On German Concerns About US Monetary Policy

Kevin has raised the issue of differing attitudes in Europe and the US about the need for expansionary fiscal policy, with the Germans being particularly reluctant to adopt expansionary policies. This piece in today’s FT shows that some of the difference in attitudes reflects German concerns about US monetary policy.

The piece cites Christoph Schmidt, an adviser to Angela Merkel, as saying:

I see an inflationary risk in the US in the medium term because of the development of money supply there.

It also cites Klaus Zimmermann, president of DIW:

The central banks in the US and the UK are now literally printing money. This creates an inflationary potential that is difficult to stop.

In other words, rather than recommending that Europe follow the US in providing more fiscal stimulus, these influential German economists prefer to argue that US policy has already become dangerously expansionary and provides a bad example.

In my opinion, these statements illustrate three popular misconceptions. Continue reading “On German Concerns About US Monetary Policy”

European Fiscal Assistance: Only with Conditions

Axel Weber made an interesting speech last night. He recognises that European fiscal assistance to a member state may be possible, but only under extreme conditions. Moreover, in order to comply with the ‘no bailout’ clause, any loan would have to be conditional (he does not specify the list of conditions).

Key part of the speech:

“It should be emphasised that the “no-bail-out” rule, as stipulated in the EC Treaty, is an indispensable instrument for preventing moral hazard behaviour by the member states. With that in mind, issuing blank cheques would definitely be the wrong course of action.

Yet, EMU is our common destiny. If any kind of help for a member state were necessary in the improbable case of an extreme emergency, the clear conditionality of such support would be essential in order to comply with the Treaty.”

Krugman on Europe

Paul Krugman’s article in today’s NYT  describes his perspective on the European situation.  His main focus is on thedifficulty in European-level policy coordination, in view of the current institutional configuration. However, he also flags the adjustment difficulties facing Spain (largely similar to those facing Ireland):

In the past, Spain would have sought improved competitiveness by devaluing its currency. But now it’s on the euro — and the only way forward seems to be a grinding process of wage cuts. This process would have been difficult in the best of times; it will be almost inconceivably painful if, as seems all too likely, the European economy as a whole is depressed and tending toward deflation for years to come.

It is interesting to note that Krugman accepts the thesis that wage cuts are required as part of regional adjustment within the euro area (indeed, he has signalled this on his blog in the past).  For Ireland, the level of pain may be lower than in Spain,  in view of the relative flexibility in the labour market and the potential for the social partners to contribute a pain-reducing level of coordination to the wage adjustment process as part of an overall reform package. However, a slow rate of adjustment will lead to a prolonged period of high unemployment.  In addition, the slower the rate of economic recovery, the worse will be the fiscal situation.

Deutsche Bank on the Irish Economy

Deutsche Bank have an online summary analysis of the problems facing the Irish economy (hat tip Turbulence Ahead).  Overall, it provides a reasonable account of the current situation.   However, it does perpetuate the misleading impression that the the scale of the Irish banking system is extraordinarily large relative to its GDP.  As has been noted repeatedly on this blog and elsewhere in the domestic media,  the aggregate statistics are dominated by the ‘pure offshore’ activities of international banks at the IFSC, with the ‘domestic’ component of the banking system large but not to this ‘off the charts’ extent.

Quote for the day

“We have reached our limits,” said Axel Weber, president of Germany’s Bundesbank, in Frankfurt on Tuesday. “The expectation that we could neutralise this ­synchronised recession through short-term fiscal policy measures is false. We should not even try. There will be costs.”

From this. Apparently they think that the SGP is the key to preserving monetary union, rather than, say, preventing mass unemployment.

For those of us in secure employment, this is shaping up to becoming a fascinating natural experiment in applied political economy.

Update: Christina Romer has a very nice introduction to the lessons of the Great Depression for today’s policy makers here.

ECB on Asset Support Schemes

The ECB released what looks to me like an important document on Friday.  In response to a February 26 Communication from the European Commission,  it sets out the ECB’s recommended guidelines on “asset support schemes”, i.e. over-priced purchases of impaired assets by the state or under-priced state insurance of these assets.  I have described my objections to these proposals a number of times and won’t go into them again here.  A quick look at the ECB document didn’t reveal anything that made me more convinced of the merits of these proposals (though I may report back after I’ve had a bit more time to read the document in detail).

