(7/20/2015) Alexis Tsipras, the Greek prime minister, has the chance to play a role for his country analogous to the roles played by Korean President Kim Dae Jung in 1997 and Brazilian President Luiz Inácio Lula da Silva in 2002. Continue reading
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.
Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet. Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961. Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007. Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable.
The phrase “black swans” has come to be used to mean a very unlikely event of this sort. Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time. This is nonsense. If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong. This is like the case when “hundred-year floods” turn up every few years.
A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it. A still better interpretation is that statistical distributions have “fat tails,” in technical terms. But it would be nice to get beyond the Jurassic Park lesson (“don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events.
What does “black swan” really mean? In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries.
Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.
1. “All swans are white.” The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction. But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697. A 19th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books. It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event. A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.
2. “Terrorists don’t blow up big office buildings.” Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings. These warnings were not taken seriously by those in power at the time. Many Americans did not know the history of terrorist events taking place in other countries and in other decades.
3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall. After all, “they never had before,” which meant that they had not fallen in living memory in the United States. They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s. Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.
4. “Volatilities are low.” During the years 2004-06, financial markets perceived market risk as very low. This was most nakedly visible in the implicit volatilities in options prices such as the VIX. But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices. One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”). They should have gone back much farther – or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.
5. “Big banks don’t fail.” “Governments of advanced countries don’t default.” “European governments don’t default.” Enough said. Greece‘s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans. The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk. Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.
My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.