When French president François Hollande pre-announced the ECB Governing Council’s long-awaited adoption of “quantitative easing” at its meeting tomorrow, German chancellor Angela Merkel was quick to respond by pointing out that this was still the independent ECB’s decision alone. It was good of her to do so. For in recent times one could not help getting the impression that the German political elite had forgotten all about that precious centerpiece of German monetary orthodoxy: that the independence of the central bank was the most important safeguard of solidity in the world.

Against the background of an ill-informed German public and an ideology-stricken German media landscape that excels in nothing more than keeping alive hyperinflation phobia even as the land of the euro is at acute risk of sinking ever deeper into the morass of deflation, Germany’s body politic got carried away with their self-righteous assumption that it was in everyone’s best interest to accept the reality of German hegemony over Euroland in all matters of economic policy, including monetary policy. Yesterday’s Financial Times quoted the former ECB governing council member Athanasios Orphanides on what would appear to be a rather intolerable (since illegal) state of affairs: “It is as if it’s accepted that the euro area’s modus operandi is to clear things with Germany, and for the ECB to constrain its actions to what is best for Germany … This is inconsistent with and violates the [EU] treaty.”

So if the ECB finally goes ahead tomorrow with some kind of QE, ignoring German resistance, what will QE actually do for Euroland? continue reading…

Wolfgang Münchau is one of those rare sensible voices in the international media reporting on the euro crisis. He has been consistently right in his gloomy assessments of euro crisis management in recent years. He is also correct in pointing out that the observed deflationary trend in the eurozone is not primarily due to any recent oil price shock but mainly driven by the chosen deflationary intra-area “rebalancing” path: with German wage-price inflation well below the 2-percent stability norm, everybody else is forced into deflation to restore their competitiveness. (See here: “Beware what you wish for when it comes to ECB measures”)

But Münchau got it pretty wrong in his FT column this week suggesting that so-called helicopter drops of money would constitute monetary policy. Milton Friedman famously used the helicopter analogy in pushing his monetarist mantra, but he forgot to mention that central banks are not in the business of running money-dropping helicopters. Friedman’s story went like this:

“In our hypothetical world in which paper money is the only medium of circulation, consider first a stationary situation in which the quantity of money has been constant for a long time, and so have other conditions. Individual members of the community are subject to enough uncertainty that they find cash balances useful to cope with unanticipated discrepancies between receipts and expenditures. … Under those circumstances, it is clear that the price level is determined by how much money there is—how many pieces of paper of various denominations. If the quantity of money had settled at half the assumed level, every dollar price would be halved; at double the assumed level, every price would be doubled. … Let us suppose, then, that one day a helicopter flies over our hypothetical long- stationary community and drops additional money from the sky equal to the amount already in circulation. … The money will, of course, be hastily collected by members of the community. … If everyone simply decided to hold on to the extra cash, nothing more would happen. … But people do not behave in that way. … It is easy to see what the final position will be. People‘s attempts to spend more than they receive will be frustrated, but in the process these attempts will bid up the nominal value of goods and services. The additional pieces of paper do not alter the basic conditions of the community. They make no additional productive capacity available. … Hence, the final equilibrium will be a nominal income [that has doubled] … with precisely the same flow of real goods and services as before” (Friedman 1969, p. 4).

However, as Keynes acutely observed, a central bank is a “dealer in money and debts.” A central bank issues its monetary liabilities by buying debts and/or making loans. Handing out banknotes or making transfers into deposits to the public for free constitutes not monetary policy, not even unconventional monetary policy, but plain and simple fiscal policy. And who would want unelected central bankers to be in charge of taking such a decision; even if it may well be the right one?

Of course, the eurozone fiscal authorities may in principle agree on a fiscal expansion – if they somehow manage to overcome both the legal hurdles they have set themselves and, probably more important, successfully crawl out of the intellectual hole they have dug for themselves. Similarly, under today’s outright deflationary conditions, it has, at last, become conceivable that even the ECB might embark on a “largish”-scale purchase of government debts purely with its monetary policy mandate of maintaining price stability in view; which is crucial for legal reasons, as Wednesday’s preliminary ruling by the European Court of Justice reminded us.