In the Irish context, my concern is that the EU and ECB documents seem likely to convince the government that these schemes should be pursued.  However, there are other ways to go about dealing with our banking problems and a broader debate needs to be had than simply focusing on the details of how asset support schemes should be implemented.

A Eurozone Safety Net?

From the FT:

Eurozone authorities would help a member-state in serious economic difficulties before it needed to turn to the International Monetary Fund because of a risk of debt default, a senior EU policymaker said on Tuesday.  “If crisis emerges in one eurozone country, there is a solution before visiting the IMF,” Joaquín Almunia, the EU’s monetary affairs commissioner, said. “It’s not clever to tell you in public the solution. But the solution exists.”


Mr Almunia’s comments made clear not only that EU policymakers would not remain impassive in the face of a crisis in a eurozone country, but would act pre-emptively before a bail-out became necessary. “By definition this kind of thing should not be explained in public. But we are equipped intellectually, politically, economically,” he said.

I’m not sure that it’s really so clever to keep this solution a secret.  As the FT piece notes, there are serious legal restrictions in place that can hinder this kind of thing, such as restrictions on ECB lending to governments (The ECB website states “The Eurosystem is prohibited from granting loans to Community bodies or national public sector entities.”) and the so-called no-bailout clause in the Maastricht Treary prohibiting collective liability for debts (considered “an important pillar on which the European Union was founded” by reliably hard-line ECB Executive Board member Juergen Stark.)

Would it not be better for the Eurozone countries to have an explicit debate about this and, if necessary, outline a strategy and explain why it is legal?  Wouldn’t financial markets be less jittery if they could be genuinely assured that a coherent Eurozone strategy was in place?

VOX: Ireland in Crisis

Written by Patrick Honohan and Philip Lane, there is a new essay posted on the VOX website that seeks to explain the current state of the Irish economy and recommends a shift in fiscal strategy: you can read it here.

Update:  A shorter version of the article appears in the March 1 edition of the Sunday Business Post.

Update:  The article is also cross-posted at Roubini Global Monitor.

De Larosiere on Bank Regulation

On a first reading, there is an elephant in Jacques de Larosiere’s kitchen. The report recommends a new architecture for pan-European supervision, falling short of a single pan-European regulator as Kevin O’Rourke notes. It also recommends revisions to Basel II, without much in the way of specifics. The report has been welcomed by the Commission and is to be considered by EU Finance ministers next month.

The elephant is moral hazard. European governments have instituted wide-ranging guarantees of bank liabilities, amounting to de facto (and potentially free in some cases) unfunded deposit insurance for commercial banks. The report rattles on about the possibility of a limited and pre-funded deposit insurance scheme, with the option of national variations on a European template. But it seems to me that the genie is out of the bottle, and that, if and when business-as-usual returns, the public will not believe that there are deposit insurance limits. If there is a systemic crisis, Governments will be expected to step in. Even if there is just one distressed commercial bank, it is difficult to see how the clamour for retrospective liability guarantees can be resisted. These expectations could be with us for generations.

Clearly there are categories of near-banks (hedgies, prop-trading units) which could credibly (in the eyes of the public) be placed outside the pale, and denied guarantee. But how to prevent banks, believed to be guaranteed, from lending to these entities at inadequate rates, endowed with too-cheap funds from the public deposited on the basis of an assumed guarantee?

The net question is this. What are the implications for regulation and supervision of a European banking system in which liabilities of all the main commercial banks are perceived to be guaranteed?  Can it be less than Glass/Steagel, plus high capital and liquidity ratios, plus intensive supervision and risk monitoring beyond anything thus far contemplated?

Margaret Thatcher lamented, at the end of the Cold War, that nuclear weapons could not be de-invented. Can the perception of perpetual availability of retrospective and ‘costless’ bank liability guarantees be de-invented?

