The presence of asymmetric economic shocks and cycles in Europe has led many to believe that fiscal union is the (only) answer. I am neither sure that it is a politically smart way to go forward, nor do I think it is politically feasible: a constant bail-out of weaker countries is off the table for Germany, in part because the inner-German transfer system between its states is such a disincentivizing freak show that nobody in Germany wants that on an even larger scale. And the Italian government has just proven that this fear is real.
Moreover, I am not sure whether the fiscal union envisioned by many would have prevented the crisis in, say, Spain or Ireland, the former poster children of budgetary prudence. No, we need to think more broadly about what we can do to improve the macroeconomics of the Eurozone in the future. In the last post on the issue I discussed how the ECB can induce a fiscal and regulatory policy response in overheating or bubbly countries.
But there is more we could do: use monetary policy. Wait, isn’t that exactly what we cannot use in a monetary union to deal with asymmetric shocks? Actually, we can.
Before we start, let me offer a graph from a San Francisco Fed letter (HT: David Beckworth) that shows how problematic it is if regions in a monetary union are hit by asymmetric shocks:
The dotted black line is the actual rate setting, the red and blue lines are the hypothetical Taylor-rule recommended setting for the core economies and the periphery respectively. The diverging inflation in the Eurozone is therefore hardly suprising.
But how can we possibly differentiate monetary policy in a monetary union? In the words of Markus Brunnermeier:
It is important to note that while the short-term interest rate across the currency union has to be identical, the long-term rate for risky loans need not be. It is this risky long-term rate extended to firms and home buyers that affects real economic activity.
In order to understand how the ECB can accomplish that, we need to review the refinancing of banks at the central bank. The collateralised loans and repurchase agreements (repos), the main ways how the ECB provides money, require banks to provide assets as collateral or subjects of the repo. These assets must have a certain credit rating, and will be valued at the current market price minus a “valuation haircut”, depending on their rating and maturity date. So far this is only used in order to limit the risk for the central bank. But it could be more than that.
As Markus suggests, monetary policy could use regionally differentiated haircut policies to increase financing costs in overheating countries, while lowering it in countries that are economically lingering. Contrary to what I have proposed before, in this case the location of the bank matters that wants to refinance itself at the ECB, not the origin of the bond. This policy might influence the interest rate that firms and households face, if refinancing for, say, Greek banks becomes more costly and they pass it on.
Besides increasing the cost of refinancing for banks in overheating countries, the ECB could use regulatory powers to mimic differentiated monetary policy. One idea is to increase the bank’s capital requirements for credit given to firms and households in overheating or bubbly economies. The advantage of this approach is that the location of the debtor matters, not of the bank that supplies the loans. The other approach, advanced by Markus, is to regulate collateral requirements for loans and mortgages to firms and households in such countries.
All proposals for differentiated monetary policy seem to suffer from some practical difficulties: in perfectly integrated capital markets they don’t work. In this latter proposal, an investor in Germany might get financing from a French bank to invest in Spain, circumventing any restrictions. I have two objections: First, are capital markets really frictionless across borders in Europe? And second, even if they are: in case a housing-boom-house-of-cards falls apart, the losses will fall on investors and banks outside of the affected country, thereby spreading the formerly asymmetric shock to other countries while reducing it in the originating country.
All proposals to differentiate policy are meant to improve the macroeconomics of the Eurozone. They won’t solve all the problems, some nominal adjustment will be necessary. So over and above this, monetary policy in the Eurozone needs to change in other important aspects, too, in order to facilitate this adjustment. But an appropriate monetary framework for the Euro can contribute much more than is commonly assumed and probably more that any politically messed-up fiscal union ever will.
Well I think you’ve said it all: ” in perfectly integrated capital markets they don’t work”.
And yes, I think the markets are nearly fractionless. Just look at the billions of debt denominated in Euros (and Swiss Franc) Hungarians have or Austrians in Swiss Francs or Icelanders in Yen.
I’d rather propose a “real estate transfer tax”. Hike it, when a bubble is forming, lower it, when house prices are falling.
Yepp, you won’t get any bubbles outside the real estate market. But hey, when did we have the last bubble in manufacturing?
