Archive for the Category Eurozone


There’s only one AD

Like any single currency area, the eurozone has only one AD.  That’s true despite the fact that it contains 19 countries.  In contrast, China has 4 ADs, for Mainland China, Hong Kong, Macao and Taiwan.  (The Taiwanese constitution says they are part of China, who am I to argue?)

Here is the eurozone unemployment rate:

screen-shot-2016-09-09-at-11-18-11-amThe disastrous policy tightening of 2011 pushed eurozone unemployment up from 10% to 12%.  Then policy eased slightly, and NGDP started growing again. Unemployment fell back to 10%, about the rate of 1999, when the euro was created.

Unemployment is still very high in Greece and Spain, but that fact does not and should not matter to the ECB.  There is only one AD for the eurozone, and it needs to be appropriate for the entire region, not any single country.  By analogy, the unemployment rate in Nevada should have and does have no bearing on Fed policy, which looks at the national unemployment rate.

That doesn’t mean ECB policy is not too tight—after all, they target inflation, not unemployment.  But here again I detect a weird pattern among pundits, to talk almost as if there are two ADs for the eurozone, one for inflation and one for unemployment.  Consider the ECB’s recent action, or should I say non-action:

US and European equities are under pressure as disappointment over the European Central Bank’s decision to stand pat on monetary policy and uncertainty over the Federal Reserve’s interest rate trajectory force up borrowing costs. . . .

Ian Williams, economist at Peel Hunt, said investors appear “rather underwhelmed by the ECB announcement, both the absence of further policy action and the lack of guidance offered by Mr Draghi at his press conference about what may come next”.

Fixed income analysts at Citi said the ECB had introduced volatility by failing to even discuss QE. “The decision not to extend the timetable of QE from Mar-17 weakens forward guidance and is bearish.”

So the ECB tightened monetary policy yesterday—why does that matter?  Here’s why it’s a big deal; roughly 90% of pundits, and even professional economists, don’t seem to have a clue as to what’s going on.  If asked to explain the recent ECB non-action, most would say the ECB is satisfied with the pace of recovery, including the fall in the unemployment rate, and that it expects inflation to rise in the future. They may not agree with that outlook (I don’t think inflation will rise as much as the ECB expects) but that’s why the ECB effectively tightened yesterday, disappointing markets.  So far, so good.

But when the discussion turns to inflation, these same pundits will insist that the ECB is trying and failing to hit its inflation target, and/or they are out of ammo.  In other words, the implicit assumption is that a single monetary policy can target two different ADs, one for inflation and one for employment.  On the employment front, the ECB still does normal monetary policy, tightening when they think the recovery needs no more juice.  But on the inflation front the pundit class insists the ECB is out of ammo.

Of course none of this makes any sense.  Obviously the ECB is not out of ammo, or markets would not have reacted negatively to their recent tightening of policy   So why do so many economists think they are out of ammo for inflation, but not employment?

Maybe they are dumb.

More plausibly, pundits and economists are smart, but excessively deferential to the wizards behind the curtain of our central banks.  People like Yellen, Bernanke, Draghi and Kuroda are deserving of our respect.  They are more qualified than most pundits and most economists, including me.  So if they are falling short on inflation, people assume that it must be because they do not have the tools to hit the inflation target.

What’s wrong with this view?  I think it’s a mistake to judge the competence of central banks by the competence of their leaders.  Central banks are complex and powerful institutions, embedded in even more complex and even more powerful political entities.  Assuming that the performance of the central bank represents the competence of their leaders is a big mistake, even if the leaders voted in favor of the recent policy action.  If the central bank heads had been assigned to the position of dictator of the world, we might be seeing an entirely different set of monetary policies.

PS. The ECB currently forecasts 1.6% inflation by 2018, which is close to its target of slightly below 2%.  I think they are too optimistic.  But excessive optimism and lack of ammo are two entirely different concepts, which most people don’t seem to be able to grasp.

Alternative for America

The German political party “Alternative for Germany” was founded in 2013 by a bunch of professors who thought the euro was a mistake, largely responsible for the depression in southern Europe.  Its other views tended to be fairly mainstream conservative.

Not any more.  In just three short years the AfD has morphed into a xenophobic, nationalist, pro-Russian party with nostalgia for the days when East Germany was run by the communists.  Many of its original supporters have abandoned the party:

It is not clear why the AfD is so popular in [low income, eastern] Mecklenburg. Its hallmark is anti-immigrant rhetoric. But Mecklenburg has just 23,000 refugees, or 1.5% of the population. Foreigners make up 3%, and most are Poles or ethnic Germans from Russia. Muslims are a rare sight. Yet even before the refugee crisis, about one in three locals told pollsters that “because of the many Muslims, I sometimes feel like an alien in my own country”.

