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 …

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.

People in Scotland are heading to the polls today to decide the question of secession. One of the major policy questions for an independent Scotland is whether the country should attempt to keep the pound. As many have now begun to appreciate — with a little help from the eurozone spectacle — this would likely be a big mistake.

In “Euroland’s Original Sin,” Dimitri Papadimitriou and L. Randall Wray explained why a separation between fiscal and monetary sovereignty — when countries do not issue their own currency yet retain responsibility for fiscal policy — is the root of the problem in the eurozone. Any country with this setup will face budgetary constraints to which currency-issuing nations are not subject; the kind of constraints that can generate a sovereign debt crisis if, for instance, the country’s fiscal authority is forced to handle the fallout from a large banking crisis. This is a drum that many people affiliated with the Levy Institute have been banging for some time (well before the eurozone fell into its current mess).

Recently, both Paul Krugman and Martin Wolf  have written columns in which they make similar arguments in the context of Scottish independence (and the SNP’s ostensible plan to retain the pound). Philip Pilkington wrote a policy brief a few months ago in which he also argued, with the aid of an analysis of Scotland’s financial balances, that retaining the pound would leave the country open to a eurozone-periphery-style crisis. Pilkington’s story focuses on Scotland’s reliance on oil and gas revenues and the particular instability that could be generated, for a currency-using (vs. issuing) Scotland, by oil price fluctuations.

Although Pilkington suggests it might make sense to retain the pound in the short run (during which time he advocates the use of “tax-backed bonds” to limit instability, a proposal Pilkington originally developed with Warren Mosler [see here and here] for the eurozone), he argues that Scotland ultimately needs to move toward issuing its own freely-floating currency. The question is how to move from the first to the second phase with a minimum of disruption. The policy brief thus lays out a “dual currency” transition plan for Scotland: continue reading…

 
[WolframCDF source=”http://multiplier-effect.org/files/2014/09/alternative-fiscal-policies.cdf” width=”397″ height=”448″ altimage=”http://multiplier-effect.org/files/2014/09/alternative-fiscal-policies.png” altimagewidth=”397″ altimageheight=”448″]
Here is a new Wolfram CDF, which I have constructed based on a macro model. The assumptions behind the model–other than the exact parameter values–are loosely stated in this list:

1) industries dominated by a handful of firms, rather than perfect competition
2) production technology that requires capital and labor inputs
3) chronic underemployment and less-than-full capacity utilization (percent of capital stock in use at a given time)
4) sovereign money and a policy-determined interest rate
5) two groups of households, only one of which has money to save
6) net investment a function of the profit and capacity utilization rates
7) budget deficits offset by the issuance of treasury bills and sovereign money
8) a government that employs workers to produce free public services
9) a fiscal policy rule with (a) a balanced budget target (labeled “0” in the CDF above) or (b) public production and capacity utilization targets (labeled “1” in the CDF above)
10) nonlinear functions that result in endogenous cycles in this figure for some parameter values and policy functions (try different parameter values with policy rule “1” for example)
11) gradual adjustment of public and private-sector output toward levels indicated by one of the two fiscal policy rules and output demand, respectively.

The arrows in the CDF show directions of movement in 2D space, where the two axes represent public production (horizontal) and capacity utilization (vertical). We got a different look at the same model in this previous post. In this new CDF, I have tried to improve on the realism of the parameter values. Here is a link to the download site at Wolfram for the needed CDFPlayer software.

The most serious omissions in the model above, by the way, are a foreign sector, a mechanism by which the broad price level can change over time, and commercial bank deposits and loans. As mentioned before, I am working on adding these and other new features to a larger version of the model depicted above for the upcoming International Post Keynesian Conference in Kansas City later this month. Any macroeconomic model, of course, is only an abstract and simplified version of a real economy. But the bottom line is that (1) guiding fiscal policy with a balanced-budget target leads to instability in all cases, while (2) the output-stabilizing fiscal rule generates a business cycle of varying size or convergence to a point.

From time to time, I call attention to solid coverage of the Federal Reserve in the popular press, for example this post, which links to an interesting William Greider profile of Ben Bernanke. Nicholas Lemann profiles the new Fed chair in the July 21 issue of The New Yorker. One of the key themes of the newer article is that Yellen is “the most liberal [Fed chair] since Marriner Eccles,” and an “unrepentant Keynesian.”

