Thursday, October 2, 2014

Europe According to Draghi

PARIS – Central bankers are often proud to be boring. Not Mario Draghi. Two years ago, in July 2012, Draghi, the president of the European Central Bank, took everyone by surprise by announcing that he would do “whatever it takes” to save the euro. The effect was dramatic. This August, he used the annual gathering of top central bankers in Jackson Hole, Wyoming, to drop another bomb.

Draghi’s speech this time was more analytical but no less bold. First, he took a side in the ongoing debate about the appropriate policy response to the eurozone’s current stagnation. He emphasized that, along with structural reforms, support for aggregate demand is needed, and that the risk of doing too little in this respect clearly exceeded the risk of doing too much.

Second, he confirmed that the ECB was ready to do its part to boost aggregate demand, and mentioned asset purchases, or quantitative easing, as a necessary tool in a context in which inflation expectations have declined below the official 2% target.

Third, and to the surprise of most, Draghi added that there was scope for a more expansionary fiscal stance in the eurozone as a whole. For the first time, he expressed the view that the eurozone had suffered from the lower availability and effectiveness of fiscal policy relative to the United States, the United Kingdom, and Japan. He attributed this not to pre-existing high public debts, but to the fact that the ECB could not act as a backstop for government funding and spare fiscal authorities the loss of market confidence. Moreover, he called for a discussion among euro members of the eurozone’s overall fiscal stance.

Draghi broke three taboos at once. First, he based his reasoning on the heterodox notion of a policy mix combining monetary and fiscal measures. Second, he explicitly mentioned the aggregate fiscal stance, whereas Europe has always looked at the fiscal situation exclusively on a country-by-country basis. Third, his claim that preventing the ECB from acting as a lender of last resort imposes a high price – making governments vulnerable and reducing their fiscal space – contradicts the tenet that the central bank must not provide support to government borrowing.

The fact that Draghi chose to confront the orthodoxy at a moment when the ECB needs support for its own initiatives is indicative of his concern over the economic situation in the eurozone. His message is that the policy system as it currently works is not suited to the challenges that Europe faces, and that further policy and institutional changes are necessary.

The issue now is whether – and, if so, how – conceptual boldness will translate into policy action. There is less and less doubt regarding the benefits of outright asset purchases by the ECB. What was long regarded as too unconventional to be contemplated has gradually become a matter of consensus. It will be operationally difficult, because the ECB, unlike the Federal Reserve, cannot rely on a unified, liquid bond market, and its effectiveness remains uncertain. But it will most likely take place.

At the same time, there is little doubt that fiscal policy will fall short of Draghi’s wishes. There is no agreement in Europe on the concept of a common fiscal stance, and the backstop that the ECB could provide to sovereigns can be offered only to countries that commit themselves to a negotiated set of policies. Even this conditional support within the framework of the ECB’s so-called outright monetary transactions (OMT) program has been opposed by Germany’s Bundesbank and constitutional court.

Draghi’s initiative on this front should thus be interpreted not only as a call for action, but also – and perhaps even more so – as a call for reflection on the future approach to eurozone policymaking. The question is this: How can the eurozone define and implement a common fiscal policy without having a common budget?

International experience shows that voluntary coordination is of little help. What happened in 2009 was a rare exception; shocks like that which followed the Lehman Brothers bankruptcy – sudden, strongly adverse, and highly symmetric – come once in decades. At the time, all countries faced essentially the same issue, and all shared the same concern that the global economy could slide into a depression.

Europe’s problem today, though serious, is different: a significant subset of countries does not have fiscal space to act and would therefore be unable to support demand. And, though Germany is doing much better than anyone else and has fiscal space, it does not wish to use it to benefit its neighbors.

If joint fiscal action is to be undertaken, a specific mechanism would be needed to trigger it. One could think of a joint decision procedure that would, under certain conditions, require budget laws to be approved by the national parliament and a majority of partner countries (or the European Parliament).