Achieving Devaluation Inside EMU

There is a fascinating press release from SIPTU (the largest union) today: you can read it here.  The key segments of the press release are:

“Speaking after the meeting, the Union’s General President Jack O’Connor said, “The assault under way is about correcting the problem in the public finances without the wealthy contributing a single cent. It is equally about achieving the adjustment, which would normally be brought about through a currency devaluation, by driving down wages across the private sector as well.”


“While a devaluation would affect all sectors of society, cutting pay achieves the same results exclusively at the expense of workers.”

For a member of a monetary union, the analogue of currency devaluation is to engineer a reduction in the general price level relative to the price levels of trading partners (measured in the same currency). This indeed involves a reduction in the inflation-adjusted level of wages across the economy. In relation to the owners of firms, the impact on margins is ambiguous and depends on the structure of each industry. Firms that are exporters and are price takers on world should see an improvement in profitability, as should firms that produce goods and services that are close substitutes with imports. In contrast, firms in ‘nontraded’ sectors may well experience a decline in profitability, especially if these firms use imported inputs.

These considerations are basically similar whether the real devaluation takes the form of a currency devaluation or a decline in the general level of domestic wages and (domestically-influenced) prices.

The major problems with the current situation are:

(i) the national pay agreement is not supporting the attainment of real devaluation. Since the pay increases are still being implemented by ESB, Bank of Ireland and others, the goal of a ‘uniform’ movement in wages across the economy is being inhibited.  It would be better to cancel the existing agreement (the macroeconomic conditions now are far worse than when the deal was reached in September 2008).

(ii)  Wage adjustment is best accompanied by policies to promote competition among firms and, in regulated sectors, to ensure monopoly power is not abused.

(ii) while it is obvious that the overall fiscal adjustment package will require substantial tax increases (including a higher tax take from high income groups), the delay in announcing this component of the deal raises perceptions of unfairness, in addition to increasing uncertainty about the expected level of post-tax incomes for all groups in society. The government could do more in terms of explaining the likely nature of tax increases over the coming years (at least in broad terms). While the Commission on Taxation may have ideas in terms of expanding the tax base, much of the adjustment will be in terms of income taxes and (possibly) VAT.  The general strategy regarding these components could be communicated more quickly.

It gets worse

It was always obvious that the crisis would put global economic multilateralism under pressure. But today’s roundup from Eurointelligence makes grim reading. Incredibly, the crisis seems to be threatening economic openness within the European Union itself, as a result of President Sarkozy’s comments on French car companies operating in eastern Europe.

I don’t believe that the future of the European project will depend on what happens in a couple of peripheral economies of marginal significance. Rather, it will depend on the answer to two fundamental questions. How much do the Germans really want the Single Currency? And how much do the French really want the Single Market?

While I remain optimistic, we are only a year into this crisis. By the time we are through with it, the answer could yet turn out to be: ‘not enough’.

Deflation and Competitiveness

David McWilliams has expressed concern about the risk of deflation in Ireland and recommends that we “engineer inflation by pumping money into society”: you can read his article here.

For a member of a currency union,  there is a natural limit to national-level deflation.  Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a while), this is self-correcting since it implies an improvement in competitiveness, which will in turn generate a boost in economic activity and a return to an inflation rate at around the euro area average. In contrast, no such self-correcting mechanism operates for a country with an independent currency. So long as the ECB avoids deflation at the euro area level, a true deflationary spiral for Ireland is not possible.

Of course, even if deflation (or low positive inflation) is just a temporary phase for Ireland, it can last for several years. It certainly amplifies the extent of the downturn, since it implies the real interest rate (the nominal rate minus the expected rate of inflation)  will be high. This is the mirror image of amplification of the boom period that was generated by the low real interest rate during our prolonged period of relatively high inflation.

One lesson is that it is much better to have a sharp fall in the price level now (generated by wage cuts and efforts to cut markups through more aggressive competition policies), rather than a gradual decline in the price level over several years.

It is worth remarking that the structure of the national pay deal does not provide the appropriate kind of ”incomes policy” that can help this process. In particular, deviation from the national pay deal is only permitted if a firm is in very serious financial distress. Rather, we need cost reductions even in sectors that are still profitable, since prices of all goods and services matter for the level of competitiveness.

A good example is the ESB.  It would be very useful to see wage correction in this sector, which will help to reduce input costs for many businesses.