Mecklenburg does have a longstanding core of far-right voters: it is the only state where the NPD, a party considered neo-Nazi, has seats in the assembly. But the AfD draws more support from former non-voters and The Left, a party descended from East Germany’s communists. In the West, that may seem illogical. But it matches the gut feelings of many locals. One of the AfD’s themes is Ostalgie, “nostalgia for East Germany”. It nurtures a sense of solidarity against all outsiders, including western Germans and cosmopolitan elites.  Since reunification people in the region have felt they were “overrun by the West”, says Mr Holm.

At campaign events Mr Holm evokes 1989, when Ossis marched in solidarity against the communist regime. Now the enemy is perceived political correctness imposed by Berlin. The tone is invariably pro-Russian and anti-American. Asked how they feel about Russia’s invasion of Crimea, supporters compare it with America’s war in Iraq. “If the Ami does it it’s okay, but if Russia does it, it’s wrong?” asks one.

Actually, yes.  We did not annex Iraq.

To give you an idea of just how bizarre this is, imagine an American analogy:

1.  Suppose that in just a few years, the formerly anti-big government Tea Party was taken over by a nationalist faction that favored a xenophobic, soft on Russia, big government, more spending, vastly bigger deficits, anti-trade, anti-free press candidate who railed against political correctness and elites in general.

2.  And suppose the core supporters of this candidate were not in affluent Republican areas, but rather in poor white areas like West Virginia.  And suppose those poor whites of West Virginia were freaking out about immigration, despite the fact that hardly any immigrants want to live in their poor, backward state.

I know, I know, it could never happen here.  But then 3 years ago I would have said there wasn’t one chance in a million that the AfD would suddenly change into a party with nostalgia for East Germany.

Lesson: As I keep saying, it’s not about who wins and loses elections, it’s about the nature of the parties, and how they change over time.  FDR and LBJ made the GOP more moderate (for a while).  Reagan and Thatcher made the Dems and Labour more moderate (for a while), and so on.  That’s what matters.

If you make a pact with the devil, and allow your favorite party to be taken over by evil people, and vote for them anyway as the “lesser of evils”, you’ll find out that in the long run you’ve only made the opposition stronger, and you’ve completely discredited your favored ideas, which won’t even be adopted by the usurper who stole your party.  No, your ideas will not be adopted.  But when he or she fails, as he surely will, your ideas will be blamed, and discredited.

The next president will be a failed president, and will be rejected by the voters in 2020.  The election you really want to win is the 2020 election, which will offer the possibility of dramatic policy reform.  What shape do you want your party to be in at that time?  Do you want it to be a discredited party, about to be steamrollered by the opposition?  Or the eager opposition party, about to take charge?

If I were a Republican (I’m not), I’d pray for Hillary to be defending her record in 2020

The most important election this fall?

You can make a pretty good argument that the most important elections this fall are the various state referenda over pot legalization.  If they pass in California and elsewhere, the momentum to legalize pot will become unstoppable.  But coming up fast is the Italian referendum on constitutional reform, which will be held sometime before the end of October.  Over at Econlog, I have a new post discussing how this referendum has taken on much greater importance after the Brexit vote, and could trigger a major eurozone crisis.

Some commenters made much of the fact that European stocks rallied after the “knee jerk” post-Brexit plunge.  They scolded me for putting so much weight on the market’s instant analysis.  What they fail to understand is that all market moves are provisional—we do the best we can with the information we have.  And would I be out of line to point out that the brief rally in eurozone stocks has unraveled, and that they are back down to the levels of that supposed “knee jerk reaction”?  Of course further changes will occur, and I have no idea whether we are going up or down from here. But I’m confident that the 14% decline in Italian stocks since the Brexit vote is telling us something important about both the health of the Italian banking system, and the risks of the October vote.  Ditto for the global plunge in yields on safe bonds.

Given the recent fallout from Brexit, if things continue to get worse in Italy and the eurozone between now and October, it’s not hard to imagine an intense international focus on the Italian referendum, with a no vote seen as likely to lead to an unraveling of the euro.  I’m not saying that will happen (the risks still seem less that 50-50 to me).  But I find the timing of that momentous referendum kind of interesting, given the timing of our own election, and given the anti-EU views of one of our candidates.  At the very least this is something to watch for.

PS.  Note that the Italian political system appears incapable of doing anything, and thus the silver lining of a no vote is that this incompetence would continue.  Incompetence is normally a bad thing, but if you are dealing with a government that wants to exit the EU, it’s actually good.

Currency depreciation doesn’t offset tariffs

One of my few remaining thoughtful commenters (ChrisA) left the following comment:

On the UK exports being affected by tariff’s after Brexit – couldn’t that be taken care of by a fall in the pound vs the Euro? I don’t actually think a tariff war between the UK and the EU is actually going to happen, since the trade deficit is so much in favour of the EU they have a strong incentive to be sensible. But even in the worst case we couldn’t be talking about tariffs of more than 10%, which is easily taken care of by the fall in the pound that has happened over the last week. And remember that applies to all of the exports of the UK to all of the world, not just to the EU.