The article usefully contrasts Yellen’s policy views with those of orthodox macroeconomics. Yellen identifies as an adherent of the philosophy that government is capable of greatly improving on the outcomes of a modern capitalist system. (For many, this is the essence of what is known as the liberal view in the US political realm. Yellen’s liberalism will matter (1) in financial regulation, and (2) in macro policy, where the Fed is influential.)

Of course,  there are many varieties of liberalism. Here is a perhaps-characteristic Yellen quote from the article, explaining economics as a personal career choice: “What I really liked about economics was that it provided a rigorous, analytical way of thinking about issues that have great impact on people’s lives.  Economics is a subject that really relates to core aspects of human well-being, and there’s a methodology for thinking about these things. This was a very appealing combination to me.”

The quote continues, “Market economies are capable of massive breakdowns that can result in long, devastating periods of high unemployment. And I felt that economists had really learned something about how to address that.”

On the other hand, the article expresses sympathy with the view expressed by Bernanke and others that Keynesian economics  itself (as practiced by most academic economics departments) did not foresee the financial crisis that began about 2008. As readers of this blog know, of course, economists affiliated with the Levy Institute and its Minskyan tradition were among the few who did anticipate a crisis. The article notes that Yellen herself “began to be concerned that there was a dangerous bubble in housing markets” in 2005 and 2006, but quotes her as conceding that she “absolutely did not see it as something that could take the financial system down.”

What about the role of bank money and nominal wages, topics on my own mind with the approach of the International Post Keynesian Conference, which the Levy Institute is partially sponsoring? continue reading…

On Saturday, Daniel Alpert delivered the closing remarks at the Levy Institute’s Hyman P. Minsky Summer Seminar:

Minsky had the rarely seen ability to stand back from all he had learned—even at times from his own mentors—and not only see and articulate what was misunderstood, what wasn’t working, but also to explain why conventional wisdom is often not always all that wise and why markets often proceed in delusional fashion.  And by this I mean not merely the often irrational animal spirits of markets, nor the Keynes’ casino, nor his beauty contest, but an almost collective agreement to ignore the most obvious of fact-pictures staring right back at us.  And often, to ignore them because they force consideration of exogenous variables that aren’t readily incorporated into existing mainstream models, to ignore them because they are too heterodox to be considered by those who have invested their lives work in developing and interpreting mainstream theory, or to overlook them because they involve understanding the often obtuse complexities of actual market operations that go beyond ivory tower theories of market behavior.

Read Alpert’s full remarks here.

Last week the ECB’s governing council agreed on interest rate cuts and some fresh liquidity measures. The policy move has sparked off quite some excitement in all kinds of corners. Certainly financial markets highly welcomed the ECB’s much-awaited new easing initiative, with stock indices surging and bond yields plunging to record levels. International commentators generally felt that the ECB was – finally, if belatedly – doing the right kind of thing. And, generally speaking, the European political body seems to be sufficiently famished, and perhaps also a little terrified by the recent EU parliament election results, to welcome any perceived easing of pain. Only one party felt seriously short-changed by the euro’s independent guardian of stability: German savers.

In Germany, the ECB’s latest policy decisions, featuring a negative interest rate to be paid by banks to the ECB for lending to the ECB by means of its deposit facility, triggered an across-the-board outcry orchestrated by the German media, ranging from heavyweight tabloid Bild to the mouthpiece of Germany’s conservative intelligentsia Frankfurter Allgemeine Zeitung. German savers appear to be up in arms against the ECB’s outrageous decision to shave 10 basis points off its key policy rate and introducing a negative rate on its deposit facility. The president of Germany’s savings bank association declared that the ECB’s move amounted to expropriating German savers. And former ECB executive board member Jürgen Stark, who had resigned back in 2012 for “personal reasons,” which seemed to be all too clearly related to the ECB’s government bond buying program, was glad to add fuel to the flames by declaring in an interview that the ECB was breaching its mandate.

