Options for the Eurozone

Nouriel Roubini has written a number of good pieces on the Eurozone crisis.  His latest one in the Financial Times is no different.  It provides a summary of how the Eurozone got to this point and the options left for it going foward.  Here are the options according to Roubini:

(1) The euro could fall sharply in value towards – say – parity with the US dollar, to restore competitiveness to the periphery; but a sharp fall of the euro is unlikely given the trade strength of Germany and the hawkish policies of the European Central Bank.

(2) The German route — reforms to increase productivity growth and keep a lid on wage growth — will not work either. In the short run such reforms actually tend to reduce growth and it took more than a decade for Germany to restore its competitiveness, a horizon that is way too long for periphery economies that need growth soon.

(3) Deflation is a third option, but this is also associated with persistent recession. Argentina tried this route, but after three years of an ever deepening slump it gave up, and decided to default and exit its currency board peg. Even if deflation was achieved, the balance sheet effect would  increase the real burden of private and public debts. All the talk by the ECB and the European Union of an internal depreciation is thus faulty, while the necessary fiscal austerity still has – in the short run – a negative effect on growth.

(4) So given these three options are unlikely, there is really only one other way to restore competitiveness and growth on the periphery: leave the euro, go back to national currencies and achieve a massive nominal and real depreciation. 

A key point here is that ultimately a real depreciation is needed for the troubled Eurozone countries.  How it gets done is the burning question.   

Fiddling While the Eurozone Burns

So the European Central Bank (ECB) has decided to follow through on its plans to tighten monetary policy this year. The ECB will begin by raising its benchmark interest rate next month.  This is unbelievable. The Eurozone is under severe pressure that could ultimately lead to its breakup and yet the primary concern at the ECB is tightening monetary policy according to schedule.  If followed through, the consequences of this are not only bad for the Eurozone, but for the rest of the global economy too.  The slow-motion bank run now taking place in the Eurozone could easily turn into another severe global financial crisis.  

So why then is the ECB pushing so hard for monetary policy tightening?  From the New York Times we learn the answer:

With Germany, the euro zone’s largest economy, growing so quickly that some economists fear overheating, the E.C.B. has been trying to nudge interest rates back to levels that would be normal in an upturn.

Silly me, I thought the ECB's mandate was for the entire Eurozone not just Germany.  Now Germany is the largest economy in the Eurozone and so its economic conditions have a large influence on the the Eurozone aggregates that the ECB targets.  So maybe I am being too hard on the ECB here. Still, if the ECB really desires to save the Eurozone in its current form then tightening monetary policy is a move in the wrong direction.  

Here is why. If the ECB were to ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity.  Currently, there is far less economic slack in the core countries, especially Germany.  The price level, therefore, would increase more in Germany than in the troubled countries on the Eurozone periphery.  Goods and services from the periphery then would be relatively cheaper.  Thus, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels.  In other words, there would be a much needed real depreciation for the Eurozone periphery.  This  would make Greece, Portugal, Spain, and other periphery countries more externally competitive.

Again, the relative price level change would not be a permanent fix to the structural problems facing the Eurozone--it is not an optimal currency area and there needs to be debt restructuring--but it would provide more flexibility in addressing the problems. Tightening monetary policy, on the other hand, would only make matters worse. It would force all of the needed real depreciation for the periphery on wages and prices in the troubled countries.  That only increases the pain for them and makes it more likely they will leave the Eurozone.  This seems so obvious to me.  Why isn't it obvious to ECB officials?  Why are ECB officials fiddling while the Eurozone burns?

P.S. See Kantoos latest idea for saving the Eurozone: apply countercyclical haircuts on bonds accepted by the ECB for refinacing (HT Matt Yglesias).

Ten Questions I Wish Ben Bernanke Would Answer Today

Mark Thoma cues us in on the hot issues to look for in Ben Bernanke's speech today.  Here are ten questions Bernanke will not answer in that speech, but I wish he would consider: 