I see this claim quite often, but it doesn’t hold up to close scrutiny.  Tariffs on imports are essentially a tax wedge on trade, which reduces both imports and exports.  When people talk about using “currency depreciation” as a policy tool, they are often referring to an expansionary monetary policy.  However, although monetary stimulus does reduce the nominal exchange rates in both the short and long run, it only reduces the real exchange rate in the short run, until wages and prices have adjusted.  After that, the price level rises to restore the previous real exchange rate.

There’s no getting around the fact that trade barriers make economies less efficient, by diverting output from the tradable to the non-tradable sector.  This conclusion is not affected by whether the UK has a trade surplus or deficit, so I don’t agree that the EU has an “incentive to be sensible”.  Indeed, an import tariff might well reduce exports by just as much as it reduces imports, even if one’s trading partners do not retaliate.

Some commenters also criticized claims of a skilled labor shortage in Spain.  Over at Econlog, I have a new post that explains why they are wrong.

The Brexit shock and its aftershocks

I just spent some time looking at stock market reactions around the world, over the past three trading days.  I’m too lazy to compute all the exact numbers, but I’ll give you a rough sense of what I found:

1.  The FTSE100 is down less than almost any other market, but I originally misinterpreted this fact.  It’s dominated by large multinationals that benefit from the lower pound.  Vaidas Urba suggested looking at the FTSE250, which focuses on domestic British companies.  There we see a drop of around 10%.  Think of that as one bomb going off—the “British economic chaos bomb”.

2.  The German and French markets are down by about 8%.  Think of those as representing the heart of the eurozone.  The PIGS seem to be down about 13%. So the Brexit explosion detonated another blast in southern Europe, which we might call the “potential eurocrisis bomb”.  The 8% declines in Germany and France represent fallout damage from these two bombs.  The UK is not directly impacted by the euro bomb, and that explains why it suffered only slightly more than Germany and France.

3.  Sweden and Denmark are outside the eurozone, and declined by 4% to 6%.  This is collateral damage from generalized European risk.

4.  At a global level, you tend to see declines of around 3%, say in the range of 2% to 4% in places like the US, Canada, Australia, Korea, Hong Kong, etc.  So that’s collateral damage to the global economy.

5.  China actually went up, but they tend to follow their own drummer.

6.  Japan is down about 6%, and fell especially sharply last Friday.  I see this as a third bomb.  As the first two bombs detonated, there was a flight to safe havens, and for some reason I don’t understand very well the yen is considered a safe haven.  So the yen appreciated strongly and the “strong yen bomb” drove Japanese stocks down by more than other non-European markets.

7.  The FTSE250 did especially poorly on Monday (compared to other markets), which fits my political chaos theory, as the media portrayed the British government as being clueless about how to handle the situation.  Things were a bit better on Tuesday.

A few points I’d like to emphasize.  This general market pattern was somewhat predictable, conditional on the vote (which of course was not well predicted.)  In other words, prior to the Brexit vote, we’d seen markets rise on optimism that “Remain” would win, and so it was possible to clearly see how investors thought a Brexit vote would affect various markets.  The size of the declines (after the results were announced) were not really a surprise, given that markets had rallied strongly on small increases in the probably that Brexit would fail.  We knew this was a really big deal.

The second point is that I think it’s useful to view market reactions in terms of one bomb triggering another, albeit often for very different reasons. The hit to Greek stocks occurred for very different reasons from the hit to Japanese stocks.  Outside of the UK, this was an almost purely monetary story, and commenters tell me that even within the UK, markets rallied strongly on a statement of support by (BOE head) Mark Carney.  So I still think at a non-British level this is an essentially a monetary story, and within the UK it is mostly real, but partly monetary.

This article claims that almost all experts agree that this is basically a British problem:

Experts agree: When the dust settles, there will be a clear main victim of Brexit

After the Brexit vote, economists agree that the UK economy is going down.

Just to be clear, I think that is certainly a possible outcome—recession in Britain and no recession elsewhere.  But I also think we need to take these stock market reactions more seriously.  Even with the recoveries today, eurozone markets are down sharply from Thursday’s close; declines almost comparable to the UK (FTSE250), or (in the case of the PIGS) even steeper.  The markets are telling us that there are big risks for all of Europe, and non-trivial (but modest) risks for the global economy.

Because the shock to the UK is more of a real shock, perhaps the damage there is more unavoidable.  In that sense I agree with the article.  But if the eurozone damage is more uncertain (a crisis may or may not occur) the size of the stock price decline suggests that if a crisis does occur, it could well be worse that the recession that might hit the UK.  The 8% German/French stock price decline could represent a 1 in 5 chance of 30% or 35% declines, if a eurozone domino effect develops.  So we should not be complacent and assume that this is just a UK problem; the rest of Europe needs to take this very seriously.  Right now, almost no plausible amount of monetary stimulus from the ECB would be excessive.  It’s pedal to the metal time.

Fed stimulus would also help.  Perhaps a statement by Yellen that the Fed is ready to move very aggressively to address any global problems that could also impact aggregate demand in the US.