Tag Archives: EMU

Considering QE, Mario? Buy US Bonds, Not Eurozone Bonds

Share Button

         The ECB should further ease monetary policy.  Inflation at 0.8% across the eurozone is below the target of “close to 2%.”  Unemployment in most countries is still high and their economies weak.  Under current conditions it is hard for the periphery countries to bring their costs the rest of the way back down to internationally competitive levels as they need to do.  If inflation is below 1% euro-wide, then the periphery countries have to suffer painful deflation. 

The question is how the ECB can ease, since short-term interest rates are already close to zero.   Most of the talk in Europe is around proposals for the ECB to undertake Quantitative Easing (QE), following the path of the Fed and the Bank of Japan, expanding the money supply by buying the government bonds of member countries.  This would be a realization of Mario Draghi’s idea of Outright Monetary Transactions, which was announced in August 2012 but never had to be used. 

           QE would present a problem for the ECB that the Fed and other central banks do not face.  The eurozone has no centrally issued and traded Eurobond that the central bank could buy.   (And the time to create such a bond has not yet come.)   That would mean that the ECB would have to buy bonds of member countries, which in turn means taking implicit positions on the creditworthiness of their individual finances.   Germans tend to feel that ECB purchases of bonds issued by Greece and other periphery countries constitute monetary financing of profligate governments and violate the laws under which the ECB was established.  The German Constitutional Court believes that OMTs would exceed the ECBs mandate, though last month it temporarily handed the hot potato to the European Court of Justice.   The legal obstacle is not merely an inconvenience but also represents a valid economic concern with the moral hazard that ECB bailouts present for members’ fiscal policies in the long term.  That moral hazard was among the origins of the Greek crisis in the first place. 

Fortunately, interest rates on the debt of Greece and other periphery countries have come down a lot over the last two years.    Since he took the helm at the ECB, Mario Draghi has brilliantly walked the fine line required for “doing what it takes” to keep the eurozone together.  (After all, there would be little point in preserving pristine principles in the eurozone if the result were that it broke up.  And fiscal austerity by itself was never going to put the periphery countries back on sustainable debt paths.)  At the moment, there is no need to support periphery bonds, especially if it would flirt with unconstitutionality.

        What, then, should the ECB buy, if it is to expand the monetary base?   It should not buy Euro securities, but rather US treasury securities.  In other words, it should go back to intervening in the foreign exchange market.   Here are several reasons why.   

First, it solves the problem of what to buy without raising legal obstacles.  Operations in the foreign exchange market are well within the remit of the ECB.    Second, they also do not pose moral hazard issues (unless one thinks of the long-term moral hazard that the “exorbitant privilege” of printing the world’s international currency creates for US fiscal policy).

Third, ECB purchases of dollars would help push the foreign exchange value of the euro down against the dollar.  Such foreign exchange operations among G-7 central banks have fallen into disuse in recent years, in part because of the theory that they don’t affect exchange rates except when they change money supplies. There is some evidence that even sterilized intervention can be effective, including for the euro.  But in any case we are talking here about an ECB purchase of dollars that would change the euro money supply.  The increased supply of euros would naturally lower their foreign exchange value. 

Monetary expansion that depreciates the currency is effective.  It is more effective than monetary expansion that does not, especially when, as at present, there is very little scope for pushing short-term interest rates much lower.

Depreciation of the euro would be the best medicine for restoring international price competitiveness to the periphery countries and bringing their export sectors back to health.  Of course they would devalue on their own, if they had not given up their currencies for the euro ten years before the crisis (and if it were not for their euro-denominated debt).   Depreciation of the euro bloc as a whole is the answer.

The strength of the euro has held up remarkably during the four years of crisis.  Indeed the currency appreciated further when the ECB declined to undertake any monetary stimulus at its March 6 meeting.  The euro could afford to weaken substantially.  Even Germans might warm up to easy money if it meant more exports rather than less.

        Central banks should and do choose their monetary policies primarily to serve the interests of their own economies.  The interests of those who live in other parts of the world come second.  But proposals to coordinate policies internationally for mutual benefit are reasonable.   Raghuram Rajan, head of the Reserve Bank of India, has recently called for the central banks in industrialized countries to take the interests of emerging markets into account by coordinating internationally.  

How would ECB foreign exchange intervention fare by the lights of G20 cooperation?  Very well.  This year the emerging markets are worried about tightening of global monetary policy.  The fears are no longer monetary loosening as in the “Currency Wars” talk of three years ago.  As the Fed tapers back on its purchases of US treasury securities, it is a perfect time for the ECB to step in and buy some itself.