Fiscal expansion paired with QE may seem equivalent to a helicopter drop. But it is not. continue reading…

The Advocate General (AG) has spoken on the ECB’s OMT program today. Apparently the markets were more concerned about the latest U.S. retail sales numbers than delighted about the “okay in principle provided that” signal sent from Luxembourg to the German triangle of euro power (Frankfurt, Berlin, and Karlsruhe).

First of all, in the AG’s view, OMT constitutes monetary policy but not economic policy. That was one of the critical issues. The German Constitutional Court (GCC) had preliminarily concluded that the ECB may be stepping outside the monetary policy domain, for which it enjoys exclusive competence. In its previous judgment on the Pringle case the ECJ found that the ESM constitutes economic policy, which remains primarily a national responsibility in Europe’s Economic and Monetary Union, and does not encroach on the ECB’s territory. On OMT the opposite verdict was reached, based on the following evaluation:

“in order for a measure of the ECB actually to form part of monetary policy, it must specifically serve the primary objective of maintaining price stability and it must also take the form of one of the monetary policy instruments expressly provided for in the Treaties and not be contrary to the requirement for fiscal discipline and the principle that there is no shared financial liability. If there are isolated economic-policy aspects to the measure at issue, the latter will be compatible with the ECB’s mandate only as long as it serves to ‘support’ economic policy measures and is subordinate to the ECB’s overriding objective” (AG 2015, No. 132).

In other words, the AG sides with the ECB’s argument that OMT is about “unblocking” the monetary transmission mechanism, and hence monetary policy, rather than a measure designed to facilitate the funding of certain member states, which would make it economic policy instead. OMT is judged to be an unconventional monetary policy instrument designed to meet the exceptional challenges of the day.

“Despite the efforts of the European Union (‘the Union’) and the Member States, the risk premia for bonds of various euro-area States rose sharply in the summer of 2012. In the face of investors’ doubts about the survival of monetary union, the representatives of the Union and of the States of the euro area repeatedly stressed that the single currency was irreversible. It was at that time that the President of the ECB, in words that were subsequently repeated over and over again, stated that he would, within his mandate, do whatever it took to preserve the euro” (AG 2015, No. 20).

While the objective of “preserving the euro” would seem to go well beyond the supposedly narrow monetary mandate of maintaining price stability, the ECB, in a way, merely promised to back up with money what the political leaders had declared to be their ultimate economic policy objective: the irreversibility of the common currency. This would seem to also make it an incident of ECB “support” of the union’s general economic policy: supportive words on words of support. A less generous observer might be tempted to say that failure on the part of the political authorities to establish sound institutions and policies that would foster area-wide prosperity and the sustainability of the common currency gets temporarily plastered over by the threat of meeting speculative attacks by throwing central bank money at it.

The AG has interesting things to say on market speculation. continue reading…

On Wednesday, January 14, 2015, the European Court of Justice (ECJ) Advocate General Pedro Cruz Villalon will publish his opinion on the European Central Bank’s (ECB) “Outright Monetary Transactions” (OMT) program. The Advocate General’s opinion will give us important clues and is likely going to shape the court’s later ruling on the matter. What is at issue?

The OMT program played a critical role in calming the markets since the height of the euro panic in the summer of 2012. ECB president Mario Draghi kicked off the counterattack on the markets by dropping his by now famous “whatever it takes” hint in a speech in late July in London. A few days later, on August 2, 2012, the ECB announced that “the Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective.” The technical details of the OMT were then published on September 6, 2012, when the bank also terminated its earlier Securities Markets Programme (SMP) under which it had purchased fairly small quantities of government debts issued by euro crisis countries. Moreover, any purchases were sterilized to preempt “monetary financing” accusations (see here).