The German media reaction to the ECB rate cut is more than a bleak statement about the quality of economic journalism in Germany. One probably has to concede that it also well reflects the general state of mind and German psyche about Europe’s common currency project and the havoc it has wreaked across the continent. There are some important lessons here for Germany’s euro partners – and beyond.

First of all, these events once again highlight that in the German euro debate superficial morals prevail over any economic expertise. In Germany, saving is by its nature always virtuous. Savers, as creditors, occupy the moral high ground. Creditors are simply morally superior to debtors. In fact, debtors are suspected to be afflicted by some moral defect. As savers apparently have a moral right to get paid interest, the ECB’s move is seen as expropriation; its decision to make the creditor pay what seems like a “Strafzins” (penalty interest rate) for lending to the debtor seems outright immoral.

Within these pseudo-moralistic dimensions inspiring the German euro debate economic reasoning is conspicuous for its absence. It is somehow lost that there can be no creditor without any debtor. It is also lost that Germany as a nation can only run a current account surplus if other nations run deficits and pile up debts. So it has never entered the German national debate that Germany only managed to balance its public budget thanks to other countries’ willingness to borrow and spend on German exports. Instead, morally, it seems a clear-cut case that Germany has done everything right. If there is trouble in the system, it must be because of others’ failures and moral deficiencies. continue reading…

Paul McCulley, a familiar face at Levy Institute events (he gave a keynote at our Rio conference and at last year’s Minsky Summer Seminar), is back at PIMCO and his first note is (predictably) worth a read.

His latest essay looks at Federal Reserve policy from the standpoint of what McCulley terms the Fed’s “secular victory in the long War Against Inflation” and discusses, among other things, how the Great Moderation fed into Minskyan financial instability, how we should think about the Fed’s “neutral” real policy rate, and what this means for the question of whether stocks and bonds are overvalued. Here he is on the Taylor Rule:

The “neutral” real policy rate is not secularly constant.

It evolves as a function of changing “real” economic variables – demographics, technological progress, productivity, etc. – as well as changing institutional arrangements, notably changes in the degree of regulation of banking and finance, domestically and internationally. Thus, the notion of a “fixed” center of real policy rate gravity for prudent monetary policy is an oxymoron.

Which is why, for me, it is so befuddling that the Fed, and thus the markets, still clings – even if reluctantly – to one man’s estimate of an “equilibrium” real fed funds rate, made in 1993: John Taylor, who assumed it to be 2%, which, in his own words, was because it was “close to the assumed steady state growth rate of 2.2%.”

And that assumption became embedded in his ubiquitous Taylor Rule.

[…]

… that’s the origin of the 4% number that, to this day, the FOMC prints as its “longer-term blue dot” for where the fed funds rate “should be” (if the Fed were, theoretically, pegging the meter on both of its mandates).

I’ve got to hand it to John, whom I’ve known and liked for a very long time: Twenty-one years on, and you are still hardwired into the catechism of Fed policy!

But surely, economic life has changed since 1993, about the same time that Al Gore was inventing the Internet.

I believe the FOMC’s 4% nominal longer-term blue dot – which implicitly embeds John’s 2% real rate assumption – is wrong, unless we want to say that 2014 is 1993 redux. I don’t.

Read the whole thing.

The funny-shaped surface in the Wolfram “CDF” below (software download link) depicts excess demand for goods. The flat one represents the zero line where supply and demand are equal. On each axis is a variable that affects the degree to which demand outpaces or falls short of supply: (1) firms’ share in the price of goods, after paying wages, which equals the pricing markup m divided by (1 + m); and  (2) the income and production generated by the private sector, measured by capacity utilization. The height dimension measures excess demand for goods.

The sliding levers at the top of the CDF allow one to change (1) (“chi”) the percentage of disposable income spent by the wealthy households who own most stock, as well as all government-issued securities; (2) the rate of production by the public sector, which hires workers to produce services; and/or (3) the annual compound real interest rate (yield) on government securities. All of the other parameters are held constant as you move the levers. Click on the “plus” sign next to a lever, and further information appears.

[WolframCDF source=”http://multiplier-effect.org/files/2014/04/3D-excess-demand-graphN5.cdf” width=”331″ height=”361″ altimage=”3D-excess-demand-graphN5.png” altimagewidth=”309″ altimageheight=”351″]

Click here for a much larger, easier-to-read version of this CDF on a webpage of its own.

