Well, in my opinion, the stock market has a BA in Learning Disability. I need only remind readers of the fact that the S&P reached its all-time high in October 2007 after the credit markets froze and the CDO price index collapsed.

More recently, everytime there is an EU summit, the market erupts in euphoria: crisis over! The stock market is so bored with the euro crisis, and so totally uninterested in anything exogenous to its earnings models, that it will grasp at any straw that will allow it to go back to studying eps models and earnings “surprises”. I see no information value about the summit in the market’s reaction on Friday.

So what happened in Brussels? Not much, as far as I can make out:

1. An EUR 120 billion stimulus package using existing EU money. Yawn.
2. Direct EFSF/ESM bank recaps, once each eurozone member has surrendered its bank regulatory authority to an EU regulator yet-to-be-named. That will be a simple matter!
3. Something very convoluted about the ESM’s priority of claim at Spanish banks that is supposed to make bondholders feel better.
4. Allowing the EFSF/ESM to buy government bonds in the secondary market with an eye to reducing yields.

What didn’t happen?
1. No agreement about fiscal union, which is Germany’s precondition for eurobonds.
2. No mechanism to allow (or force) the ECB to buy government bonds in the primary market.
3. No (public) jawboning of the ECB for monetary stimulus.
3. No mention of Greece, which is still trying to renegotiate its bailout.

I have to assume that the market’s euphoric reaction reflects the view or the hope that Merkel and Schauble have had a meaningful change of heart about Germany’s role in saving the eurozone. I see no evidence of this. And there is still the small matter of the Bundestag (which has not yet passed the “fiscal pact”) and the Constitutional Court which looks fish-eyed at any loss of German sovereignty.

Once again, the EU has solved the immediate crisis (Spain’s insolvent banks) without providing a roadmap for any sort of final resolution. In my view there remain the following eurozone scenarios:
1. Breakup and chaos, as the PIIGS face daunting borrowing costs and default.
2. Fiscal union permitting the issuance of eurobonds.
3. The ECB provides inflationary stimulus and refinances the PIIGS.

Germany does not want #1 to happen, and is prepared to discuss #2, but no one is jumping at the chance to permanently surrender their sovereignty to Berlin, and anyway it requires a new treaty. #3 is the best solution, but it is not under consideration and it also requires a new treaty.

The spotlight now shifts to Athens, where the new government will have to choose between massive mandated budget cuts (and riots) or exit (and riots).

Thursday, June 28, 2012

The ECB can easily save the eurozone


As a thought-experiment, let’s imagine that Germany decides to permit (or is forced to permit) a monetary rescue of the eurozone, as opposed to a fiscal (eurobond) approach.

There is a rate of inflation (perhaps 8-10%?) that will allow the PIIGS’s to close their budget gaps, as nominal revenues race ahead of expense. So the PIIGS will be in surplus and their debt/GDP ratios will start to decline. Additionally, the euro will weaken in the foreign exchange markets, which will improve the current account positions of the PIIGS as well. That’s a pretty good start.

Let’s also say that the ECB stands ready to refinance the maturing debt of eurozone members based upon certain fiscal criteria and at various risk-adjusted interest rates (which are lower than current market rates). This will expand the ECB’s balance sheet, perhaps at the desired rate or perhaps above it. To the extent that the ECB’s asset growth exceeds the targeted rate of inflation, it can sterilize its purchases by selling “ECB bonds” to the public (just as the Fed can sterilize purchases of agency MBS by selling Treasuries). Investors replace their risky government bonds with “riskless” ECB bonds (riskless, because the ECB prints euros).

This would mean that not only would the PIIGS be in surplus with declining debt ratios, but also that they would no longer face refinancing risk. Crisis over. And not only would Germany not have to bail out anyone, it’s own creditworthiness would improve as well (at the expense of its credulous bondholders).

Frankly, I can’t imagine a better outcome for all. Europe would immediately enjoy nominal growth, followed by real growth as confidence and investment return. Just as inflation is always and everywhere a monetary phenomenon, so is nominal growth. If the Bank of Italy can manage it, so can the ECB.

The costs of this strategy are that price stability is sacrificed for growth, and holders of low-yielding euro-denominated bonds will suffer. The sacred “credibility of the euro”, so near and dear to the Germans, will be shattered forever. It might even become, temporarily, a “high yield currency”. A weak euro with volatile inflation will theoretically raise the risk-free real rate of interest in the eurozone.

But why do modern central banks exist? Don’t the reasons include (1) preventing financial collapse, and (2) preventing depressions? If so, Germany will have to discard the “hard euro” shibboleth, and accept what the US has already done, which is dual mandates of low inflation plus growth. Hyperinflation is an extremely destructive and inequitable event, but that is not what is recommended. What is recommended is inflation such as the world experienced in the 1970s, which did not end Western civilization.

Everything that I have written above is already in Mario Draghi’s mind. The problem is that it will take much more dislocation and distress to force Germany to permit the ECB to “go wild”. They are wedded to the hard euro and to the single mandate. So in the end they will have to choose between a Mediterranean monetary policy or a Mediterranean economic collapse. Please pick one.