Another way to express this point is that the national pay deal can accomodate firm-specific shocks but not macro-level shocks. To respond to macro-level shocks, the national pay deal should be re-negotiated to allow a generalised reduction in costs across the economy. (As a complement, competition policies could be reinforced and ‘administered’ prices could be forced down.)

French balloon shot down over Berlin

Predictably, if sadly, Sarkozy’s idea of a Berlin summit to discuss what should be done if a Eurozone member were to get into trouble has been dismissed by Berlin. Discussing such things ex ante, on a purely theoretical basis of course, will turn out to be preferable to discussing them ex post, if ex post ever arrives. The German reasoning is that some things just shouldn’t be talked about in public:

A Berlin, un porte-parole du gouvernement, Thomas Steg, a estimé qu’une telle rencontre n’est “pas nécessaire dans l’immédiat. L’expérience nous a appris qu’il y a certains sujets relevant de l’Eurogroupe dont il vaut mieux ne pas discuter en public”.

Whether saying publicly that there are certain things that you shouldn’t talk about publicly is in fact reassuring, is probably something that one could debate.

How to Fix the Economy

Alan Ahearne is today’s contributor to the Irish Times series: “Income Tax Rates Will Need to Rise.” (As usual, headline does not give full flavour of the article.)

The fiscal plan of Fintan O’Toole is also worth reading: “Government Reaction to Crisis Needs to be Credible.” A longer version of this article would have been even more interesting, in which the economic consequences of the pay element of his plan might be explained in more detail.

Issues in The Sovereign Credit Default Swap (CDS) Market: Guest contribution by Dan Donovan

I am pleased that Dan Donovan (a highly-experienced trader in the financial markets) has taken the time to write an explanatory note on some of the most important features of the sovereign CDS market. See his contribution below.
From Dan Donovan:

As the current malaise in the credit markets unfolds one of the rapidly emerging issues has been the markets concern about various sovereign solvency issues, most particularly with regard to the ability or otherwise of countries to be able to pay for the varying forms of bank guarantee’s they have proffered.

Most agents seeking to express views that sovereigns would be unable to meet their commitments and or that the cost of doing so will escalate have been doing so via the Credit Default Swap market; buying “insurance” against the default of the named sovereign. It is note worthy how quickly and dramatically the cost of this insurance has escalated.. Ireland as can be seen below (ex Iceland) has borne the brunt of this position taking.

5y                  10y
Port     134/144       130/150
Ital      177/187       172/182
Gree    260/290       255/285
Spa     148/158       145/160
Irel      260/300       240/290
UK      140/150       137/147
Denk    109/119       108/120
Swe      110/125       115/130
Aust      145/155       145/145
Ger           56/66            56/66
Fran          63/73             64/74
Finl           55/65             57/67
Belg     115/135       113/133
Neth     105/125        105/120
Iceland  925/975          800/1000

Source JP Morgan.

It is tempting to dismiss such moves as merely a thin market overreacting to the current zeitgeist, for instance it now costs roughly 3 times as much to insure against a default of the UK government as it does to insure against the default of Cadburys! There are however some important issues to consider regarding the implications of such moves.

Price Setting: Many participants in the market are able to switch between writing CDS insurance and buying Government bonds. As such the CDS market which is more active than the underlying market can have the effect of defining the cost of borrowing for sovereigns despite the fact that there is very little in the way of transparency regarding who the agents in this market are and what volumes have been traded. Governments could be forced by virtue of this market to pay unnecessarily high (perhaps punitively high) borrowing costs.

Agency Issues:  The existence of the Sovereign CDS market may change, considerably, the motivation of traditional suppliers of credit extension to sovereigns.

Whilst the CDS market is a zero sum game, it is however conceivable that certain groups can accumulate considerable positions in the CDS (buying insurance) of a given Sovereign without holding any underlying positions in the securities referenced by such a CDS. It would then be optimal for such agents to fail to support the issuance programmes of the country in question. The reason being that this will benefit the CDS they own via the spread moving wider or in the extreme technical default of the Sovereign triggering the CDS contract. Under normal circumstances this issue would be so remote as to be irrelevant, but these are far from normal times and as such these issues need consideration.