At the curved line where the two surfaces intersect (the edge of the dark blue region when viewed from above), aggregate demand is just equal to private-sector output, and there is no tendency for capacity utilization to change. Finding this intersection gives us the set of combinations of output and the distributional parameter at which all newly produced units are being sold, and no new goods orders are stacking up unfilled. Experimenting with the CDF, one finds that capacity utilization is usually higher: (1) when the share of the “K-sector”, or capital-owning sector, (m/(1 + m)) is lower, (2) when that sector spends a greater percentage of its disposable income, or (3) when government production and payrolls are larger.

One should keep in mind the simplification required to construct such a “small” model, which in graphical form represents only an imaginary economy; the numbers are not intended to mirror those of any particular country or data set–but the economic  system portrayed in the CDF is meant to be similar in many of its essentials to that of large industrialized nations with their own currencies, huge companies, liquid securities markets, floating exchange rates, etc. Another possible way to interpret this highly “stratified” industrial system is as an entire global economy in a mere 3 sectors: workers; firms/wealthy households; and government/central bank.

A larger version of the model featured an unemployment benefits system. To come: a discussion of the movements over time that may or may not bring the economy closer to the line where excess demand just reaches the flat surface and no higher. The model still has only a rudimentary financial system, with no private borrowing. Hence, the interest rate lever acts upon the economy solely by changing the amount of interest payments from the government to households–a distributional and fiscal variable in its own right and an MMT insight. (Business investment depends on capacity utilization and the gross after-tax profit rate.) The model is drawn more or less directly from Levy Institute working paper 723 (see this previous post) as revised recently for the academic journal Metroeconomica.

Chicago Fed President Charles Evans spoke at last week’s Minsky conference, and news reports have focused on his comments regarding the expectation that the Federal Reserve will wait at least six months after the end of QE before beginning to raise interest rates (Evans: “It could be six, it could be 16 months”; “If I had my druthers, I’d want more accommodation and I’d push it into 2016,” but “the actual, most likely case I think is probably late 2015”).

But his speech might also be of interest to those who have been following the debate over whether the Federal Reserve is, let’s say, equally passionate about the two sides of its “dual mandate” (price stability and maximum employment). Right now, the Fed is missing both of its ostensible targets, with inflation below 2 percent and unemployment above the Fed’s estimate of the “natural” rate, which ranges from 5.2 to 5.6 percent (for Evans, it’s 5.25 percent). Many have suggested that the Fed appears much more concerned about inflation rising above 2 percent than it does about high unemployment, or below-target inflation, for that matter.

In the video below, Evans shares his view of how the Fed should “score” its hits and misses on unemployment and inflation:

the 9 percent unemployment rate we faced back in September 2011 can be depicted in “inflation-loss equivalent units” by showing the inflation rate that gives an equivalent loss when unemployment is at its sustainable rate. So what is that rate? If unemployment was at its natural rate, what would be the inflation rate that would make you equally uncomfortable as if you were facing the 9 percent [unemployment] rate? The answer is 5-1/2 percent inflation. […]

I think we need continued strongly accommodative monetary policy to get inflation back up to 2 percent within a reasonable time frame. After all, notice that the red and green regions of the bull’s-eye chart [posted below] show modest inflation above 2 percent is much more acceptable than even 6 percent unemployment.

Here he is on the outlook for inflation:

Despite current low rates, I still often hear people say that higher inflation is just around the corner. I confess that I am somewhat exasperated by these repeated warnings given our current environment of very low inflation. Many times, the strongest concerns are expressed by folks who said the same thing back in 2009, and then in 2010, and … well, you get the picture. […]

[A]nother potential source of inflationary pressures would be rising inflation expectations. Here, I mean a breakout of inflation expectations separate from any fundamentals that might accompany the previously discussed cases of rising commodity prices and stronger bank lending. One could think of this as the spontaneous combustion theory of inflation. The story goes like this: Households and businesses simply wake up one day and expect higher inflation is coming without any further improvement in economic fundamentals. Without appealing to esoteric economic theories of sunspots, these expectations don’t seem sustainable in the current environment.

The rest of the videos of speakers and panelists from the conference will be posted here.