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.


Fiscal Policy and Growth In Europe

Interesting Graph pointed to by Brad and Paul but without a lot of context or information. More data please people! But it shows the normal centre-left story: Austerity – not a good idea.

A little left out here though… thoughts below the fold. Continue reading

A Safer Way to Save the Eurozone

Cross published from my Uni paper, not sure if I’m allowed. But hey, I’ve nothing else written.

For the fourth or fifth time in as many years Europe needs a rescue plan. A group of academics from all around Europe, including LSEs Professor Luis Garicano and Professor Dimitri Vayanose now have a proposal which may be part of the last rescue plan necessary.

The problem is simple. Many countries, from Greece to Portugal, Italy, Spain and Ireland, carry debts they may not be able to pay back in full. Failure to pay back these debts would return Europe to recession because much of this debt is held by European banks who once considered it safe.

There is enough money in Europe to pay these countries debts, it is just that it is earned and spent in Germany by Germans, and the Germans are understandably keen to keep it this way. Previous plans have fallen short because the citizens of northern Europe are unwilling to commit to a bailout of southern Europe.

A rescue plan is not elusive because the economics are hard, politics is the fundamental problem. A successful plan to save Europe from renewed crisis will need to leverage Europes economic clout to shore up confidence in its riskier members in a way which does not put German taxpayers money in harm’s way. Eurobonds, once mooted as a potential solution to Europes woes were rejected for just this reason. They would have left Germany and other safe European countries on the line for the risky borrowing of other European countries.

Their rescue plan, published at the Euro-nomics website, is gaining traction with many of institutions at the heart of Europe. They propose to bundle up a portion of the debts of all Eurozone members and split it into a safe senior tranche and a risky junior tranche. Complex financial products got us into this mess and it is hoped that they may well get us out.

The senior tranche of debt would be known as European Safe Bonds (or ESBies, if you like your financial derivatives to have cute names) and would be amongst the safest financial assets in the world. They would be backed by the first 70% of debt payments from all European countries. Were things to go badly wrong through the Eurozone and many countries were to default ESBies would remain safe.

By their calculations, this means ESBies would only suffer losses every 600 years or so. They would be dull and their rewards would be meagre, just what Europe needs in these troubled times. Those who wanted higher returns, hedge fund and private equity investors, could gamble on the junior tranche without the problems caused by risky bonds being held by large banks.

This is important, rescue Europe and you rescue the employment opportunities of everyone who graduates from LSE next year. It would take a few months to get up and running but even moving towards this solution would calm markets and help return Europe and the world to stability.