Rather predictably, like in the case of the earlier SMP, the OMT immediately came under sharp attack by Germany’s monetary orthodoxy. As a result, the OMT is also under review by Germany’s own Constitutional Court (GCC). In early 2014, the GCC referred the matter to the ECJ, not without publishing its own preliminary assessment though. Largely following the Bundesbank’s critical assessment of OMTs as persistently argued by its president Jens Weidmann, the GCC criticized the OMT on a number of counts, suggesting that the ECB may be overstepping its own monetary policy mandate and the OMT may also be in conflict with the “monetary financing” prohibition (TFEU Article 123).

For instance, the GCC challenges the selectivity of OMT; as a supposed monetary policy measure that would only set out to purchase the debt securities of particular members facing funding pressures. It takes issue with the conditionality of OMTs (the supported member state must be in an ESFS/ESM “stabilization” program and adhere to its rules). It is also worried about the unlimited volume of the OMT and the assumption of default risk on the part of the ECB (fearing a euro “transfer union” and risks for German taxpayers). And, given the ECB’s claims that it was fighting any irrational components in observed risk spreads, the GCC also questions whether a central bank is able to separate interest rate spreads into rational and irrational components.

The last point illustrates that the ECB made some strategic mistakes in selling OMT. In the context of the euro break-up discussions at the time, the ECB referred to irrational market bets leading to explosive risk spreads. The ECB was keen to send out the message that the euro was here to stay, as Mr. Draghi’s famous promise made clear. And that was probably an important part in making OMT work without actually having to activate it. The point is that in the context of the EU treaties, the ECB has exclusive responsibility for monetary policy with its primary price stability mandate, but not for economic policy. One can make the argument that preventing euro breakup is a precondition for maintaining price stability in the euro area. But then one could argue the same for preventing a nuclear war or climate change. Clearly the political authorities and not the ECB are ultimately in charge of keeping the euro whole. It may be laudable for the ECB to step in when the political authorities fail to live up to the task, but, strange as it may seem, it is the ECB rather than the political authorities that ends up facing legal challenges for its conduct (supposedly for overstepping its mandate when the political authorities have been failing to take the necessary steps to heal the euro all along).

Be that as it may, OMT served its purpose well, and without actually ever being activated. I called it a bluff at the time, but it turned out to be a hugely successful one. I called it a bluff, among other things, because it seemed clear to me that the “more-of-the-same” conditionality attached to OMT could only push the euro area ever deeper into the mess rather than rescue anyone, and even with more accommodative monetary policy. I turned out to be partly right and partly wrong. Certainly the state of the euro area economy today, despite years of freeloading on global growth, remains extremely fragile. But, entranced by Mr. Draghi’s promise, the markets have stayed calm all along and played along watching the euro area sink into outright deflation. So does OMT still matter today then?

First of all, and contrary to the widespread view that the ECJ won’t ever do anything that could threaten the euro or ECB, it is perfectly conceivable that the Advocate General’s opinion will be critical of certain aspects of the OMT. After all, the GCC’s reasoning followed closely an earlier ECJ ruling on a related matter, namely on the ESM (the Pringle case). In that case, the ECJ went out of its way to declare the ESM purely a matter of economic but not monetary policy. Now the issue is the opposite: is OMT purely a matter of monetary but not economic policy? The ECJ will want to make sure not to contradict itself. And that won’t be as easy as just saying that OMT is brilliant and flawless.

