It’s not what the ECB isn’t doing, it’s what they are doing

Although there has been a lot of good discussion about the political difficulties involved in solving the euro crisis, almost everyone seems to be missing two important points, or at least not paying enough attention to these points:

1.  While the Greek crisis and the threat of European recession are related, they are two distinct problems.  Causation runs in both directions.

2.  The role of the ECB in the threat of recession is not passive; it is actively promoting a deflationary policy that it is under no obligation to enact.

Friedman and Schwartz showed that a central bank doesn’t have to be “doing anything” in order to dramatically tighten monetary policy.  They don’t need to raise their target interest rate, and they don’t need to reduce the monetary base.  David Beckworth has a good discussion of how passively tightening relates to the current recession.

I admit that the concept of passive tightening is an acquired taste.  Most people still want to see evidence that the central bank “did something” before they will accuse it of malfeasance.  But here’s what I find most amazing of all.  The ECB isn’t just engaged in passive tightening, they are actively tightening by the most conventional criterion for tight money–they are raising interest rates.  And the monetary tightening is driving inflation expectations sharply lower, despite their mandate to produce stable inflation.  Lars Christensen recently sent me the five year, five year forward “TIPS spreads” from Europe:

So I have a bit of a problem with Venn diagrams showing no overlap between what policies would be helpful, and what policies would be politically feasible.  I certainly understand the sense in which these are true.  But there is a danger that we pundits will become excessively fatalistic.  There are no legal, institutional, or cultural barriers against the ECB refraining from monetary tightening right now.  There are no legal, institutional, or cultural barriers preventing the ECB from keeping the expected inflation rate roughly stable, at levels similar to those of recent years.  It’s obviously not easy to convince them to do so, but I don’t think we should view the task as impossible.  If we took that fatalistic attitude then there would be no hope for sound public policies, and we pundits might as well just close up shop.

Keeping inflation expectations stable would not solve the Greek debt problem.  But it would help much more than most people realize, in two distinct ways.

Let’s start with the risk of recession.  We know from painful experience in the US that solving a financial crisis doesn’t solve the problem of AD shortfall.  When I pointed out in late 2008 that the real problem was falling NGDP, not financial turmoil, I was viewed as something of a nut.  My heterodox view is pretty much conventional wisdom in America circa 2011.  Aggregate demand/recession and financial turmoil are logically distinct problems.  The second point to emphasize is that demand shortfalls tend to reduce inflation expectations.  We’ve known this for a long time, but recently it has become truer than ever, thanks to the peculiar nature of the world oil market.  We used to think inflation fell gradually during recession, due to sticky prices.  But now the price of oil is very sensitive to expected NGDP growth, and hence headline inflation (which is used in TIPS spreads) actually falls fairly fast during demand-side recessions.  So any policy that prevents TIPS spreads from falling sharply will, ipso facto, sharply reduce expectations of a demand-side recession.  It doesn’t mean a recession can’t occur with stable inflation expectations, but it’s likely to be much milder.

Go back and think about what that graph means.  Then think about the fact that this post isn’t relying on controversial “passive tightening” arguments; the ECB is actively and openly raising rates to reduce aggregate demand.  They are engaged in monetary tightening by any reasonable definition.  And this monetary tightening is reducing inflation expectations and increasing the likelihood of recession.  There really should be even more outrage than there is.  We are not talking about a conservative, hide-bound institution that is too cautious to take the bold action needed (as many assume), we are talking about a rogue elephant that is actively and aggressively driving Europe into recession.  That’s an outrage.

Even worse, a new recession with falling eurozone NGDP will make the debt crisis much worse.  Just to be clear, I’m not saying a policy of steady eurozone inflation would solve the debt crisis, obviously it wouldn’t.  But the current policy is making it far worse than it needs to be.  The US made the same mistake in mid-2008.  Even at that time the subprime crisis was well understood, and estimated losses to the US banking system were quite high.  But when the Fed drove NGDP expectations much lower in late 2008 (passive tightening) the debt situation got far worse, and spread far outside the original subprime sector.  Now we are seeing the euro sovereign debt crisis spread to more and more countries.  I wonder why?  Do investors understand that falling NGDP makes the Italian and Spanish debt situation even worse?  Might they be market monetarists?

PS.  Please don’t tell me about the official eurozone inflation target.  Even if expected inflation is right on target, the euro “TIPS spreads” will be a bit above target, as under a fiat money regime the tail risk of high inflation almost always exceeds the tail risk of rapid deflation.  There is a reason why TIPS spreads are typically a bit above 2% during “normal times.”