@ Kantoos
I need to apologize for deviating from the agenda of your article but the position of yours expressed in the passage
“…in part because the inner-German transfer system between its states is such a disincentivizing freak show…”
is a bit drastic from my point of view. I can surely see the negative effects on the side of those “debtor states” to clean up their bugdet deficits and a bit less of the “creditor states” being discouraged to make wealth efforts but I primarily think of it as a regulatory problem (‘reducing’ the disincentives) that needs to be delt with. By reading your thoughts about this I get the impression that you would rather like to abandon the whole transfer system what I would decline that because of adverse social, political and even economic effects as increasing emigration from debtor states, further strengthening of right-wing extremist parties (especially East Germany) and a short- and mid-term decay of (mainly) provincial infrastructure.
I would therefore really like if you could write a post on that transfer issue sometime in the future.
Thanks in advance!
@Kantoos,
Usually I like your suggestions, but this one is too difficult to like. At least if I understand it. You would like monetary policy to *appear* differentiated, in order to be able to cater for geographically different economic conditions. Of course, the ideal policy would be the exact monetary provision (assuming that we know what that is, maybe one according to market monetarist ideology, maybe according to something else, like tea leaves or sheeps’ entrails) at the exact time in the exact place.
So I have two problems with your idea: we do no know what the right monetary policy would be ( you refer to interest rates (albeit customer facing ones, ie inclusive of risk and search costs as well as a profit margin) but if the IS curve slopes up as Nick Rowe argued recently, what good is done by a policy, for instance that would present businesses (to keep it simple, not residential investors etc) with *compellingly attractive* interest rates for investment in productive assets. Generally higher rates (at least the mid point between deposit and loan) might be better.
Second, it is very hard, in the *single market* to aim correctly: banks operate away from their home country, borrowers source funds outside those countries. Equity especially, the rocket fuel of economic growth, tends to be scarcer in the EUR than in the larger EU (UK) and more so than in the world as a whole. Do you propose to push easy money towards Greece (where there may be no productive business that could absorb it for growth, rather than for owners’ capital flight; a crass exaggeration but appealing to Northern populists) and force German banks to ration credit?
That reminds me of the more entertaining aspects of Socialist economics..Some people on this blog cherish the Dampflok. I like the Trabant..
So, back to the drawing board. I guess if you would try to differentiate, and still keep the EUR, one would end up with something like the gold standard: lots of local currencies, all with a fixed rate of exchange into gold, until the gvt decides to change the parity. The euro works better in Latvia than in Greece, maybe, maybe because Latvia has the option (very valuablbe politically) to either reduce wages or devalue when productivity is too far out of line with the reference standard. It earns an option premiumOf course that requires a small state with little debt. In Denmark, the gvt has strongly denounced that option and hence Denmark pays..
I wish there would be a way to let monetary policy rather than fiscal policy with its long term and potentially perverse cost (would you like interest payments to foreigners to crowd out your old age pension in 2030? or see you children’s study become unaffordable?) I would be all for it. But first the credit channels should be made to function (that means making the *relevant* banks solvent, if necessary by nationalizing or even europeanizing them) and second, the EU must coose new initial conditions (similar to the choices W Germany had when it was presented with the opportunity to acquire the DDR, and which led to a very expensive , but politically expedient, solution). Second, the existing debt overhang must be removed.
Not easy, but not too different from many sovereign debt puzzles solved in the past 40 years.
Isn’t a differentiated policy what the ECB already does, practically, when it allows the Bank of Greece to give credit to troubled greek banks? I see a relationship here with the deficits in the settlement system (Target2).
Brilliant idea – different costs of lending throughout the EU region, as decided by the ECB which would use a variety of instruments to increase lending rates in areas with high inflation, and lower it in areas with low inflation.
From Brunnermeier’s paper:
“…In contrast, regional monetary tools can be directly
targeted wherever the imbalances appear, and they directly impact certain term
or credit spreads. By using monetary tools to lean against the imbalances, the
ECB not only can increase financial stability, but also can reduce dispersion of
inflation within the euro area..”