At this point, the OMT verdict is mostly relevant because the ECJ ruling might imply constraints for the ECB’s design of any “quantitative easing” (QE) strategy, the option of purchasing government bonds in particular. For sure, QE is not OMT. The ECB intends to buy the debts of all member states rather than of a few. As usual, there will be minimum quality standards (credit rating) of what the ECB is willing to buy, which may be an issue in the case of Greece. But there will be no explicit conditionality of the kind featured in the OMT. And with EONIA at zero (or even slightly negative) and the euro area as a whole officially in a state of deflation today, there is no longer any difficulty justifying QE as nothing else but a monetary policy measure designed to meet the ECB’s price stability mandate (on which it currently fails conspicuously). With QE now conventionally accepted as the unconventional monetary policy tool of last resort, the monetary financing issue can also be put to rest more easily. It is noteworthy that the ECB stopped sterilizing its purchases under the SMP in the summer of last year, even before officially embarking on QE …

Greece is back in the headlines as upcoming elections look likely to produce a workable majority for the anti-austerity Syriza party. Some suggest this would represent the first step toward the country’s inevitable exit from the eurozone. Not so fast, says Dimitri Papadimitriou in an interview with Bloomberg Radio’s Kathleen Hays and Vonnie Quinn (segment begins around 13:40).

A Syriza victory would likely usher in significant changes — most notably the plan to write down Greece’s public debt and end austerity policies — but Papadimitriou emphasizes that pulling Greece from the eurozone is not part of Syriza’s platform. And he suggests that much of the “Grexit” talk being deployed by the current government in Greece and other European policymakers (particularly in the vicinity of Berlin) should be understood as a scare tactic directed at the Greek electorate. (In that vein, Peter Spiegel recently reported in the Financial Times that “privately, European officials acknowledge that 2015 is not 2012. Nobody really believes Grexit is imminent.” Spiegel’s article, which contains this particular gem, is worth reading in full: “At the core of Mr Tsipras’s economic platform is debt relief, an idea so unthinkable that nearly every mainstream economist has advocated it.”)

Contrary to those who now confidently claim the eurozone would be just fine if Greece were to leave or be forced out, Papadimitriou cautions that we do not really know what the contagion effects would be (how it would affect, for instance, depositors in various banks in Portugal and elsewhere). Eurozone policymakers who are (genuinely) sanguine about a breakup should be thinking about whether this could be their Lehman Brothers moment, he says.

But a new direction — moving beyond austerity and internal devaluation — is urgently needed. And Papadimitriou argues that, much as the Federal Reserve has been unable to gain much traction, Draghi’s version of QE won’t have a big impact on the real economy (though Papadimitriou does allow that it could help a bit in Greece because that country is “starving for liquidity”). It’s fiscal policy, he says, not monetary policy, that holds the key to recovery in Greece, and ending the austerity experiment would be the first step. (On that front, Papadimitriou suggests there are signs that may indicate a desire to relax the “German occupation” of Greek fiscal policy.)

However, ending austerity is not nearly sufficient. Papadimitriou points out that even if the Greek economy quickly returns to moderate rates of economic growth (by no means a given) it would take more than a decade-and-a-half to get back to the employment levels of 2009. Greece needs a “New Deal,” he says — perhaps funded by a moratorium on interest payments on Greek debt held by the public sector — and which should include an idea included in the original New Deal: the expansion of a direct job creation program.

For more on the latter proposal, this policy brief lays out the macroeconomic payoffs of implementing direct job creation programs of various sizes in Greece (notably, a one-year moratorium on interest payments could cover the net cost of a 440,000-job program for three years. Given the positive multiplier effects involved, a program that size could cut the number of unemployed in half).

Beyond that, he argues, there should be no more muddling through in the eurozone. Ultimately, the goal should be to fix the incomplete euro architecture. Papadimitriou has written that the key mistake in the eurozone setup was the designed divorce of fiscal policy from a sovereign currency: see, e.g., “Euroland’s Original Sin.”

(Here are a couple of possible avenues for approaching those more fundamental design issues: Jörg Bibow, “The Euro Treasury Plan“; Mario Tonveronachi, “The ECB and the Single European Financial Market.”)