         Jeffrey Anderson and Jessica Stallings, “Euro Area Periphery: Crisis Eased But Not Over,” Institute of International Finance, Feb. 13, 2014.
         Kathryn Dominguez and Jeffrey Frankel, 1993, Does Foreign Exchange Intervention Work? (Institute for International Economics, Washington, D.C.).
         —“Does Foreign Exchange Intervention Matter? The Portfolio Effect,”1993, American Economic Review 83, no. 5, December, 1356-69. 
         Rasmus Fatum and Michael Hutchison, 2002,  “ECB Foreign Exchange Intervention and the Euro: Institutional Framework, News, and Intervention,” Open Economies Review, 13, issue 4, 413-425.
         Marcel Fratzscher, 2004, “Exchange Rate Policy Strategies in G3 Economies,” in C. Fred Bergsten, John Williamson, eds., Dollar Adjustment: How Far? Against What?  (Institute for International Economics, Washington, DC).
         Stefan Reitz and Mark P. Taylor, 2008, “The Coordination Channel of Foreign Exchange Intervention: A Nonlinear Microstructural Analysis,” European Economic Review, vol. 52, issue 1, January, 55-76.
         Lucio Sarno and Mark P. Taylor, 2001, “Official Intervention in the Foreign Exchange Market: Is It Effective and, If So, How Does It Work?” Journal of Economic Literature, 39(3), 839-868.

[A shortened version of this column appears as my March Project Syndicate op-ed.  Comments can be posted there.]

Share Button

Can the Euro’s Fiscal Compact Cut Deficit Bias?

Share Button

     Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement.   The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires  member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP.  A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks.   In other words, the target is cyclically adjusted.  The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.

    Will the new approach help?   The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.  

     There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year.  [“The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time.”]  But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

    Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction.   Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere.  During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely.  Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies.  During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound.  Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.

     Fiscal rules such as the SGP ceilings won’t constrain budget deficits, if forecasts are biased.  The reason is that governments can in any given year forecast that their growth rates, tax revenues, and budget balances will improve in the subsequent years, and then next year say that the shortfalls were unexpected.   Indeed, it turns out that the eurozone bias in official forecasts during 1999-2011 can be neatly characterized as responding to the SGP’s 3% limit on budget deficits by offering over-optimistic forecasts each time governments exceed the limit.  In other words, they adjust their forecasts rather than their policies.   (The results described here come from a new paper, coauthored with Jesse Schreger: Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone,” forthcoming 2013 in the Review of World Economy, vol.149, no.2, from Germany’s Kiel Institute.)

    Phrasing the budget rules in cyclical terms, while highly desirable in terms of macroeconomic impact, does not help solve the problem of forecast bias.  It can even make it worse.  In a year when a forecast for the actual budget deficit turns out to have been over-optimistic, the government has to admit that it made a mistake, which can carry some embarrassment.  In a year when a forecast for the structural budget deficit turns out to have been over-optimistic, the government can still claim that its own calculations show the shortfall to have been cyclical rather than structural.   After all, estimation of potential output and hence the cyclical versus structural decomposition is notoriously, even after the fact.

   Will it help that under the fiscal compact the rules are to be adopted at the national level, as opposed to the supranational level on which the SGP operated?  A look at the various rules and institutions that have already been tried by European countries shows that some work and others don’t.  Creating an independent fiscal institution that provides its own independent budget forecasts works, in that it reduces the bias in projections.  Euro area governments with an independent budget forecasting institution have a mean bias when making forecasts while in violation of the Excessive Deficit Procedure (EDP) that is smaller by 2.7% of GDP [at the one-year horizon], compared to euro area countries that are in violation of the EDP without such an independent fiscal institution.

    It would be better still if the governments were legally bound to use these independent forecasts in their budget plans (thereby borrowing an innovation from Chile).  

   Regardless how well-designed the rules are, clever and determined politicians can find ways around them.  One of the tricks is the privatization of government enterprises which reduces the budget deficit this year on a one-time non-repeatable basis, but might raise it in the long-term if the enterprise had been earning profits.  Another trick is phony legislated sunsets on tax cuts, in order to make future revenues look larger despite the political intention later to make the tax cuts permanent. 

   Still, other things equal, the right institutions can reduce the procyclicality of fiscal policy in the short run and help deliver debt sustainability in the long run.    Examples of the right institutions are cyclically adjusted budget targets combined with independent agencies that make independent fiscal forecasts.  Things can still go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

     [The original of this post appears at Project Syndicate.  Comments may be posted there.]