Possible Solutions: It is certainly arguable that CDS contracts have been far from a force for good in these times and have done more damage than good and should be outlawed. It would be difficult to “put the Genie back in the bottle” however and as is the case in banning short selling may have severe unintended consequences. One simple strategy would be to enforce disclosure of all agents Sovereign CDS positions. Such transparency could be delivered in a very short time frame and would enable Issuers and the market in general to understand and interpret the actions of the varying market constituents more clearly.

Deflationary spirals

It appears that the fear of a deflationary spiral is being used as a major argument against wage cuts. My impression is that the idea is gaining traction out there in the real world, and so it seems worthwhile restating the reasons why it is wrong.

‘The’ price level in the Irish context is the European price level, which is determined by policy in Frankfurt. Nothing that happens in Irish labour markets will move this price level by one iota in either direction, and so nothing that we do here will set off a deflationary spiral. What we can influence is a relative price, namely the relative cost of living and doing business here. This relative cost exploded during the bubble, and it will eventually come down. The only issue is whether this happens quickly, or whether relative Irish costs will be ground down by unemployment and stagnation over the course of many years.

David Begg is right to fear a deflationary spiral, but what will determine whether we get one or not is the relative supply of ideologues and pragmatists in the ECB, not anything that happens here. And the sort of intertemporal logic which explains why deflation is so damaging can be turned on its head in the Irish context: as Philip points out, it implies that wage cuts need to happen all at once, now.

The Government should announce that all public sector wages, which it controls, be cut by x%, where x is determined by real exchange rate considerations. It should strongly suggest that all private sector wages be cut by the same amount. Ideally we would all jump together, and so the wage cuts would come into effect simultaneously on a given date. St Brigid’s Day would seem appropriate.

Did the Euro contribute to the Irish bubble?

Jim O’Leary discusses Ireland’s EMU membership in his Irish Times column today.  An interesting question is whether Ireland would have avoided a bubble had it opted not to join EMU.  The issue here is the relevant counterfactual.  Since quite a number of non-member European peripheral countries that were growing quickly for convergence reasons also enjoyed credit booms due to the global decline in risk aversion and compression of spreads, it is not so obvious that staying outside EMU would have delivered stability (think of Iceland and various CEE countries).

If expectations of price appreciation grip the housing market, small differences in the level of interest rates do not make too much difference.  To the extent that high levels of immigration helped to fuel perceptions of strong fundamentals in the housing market, that dimension is orthogonal to EMU:  the two other countries that were early liberalisers were also not members of EMU (Sweden and the UK).

Accordingly, if the relevant comparison set is composed of other non-advanced European countries (in terms of income levels relative to potential in the late 1990s), then it is not clear that EMU was a fundamental factor.   Rather, key differentiating factors may include the quality of banking regulation and the probity of fiscal policy.

Clearly, this is a very open debate that calls for more research!

Krugman: Nominal Wage Cuts Necessary but Difficult

Paul Krugman discusses the problem facing those EMU member countries that are currently suffering from a lack of competitiveness (note, by the way, his use of the word competitive!) and accepts that nominal wage reductions are a necessary part of the adjustment: you can read his discussion here.

He also links to a posting by Edward Hugh that probes the difficulties involved in engineering nominal wage reductions: you can read it here.

Ireland and EMU

The Daily Telegraph gives prominence today to the recommendation by David McWilliams (made on RTE radio over the weekend) that Ireland should consider leaving the euro area: you can read the article here. The notion that Ireland or some other member country might leave the euro area is now a factor in the government bond market.

However, the adverse economic consequences of leaving the euro area are so large that this option should not be taken seriously. Barry Eichengreen has written a comprehensive paper on this topic, which you can download here.

The benign scenario described in the comments attributed to McWilliams in the Telegraph article envisages Ireland being able to use monetary independence to achieve real exchange rate depreciation in a stabilising fashion. However, a new Irish currency would be emphatically not trusted by the markets (a government that is willing to take the steps to exit the euro area is not a government that can be counted upon to keep its promises), such that either the new central bank would have to offer high interest rates or the government would have to impose capital controls. Neither is a recipe for a growth recovery.