mardi 9 septembre 2014

I don't understand most German economists.

A good example of what I mean by "most German economists" can be found in this interview of Michel Heise, chief economist at Allianz: Link. Let's go over his arguments against Quantitative Easing one by one : 
“There are several reasons why the ECB should not go down the route of QE. First, the recent low inflation rates are in part a result of the decline in oil and other commodity prices. They also reflect necessary adjustments in the eurozone periphery – wage moderation and the impact of structural reforms are feeding through into lower prices across the board, which is exactly what countries such as Greece and Portugal need to restore competitiveness and bolster purchasing power. There is no sign of a vicious circle of falling inflation expectations and consumer restraint. Inflation rates will gradually climb again as the economy recovers.“
Yes, low inflation rates are in part a result of the decline in oil and other commodity prices, but not entirely. See in the graph below total and underlying inflation (excluding commodity prices). Underlying inflation considerably slowed, from 1.7% in 2012 to less than 1% in 2014. It is much less volatile than total inflation, and hard to move. Moreover, using the slowdown in commodity prices to justify doing nothing is hypocritical, because the ECB (under President Trichet and with the Bunbesbank's approval) raised rates in 2011 to counter rising inflation, when in fact underlying inflation stayed on track. The same people that looked only at total inflation in 2011 now look only at underlying inflation, in both case to oppose expansionary policy.

Source Eurostat. Month on Month %change

Greece and Portugal do need lower inflation than Germany to restore competitiveness, but that does not mean that eurozone inflation has to stay low, it just means that Northern Europe has to be over 2% and Southern Europe below 2%, so that the average is 2%. Moreover, to quickly restore competitiveness you need a big inflation gap between Germany and Portugal, and a big gap is easier to get with Germany inflation à 3% than 0.9%. The reason for this is downward stick nominal wages. 

A big source of misunderstanding with the question of competitiveness is whether inflation in Portugal is linked to Portugal’s competitiveness outside the eurozone. The answer is no. What matters for Portugal’s competitiveness outside the eurozone is the exchange rate, which is linked to inflation in the eurozone as a whole. Another way of looking at it is that Portugal’s competitiveness outside the eurozone will improve by the same amount if it has 1% inflation versus 2% in the eurozone than if it has 0% versus 1%, what matters, again, is the inflation gap. 
“Second, although the ECB has several options when it comes to implementing QE, there are serious objections to all of them. Buying asset-backed securities or corporate bonds would expose the European taxpayer to credit risk. If the ECB bought bonds issued by eurozone governments in proportion to each country’s output, its intervention would be focused on Germany, where bond yields have already hit rock bottom, with the 10-year yield now below 1 per cent. But any programme of asset purchases that concentrates on the slower-growing economies would result in a politically unacceptable redistribution of risk in the eurozone and set the wrong incentives for fiscal policy.“
I love this argument, because it can be used in favor of QE instead of ABS-purchase. It’s true that it’s hard to evaluate the risk level of each eligible asset, unless the ECB decides to buy government bonds, for which the degree of risk is really easy to assess : almost zero. Even Greek bonds became risky only after markets understood mid-2011 that the ECB won’t be buying them. It’s true that assets purchase programs will expose the ECB, and in the end the European taxpayer to credit risk, each Member State according to its central bank’s share in the ECB. But credit risk is not exogenous. By buying assets, the ECB contributes to reducing (by a significant amount) the level of credit risk in the eurozone and in troubled countries. To think that such risk is unbearable, you need to think that these assets are overvalued, when they obviously are not and won’t be once the ECB starts QE.
As for “the wrong incentive for fiscal policy”, it just shows an obsession with fiscal policy, which was just fine before the crisis despite low borrowing rates everywhere. Structural deficits in troubled countries are falling fast, despite renewed confidence and low borrowing rates. This line of argument: “if markets don’t pressure them those lousy southern politicians won’t stop spending above their mean” is just a Greek story, it is not applicable to Portugal, Spain, Italy and even France.