With the January 25th elections in Greece approaching, Dimitri Papadimitriou writes about the future of Greek policy and the discussions that took place at a recent Levy Institute conference in Athens:

At the Athens economics conference, Europe At The Crossroads, the participants were a diverse collection of policymakers, overflowing with disagreements on the very best route to growth. Nonetheless, with one notable exception (the leader of Ireland’s central bank, endorsing European Central Bank policy), the overwhelming majority united on a single principle:

The bailout and its related austerity programs have failed miserably. […]

The home base of some of the conference’s strongest austerity critics may come as a surprise. Peter Bofinger of Germany, the only Keynesian in Chancellor Angela Merkel’s council of economic advisers, described the risks the current approach poses for Greece, France, and Italy, and outlined why a continuation also threatens to destroy the rest of Europe.

That includes Germany. Pointing to serious weaknesses in its economic foundations, Bofinger particularly singled out the FRG’s problematic physical infrastructure, an issue echoed by Elga Bartsch, Chief European economist at Morgan Stanley. And Bofinger raised the widely ignored fact that — despite endless German bellyaching about the so-called EU drain on its wealth — Germany’s contribution to other members of the European Union has been exactly zero euros.

Read the rest: “Hello 2015. Goodbye Austerity?”

You can listen to the Bofinger presentation here.

The rest of the presentations from the Athens conference, including that of Syriza MP Yannis Dragasakis, can be found here; slides are posted here. Video of the presentations will be posted shortly on the Institute’s YouTube page.

A New York Times article over the weekend delves into the history and rationale of the 2 percent inflation target, beloved of central bankers everywhere and a fairly recent innovation. Of course, the US Federal Reserve has a dual mandate, which includes both inflation and employment goals. The Fed said last week that it was most likely to start raising interest rates around the summer of 2015, but many countries’ central banks are moving in the opposite direction, solely because inflation is falling short of their targets.

Private borrowers—who usually have higher propensities to spend than lenders—benefit from an easing of the burden of debt when wages and prices move broadly upward. Also, for governments with debts that they cannot service with their own currency, inflation eases the burden of making payments, as tax revenues tend to rise in step with nominal wages and prices. Of course, falling prices have the opposite effect. The resulting changes in spending reverberate through the rest of the economy. Recent data show that there exists a strong threat of deflation around the world in economies such as Japan and the Eurozone, where core inflation has recently turned negative.

The effect of deflation on spending by indebted households was noted by Keynes in Chapter 19 of the General Theory (pp. 268-269). Michal Kalecki also argued to this effect in a critique of the so-called Pigou effect (falling prices would supposedly restore full employment by raising the inflation-adjusted wealth of households). The New York Times emphasizes instead the point that lower inflation makes it easier for some inflation-adjusted wages to fall, given that wages do not move downward as easily as upward. It also mentions that modest inflation permits central banks to lower real short-term interest rates below zero. Thoughts that deflation might be coming in much of the world are very sobering.

The Levy Economics Institute of Bard College co-organized an international conference on November 21-22 in Athens, Greece, on the continuing crisis in the eurozone.

Among the speakers were:

• Elga Bartsch, Morgan Stanley’s chief European economist;

• Peter Bofinger, a German academic economist and a member of the German Chancellor’s Council of Economic Advisers;

• Marek Belka, governor of Poland’s central bank;

• Giannis Dragasakis, a Greek politician and member of the Greek parliament for the Coalition of the Radical Left (SYRIZA);

• Heiner Flassbeck, a former director of the Division on Globalization and Development Strategies of the United Nations Conference on Trade and Development (UNCTAD) and former vice minister of the German Federal Ministry of Finance;

• Patrick Honohan, governor of Ireland’s central bank;

• Stuart Holland, a British academic economist teaching in Portugal and a former member of the British parliament;

• Stephen Kinsella, an Irish academic economist;

• numerous Greek economists, including Panagiotis Liargovas, the head of Parliamentary Budget Office at Greek Parliament; and, last but not least,

• scholars from the Levy Institute, including its president (Dimitri B. Papadimitriou), who heads the Institute’s macro-modeling team projects.

Adding to this rather illustrious list of speakers were panel moderators from The New York Times, Wall Street Journal, Bloomberg News, National Public Radio (USA), and various daily newspapers in Greece.