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23 Responses to “It’s not what the ECB isn’t doing, it’s what they are doing”

  1. Gravatar of Scott N Scott N
    4. October 2011 at 06:00

    Scott, since 2008 I have believed that the Fed would not allow any further drops in NGDP in the U.S. I’m not so sure anymore. I think the Fed is so fixated on CPI and PCE inflation measurements that it may take its eye off the ball long enough for NGDP to drop another 5%.

    This is how I imagine it will happen. Europe will crash with a cascade of bank and sovereign failures. This has already begun with Beglium bank Dexia and Greece. This will quickly spread to the U.S. and cause a large drop in NGDP. By the time the CPI and PCE are low enough for the Fed to act, it will be too late. We will have lost another 5% NGDP.

    I hope this doesn’t happen, but it seems less and less likely every day.

  2. Gravatar of Scott N Scott N
    4. October 2011 at 06:03

    Here is Bernanke’s bottom line from his remarks to remarks to Congress this morning:

    “Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy.”
    http://www.federalreserve.gov/newsevents/testimony/bernanke20111004a.htm

    God help us all, we are so screwed.

  3. Gravatar of Scott N Scott N
    4. October 2011 at 06:07

    Sorry, In the first post, I meant more and more likely. I shouldn’t type while I’m really mad at the Fed since I make a lot of typos.

  4. Gravatar of TGGP TGGP
    4. October 2011 at 06:20

    “we pundits might as well just close up shop”
    Not all people would view that as a bad outcome.

  5. Gravatar of Steve Steve
    4. October 2011 at 06:34

    Scott, a million points here:

    1) The economic data releases haven’t been bad yet.
    German CPI was +0.1% M/M and +2.6% Y/Y. The German view is they should continue tightening until it’s well below 2.0%.

    2) Plosser says the stock market has forecast 9 of the last 5 recessions and therefore should be ignored.

    3) NGDP could drop 5% very quickly as Scott N suggests above. We will then resume a +3% NGDP trend from a new lower base, at least until the next crisis.

    4) Energy companies usually set their budgets in the fall. A couple small ones have already cut 2012 capital spend by 40 percent. The AS decline is resuming. Next year when oil rallies from 60 to 80 the hawks will be screaming that QE3 is hyperinflationary.

  6. Gravatar of Morgan Warstler Morgan Warstler
    4. October 2011 at 07:43

    Jesus.

    Mundell has already TOLD us what the ECB requires:

    The Greeks and Italians are gong to have to cut their pension to 50% of salary, likely retire later, etc.

    It is simple, if Greece doesn’t make the cuts required, they will be booted, and then used as an example to all others what happens when you don’t make the cuts.

    NO ONE is going to loan money to Greece if they leave the Euro, they are not self-sustaining, they will implode.

    —-

    Look guys, you need to start taking the decision makers at their word…

    If Mundell and the Germans can be honest and say, “cut pensions, stop tax cheats”

    Why don’t you accept that the hawks on the Fed have the same ind of brass tacks prescription for the US?

  7. Gravatar of K K
    4. October 2011 at 08:37

    Scott: “Do investors understand that falling NGDP makes the Italian and Spanish debt situation even worse?  Might they be market monetarists?”

    Only fresh water monetarists don’t understand this. If you want the Keynesian perspective you can consult Eggertsson and Krugman (2010)

  8. Gravatar of marcus nunes marcus nunes
    4. October 2011 at 08:52

    Scott
    If you do the by now “standard” graph of NGDP and trend for Germany and separetely for the other euro countries and below the graph of ECB policy rates, you´ll discover that the ECB is “doing it´s job” which is to set MP according to the needs of Germany!

  9. Gravatar of K K
    4. October 2011 at 09:39

    Scott: “Even if expected inflation is right on target, the euro “TIPS spreads” will be a bit above target, as under a fiat money regime the tail risk of high inflation almost always exceeds the tail risk of rapid deflation.”

    That’s not correct. Expected inflation includes the tail events. It’s not some kind of median. A positive risk premium is an *additional* discount to the expected outcome. Positive risk premium (in theory) results from positive beta, i.e. a risky position with positive correlation with the market.  The inflation risk premium is positive if higher inflation is correlated with a down market, and negative if it’s correlated with an up market. So right now, given that implied inflation has positive covariance with stocks, we might expect a negative risk premium, i.e. implied inflation trading lower than the expectation. This is, of course, theory only (CAPM), and not a really great one. But it rests on the same foundations as the rest of modern micro, and it’s all we got.