Share Button

The Hour of the Technocrats

Share Button

The Hour of the Technocrats has arrived.   In desperation from debt crises that their gridlocked political systems have created, Italy and Greece both in November chose new Prime Ministers who are technocratic economists rather than politicians:   Mario Monti and Lucas Papademos, respectively.  One can even describe them as professors:  Monti has been president of the prestigious Bocconi University when not a European Commissioner in Brussels, and Papademos has been my colleague at Harvard Kennedy School in the year since he finished his term as Deputy Governor of the European Central Bank (even teaching a class I usually teach).

No doubt, whatever happens, pundits who evaluate their performance will soon be writing: “Professors Earn ‘A’ in Economics, but Flunk Politics.”   This will be unfair.   It is not lack of political ability that will stymie them, but lack of political power in the mandates they have been given.    Mario Monti, despite very strong popular support among Italians for his technocratic government, does not have a parliamentary majority that he can rely on.   Berlusconi, in boasting that he can pull the plug on Monti anytime he wants, has made it clear that he still will not lay aside his personal political interests for the good of the country even when everyone understands what he is doing.   

Lucas Papademos in Greece has been dealt an even weaker hand.  Despite his best efforts to insist on a term longer than three months and the ability to appoint some members of his cabinet, as requirements for accepting the Prime Ministership, in the end he could not get even these minimum conditions.

The elevation of these two outstanding civil servants comes after a period when some other professors have been squeezed out by the political process.   Several good technocratic economists from emerging market countries were passed over in June, when choosing the successor to Dominique Strauss-Kahn as Managing Director of the International Monetary Fund.

Next, an example from Germany. Axel Weber in January 2011 resigned as President of the Deutsche Bundesbank and member of the Governing Council of the European Central Bank.  The interpretation in the press was that his statements opposing ECB purchases of bonds issued by troubled periphery countries had been evidence of political naivety on his part.   The press could not imagine that a technocrat might voluntarily relinquish a sure shot at a position of great power — successor to Jean Claude Trichet as ECB President — on a matter of principle.    But that is precisely what Weber was doing.  The willingness to give up power if necessary is one of the advantages of professors for such positions.  (It is a different matter that the ECB presidency then went to Mario Draghi, who is also an economist and technocrat, and in fact the perfect man for the job.)

It is a mistake to conflate technocrat elites (they are the ones with the PhDs or other advanced economics degrees) with other kinds of elites (the ones with money or power, especially if they got them from their parents).   Most economists understood very well the possible downside of European monetary union.  In the late 1980s, when Jacques Delors asked major European leaders what the next step should be in the European integration project, they underestimated the technical difficulties when they opted for monetary integration.

Technocrats can play a useful role.  One of their advantages is acting as an honest broker when traditional politicians have become discredited or parties are deadlocked.  Another is the credibility that comes when they are not motivated by getting re-elected, either because their term in office has been limited in advance or because it is know that they in fact prefer the quiet life back at the university.  The most obvious advantage to technocrats comes when the biggest problems facing the country are in large part technical such as proposing economic reforms or negotiating loan terms.  A good precedent in Italy is Carlo Ciampi, who took the governing reins in 1993 after Italy was forced to drop out of the European Exchange Rate Mechanism, but managed to repeal the scala mobile (the wage indexation system), beat down inflation, and re-board the train of European monetary integration. 

Obvious disadvantages of some technocrats include lack of managerial experience, lack of perceived legitimacy, and lack of a domestic political powerbase.   Monti and Papademos both have managerial experience and, for now, perceived legitimacy.   The last of the three factors will be the limiting factor for them.

Among current heads of state who could be considered technocrats are President Felipe Calderón of Mexico, President Sebastián Piñera of Chile, and President Ellen Johnson Sirleaf of Liberia.  Nobody could accuse these three of having led sheltered lives or being unaccustomed to making difficult decisions.   But it happens that all three received their ivory tower training at the Harvard.  Calderón took a record three courses from me.   Unfortunately, dealing with violent drug lords was not on my syllabus. 

Having shiny international credentials is not always an advantage.  When Sirleaf received the Nobel Peace Prize in 2011, the speculation was that this evidence of her good image abroad could hurt her with the voters at home in her campaign for re-election.   Analogously, Prime Ministers Monti and Papademos hold gold card memberships in the clubs of EU and euro elites that will help them obtain support for their countries abroad but leave them vulnerable domestically to charges that they are lackeys of foreign powers.

It is good that Rome and Athens, the two seats of classical western civilization, have turned to these two civilized men for leadership. I hope the politicians realize that Monti and Papademos cannot work miracles if they are not given the political tools to get their policies enacted.   

[A version of this column appeared Nov. 25 on Project Syndicate.  Comments can be posted there]

A subsequent blog post will extend the discussion of technocrats to some recent examples from the United States of highly qualified academics who have been blocked from office for political reasons.


Share Button