Or one could think of a mechanism inspired by the “tradable deficits permits” imagined by Alessandra Casella of Columbia University. In this scenario, countries would be allocated a deficit permit consistent with the desired aggregate stance, but would be free to trade them; a country willing to post a lower deficit thus could cede its permit to another one willing to post a higher deficit. In this way, the aggregate stance could be achieved while accommodating national preferences.

Any mechanism of this sort raises a host of questions. But the fact that the official in charge of the euro is raising the issue indicates that the common currency’s architecture remains in flux.

A few months ago, the consensus was that the time for redesigning the euro had passed, and that the eurozone would have to live with the architecture inherited from its crisis-driven reforms. Not anymore. It may take time before agreement is reached and decisions are made, but the discussion is bound to resume. That is good news.

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  1. CommentedLance Brofman

    "..An old economics joke is “A recession is when you are out of work. A depression is when I am out of work.” However, the differences between a recession and a depression are not simply how many people are unemployed. It is important for investors recognize and understand the significance of the differences between recessions and depressions.
    The key difference between a recession and a depression is that a recession can be ended by monetary policy alone.

    If every few years you got the flu and now you had a strep throat it would be incorrect and possibly dangerous to think that you just had a bad case of the flu this year. Over the last hundred years there have been numerous recessions but only two depressions, the depression of 1929-1941 and the depression that began in 2007. The symptoms of strep throat and scarlet fever may be similar to that of the flu or common cold. However, causes of the former are the streptococcus bacteria while influenza is viral. Hence, strep throat and scarlet fever require antibiotics which are useless against viruses. Likewise, believing that the depression that started in 2007 is just a severe recession is quite dangerous to both investors and policy makers. As long as many policy makers appear not to realize the distinctions between recessions and depressions, investors ignore those distinctions at their peril

    The effects of the 2007 depression are much less severe than the 1929-41 depression because of safety-net benefits now provided. Consider the horrendous, though not uncommon situation of a household in 1932 comprised of elderly grandparents being supported by their working-age children with young children of their own, when the breadwinners became unemployed. The 1932 family would be destitute. Today the grandparents would have social security and Medicare benefits. Their working-age children could now collect unemployment benefits for up to 99 weeks. Additionally, the entire family could also be eligible for food stamps, Medicaid, rent subsidies, heating fuel subsidies, free school lunches and other benefits. The 1932 family might also have had a bank account in one of the many banks that failed and lost their savings. Today, Federal Deposit Insurance protects such bank accounts. You might say we are now in a depression with benefits.

    The difference between a depression and a severe recession are not just semantic. Recessions occur when the Federal Reserve raises interest rates in an effort to slow down an overheated economy. Most importantly, recessions end when the Fed lowers interest rates. In a recession the pent-up demand for housing and durable goods means that monetary policy alone can cure the recession. Just as antibiotics can be effective against bacterial infections but not against viruses, monetary policy alone cannot end a depression. Furthermore, modest fiscal stimulus and the automatic stabilizers that can hasten the end of recessions cannot end a depression. There can be ups and downs in the unemployment rate during a depression. However, the unemployment rate remains elevated. It was 14.5% in 1940 and 9.7% in 1941.

    If we are in a recession, economic activity will fully resume just from the monetary and fiscal stimulus that has already occurred. Ultimately interest rates will rise. However, if we are in a depression, even one with safety-net benefits that mitigate the hardships, interest rates will remain relatively low for decades as was the case in Japan and the USA of the 1930s, where only World War II ended the depression. .."

  2. CommentedJohn Morgan

    "....his claim that preventing the ECB from acting as a lender of last resort imposes a high price – making governments vulnerable and reducing their fiscal space..."