  10. Gravatar of ssumner ssumner
    4. October 2011 at 12:41

    Scott N, I have gone through the same re-assessment of my views.

    TGGP, But surely us pundits don’t agree!

    Steve, Among the 5 the market (and I) did predict was the 2008 recession caused by Plosser and company.

    I agree that those views are out there, and it’s very discouraging. The ECB’s mandate is debateable, but we can all agree that ITS JOB IS NOT TO TARGET GERMAN INFLATION.

    Morgan, It’s long past the time when a cut in pensions would solve their problems.

    K, In 2010, but who was saying in 2008 that the real problem was nominal?

    Marcus, Unfortunately, you may be right.

    K, You misunderstood my argument. I never denied that expected inflation might normally be a bit above 2%, even when the ECB is doing it’s job. I explained why that’s to be expected.

    I never said expected inflation was some sort of median. Rather that the ECB implictly targets the most likely outcome, which explains why the TIPS spreads there (and here) often slightly exceed 2%. tightening.

    Whatever their true target, there is no reason to drive inflation expectations much lower RIGHT NOW.

    Regarding your risk argument, never reason from a price change. In the 1970s high inflation hurt stocks. Even for a few weeks around the Libyan revolution (supply shock). When there is a positive covariance it’s not because of some underlying connection between inflation and stocks, but because at this particular time the markets see excessively low AD as the big problem. We have lots of other indicators that tell the same story.

  11. Gravatar of marcus nunes marcus nunes
    4. October 2011 at 12:55

    @ScottN
    I got to that conclusion a few months back. It´s being confirmed every time B opens his mouth:
    http://thefaintofheart.wordpress.com/2011/06/23/now-i-get-bernanke/

  12. Gravatar of Morgan Warstler Morgan Warstler
    4. October 2011 at 13:26

    Scott,

    You’re wrong.

    This is about how good the Greeks have it going forward.

    The ECB just want to make sure they have it worse than the Greeks want to have it.

    Once the Greeks are beaten into submission, and have to become German or live as paupers, everything will be deemed “fine”.

  13. Gravatar of K K
    4. October 2011 at 21:13

    Scott: “When there is a positive covariance it’s not because of some underlying connection between inflation and stocks”

    CAPM doesn’t care why things are correlated. Nor do I. CAPM just says that if an asset has positive covariance with the market then that asset will price at a discount to it’s expected return. This suggests that the implied inflation from TIPS is currently below, not above, the expected value of inflation. So whatever it means not “to reason from a price change” this is how CAPM works.

    “Even if expected inflation is right on target, the euro “TIPS spreads” will be a bit above target”

    When you say “expected” I assume you refer to the expectation rather than the most likely outcome.

  14. Gravatar of GregorS GregorS
    5. October 2011 at 00:13

    Scott and K,
    while the risk premium for inflation’s correlation with the stock market – let’s call it the “hedge premium” – might be negative right now, shouldn’t there also be a more fundamental “volatiliy premium” on inflation futures that represents aversion to high variance in expected inflation? If that exists I would argue that it is arguably higher now than in the past as inflation expectations change rapidly and have big swings. As for reasons for that aversion to inflation variance (besides an appropriately shaped utility curve), how about thinking about inflation as being short a put on necessities, ie having promised to buy butter, bread and pay rent at a fixed price in the future – that short put should become more of a liability (more valuable to the buyer) as volatility of the underlying price (inflation) increases.

  15. Gravatar of FT Alphaville » The crisis that was always coming FT Alphaville » The crisis that was always coming
    5. October 2011 at 03:35

    […] Italy and the UK – FT Alphaville How to keep the euro on the road – Martin Wolf / FT It’s not what the ECB isn’t doing, it’s what they are doing — The Money […]

  16. Gravatar of K K
    5. October 2011 at 04:52

    GregorS:  If the asset doesn’t contribute to the variance of the market porfolio then it doesn’t contribute to the risk of the representative agent. So variance doesn’t matter except to the extent that it’s *co*variance with the market.

    If an asset is a big part of the market then it’s more likely to contribute to the variance of the market *even if* it’s uncorrelated with the other assets. But if it has really negative correlation with other important risk assets (inflation is currently negatively correlated with stocks), it may actually *reduce* market variance. This is why the market wants more bonds right now. They are critical negative contribution to market variance. And if this is the case, then treasury forward rates trade below market expectations of the short rate.

