If negative interest rates are a tax then positive interest rates are a subsidy from the future

I find people’s instinctive negativity about about negative interest rates a little annoying. This post is particularly strange. I pick it out for no other reason than Frances Coppola tweeted it.

Interest rates are kind of a fiction. When we save we’re buying something now to sell later, that is what is actually happening and it is intermediated by finance. Islamic Finance has a much clearer mechanism to illustrate this. People do not expect the European economy to be much large in the medium term than it is now, this means that  durable assets, equity and other savings vehicles won’t be worth much more either this makes finding a positive return difficult.

This has nothing to do with Keynesian ideas of natural rates of interest or socially optimal policy. Transmitting purchasing power through time is just really difficult so periods of negative interest rates shouldn’t be seen as an aberrant tax but as a consequence of technological stagnation in finance or terrible macropolicy making.

I think you can make a very strong case for bot. Finance has grown faster than the rest of the economy since the 1940s but it hasn’t proven four times as effective at intermediating.


I’m on record calling the ECB insane and I’ll do it again. Bad policy making is an incredibly important reason for why interest rates might go south of zero. It’s difficult to be confident we’ll be richer in the future than the past when unemployment in Europe is doing this:


At the moment far too many people want to buy stuff now relative to the future. Ten percent of firms close each year. You need to spend one percent of your home’s value on upkeep each year. This is another way of saying that buying stuff now and then selling it for more in the future is a pretty amazing thing, low interest rates, even negative interest rates are nothing to be amazed by. They’re the only way to reconcile the present and the future.

The insane ECB

If you haven’t been paying attention the Fed said Tuesday “shit is all fucked up and bullshit and even though there’s loads we could do to diminish the shit and the fuckedupness we have decided against it.”

The ECB said today “shit is all fucked up and bullshit and even though there’s loads we could do to diminish the shit and fuckedupness we have decided against it, in fact we are going to make things worse.” See this tweet from Joe Gagnon:

The ECB have announced that if you raise taxes, and in doing so raise prices, they will respond with tighter monetary policy, just as people like Scott have feared.

Higher taxes reduce demand other things equal, this is easy to understand as everybody understands taxes making them poorer. That doesn’t have to be the case of course, because a  the central bank can accommodate this. This is especially important if tax is increased on final prices because it will look like high demand is pushing up prices even though taxes are in fact reducing demand.

Let me repeat, the ECB is combining tight fiscal policy with tight money, they are quite literally making poor people poorer. They are lunatics! Or Monsters…Honestly, Trichet and now Draghi are causing an epic amount of suffering in Europe.

The ECB as Schroedinger’s cat

The European Central Bank is at all times both fulfilling its legal mandate and ignoring it. Until you look closely it is impossible to tell which it is, and once you have decided which it is it can only be because you have lost sight of its mandate as set down in law. This explains a lot: Even I can’t decide whether Mario Draghi relentlessly adheres to or has completely abandoned the whole ECB mandate.

One of the reasons that Europe is collapsing and the whole world is heading for a recession within a depression is that the ECB is charged solely with maintaining price stability not supporting economic growth. Their duty, they argue, is to without prejudice support a European wide inflation rate below, but close to 2%. However, the mandate as set out in law is so convoluted as to leave the ECB council capable of simultaneously adhering and violating both the letter and spirit of the law. No wonder Europe is a mess.

They are not just charged with maintaining price stability, as interpreted, they are also empowered to…

Without prejudice to the objective of price stability, it shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union. [my emphasis throughout]

This implies that although the ECB cannot ignore inflation, it has leeway to support the policies of member states and the Union as a whole. By this criteria the ECB should have done everything in its power to keep inflation and inflation expectations running at really, really, really close to 2%. Instead they have crashed. The mandate is wider than price stability and includes supporting economic policy making rather than sabotaging it.

However, the mandate continues…

The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 119 of the Treaty on the Functioning of the European Union.

This part of the mandate implies that the ECB is empowered to not support the policies of member states if they are not compliant with “free competition, favouring an efficient allocation of resources.” That would certainly have empowered Trichet, and now Draghi, to withhold such support as is possible if they consider member states’ policy “insufficiently favourable to an efficient allocation of resources.”

At the moment it appears Draghi is refusing to cut interest rates below 1% to blackmail Greece and France into policies deemed favourable to “Article 119 of the Treaty on the Functioning of the European Union.” This seems like something that should be impermissible for a central bank but it is in fact within the Feds mandate. So refusing adequate policy until member states change policy is merely the ECB laying greater weight on supporting certain policies over others, as it is mandated.

The mandate references Article 119 which says…

1. For the purposes set out in Article 3 of the Treaty on European Union, the activities of the Member States and the Union shall include, as provided in the Treaties, the adoption of an economic policy which is based on the close coordination of Member States’ economic policies, on the internal market and on the definition of common objectives, and conducted in accordance with the principle of an open market economy with free competition.

