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 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.
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.
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!