Why does the ECB not follow good recommendations such as this? TWo ECB board members are sitting next to Brunnermeier in the picture on front of Brunnermeier’s paper. What is the point of having a conference, if they do not take any notice?
If a policy as suggested would be implemented, it would lead at the moment to slightly lower interest rate in the periphery, and slightly higher ones in the core. Just what is needed to help the highly indebted nations of Spain, Ireland and Greece.
There is no doubt, something like that would have prevented the crisis in Ireland and Spain, as interest rates would have been raised there, to prevent an over-heating of the economies. The criisis would have been much smaller, if not completetely non-existent.
And keeping to the Maastricht criteria would have prevented Greece, Portugal and Italy overindebtedness.
(In the discussion to http://kantooseconomics.com/2011/06/08/greece-should-have-had-short-hair-the-whole-time/ I had come to a similar conclusion, suggesting a tax to increase the cost of foreign financed credit in countries with high inflation. However, it obviously helps if similar ideas come from a Princeton economic professors.)
Lieber Kantoos,
und wieder einmal verstehe ich Ihren Ansatz nicht. Ich habe mir die beiden verlinkten Dokumente von Gros und Brunnermeier angesehen und geschaudert. Wenn die Italienische Politik tatsächlich gesagt hätte, dass die von ihr verlangte Sparpolitik doch am Ende das Defizit nur vergrössert, dann wäre es wohl das einzige, was man an den Italienern NICHT kritisieren könnte. Und so ist das auch nicht gelaufen, da bin ich ganz sicher.
Da ich ja mittlerweile in “Teebeutelfaktor” (TF) rechne und auch gerade an einem internen Bewertungssystem arbeite komme ich hier ganz locker auf einen TF von 0,5
Und Brunnermeier…. Auch dieses paper ist ja ein echter Höhepunkt. Also 2010 so etwas zu veröffentlichen und darin eine Inflationswarnung nach der anderen loszutreten. Dann noch die schöne und interessante Formulierung “… increase inflation expectations in the VERY long run …”
Wann soll das denn sein ? Lange nachdem wir alle tot sind ?
Auch ohne den Herrn Stark auf dem Titelbild zu berücksichtigen, für mich ganz klar: TF 0,8
Ich denke nicht, dass hier auch nur ein Gedanke zu finden ist, der als Grundlage für darauf aufbauende Theorien geeignet ist.
Schönen Gruß Ludwig
P.S. Der TF geht so von 0,0 bis 1,0 (ist aber ja vielleicht nach oben doch offen).
PP.S. Zum Deutschen Länderfinanzausgleich sag ich jetzt erst mal lieber nix.
Ich glaube nicht, daß irgendein Framework – und sei es noch so clever – Blasen verhindern kann, so lange die Banken ungehindert Geld schöpfen können. Das Kern des Problems liegt doch im Geldsystem. Kantoos, haben Sie sich schon mal mit dem Vollgeldansatz von Huber beschäftigt? Die Trennung von Geldschöpfung und Kreditvergabe (wie sie dieser Ansatz vorsieht) ist meines Erachtens Grundvoraussetzung dafür, daß wir jemals einigermassen stabile Verhältnisse bekommen.
@egghat
“in perfectly integrated capital markets they don’t work”
This is generally what we are being told. “Any restriction on the capital markets will not work,”
Of course they would work, inter-european and international money transfers all go via central bank accounts. In the Euro area via the ECB. National Central Banks therefore know where the money comes from and could increase lending rates as appropriate – if too much money comes in from abroad to finance a credit bubble.
.
It is definitly not true, that the inner-german transfer system is disincentivating. Just look at Bavaria, which is a country, which was getting money over decades from this system and has become a country, which is now in the position, to give money.
And you should understand, what this system was made for: to egalize the different economic situations of the states. If you draw borders, you do not do this on white paper but on this globe, which is naturally and socially different at every place. You cannot expect, that the entities, you create, will all have equal chances and that those chances will be the same forever. If you implement a transfer union, you will always have countries, which will receive, and those, who give and where there will only little changes overn the time. And there is very little, what you can do about it. But politically it is important, that you keep the economic difference in a country as small as possible. That is the purpose of the transfer system and yes, it has its costs.
