The exit option – why Yanis’ views are inconsistent

Who has an exit option? Exit sign in Greek, by chezrobyn

This is just a short one in my ongoing discussion with Yanis Varoufakis, which in our terminology is KE5, but refers to YV1.

After listing all the negative implications that an exit would have for Germany – legally, economically, politically – Yanis writes

My point is not that Germany plans to exit the Eurozone. No, my point is that, courtesy of being a surplus country within a common currency that is in Crisis, the fact that it can leave the Eurozone (i.e. an announcement that it will leave will cause a capital flight into Germany, independently of the fact that it does not want to leave, and of the other costs it involves) gives it an enormous bargaining advantage in relation to, for example, France or Italy which cannot leave whether they want to or not (courtesy of being in deficit, a fact that ensures a capital flight from them if they announce such a move).

Whether a country can exit the eurozone is a matter of costs and benefits, very simple. Greece has high costs, but also the advantage of devaluation. The same is true for Italy, whose private sector has relatively low euro-denominated debt levels. Germany’s costs would be extremely high. I find it difficult to compare these costs, but I am not convinced that Germany’s costs are so much lower than those of the others. They are just, well, different. Since bargaining power depends on the cost of the outside option, the costs for Germany would have to be considerably lower for it to have an exit-related “enormous bargaining advantage”. I don’t see that.

One additional aspect of the Greek exit – and I don’t want to be misunderstood here – is that it could be beneficial for the Eurozone as a whole, and especially for Spain and Italy. The argument is somewhat cynical, my apologies, but I think Yanis’ view on a Greek exit is somewhat inconsistent. If the Greek exit is as horrible as Yanis argues it might be for Greece itself, this is an important committment boost for Italy and Spain – after all, if it is horrific for a country that is already so deep in trouble and has a hopelessly overvalued exchange rate, there is no way that Spain and Italy will leave the Eurozone. A Greek exit, if it is horrific, could help Spain and Italy in their effort to convince investors, savers, depositors and banks that the euro is in their countries to stay. A positive outcome of a Greek exit for the Greek economy would be much worse for Italy and Spain.

Please note once again that I am not cynical myself. I just think that Yanis position – a Greek exit is horrific for Greece and then Italy and Spain will follow – is not entirely consistent.

Γερμανία, ο νέος εχθρός της Ελλάδας? Yet another response to Yanis’ response.

Germany and Greece signing the Versailles Treaty bailout agreement…?!

This is yet another post in my ongoing discussion with Yanis Varoufakis. Please have a look at Yanis’ most recent response on the transition period to his Modest Proposal. Three quick remarks before I start with the topic of this post:

  • The MP basically leads to each existing government bond being partly backed by the ECB, and party by the national government. No legal problems, more like the “two bonds” transition I suggested. It also means that the refinancing of existing debt will be cheaper in the future (unless MM theorem holds, which it probably doesn’t).
  • Marginal debt, however, will not. It will be more expensive to sell new bonds above refinancing old ones. My mentioning of the MM theorem was supposed to show that interest rates on remaining “red” debt will go up, and considerably so. What are the consequences if you don’t believe that the MP will make the crisis go away? Yanis doesn’t really seem to want to answer this question…
  • Finally, the fact that countries don’t have equity is not relevant to whether the MM theorem applies or not, in my view.

Today’s post is in our terminology KE4 in response to YV1 and it deals with the blame game between Germany and Greece, as well as historical comparisons.

In my original post, I claimed that Yanis had in the past blamed Germany for economically exploiting Europe. I didn’t mean to suggest that he is playing a simple blame game, my apologies. I should have been more precise: the view that Germany has benefited from the euro and that its economic model brought the periphery into these troubles in the first place (the alleged German “mercantilism”), is misplaced in my view. But more importantly, such statements about the German economy open the door to blame games, which is dangerous.

Because let’s be honest, Yanis: whether Germany on aggregate has benefited or lost from the euro is a question that cannot be answered with a sufficient degree of confidence, there are valid points on both sides, and nobody knows the counterfactual. The same is true for whether German workers have benefited from it, or were hurt. Neither of us should put too much faith into his own analysis and judgement, the German economy is much too complex for that. It is fine to endorse Hainer Flassbeck if one agrees with him, or Hans-Werner Sinn for that matter, but one should also note that there are very well-reasoned positions all the way to the other side. I am somewhere in the middle, arguing that benefits and costs of the euro roughly balance for Germany.