2. Concurrently with the foregoing, and as provided in the Treaties and in accordance with the procedures set out therein, these activities shall include a single currency, the euro, and the definition and conduct of a single monetary policy and exchange-rate policy the primary objective of both of which shall be to maintain price stability and, without prejudice to this objective, to support the general economic policies in the Union, in accordance with the principle of an open market economy with free competition.

3. These activities of the Member States and the Union shall entail compliance with the following guiding principles: stable prices, sound public finances and monetary conditions and a sustainable balance of payments.

The ECB has overseen a colossal balance of payments crisis, with the Eurozone periphery persistently running deficits and the core running surpluses. In 1992, at the signing of the Maastricht treaty, they saw this problem coming and specifically empowered the institutions of Europe to deal with it, and they have failed. This imbalance, rather than government profligacy is at the core of the Eurozone crisis. Certainly under Trichet, and now under Draghi, this part of the ECB’s mandate has been completely ignored.

A mandate is fulfilled or unfulfilled, but it is impossible to tell if the ECB has, is or will fulfil its mandate in its entirety. The ECB has failed or succeeded, and is on target to achieve or betray its objectives, it has achieved its aims “impeccably” or it is insane.

To be honest, I’m too tired to work out which it is, all I know is that all this makes me very pessimistic.

Its a Central Banking Crisis Too

Much like Frances Coppola, I like charts. I think in pictures and words not numbers; I find it significantly easier to translate graphs into reality. But, unlike Frances, I hold the ECB peculiarly responsible for the Eurozone crisis, where she places more blame on the banking sector in general. I hope to present some graphs to convince Frances that the ECB is the real bad guy in Europe.

I have repeatedly called the European Central Bank insane for failing to save the Euro. That might be a little unfair, lots of banks acted insane during the 2000s, but the ECB’s monomaniacal and slavish adherence to inflation targeting led the bank to make two specific policy errors which have had grave consequences.

These policy errors exaggerated the errors of Europe’s banks and turned a balance of payments problem into a triple currency, banking and sovereign debt crisis. It wasn’t debt or deficits that sent the Eurozone periphery into crisis it was consistently importing more than they exported.

Such a lopsided Eurozone demanded flexible demand management, the right amount of demand for Germany had clearly been to inflationary for Ireland et al. However, when the crunch came the ECB was found wanting. Four times the ECB focussed too heavily on short term inflation and raised rates, or failed to cut rates, in error. Below is a graph of Eurozone interest rates as set by the ECB.

In 2008, rapid growth in the developing world pushed up commodity prices and headline inflation around the world. Simultaneous with this the world financial system had begun to blow up. In July 2008 the ECB hiked rates despite it being well aware it was operating in a period of acute financial stress (see chart 2). That is the first error, an over reaction to headline inflation. This error was felt across the world, as described by Lars here.

A few months later, in September, Lehman Brothers collapsed. In September the ECB did not alter its headline interest rate, it waited until October to cut rates. As a consequence of this passive tightening expected inflation in the Eurozone fell well below the ECB’s target rate (see chart 5) and the financial crisis began proper. That was the second error, it was quickly regretted and over the next eight months interest rates were cut to 1%, but no lower.

In April 2011, the ECB once again began to increase interest rates in April 2011 to fight higher inflation. This proved to be a mistake which was reversed between October and December 2011. The consquences of this mistake are plain to see. The below graph was cribbed from Tim Duy and shows the subsequent increase in unemployment.

The cause of this increase in human misery was  decrease in aggregate demand and expected future aggregate demand. Caused by the same demand shock, the borrowing costs of the Eurozone periphery spiked compared with the borrowing costs of Germany. Greece’s ten year borrowing costs spiked from being 9.49% higher than Germany’s to 12.64% higher. Similar movements can also be seen for Ireland, Portugal and Spain by comparing this data from late March 2011, with this data from May 2011.

The ECB’s fourth and enduring mistake is keeping interest rates at 1%, rather than cutting all the way to zero, and in failing to communicate that they will continue to be as accommodative as is necessary to boost growth. The ECB has failed to use the conventional tools and has actively sabotaged itself by failing to convince anyone it is willing to be as accommodative as is necessary to rescue the Eurozone from crisis.

This isn’t entirely the ECB’s fault, they’ve been given a very narrow mandate to maintain price stability. But mandates can be reinterpreted as necessary and blowing up the world financial system and throwing millions out of work to keep a lid on poorly recorded, probably inaccurate, inflation rate is an insane way to interpret a mandate for price stability. So I’ll probably keep calling the ECB insane.

Competitive Devaluation #ftw to save the Eurozone

Monetary policy is confusing, but one thing most people understand is currency devaluation: Make your currency cheaper and foreigners will buy lots of stuff from you generating jobs and growth. The two are largely synonymous but not a lot of people understand that.

One person who I thought would understood that is renowned macroeconomist and economic geographer Paul Krugman. So even though I’m on his turf, and this post brings me directly into conflict with rule one, I’m going to plough on regardless. Today he expresses some disbelief towards the idea that a devaluation of the Euro would be feasible:

Jeremy Siegel echoes a lot of what some of us have been saying for years about the infeasibility of internal devaluation, but then argues that the answer is devaluation of the euro as a whole. Um, against whom?