1. Does the recent decline in the Treasury break-even inflation expectations raise concerns for the Fed?
2. On a per capita basis, domestic nominal spending is still below its pre-crisis peak level.  Should the Fed be concerned about this?  
3. In past speeches you and other Fed officials have mentioned the Fed could raise the interest payment on excess reserves (IOR) as a way to prevent the large stock of excess reserves from being invested in higher yielding loans or securities.  In other words, you and other Fed officials have claimed the Fed can effectively tighten monetary policy by raising IOR. By that same reasoning, wouldn't that mean the Fed could lower the IOR to loosen monetary policy and thus, by implementing IOR in the first place in late 2008 the Fed effectively tightened monetary policy then?
4. If Congress would sanction it, would you be interested in adopting an explicit level target over a growth rate target?  
5. If so, would you go with a price level target or a nominal GDP level target? Explain your choice.
6. Do you feel political pressure both inside the Fed and from Congress is constraining the Fed from making optimal monetary policy?
7. Though the Treasury break-even inflation expectations series mentioned above is useful, one has to be careful in interpreting it because both aggregate supply shocks and aggregate demand shocks can influence it.   Wouldn't it be better to just cut to the chase and have a futures market for nominal GDP that would directly measure aggregate demand shocks? 
8. How do you reconcile your aggressive recommendations for Japanesse monetary policy   in the 1990s with the Fed's relatively modest approach to U.S. monetary policy today?
9. Why do you think that FDR's original QE program in the early 1930s was so much more effective  than the 2010-2011 QE2?
10. At the September, 2008 FOMC meeting the Fed decided not to cut the federal funds rate because it was concerned about headline inflation.  In the press release it mentions that commodity prices were behind the rise in headline inflation.  By implication, then, the Fed failed to act because it was responding to a rise in commodity prices.  Do you see any parallels to today's environment?

Maybe someday we will know the answer to these questions.

How Effective is Monetary Policy?

Nick Rowe reminds us that if a central bank is doing a good job in terms of hitting its nominal target, then both the indicator variables and the monetary policy instrument it uses should not be correlated with the target. For example, say the central bank were targeting a nominal GDP growth of about 5% a year and adjusted the stance of monetary policy to offset velocity shocks so that the 5% target was hit on average.  Though the stance of monetary policy would be systematically related to the velocity shocks it would not be correlated with nominal GDP growth. An observer, not knowing any better, might study the empirical relationship between the stance of monetary policy and nominal GDP growth and conclude monetary policy is ineffective with regards to nominal spending when in fact it is very effective.  

This insight is important for several reasons. First, it helps shed light on why it monetary policy shocks  in empirical studies appear to have less of an effect on the U.S. economy after 1980 than before. For example, below are two figures showing the typical response of real GDP to a 0.25% federal funds rate shock during these two periods.¹ (Click on figure to enlarge.)

Just looking at these two figures could lead one to conclude monetary policy became less important over time.  Some observers, however, argue that during the latter period monetary policy did a better job responding to economic shocks and thus, helped paved the way for the "Great Moderation" in economic activity.  If so, it would make it difficult to find as strong a relationship between the Fed's operational instrument, the federal funds rate, and economic activity during the "Great Moderation" than before.  This is the point Nick Rowe is making.  It is also one that Jean Boivin and Marc P. Giannoni convincingly make in this influential paper (ungated version). 

Second, this line of reasoning also means that one cannot look at measures of money--monetary base, M1, M3, etc.--and conclude they are unimportant for monetary policy.  Adam P. notes, for example, that with an inflation-targeting central bank a zero correlation between the monetary base and the inflation rate does not mean that the monetary base is inconsequential for inflation, but only that the central bank is doing its job well.  Similarly, Nick Rowe explains elsewhere that if a central bank is successfully targeting a nominal GDP growth rate, then one should not expect to find a relationship between the money supply and nominal GDP growth. Again, this does not mean money is unimportant. What it does mean is that the central bank is managing to offset shocks to velocity and money supply such that nominal GDP growth is being stabilized.

Josh Hendrickson makes a strong case that during the "Great Moderation" the Federal Reserve effectively was targeting nominal GDP growth of around 5%.  If so, then the above reasoning implies that during this time there should be a strong negative relationship between the growth rates of the money supply (M) and velocity (V), but little if any relationship between that of the money supply and nominal GDP.  However, this should be less true prior to this time when the Fed was not stabilizing the nominal GDP growth rate--the period of the "Great Inflation"--and there really was no nominal anchor for U.S. monetary policy.  The graphs below provide evidence on this claim.

Using M1 as a measure of the money supply, the first two figures show the relationships in question for the "Great Moderation" period.  They show that there was a strong relationship between the money supply and the velocity growth rates, but essentially no relationship between the money supply and the nominal GDP growth rates:

Now let us look at the period prior to the "Great Moderation."  Here we find that the growth rates of the money supply and velocity are not related, but there is some relationship between the money supply growth rate and that of nominal GDP:

Similar evidence can be found using other monetary aggregates.  Now these graphs should not be interpreted as meaning the Fed should target a monetary aggregate.  Rather, they should be viewed as evidence that it is difficult to assess the effectiveness of successful monetary policy by looking at indicator variables and policy instruments.  What observers should be looking to is the central's bank's nominal target to see if it is being maintained on average.  Ultimately, that is the best indication of monetary policy's effectiveness.