While there were some disagreements on policy matters among the panelists, it seems that most speakers reached the following conclusions: continue reading…

Germany is celebrating: it is 25 years ago that the Berlin Wall came down, marking the end of Stasi tyranny, and much more than that. No doubt that is reason to celebrate, for Germany, Europe, and the world. As a German and European, I am celebrating too.

Alas, this is also an occasion for hearing that tiresome story again about how costly and burdensome it was for Germany to reunite. For instance, Terence Roth writes a piece in the WSJ titled “After Fall of Berlin Wall, German Unification Came With a Big Price Tag.” Now, this kind of statement really needs to be qualified, especially as the myth about the “burden of unification” paved the way for yet another German myth a few years later that has proven rather catastrophic for Europe: namely, the myth that Germany had to “restore its competitiveness,” which it apparently had lost in the context of reuniting. Undisturbed by any doubt or reason, the German authorities live in their mythical world of economic virtue and vice, famously referred to by finance minister Wolfgang Schäuble as his “parallel universe.” Let’s try to get the matter straight then.

To begin with, it is unquestionably true that German unification came along with a big price tag. But the price Germany ended up paying was only partly due to the wreckage that communism had produced in the east. The macroeconomic policy response, featuring ultra-tight money and mindless fiscal austerity, proved far more costly. In 1991, both Germany’s consumer price inflation and budget deficit as a share of GDP were about 3 percent. Imagine the Federal Reserve responding to the historical challenge and responsibility of national reunification by monetary overkill—which is exactly what the Bundesbank chose to do, hiking rates to 10 percent and pressuring fiscal policy into sharp tightening too. Ironically, this counterproductive macro policy mix pushed headline inflation up, apart from crushing growth. As a consequence, on top of the legacy of wreckage in East Germany, unemployment in former West Germany doubled as 1.5 million jobs (5 percent of the labor force) were destroyed. Unsurprisingly, Germany struggled until 1998 to get the budget deficit back to just below 3 percent. Only the smaller part of the rise in Germany’s debt ratio from 40 to 60 percent of GDP over the 1990s owed to East German legacies (see here and here).

This is not where the story ends though. continue reading…

Slowly but surely a new consensus is emerging emphasizing the need for Europe’s currency union to organize public investment as a means to overcome its crisis, by now in its seventh year; the outlook being truly grim. Back in July President-elect of the European Commission Jean-Claude Juncker called for a €300bn public-private investment program. ECB president Mario Draghi lent his support to the idea in his Jackson Hole speech, finally acknowledging that the eurozone is suffering from deficient aggregate demand.

Former EU Commission President Mario Monti has also recently thrown in his voice, observing that public investment has been crushed by the Stability and Growth Pact and relentless austerity drive undertaken across the continent in its name. In its latest World Economic Outlook, the IMF highlights that at the current juncture public investment is as close to a free lunch as it ever gets: countries renege on their grandchildren’s possibilities by not going for it. For far too long the debate in Europe was exclusively focused on the liability side of the public ledger: debt. But it is the asset side, the public investment undertaken, or not, which is far more relevant in shaping our future.

Today, embarking on a joint public investment initiative represents a special opportunity for the eurozone, a chance to fix the euro regime’s ultimate defect: the lack of fiscal union. The scheme proposed here is simple and straightforward. The idea is to create a Euro Treasury as a vehicle to pool future eurozone public investment spending and have it funded by proper eurozone treasury securities. The Euro Treasury would allocate investment grants to euro member states based on their GDP shares. And it would collect taxes to service the interest on the common debt, also exactly in line with member states’ GDP shares. The arrangement amounts to a rudimentary fiscal union, not a transfer union though, as benefits and contributions are shared proportionately. Nor would the joint public debt issued for investment purposes mutualize any existing national debts. Instead, the Euro Treasury securities would provide the means to fund the joint infrastructure spending that is the basis for the union’s joint future.

Currently, eurozone public investment spending is at a very depressed level of around 2 percent of GDP. continue reading…