A strong statement about Germany’s gains, however, opens the door to blame games by others who read it. Let me quote one commentator on Yanis’ blog, accusing Germany (emphasis mine):

Your government shouldn’t force illegal loans and corrupted deals for imports and artificial standards of leaving in any country and other governments shouldn’t accept. So, not only you grew your economy at the expense of others, now you say it is not logical to pay for the problems caused. Stop crying and pay up. Not the people, but your government. … The whole country of yours should go to jail on a far away planet.

If you think that this surely is not representative of Greek public opinion, I am afraid, you are wrong. I was shocked to read about this recent poll in Greece, in which 51% agree that Germany’s economic success is based on a “lack of transparency in handling big projects abroad (Siemens, corruption, bribes)”, whereas 18% think it is the competitiveness of the German economy (14% think it’s both).

This poll brings me to historical comparisons. I probably don’t have the amount of historical knowledge that Yanis has, and I know that Germans are sensitive when it comes to historical comparisons, war metaphors etc. But suggesting that Germany is imposing a “Versailles Treaty” on Greece is highly problematic. After all, what should the motivation be for such a treaty today? Retribution like in 1919?!

A New Versailles haunts Europe, by Yanis Varoufakis

… Retribution [=Vergeltung] was the order of the day, especially in the mindset of a nation that, over the past century, has accepted its collective punishment gracefully and managed to rise out of the mire through sheer hard work and extensive reform. Greece should to pay for its sins too. For Germans, the cost of saving the Greek state from the clutches of the money markets was not the issue. The issue was that Greece should suffer a deserved punishment for putting at risk a club which gallantly bent the rules to have it admitted as its member. And when the said club is the one issuing the currency in which the German people trade, save and take collective pride, that punishment took on the significance of a crucial bonding ritual. …

This is just flat-out wrong. And offensive. Germany’s motivation was never retribution. Many German policy makers simply misdiagnosed the crisis as one of public debt alone and argued, correctly according to their diagnosis, that Greece should simply spend less and tax more to get out of it. Others claimed that Greece was “under attack by speculators”, and just needs liquidity support. Both is, of course, bad economics. But the consensus policy of these two diagnoses is to loan money to Greece at high interest rates (it’s a liquidity crisis after all…), on the condition of massive budget cuts. IMF-style policy, somewhat 1980-ish, if you want. Nothing of this is retribution, and contrary to what Yanis claims, “the cost of saving Greece from the clutches of the money markets” was the main concern for the German public.

So no, I am not accusing Yanis of a blame game. But I do want to point out that his writings are at times not particularly cautious either when it comes to using slightly one-sided statements about Germany’s economy, or historical comparisons that are more often than not unnecessary, hopelessly imprecise and very dangerous. Yanis does influence the tone of the debate, he has 30.000 followers on Twitter alone. Readers may be tempted by such statements or comparisons to go where Yanis doesn’t want them to go – to blame Germany. Or, if the readers are German, they may feel offended and start retaliating. Neither of which is very helpful. Because here comes the truly shocking part of the poll above: the Greek public is so desparate that historizing myths seem to easily take hold.

  • 74% strongly agree that Germany wants to dominate Europe through its financial power, and a shocking 69% strongly agree that Germany wants to build a Fourth Reich.

Needless to say to anyone with just a shred of knowledge about Germany, both claims are beyond ridiculous. But it is hardly surprising, then, that 87% and 81% of the participants in this poll strongly agree that some form of late reparations from the Second World War should be paid to Greece.

Two caveats are in order. First, the poll, besides being poorly designed, might be biased. And I hope it is. Maybe Yanis can tell us more about the background of the institute that conducted it. Second, my German readers should not feel offended by the poll, but rather take this as a sign of just how desparate the situation in Greece really is.

Modigliani-Miller and Yanis’ response No. 2

Yanis answers once more, directly to the first part of my response, before I had the chance to write my second part. He suggests that we should clearly mark our responses as this discussion is likely to continue – which I look forward to! So this post is KE3 in response to YV2.