  17. Gravatar of If you don’t want to take on their sovereign debt, make ‘em grow! – Kantoos Economics If you don’t want to take on their sovereign debt, make ‘em grow! – Kantoos Economics
    5. October 2011 at 08:55

    […] I shortly explained this here in response to a Krugman-post. Paul answers here. PPS: Scott Sumner has a related post, warning Europe to repeat the same mistakes the US made in 2008/09. Want to share?ShareGefällt […]

  18. Gravatar of Scott Sumner Scott Sumner
    5. October 2011 at 17:54

    Marcus, Yes, but why does Bernanke call for fiscal stimulus, which raises inflation?

    Morgan, The new ECB head will be Italian.

    K, My wording was confusing. I meant that if you want inflation to be 2%, a policy likely to produce that result will lead to greater than 2% expected inflation.

    The covariance between TIPS spreads and stocks is not stable, that was my point. Positive with demand shocks negative with supply shocks. But I’ve forgotten what we were debating.

    I’d add that TIPS prices can’t fall below the par value, which makes the TIPS spread overestimate expected inflation.

    I’ve never put much weight on the level of TIPS spreads, as I favor NGDP targeting. But I certainly think the most likely explanation of the big drop in euro TIPS spreads is an actual fall in inflation (and NGDP) expectations. And there’s no reason for the ECB to be doing that at this moment, whatever their long term goal for inflation.

    GregorS, I’ll defer to K, as he knows more finance than I do.

  19. Gravatar of acarraro acarraro
    6. October 2011 at 05:54

    I have a pet theory about europe.

    I think there are similarities between the current situation and the effects of german reunification.

    I believe it is now agreed that the decision to convert east german marks at too high a value strongly hindered the unification process, by making east germany uncompetitive. Same as today, they refused to let the economy adjust by letting inflation raise above thier comfort zone. So they had a protracted adjustment process that required massive amount of fiscal policy to support politically.

    I think they are doing the same now with south europe. They had sub par growth for 10 years after unification… It looks like they want the same for Europe for the next 10.

  20. Gravatar of ssumner ssumner
    6. October 2011 at 15:55

    acarraro, But East Germany started out over valued. These countries weren’t overvalued in the early 2000s. But I agree there are some similarities.

  21. Gravatar of Lorenzo from Oz Lorenzo from Oz
    6. October 2011 at 17:50

    I was struck by a recent guest post by Henry Kaspar (scroll down to the English version) pointing out that the countries now having such trouble with the ECB’s tight money policies — Greece, Spain, Italy, Portugal — were also countries which had problems with the gold standard during its deflationary phase (1873-1895).

    It is also striking how much this is Protestant Europe having to deal with the indebtedness of Catholic/Orthodox Europe. (Highly secular France seems to sit more in the “Protestant” camp.) Psychologist Philip Zimbardo’s observations about differing Protestant and Catholic attitudes to time and their effect on long-run economic prosperity may be relevant to both the gold standard and current episodes since attitudes to/levels of debt rather matter for both.

    More generally, I take the view that the ECB/euro debacle is a manifestation of much deeper problems with the “actually existing” European project. (Slightly later and longer version here.) The ECB’s apparently “disconnected” policies are not some peculiar “one off”.

  22. Gravatar of ssumner ssumner
    8. October 2011 at 17:07

    Lorenzo, I think you might be right about the importance of cultural attitudes, although I don’t know enough to comment on your specific points. When I studied culture and neoliberalism, I found that of all 32 developed countries I considered, Greece had the cultural attitudes least favorable to adopting neoliberal policies. BTW, that study was done before this crisis.

    I’m not sure how much weight I’d put on Catholicism, isn’t southern Germany Catholic?

  23. Gravatar of Eurozone: Es ist ein Loch im Eimer « Aus dem Hollerbusch Eurozone: Es ist ein Loch im Eimer « Aus dem Hollerbusch
    25. October 2011 at 02:49

    […] Damit befindet er sich in der Gesellschaft Scott Sumners, mit dem Krugman selten einer Meinung ist. Der hatte Anfang Oktober in einem Blogpost die kontraktive Geldpolitik der EZB scharf kritisiert, insbesondere die Zinswende im April 2011, die zu einem dramatischen Verfall der impliziten Inflationserwartungen geführt hat. Sein Verdikt: They are engaged in monetary tightening by any reasonable definition. And this monetary tightening is reducing inflation expectations and increasing the likelihood of recession. There really should be even more outrage than there is. We are not talking about a conservative, hide-bound institution that is too cautious to take the bold action needed (as many assume), we are talking about a rogue elephant that is actively and aggressively driving Europe into recession. That’s an outrage. […]

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