He goes on to argue that neither Japan, America nor the developing world can provide the stimulus Europe needs as each suffers from various degrees of a depressionary malaise. But elsewhere he has called for more monetary stimulus to help resolve the Eurozone crisis:

I’d still like to imagine that next week Mario Draghi, newly installed as ECB president, will suddenly reveal himself as a supporter of quantitative easing and a 4 percent inflation target, not to mention open-ended lending to crisis countries.

Think of it this way: Krugman may be correct that Japan, US, UK etc. could not tolerate a cheaper euro, but this is logically seperate from saying the ECB shouldn’t try and devalue. This is because there are steps other Central Banks could take to prevent a cheaper Euro from negatively impacting them. Imagine the ECB buys lots of American, Japanese and British bonds in an attempt to devalue the Euro to boost growth. In that case, the Fed, BoJ and BoE could do the opposite and buy the bonds of Eurozone countries.

Sound familiar? It should. Because you would have just instigated an international quantitative easing programme, with each country buying debt from another; more QE is just what Krugman suggests is needed of Mario Draghi in the above quote. It is an odd way to organise it, but the mechanism behind it would be very similar. The currencies wouldn’t exactly devalue against one another, but they would devalue against everything else.

The ECB is a monetary superpower, much like the Fed. If it tried to devalue by encouraging a devaluation other countries would have to react with more expansionary policies of their own. When the Fed was too inflationary through the 1970s it exported it around the world, much as its tight policy was exported in 2008. All the main thing an attempted ECB devaluation would acheive would be to export more expansionary policy around the world, something sorely needed.

Still not convinced? Lets look at some history. Below is a graph I cribbed from Brad DeLong which shows the dates at which countries left the Gold Standard and the dates at which they began their recoveries.

The abandonment of the Gold Standard allowed for a country to revalue its currency.  One of the thing which prompted countries to abandon the Gold Standard was that other countries had done so first, expansionary policy was exported just as contractionary policy was exported prior to 1930. In a sense every country tried to devalue against all the others (the sequence of events and mentality of the Gold Standard is discussed here further).

Since every country cannot actually devalue against all the others what instead happened is that each national currency devalued against most other goods, in other words each country’s price level and real production began to converge (and eventually surpass) pre-depression levels. The same would probably occur were the ECB to seriously try to devalue the Euro today.

Bringing us back to the start, Krugman thinks that the EU, UK, US, Japan, and much of the rest of the world need more demand and yet pooh poohed a policy which would deliver it both directly within the Eurozone and indirectly through prompting policy changes abroad. To be honest, Krugman’s incredulity leaves me a little confused. Even if exchange rates changed not one iota, so long as each country maintains the policy described above demand would increase across the world, which is exactly what he wants.


UPDATE: Huh?! I’m having trouble parsing this. Brad DeLong links approvingly to the Krugman piece above saying that there’s no point trying to devalue, countries just need more expansionary policy, contra my point that devaluation is expansionary policy. But he also approvingly links to a paper on countries abandoning the Gold Standard (by Eichengreen again, as above) that says a more aggressive policy of competitive devaluation during the Great Depression would have been even more beneficial for the system as a whole compared with actual policy, because it would have been more expansionary in the way I described. [1]

A Euro devaluation which was met by totally passivity by the Fed, BoE and BoJ may have negative effects on net (although given the fragility of the Eurozone anything which helps stabilise it might be expansionary by whit of improving financial stability). Neither Brad nor Paul think the world’s central banks would be passive if faced with a policy of competitive devaluation from the ECB so the two arguments presented by Brad are mutually exclusive, not complementary, yet he uses one to support the other…

[1] Although I’d not read that 1986 paper before, I appear to have absorbed its lessons by osmosis, probably through reading Brad DeLong’s excellent blog come to think of it.

UPDATE the SECOND: Matthew Yglesias has written the exact same post as me, different words, but almost an identical structure. but with one difference, he’s gone soft on Krugman’s assumption of central bank passivity, which we know he thinks is a poor assumption in other situations.

The ECB is not even at the ZLB

Eurozone interest rates have been left unchanged at the record low of 1 per cent by the European Central Bank as the 17-country region struggles to return to economic growth.

To everyone calling for fiscal stimulus in the Eurozone, purlease, start directing your ire at the European Central Bank.

Arguably, when the central bank has cut rates to zero it become much less effective at helping depressed economies. But the ECB has not hit this Zero Lower Bound. It can cut rates, lots!

By not doing so they are screwing everyone and everything in the world. Causing preventable deaths, preventable defaults, preventable capacity underutilisation.

It is no exaggeration to say that these people can be described as criminally negligible. Although they are successfully keeping inflation close to if not below 2% they are also successfully destroying the Euro, if a central bank’s staff kills a currency I’d say that’s a crime.

In 30 years time they will look from Trichet and Draghi to Greece and Italy and think “how could that happen” in the same way we look at Weimar children playing with wheelbarrows of worthless currency. It is a monetary screw up of similar, if opposite, proportions.