I understand that Yanis does not want his Modest Proposal (MP) to be taken apart; he rightly says that it is a combined effort, where each part reinforces the other. However, he goes a little too far in my view and makes assumptions about how the combined beneficial effect of the MP will look like that somewhat mutes a necessary discussion about each bit separately.

I agree with Yanis that the unusually low interest rates of Germany are in part a sign of panic and disruption rather than a sign of German fiscal brilliance. And likewise for Spain or Italy, with opposite sign. But apart from that, a very famous theorem, Modigliani-Miller, tells us that the structure of how a company finances itself – under lots of idealizing conditions – is irrelevant for how much it is worth. For the MP and other suggestions of how to structure European sovereign debt, this means that when the “blue” part of the debt has higher seniority and thus, lower rates, the yields on the “red” debt will be so high that the interest rate cost will be the same in total. In theory, that is, without panic or disintegration or mutualization of debt.

Yanis knows all this, of course. And given the current situation, I expect (as he does) that the MP will lower the total interest rate costs of, say, Italian debt, so Modigliani-Miller doesn’t apply. However, will it be enough to bring the marginal rates on “red” debt to a sufficiently low level? As Yanis writes, correctly in my view, market discipline will be strengthened: the rates on “red” debt will probably go up, beyond the yields that Italy and Spain are paying now, not to mention Greece. After all, in a country like Italy with >100% of GDP in debt, the upper half (the “red” debt) would have to bear all the risk. Even in benign economic circumstances, this would lead to very high yields in my view.

Then what? If you put a lot of faith in the MP, you will argue that it doesn’t matter much as the MP will make “the crisis go away”. Unfortunately, this also ends the debate. So let us for the sake of argument put less faith in the full MP, for instance because wage and price differentials across Europe will not go away easily, leaving countries like Greece and Portugal in recession for a long time. Or because property busts like the ones in Spain and Ireland are hard to handle even outside of a currency union. As marginal yields set the incentive for how much to borrow, the pressure by markets will be very high. Will this lead countries to enact the exact austerity policies that are part of the problem right now? Fiscal waterboarding by markets, so to speak? I consider that quite likely. These countries may need a grace period, and how should we implement it?

This brings me to another misunderstanding about the MP: how is the transition period supposed to look like? Will each bond holder get two new bonds: one which is backed by the ECB, the other by the national government? Or will countries, as I assumed, just replace bonds that run out with ECB bonds? The latter will run into legal problems, as new debt will be senior to existing bonds which, as far as I know, would be a default event on existing bonds that often have a pari passu clause. On the other hand, it would give countries a grace period in which they don’t have to turn to the market, which could be helpful in current circumstances. It would be great if Yanis could clear that up.

No diamonds without pressure? Yanis’ response, Part 1

What is the right amount of pressure? Pressure gauge by wwarby

Yanis Varoufakis, whom I recommended to you in my last post, has written an extensive reply, for which I would like to thank him. I also think that such a debate is the best way to counteract the unfortunate mutual disdain that seems to be growing between Greece and Germany. I don’t ask for much (…!?), my dear readers, but I do ask you to read his response in full. My response will be split into several posts, there is simply too much to discuss. I will start with market pressure on the periphery.

Before I start, let me add two apologies. I did not represent his Modest Proposal entirely correctly because that would have taken more space than I thought was necessary for the key issues. But it turns out: I was wrong. Second, if Yanis and other readers felt that I was accusing him of a blame game, something I despise myself, my apologies. I’ll explain what I meant in a soon-to-follow post.

Regarding market pressure, Yanis writes:

Mrs Merkel told us only the other day that her objection to eurobonds is that they will reduce interest rates; something she said is counterproductive because it takes countries like Italy and Spain off the hook. … [Kantoos] may agree with Mrs Merkel (that high interest rates must be maintained as an incentive) – but this only means that [Kantoos] agrees with the first reason I gave as to why Germany is resisting proposals such as ours [The Modest Proposal, K.].

However, with Yanis’ Modest Proposal, interest rates on the non-ECB-backed bonds will go up, and in part considerably so. What is more, he writes that this is a good thing:

Since we divide each member-state’s debt between Maastricht-compliant and the rest, and suggest that the ECB manages the former but not the latter, it would be rather helpful if a ‘healthy’ interest rate spread emerges between the two classes of debt making sure that, while the Maastricht-compliant debt of fiscally-stricken member-states is cheap to refinance, there is a market determined premium to pay for excessive public debt.