A second common misunderstanding is: a capitalistic economy is a mean on how a state organizes the economy of its citizens. Its purpose is not, to make states compete with each other. What is happening in states must be a result of democratic decisions and not by the pressure of the markets. What we face today must be solved through a strong regulation of the markets. Markets need a strong regulation, since the capitalistic economy always incorporates the seed of selfdestruction, because it is driven by irrational entities: humans. Our view on economy is still driven by a view of a pre-Sigmund-Freud-aera, no matter, whether you have a liberal or communists point of view.
And also kantoos view on the german transfer system reflects only the shift (not only) germany went through in the last decades from more collectivistic attitudes to more individualistic attitudes. This is really funny, since this shift is the drive to create a global economy, which made us “individuals” even more globally interdependent and creates a even more complex global collective of all human beeings rather than bigger markets with more competition.
The reason for this is the growing of the entities in the markets. If huge combines suck up parts of a market, you do have less market. If those combines enter a less regulated global market, the speed, the markets shrink, increases. Today we have less car manufactures world wide, than we had only in germany 80 years ago. But economists all over this planet tell us, a global market is bigger – yes if you measure in square miles or money, but not if you measure in entities.
All the problems we face today, are a result of this development. Without regulation markets will shrink with increasing speed and we will face one economic crisis following each other faster and faster.
if the Euro needs different “interest-policies” (effectively this is meant) for the member countries, the countries should have own currencies again. If there is a long(!) term plan, e.g. to let Greece and other countries to have their own currencies in say 10 years, the disruptions might be very small. In each year the allowed trading spread could be increased. This would be the reversal of the process which lead to the Euro. And it took years to stabilize the currency movements in the european currency system. History get forgotten to often too fast. If the Euro doesn’t work it should be disbanded, but not in some weeks with one (or several) defaults, but in a gradual way.
Before starting to think about meddling with long term interest rates, did we already answer the question why long term interest rates haven’t been differentiated before?
Macroeconomics ignores political daily life. Bad incentives at banks were embedded in a system of bad political incentives. You need to look at why polticians act the way they do. Example: why does Schäuble always come up with the financial transaction tax when speaking about a Greek default? The two are totally unconnected, except for populistic arguments dictating political incentives of the day.
You can make plans all day long, but in the end politics will ruin them. We need competition among the political class. REAL competition. Fiscal integration is the opposite. It would be beneficial to have a European integration without the EURO, because the EURO prevents the exposition of political failure. Or why do you think politicians thought it was a great idea to let Landesbanken and other credit institutions buy up Greece debt without accumulating sufficient reserves? Political incentives. Feel good economy…
@ Mark
I in part agree with what you write, but I have two objections: first, this crisis may have changed the way banks and other investors see risk in the Eurozone, and second, if you leave these decision to a more or less independent entity like the ECB, politics may not be able to distort it.
@kantoos
First: I think how investors and banks see the risk is largely irrelevant if market’s selection machanism imposed by the politicians’ regulatory framework prefers big banks investing in high yielding debt, which in turn keeps the debt game running and political parties and structures in place.
Second: if the EURO improved how we look at Greece, will an improved ECB do the same? In my opinion, the ECB poses a systemic risk to the EU. And making it more like the central planning commitee of some communistic state seems not a good idea, especially not if the EU members see it as an advantage and not with the eyes of a farmer from the former SU, who was readily adjusted to the catastrophic results.
Why did we not learn from the systemic risk lessons? I think it is because most people don’t like to think or acknowledge their gigantic imperfections… we need more competition at each and every level, including theories and ideas! The gigantomanic developments in the EU will end badly. (to make a comparison: the most reliable software products are also those that have been tested the most… every other decision does not really matter that much)
@ egghat
well the Hungarian loans denominated in Swiss Francs were extended by banks incorporated in Hungary and supervised by the Hungarian financial regulator. The regulator didn’t act, but this is just regulatory failure, not the consequence of an integrated capital market.
The counterargument is that the single banking passport in the EU makes national regulation difficult, as subsidiaries would convert themselves into branches if threatened with restrictive regulation (branches are supervised by the parent bank’s supervisor). But in this case the solution is to demand that a bank wanting to do business in country X must be incorporated there and therefore be subject to national regulation.