Of course, the problem currently is we do not really know with certainty the Fed's nominal target.  Is it 2% inflation, 5%  nominal GDP growth, a price level target, or something else? Here the Fed could improve.  It should announce an explicit nominal target and commit to maintaining it no matter what.  Obviously, I would like it to announce a nominal GDP level target, but any announcement would be an improvement over the uncertainty we have now.

¹These responses come from a standard structural vector autoregression that included real GDP, commodity prices, CPI, and the federal funds rate. Six lags were used.

Robert Lucas Believes in Spending Shocks

Robert Lucas has been taking some heat around the blogosphere for a lecture he gave at the University of Washington.  Scott Sumner responds:

In a recent talk, Robert Lucas argued that a decline in “spending” (i.e. NGDP) produced the severe contractions of 1929-33 and 2008-09.  He argued that the slow recoveries were caused by adverse supply-side polices.  This is not “classical” or RBC economics, it’s AS/AD.   I think he’s right about the the Great Depression and the recent contraction, but only about 30% right about the current recovery (I attribute 70% of the slow recovery to lack of NGDP growth.)  Oddly, Paul Krugman and Matt Yglesias seem to think that Lucas denies that demand shocks cause recessions–which is clearly not Lucas’s view.

Let me add to this discussion by noting that recently I met Robert Lucas at a conference.  We started talking and, among other things, he expressed his support for nominal GDP targeting because it would have given the Fed more flexibility in responding to the severe spending shocks.  That is, it would have allowed the Fed to have been more aggressive with monetary policy while still being systematic.  He was also sympathetic to my view that currently there was too much concern about inflation.  At a conference dominated by inflation hawks, I found him to be a refreshing breath of fresh air.  

PS.  We also talked about his former student Scott Sumner and Sumner's proposal for NGDP futures targeting.  He was intrigued by it and compared it to Lars Svensson's work on targeting the forecast.

Watch Out, George Selgin is Now Blogging!

George Selgin is now blogging.  It is about time.  He is the individual who introduced me to nominal GDP targeting, the monetary disequilibrium view of recessions, benign vs. malign deflation, and other interesting ideas. I was fortunate to have him as a professor and now the rest of world can have access to him too.  

To get a taste of the Selgian view of the world, here is a recent article of his evaluating the Fed's performance and here is an older monograph where he promotes his Productivity Norm Rule for monetary policy. 

The Fed Already Repeated the "Mistake of 1937"

Gautti Eggertson has an interesting post where he compares current economic conditions to those that prevailed leading up to the recession of 1937-1938. Here is his description of developments in 1937:

(1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.

The Federal Reserve responded at this time by tightening monetary policy.  Fiscal policy also was tightened. These policy moves turned what had been a robust recovery between 1933 and 1936 into the second recession of the Great Depression. As a result, a full economic recovery was postponed several more years.

Eggertson explains the surge in commodity prices was the galvanizing force then behind the concerns over inflation and, thus, the tightening of policy.  Though these developments sound eerily similar to today's environment, Eggertson is confident that Fed officials will not make the same mistake:

 It is unlikely, however, that a modern economist put in the same position would respond to the commodity price rise in the same way... Fed economists today typically monitor various components of the CPI that are not influenced strongly by temporary supply disruptions. For example, one common measure tracked is “core CPI,” which excludes volatile food and energy prices from the overall CPI basket.

He then goes on to claim the Fed's response in 2008 proves his point:

In early 2008, the economy started a downward spiral that culminated in a crisis... At the same time, however, there was a temporary rally in commodity prices, driven by a rise in oil prices in early 2008, as can be seen in the figure above. This development prompted some commentators to warn against “excessive inflation.” But Fed economists and many others judged that the rise in prices was specific to commodities and did not signal an increase in overall price pressures. Largely ignoring the temporary rally in commodity prices, the Fed focused instead on core inflation and some alternative price measures 

I wish he were right, but  the Fed has already repeated the mistake of 1937. As I and others have shown, monetary policy was passively tightening by mid-2008.   A key reason is that the Fed was concerned about the very surge in commodity prices that Eggertson mentions above. In fact, it was so concerned it decided against lowering its target federal funds rate in its September, 2008 FOMC meeting.  Here is an excerpt from the press release from that meeting (my bold):

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent...

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain. 

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

In short, the Fed's inaction was driven by concerns that the surging commodity prices might push inflation  too high.  The Fed was looking to headline inflation in making this decision, not the core.  Had they been looking at the core they would not have alarmed.  Better yet, had the Fed been focused on the expected inflation rate from TIPS it would have seen that inflation expectations had been falling since July, 2008.  Doing nothing, as it did, in such a setting amounted to passive tightening of monetary policy. So contrary to Eggertson's claim, the Fed has already repeated the mistake of 1937 in 2008.  It is not clear it won't do the same again.