So Yanis agrees with Merkel?! After all, it is the margin that counts for incentives, not the average interest rate paid on debt. So what’s going on here?

Yanis would probably argue that the transition period of the Modest Proposal, during which countries can get up to 60% of GDP at the ECB at low rates, will take countries off the market for the next couple of years, and reduce pressure. This is where Yanis disagrees with Merkel and the German position. Then again, he also seems to argue that a proper market signal is probably a healthy corrective in general, as reforms and spending cuts are hard, painful and politically difficult – which is the basis for the German position. His view is not entirely clear, in my view.

My point was that too high market pressure, that forces countries into massive austerity and political turmoil, is destructive and not in Germany’s interest, for the reasons described by Yanis in his response:

From experience, I can tell you dear reader that the severity of the cutbacks in Greece have reduced our society’s capacity to reform. … [R]eform requires investment. Any CEO will tell you that to improve management structures one needs to invest in them. Greece, Italy, Spain et al are so busy cutting that no investment goes into genuine reforms. … [T]he cruelty of the austerity packages (that is evident for all who have eyes to see, and want to use them) destroys the common will to effect reforms.

In my view, and here I disagreed with Yanis, more (!) pressure is not Merkel’s aim either. Yanis wrote in his original post somewhat ambiguously (emphasis mine):

Mrs Merkel feels that fiscal waterboarding is what the Periphery needs more of these days.

Anyway. The more important question is whether giving countries a grace period might lead to too little pressure?

On the one hand, the economic situation is horrific in Greece or Spain as it is. I think one could make a valid argument that additional pressure through the market is not necessary in order for these countries to reform (which is much more important than short-term budget cuts). What is more, the outstanding debt under the Modest Proposal, that will still be traded on the market, will give countries at least an indication of what they will face when they have to turn to the market again. But is it credible that these countries have to return to the market? Can the eurozone afford this, if yields are still 8% or more? Will therefore the medium-term fiscal incentive be enough?

On the other hand, and this is something I would like to hear Yanis’ views on, a dismal economic situation alone may not lead to the most needed reforms. The powerful groups in society may still get what they want, at the expense of the overall economy and society. It is, after all, not a coincidence that Greece is in the current economic mess, is it? A grace period is fine, but conditionality, by the IMF for instance, may still be helpful to focus reforms on the right areas, and to prevent that policy makers back down when bureaucrats, banks, protected professions, public sector employees or the rich resist reforms. As far as I know, the IMF has learned a lot from past failures. It did a good job in countries like Iceland according to those involved and was not the one in the troika that focussed on austerity. The EU/ECB plus European politics is clearly not the right institution that should impose conditionality, however.

Yanis’ position is very similar to that of the German government: market incentives are helpful. Yanis acutally wants to strengthen them with his Modest Proposal (on the margin where it matters). Whether an unconditional grace period is appropriate at the moment is an open question, in my view. For the sake of the countries themselves, it might be good to engage the IMF that forces the elites to take on the most needed reforms.

Yanis Varoufakis on “fiscal water-boarding” and ECB bonds

Yanis Varoufakis at the INET conference in Berlin

Yanis Varoufakis has been covering the Euro Crisis for quite some time and wrote a “Modest Proposal” to solve the crisis early on,  that he updates regularly. I have been following his writings and also recommended him in my recommended economics blogs list (in German). I fully agree with Yanis, and have written it over and over, that a ruthless recapitalization of European banks is one important part of a solution to this crisis. His other proposals I find less convincing.

Let’s have a look at his recent post “Fiscal Waterboarding versus Eurobonds: Misrepresenting the latter to effect the former”. In essence, Yanis says that jointly and severally guaranteed Eurobonds are not the answer because they involve transfers from core to periphery taxpayers. He claims that he has found a way around this, by having the ECB issue bonds on the member states’ behalf, have the states pay off their debt at the ECB, and have the EFSF/ESM guarantee the losses of the ECB “in the remote case that some members do not redeem its bonds in the distant future”.

How is this different from a jointly and severally guaranteed Eurobond? Let’s leave out the political mess and just focus on the economics. The ECB’s role ensures that interest rates on the these bonds are very low. This lowers the debt burden of, say, Italy. However, there is no guarantee that Italy will be able to service its debt in the future. Who is standing behind these ECB bonds? Either the ECB itself, which means that it needs to be recapitalized (= will transfer lower profits to the governments). Or the insurance by the EFSF/ESM will cover losses. Either way, the other European governments pay. So there is not a big difference here: ECB bonds transfer risks.