But refusing to expose European taxpayers to credit is a valid argument against QE. But those who use this argument constructively are proposing instead to target the level of nominal GDP, something much more horrible than QE in the eyes of German orthodoxy, because it would imply an inflation target of 3% in the current conditions. A good discussion about the merits of QE vs not-QE is here : Simon Wren-Lewis and Scott Sumner
“Third, the impact of further monetary easing on output and price levels would be negligible. That is because the recession in many parts of the eurozone is caused by the hobbling effect of the unsustainable amounts of debt that were built up by public and private actors during the boom years. Over-indebted households and companies are unlikely to pile up more debt; on the contrary, they are trying to pay it down. This makes monetary policy ineffective. For many southern European banks, ECB liquidity has replaced the money market. It cannot be sensible to eliminate market disciplines for extended periods of time.”
Yes, money is not supply-determined, trying to increase the amount of credit and deposit when consumers and firms just use new credit to pay back old credit has virtually no effect. But we don’t really know that it is the case in the eurozone. At least, it’s not the case everywhere in Europe, for instance new credit may help Germany generate some inflation. That will surely help Italy, Spain and Portugal. If the increase in base money doesn’t translate in an increase in deposit and credit money, at least we have pushed on the gas pedal. If the car is still not moving, we can try something else.
“Fourth, the collateral damage from ultra-loose monetary policy is accumulating. Risks to financial stability are growing as investors are piling into riskier assets in search of higher returns. Already, some assets such as junk bonds are trading at what look like inflated prices.”
Ask the Sveriges Riksbank (the Swedish central bank), who started raising rates in 2010 for fear of an housing bubble and got the Swedish economy in the same mess as the Eurozone's
“Fifth, further monetary easing would delay the much-needed adjustments in the balance sheets of European banks and companies. An abundance of cost-free liquidity from the central bank enables commercial lenders to continue propping up weak creditors. It is exactly this type of “zombie lending” that has curbed growth in Japan for more than a decade. For many southern European banks, ECB liquidity has replaced the money market. It cannot be sensible to eliminate market disciplines for extended periods of time.“
This argument is the opposite of the third argument. You need to choose : will agents adjust their balance-sheet despite monetary easing, thus canceling any increase in base money, or will they use cheap credit to keep zombie creditors alive? First, it is not proven that those zombie creditors are numerous, if not there. They may have been created by too easy monetary policy in southern countries in the 2000’s (overheating in Spain was not countered by the ECB, because Germany was in trouble...), and if they have not disappeared, their conditions will not improve because markets will probably not make the same mistake and assume that risk is the same everywhere thanks to the euro. Monetary expansion may delay the adjustment, but the risk of doing nothing is greater.
“The ECB is right to assume the function of a lender of last resort for the eurozone. But it has already flooded the European economy with liquidity, for example through the targeted longer-term refinancing operations that are about to start.
The ECB’s forward guidance should not consist of further promises that free liquidity will be available forever. Banks that operate on the assumption that they can avoid the money market have no incentive to get into shape. They should be told that, sooner or later, interest rates will return to normal levels, an eventuality with which they must be able to cope.
Monetary policy alone cannot and will not return the eurozone to sustainable growth, as Mario Draghi, the ECB president, pointed out at the Jackson Hole gathering of central bankers last month. Improvements in labour markets and the investment climate, sustainable fiscal reforms and a shift of public spending towards growth-boosting investments in infrastructure and education are what Europe must focus on now. “
Forward guidance would begin by forecasting the target : if the ECB forecasts 1% inflation including the impact of its programs, it just means that the ECB is doing too little by its own standards. It would be better if it could do some price-level targeting, which would mean commit to 2.5% inflation the next year if it misses its target by 0.5%. That does not mean “free liquidity forever”. The ECB could for instance say it will not increase rates as long as inflation stays below x%, with x marginally higher than 2. 

So if I sum up, the ECB shouldn’t do QE because :
1)    Inflation below target is good (why do we have a target then?)
2)    ABS purchase is bad for european taxpayers
2bis) Southern governments will free ride and forget the 3% deficit limit just to spite the German taxpayer.
3)    It won’t do anything (see 5)
4)    Bubble!!!
5)    It will do terrible things (see 3)
6)  Forward guidance means free liquidity forever and ever and you don’t want that because, well, Zimbabwe.

And Michael Heise is not alone. This week's reactions in Germany after Draghi's announcement that the ECB will increase its balance sheet through direct purchases of ABS and Bank covered bonds are really disturbing. 

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