Then there is still the issue of direct cross-border lending, but also here national policies aren’t powerless – they could stipulate, for example, that a house can be registered in the property register only if the mortgage funding the home purchase satisfies certain criteria, such as capital risk weights.
Overall I agree with matt_US and others that even in an integrated capital markets regulators and legislators do not need to be powerless unless they want to. As a result, there shold be space for nationally differentiated capital and provisioning rules etc..
@kantoos:
A first step should be to revise risk weights in the regulatory capital requirements (Basel II, first pillar). According to the standardized approach on calculating risk weights all EC countries are considered riskless (risk weight of 0%).
But I guess achieving a risk-sensitive treatment of EC member countries (whether in terms of haircuts on collateralization requirements or RWA-weights) is more a political than a technical difficulty.
Therefore it seems easier to enforce risk sensitivity through refinancing conditions enacted by a more or less politically independent technocratic organisation – even if targeting is not as selective and direct as by increasing capital requirements. Or can you imagine the greek legislative body enacting/ratifying a regulation that would increase it’s own funding costs?
@ rstolli
Thanks for your comment. Your approach is interesting, too. But what do you base risk on? My suggestion was directed towards inflationary circumstances in some countries that we should counteract so as to avoid the current mess in the future. That is not necessarily related to risk (at least not as it is perceived by the markets?!)
” enforce risk sensitivity through refinancing conditions enacted by a more or less politically independent technocratic organisation ”
The autority of an _independent_ organisation will be contested as soon as it departs from a “same rule (rate) for everybody” principle.
Don’t you hear this cry: “Our datas show that our country should have got the conditions which have been unjustly granted to country X”
@ JP
May I counter with a question myself: what about an institution that prescribes fiscal policies?!
Yes, I think it will be problematic to have a Euopean institution (the ECB) dictate regulation or interest rates. But it seems less invasive than to coordinate fiscal policies, let alone transfers, bailouts or wage setting.
@kantoos
Thanks for replying. I don’t disagree with what you said here.
Nevertheless, the ECb has no army or police. Its authority stops as soon as peoples do not believe it is legitimate. May I politely say that, as a german, you are less prone to imagine that legitimacy of authority is something which could easily be challenged (I’m french, by the way).
Until now, citizens have been pleased, or not pleased, by the credit rate policies from the ECB. But it is accepted, like good or bad weather are accepted. It is more or less believed that it is a purely technical matter, thus “there is no alternative”. Credit conditions are not an electoral topic like taxes are.
I guess it will become one hot topic, when it will be materaly shown that “there was alternative, which had been granted to The Others”. It will took some times to happen. On the other hand, every european has already understood the true truth. Fiscal policies is covert good old prussian invasive imperialism. Thus, your idea may be a lesser evil. It will buy some time and permits an orderly deconstruction of the european political entity.
Then we may go for a sustainable Europe. Which will have to take into account the sociological or anthropological reality: Southern Europeans will never behave like Northern Europeans. Political power in North Europe is not the same beast than in South Europe. Both cannot be merged.
@ JP
Granted, if the ECB (European regulatory agencies) would enforce haircuts (risk weights) on e.g. Greek compared to German debt on an even slightly similar level as the market does, it would be faced with criticism like the market is. However, it would be more difficult for politicians to word the criticism, “greedy speculators” won’t do it ;-)
@ kantoos
You’re right, my comment was slightly off-topic. However, I think the current mess is due to credit bubbles with inflation/macroeconomic imbalances being a syndrom of differences in credit growth (at least for the EC internal imbalances; US-China is certainly a topic of it’s own). And getting banks to acknowledge risks hidden but inherent in their balance sheets might be a first step to reduce the inflation of credit bubbles.
Unfortunately there’s no reliable measure of risk, but there are some efficient shortcuts like “rapidly increasing the amount of credit in a specific part of the (global) economy will surely lead to an increase in risk be it individual default or systemic risk”.
But I’m probably missing some important aspects. I’m just starting to get into economics. However, I really enjoy reading your blog. By far the most interesting German/bilingual blog!