Where I can see a difference is in interest rates: Eurobonds will have yields above German rates (some weighted average of all Eurozone yields), whereas ECB bonds will probably have German rates, so Germany won’t pay more than before. Fair enough. But the problem here is that ECB bonds might increase the yield on other bonds. Sounds silly? It is not.

If the states have to recapitalize or insure the ECB, these countries’ risks increase. The ECB bond is just a Eurobond with a higher seniority, if you want: the loss-absorbing capacity of the ECB is around 2,000 – 3,000 billion euros, but this capacity is directly related to government revenues. ECB bonds will therefore be repaid first, at the expense of the government revenues that are available for other bonds. This leads de facto to a lower seniority of the normal bonds, which as we all know leads to a higher yield on these junior bonds. So by giving out ECB bonds, the yields on other bonds are likely to increase.

Yanis would have to make a more convincing case that by having the ECB issue bonds, some risk is taken out of the market, and are not just redistributed like in the case of Eurobonds. But where? There might be a safety and liquidity premium for ECB bonds that lowers yields overall, which the Eurobonds do not have to the same extent (as they are by no means perfectly safe). There might be other reasons, but in my view ECB bonds are not a silver bullet, and very close to the commonly proposed Eurobonds.

His conclusion is that Germany refuses his proposal…

… [f]irst, because Germany does not really want interest rate relief for the struggling Periphery. For some reason, which I shall not elaborate on here, Mrs Merkel feels that fiscal waterboarding is what the Periphery needs more of these days.

Secondly, because such a scheme would mean that Germany would lose its capacity to leave the eurozone as a common debt external to the European System of Central Banks will be born by the ECB, thus making it impossible for any member-state to up stumps and leave the euro. Such a loss of its ‘exit card’ (that only Germany truly owns) will reduce the German chancellor’s bargaining power, within the eurozone, inordinately.

I think both is incorrect. The pressure on the countries in the periphery has certainly helped to change their domestic policies, and I am sure Yanis agrees. More pressure is surely not in Germany’s interest, as it threatens to break up the Eurozone, which would be very costly by almost any calculation I have seen.

The second aspect sounds very weird to me: a German exit is surely not the main reason why Germany has bargaining power. A German exit would be extremely complex, legally nigh impossible, and threatening Germany’s industry that just recovered from several negative shocks (reunification, globalization, EU enlargement, higher financing costs).

Yanis writings on the Euro Crisis are important for me because they challenge my thinking, and I like that. But except for the banking aspect, I am having trouble with some of his views. Besides the above on ECB bonds, I diagree with…

  • … his tendency to blame Germany for economically exploiting Europe. That is a very one-sided view of what Germany’s economic development is about, and why it developed the way it did. So far, Germany has not gained from being in the euro (contrary to what is written again and again), and it is likely to foot a massive bill when this whole mess is over (partly self-inflicted, I know, but almost surely not the major part of it).
  • … his tendency to make this Euro Crisis look like an easy-to-solve problem which is not backed-up by any theory or evidence from the past, as far as I know. It is a full-blown mess (on a continent with legally mandated free capital movement) that is and always was very difficult to solve – including the question what a “fair” distribution of the burden looks like, irrespective of the usual moralizations.
  • …  his diagnosis that Europe suffers from an under-investment crisis. That is a strange view given that Greece, Ireland and Spain received massive EU and capital market help to over-invest in infrastructure and real estate in the past. Europe suffers from a lack of smart investment and even more importantly, from a lack of efficient, growth-promoting institutions. If he meant to say that the periphery (and the Eurozone as a whole) suffers from a lack of aggregate demand (AD), I fully agree with him. But again, there are problems with dividing up AD in the Eurozone, and above all, a problem with getting the ECB to stabilize aggregate demand, and not headline inflation.

PS: I do recommend you have a look at his blog, though, and read his views for yourself. Also, check out his Modest Proposal. You might also be interested to buy one of his books, for instance his recent “The Global Minotaur”.