    There is another factor which is reducing fiscal space. European Governments (and Argentina and Venezuela) are raiding accumulated State Pension funds or Social Security funds to hide deficits. This is done by internal government fiscal transfers, as was the case in Cyprus, where I live. The previous Cyprus government bankrupted the Social Security fund, borrowing from it by issuing Treasury Bills and rolling them over.

    Sadly, the Cyprus private sector pension and social security premiums went into providing a backstop (guarantee) for the pensions of state employees. (State employees did not contribute to either Social Security or Pensions, hence the need to raid private sector inflows).

    It was only during the Cyprus bailout by the Troika, that this irregular fiscal transfer, amounting to an accumulated €7 bn (40% of GDP), was discovered.

    As is well known, the same strategy of transferring Social Security and Pension contributions to the current account, led to Greece's bankruptcy. In the case of Greece, a law was passed that all private pension funds had to invest in sovereign bonds.

    €110 was wiped off the value of Greek bonds (PSI), because, like Cyprus, the Greek Government ran a Public Pension and Social Security Ponzi scheme. The private sector was robbed to pay the outrageous salaries and pensions of state employees. This was done to counter trade union blackmail and avert continuous strikes by militant public service trade unions.

    My point is that these massive multi-billion Social Security and State Pension fund black holes exist throughout Europe and have to be filled so that governments can meet current and future liabilities to pensioners and the unemployed.

    The Greek-style black hole in the state finances of Poland, which is not a Eurozone country (yet), is estimated to stand at €250 billion. In September 2013, PM Donald Tusk nationalised 50% of the private pension industry, worth €30 billion, to try and plug his Public Pension shortfall.

    Tusk is now President of the European Council, which means that he will support other European leaders who wish to raid the private sector pension industry to give themselves fiscal space.

    In summary, OMT or QE will be used as another source of funding to fill the black holes in State Pension and Social Security obligations that indebted European governments are hiding off their books, like Greece was doing.

    As a consequence, there will be limited fiscal expansion with OMT or QE. Undeclared government obligations must first be met. If not, the state will have to resort to mass-firing of state workers, as demanded by the Troika for Greece. This in turn leads to political instability and the loss of electoral prospects for the governing parties who perpetrate false accounting.

    As long as economists believe the false accounting provided by European governments, the Eurozone crisis will defy rational analysis.

  3. CommentedPaul Peters

    Admirable but such macro-economical measures cannot control the multi-faceted economical landscape of the Euozone. Several sorts of partial Eurobonds are needed for more precisely targeted linkage between disparate but interdependent economic sectors. Turning the volume dial on the currency is simply too inaccurate when it is more profitable for most investors to do speedy investments in emerging economies, however unsustainable that may be in the long run.

  4. CommentedJohn A Werneken

    This is terrible news. The uncompetitive should be relatively impoverished unless they wish to abandon egalitarian policy and become competitive. Debt is a good measure of action: high debt means no action as yet.

  5. CommentedJoshua Ioji Konov

    To say the least, quantitative easing combined with austerity measures will accelerate inequality, because the social expenses and governmental employment in EU has been a natural market tool for balancing the deteriorating private employment salaries with the best example has been China, but not the least Japan fir the last 10-15 years. Even so the governments lack market flexibility, at the moment they are the only market tool for helping markets equilibrium..., what EU is doing and planing to do is going to create more imbalance..., raising inequality, moreover economic stagnation.
    Mr. Draghi is planing to pour new wine in the old wineskins...

  6. CommentedVal Samonis

    Not too little, too late?

    The EuroZone (EZ) banks are almost totally out of any control or any macro prudential regulation because they decide some 97% of money creation (some 80% in the USA) and the directions of money flows. The ECB already admitted its impotence within the current set-up. The EZ banks earn their money the EZ way (pun intended!) mainly by financing the governments of the EuroZone, which is a rather unproductive use of capital resources in the longer-term. I see no productivity breakthrough in the EZ, so we might see a euro collapse sooner than later when Russia corners the EU energy market before this winter.

    Val Samonis
    Vilnius U