German fiscal stimulus

The WSJ has an interesting piece about the potential and likely effects of German fiscal stimulus (by Amit Kara, UBS):

The euro-zone economy is stagnating, and many argue that Germany is partly to blame. German households and corporations tend to save, and the country runs a large and persistent current-account surplus. That implies a deficit in other euro-zone countries. …

Germany runs a small and manageable fiscal deficit of just 1%, but the stock of government debt is high at 80% of GDP. And with a potential GDP growth rate of just 1%, any initiative that raises the debt level of Europe’s strongest economy may well bring into question the sustainability of both its own debt and that of the entire euro zone. Put differently, Germany does not boast the fiscal strength that many assume. …

All in all, an expansion in German domestic demand would have, at best, a marginal impact on the economic growth prospects of the periphery.

Do read the entire piece! One aspect that Amit does not tackle, but which I think is important, is the likely ECB reaction to an increase in German demand and its likely inflationary consequences. And I am afraid, we have to take the ECB as given…

HT: Tyler Cowen who has more.

OOH, do we measure inflation correctly?

I am very glad to welcome this guest contribution by David Lizoain on how to measure inflation correctly in the Eurozone. It is a difficult, and at times dry topic, but I encourage you all to read David’s excellent summary of the issues below.

Mario Draghi and the rest of the ECB Governing Council paid us a visit in Barcelona last week.  After witnessing the overwhelming police presence and the temporary suspension of the Schengen treaty, I can attest that these guys are serious about maintaining their price stability.

The Governing Council defines price stability “as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. What I would like to discuss in this post is not the inflation target of 2% but rather the HICP. I’d like to argue that by targeting a flawed variable (the HICP), the ECB is generating flawed policy.

The HICP has one enormous deficiency: owner-occupied housing (OOH) is presently excluded from the index, primarily because of the methodological inconsistencies that existed between the statistical methods of the different countries.

Omitting OOH means that the HICP is not as complete of an indicator of the price level as it could be. Moreover, on account of differential rates of home ownership across Europe, the weight of the omission varies from country to country. This makes it difficult to compare HICPs across countries and calls into question the appropriateness of combining the different indicators to generate a single European index. (For a nice example of the non-comparability of the HICP across countries, take a look at page 67 of Eurostat’s technical manual on OOH).

In the key paper on this subject, “Housing Prices and Inflation in the Euro Area”, Boris Cournéde pointed out the following:

The recent experience of strong house price inflation in several euro area countries begs the question as to whether the exclusion of owner-occupied housing costs might have driven a wedge between the HICP and the cost of living. The presence of any such wedge clearly matters because many important economic decisions, such as wage settlements and consumption choices, are directly influenced by changes in living costs.

The use of an incomplete HICP makes it much harder to measure and therefore correct imbalances across Europe. This factor should be taken into account when the issue of distributing inflation across Europe is raised.

Very gently, Eurostat explains that the ECB might be getting everything wrong:

From the outset, it has been considered unsatisfactory to exclude OOH from the HICP since this may give a misleading picture of the inflationary pressures present in the economy. Hence, the exclusion of OOH may impinge on the ability of the HICP to meet its primary objectives, which are, on the one hand, price convergence assessment in the EU and, on the other, the monitoring of price stability in the euro area. For this reason, the treatment of OOH in the HICP has been given the highest priority at Eurostat.

The Eurostat draft elaborates how OOH might be incorporated into the HICP.  There are various methodological options; Eurostat is opting to use a net acquisition approach.

This approach is expected to generate relevant differences in the measured rates of inflation. If a country has a housing bubble, incorporating OOH into its HICP would be expected to raise its measured rate of inflation; a housing crash would produce the opposite effect.

In the case of Spain, my assumption is that if OOH had been incorporated in the HICP during the bubble years, higher levels of inflation would have been registered – with all the consequences for monetary policy. By excluding OOH, the ECB was allowed to conduct monetary policy that was more appropriate for Germany than for Spain. Including housing would have shown with even greater clarity how competitive imbalances were building up across Europe.

A higher rate of inflation in Spain would also have implied a fall in Spanish real wages during the boom years. Coordinating wages across Europe is already difficult; if the HICP does not reflect the true evolution of the cost of living and if the HICP should not really be compared across countries, this task becomes even more complicated. (It’s worth taking a look at Andrew Watt of ETUC’s Golden Rule on this subject).

If we added OOH to the HIPC, we would expect Spain to be showing lower rates of inflation now that its housing market has crashed (which in turn would bring down the European rate). This deflationary tendency was also present when the ECB irresponsibly chose to raise interest rates in 2011. However, the HICP neither reflected the housing bubble nor the housing bust. Just as the country HICPs may not have been appropriately capturing the divergence in inflationary pressures, now they may not be capturing tendencies towards convergence.

I disagree with the ECB’s refusal to publish the minutes of its Governing Council. I disagree with the ECB’s choice to define a 2% target. But I am perplexed as to how the ECB could let such massive housing bubbles emerge and burst without incorporating OOH into their price index.

The Economist on German macroprudential regulation

The Economist picks up the same issue as I have in my last two posts: is it possible for individual countries to employ macroprudential regulation to counteract monetary policy nationally? Is it useful if Germany does so? Here are some bits, but do read the whole article:

But if Mr Weidmann is minded to take pre-emptive action, he will soon have the means to do so. … Such powers should be particularly useful in the euro area, providing countries with a national lever to pull if their banks are getting too festive (though Spain’s pre-crisis policy of “dynamic provisioning”, designed to get local banks to set aside more provisions in the good times, cautions against investing too much hope in macroprudential tools).

But in the current climate there is also the danger that such regulations may be used in bigger economies to grab back power from the ECB. By reducing credit availability national central banks can contravene the euro zone’s wider monetary stance. Speaking in New York in late April Mr Weidmann said that if monetary policy becomes too expansionary for his home country, “Germany has to deal with this using other, national instruments.” If Mr Weidmann does use his new powers overzealously that could dash one of the few remaining hopes for the hard-hit peripheral economies: a strong recovery in the euro area, led by Germany.

I disagree, as I discussed before: containing the boom in Germany will give the ECB the needed space to continue to support the periphery.

Whether the Spanish did employ these tools with the necessary force, and whether that is possible in a currency union with free capital movement is of course a difficult question. What do you think?

PS: Also check out this post over at Social Europe Journal by David Lizoain on the problem of measuring inflation and housing correctly. I haven’t thought much about this issue yet, but it is worth delving into.

How should we divide AD in Europe? Some responses.

Tim Duy, one of the best Fed-watchers out there (this was a hint for my German readers, elsewhere everybody knows this anyway), has a very good response to my last post in which I asked Paul Krugman for help, basically on how to divide aggregate demand (AD) among the countries of Europe. But Paul is very busy debating Ron Paul promoting his new book (Hands up, who else did not know about the price policies of Diocletian?), so I am more than glad to have such a substantiated response from someone else. Further below are my responses to email comments from Matt Yglesias and Karl Whelan.

Tim Duy

Tim is critical of my proposal to have the ECB tighten lending standards in Germany, and trying to do the reverse in the periphery:

I think this approach suffers from a number of challenges. First, if capital is relatively mobile, it would be difficult to prevent a loan in Spain from making its way to Germany, so I am not sure the ECB can produce a differential monetary policy. Second, it is not clear that easing lending conditions in the periphery would encourage additional spending. I don’t think it will be all that easy to reverse the process of private sector deleveraging in the periphery simply by easing lending conditions.

These are fair points, and I also think the tools of the ECB are limited. But I do believe that capital markets in Europe are less than perfect. Especially in the real estate sector, the scope for intervention in Germany is large enough to make a difference.

His second point is something I have also wondered about, and it is probably the weakest part of my argument: how do easier lending conditions and lower interest rates in Spain lead to more AD there? My best take on this is: it prevents excessive deleveraging, by lowering refinancing costs. Think LTROs. Moreover, low costs of financing could mitigate the fall in house prices, with all the positive consequences for banks and households. Think: German pensioners buying a house in Spain, and not in Germany where it is made difficult by regulation. This also benefits the Spanish government which can then scale down its austerity measures. Finally, and this is an aspect that has not been covered enough: whoever buys Spanish assets wants to refinance them in Spain, as a hedge against redenomination risk. Low interest rates and a broad range of accepted collateral do help here. Thoughts are welcome on this!

Where I disagree with Tim is here:

Also, I can’t imagine that slowing the German economy, and by extension, the overall Eurozone economy, by enacting tighter credit conditions is in anybodies economic interest. I am skepital that this demand will suddenly appear in Spain. And this, I think, is fundamentally the error in Kantoos’ argument – he seems to see this as a zero sum gain. … [A]cting to slow growth in Germany will only aggravate the drag in the periphery, thus generating more of the hysterisis effects decribed by Kantoos.

There certainly are some frictions as to how demand moves across Europe. However, the ECB will certainly react to inflation in Germany, limiting demand in the Eurozone as a whole.

I think I can even turn Tim’s argument on its head (feet?): at low levels of inflation, we are no longer so sure how inflation reacts to changes in AD. At low levels, inflation might not change that much. If we take the ECB’s inflation focus as given, how can we generate the most AD in Europe? You could make a convincing argument here that zero inflation in the periphery, but high inflation in Germany would force the ECB to lower Eurozone AD, compared to the scenario where stimulus went to the periphery, and we only have modest inflation in Germany, but hardly higher inflation in the periphery, despite the stimulus. My preferred policy might therefore not just shift AD towards Spain, but increase AD in the Eurozone overall.

Tim further refers me to an older post by Paul Krugman and his view on European inflation. But as long-term readers of my blog know, I fully share Paul’s view: we need a higher inflation target in Europe such that countries during adjustment don’t fall into disflationary traps. But this is different from my original point, where I take the ECB and its policy goals as given. That is a fundamental difference: taking the ECB as given means that we have to worry about how we distribute inflation around an average of 2%. Some commentators want to distribute 4% to Germany, and -2% to the rest. I want to distribute the inflation more evenly: 3% in Germany, and 1% elsewhere.

Matt Yglesias

This all leads nicely to a comment I received from Matt (via email). His idea is that Germany could lower its VAT as a stimulus. It has the advantage of tricking the ECB into allowing more AD in Europe as a VAT cut will lower (headline) inflation in Germany. This could be a good idea, but such a stimulus will lead to wage increases down the line as well, and then lead to a ECB response eventually. Which is why he contemplates to convince German unions in return to lower their wage demands. This is the moment, where the last person should realize that “rebalancing” is not the goal, but a means to an end. The real question is: given the constraint that the ECB will react ot inflation, what is the best thing to do for the periphery? The answer to that question is more difficult than it might seem.

Karl Whelan

All of this is an academic debate, of course, as there is no European government to decide about this, but national governments and Germany is reluctant to apply stimulus. Karl’s critique (via email) therefore mainly focused on feasibility. And he may be right: setting up a fiscal policy fund like I proposed might be way out of reach at the moment, so the second best is stimulus in Germany.

But is stimulus in Germany really more feasible? Let’s not forget that the German parties, under pressure by the public!, introduced a debt-brake based on a party-wide consensus way before this crisis. Now that unemployment keeps falling, and budgets look better than ever, this debt brake will prescribe truly Keynesian policy: run surpluses during good times. Violating this debt brake, given the current situation in other parts of Europe, is political suicide in Germany and not as feasible as it may look from the outside.

I am going to make an optimistic claim here: Hollande’s win in France will make Merkel re-evaluate her policy options. Merkel in general does come around to what is the right thing to do if the pressure is high enough – especially if she can thereby steal the left parties’ thunder. And she does have the ability to explain her turns to the people in Germany, without losing too much credibility. It happened before: a move towards more modern family support in Germany, the phase-out of nuclear energy, a minimum wage…

But since Merkel does not read Kantoos Economics, it might be a while until she realizes what’s right. :)

PS: One remark for my German readers. Hans-Werner Sinn beklagt sich in einem Brief an den Handelsblog darüber, dass die stützende EZB Politik im Süden Europa (Stichwort: LTROs) ja die Zinsen in Deutschland ceteris paribus erhöhen würden. Genau das ist mein Argument, nur finde ich es gut und richtig – im Interesse Deutschlands! – dass dies geschieht. Denn niedrige Zinsen sind nicht per se gut, sondern im Verhältnis zur natural rate of interest zu bewerten, aus makroökonomischer Sicht. Langfristig ist die Fragestellung etwas anders, denn die Zinsen in Deutschland werden vielleicht dauerhaft niedriger bleiben.

PS: Und noch eine Leseempfehlung, das Interview mit Rüdiger Bachmann im Fazit. Pflichtlektüre!


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