Illiberal Ideas Hiding Behind Liberal Names

Bringing up the name of famous economists in order to try and give credibility to otherwise often fairly dubious ideas and theories is pretty common, and in terms of marketing it certainly works. Yet more often than not it seems that these ideas in fact run very much against what the economists that are used to supposedly enhance their credibility actually wrote and thought. Adam Smith’s “Invisible Hand” is probably the most wide-spread, misunderstood and misquoted one of them. From Marx to Keynes to Friedman, every famous economist has fallen victim to these wrongful association in the past, and I find the economics profession has been doing a fairly bad job at setting the record straight or even trying to do so.

The latest occasion that also leads me to write this post is the Free Market Road Show that is currently touring all of Europe and beyond. Some of the planned speakers are actually very interesting and knowleadgeable – Madrid’s event last week, for instance, featured Mark Klugmann who presented some ideas on “charter cities” (he is currently advising Honduras’ government on how to turn these into a reality), a topic that has fascinated me for a long time (and for which I started writing a blog post over a year ago, yet never finished). Another speaker at the event was Barbara Kolm, president of the Friedrich A. v. Hayek Institute – which is also what brings me back to my original topic.

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The ECB’s Sterilization Policy And Its Fiscal Effects

First of all, it’s obvious that I have horribly failed at something I always try to do when writing a new post: coming up with a title that hopefully makes people actually want to read it. Yet I still feel this is important, and I’m thankful to Max for insisting on continuing the discussion. In the comments section of my last post, originally meant more as a general monetary policy post, a vivid discussion has emerged on what the ECBs Outright Monetary Transactions Policy (OMT) entails and particularly in what way it would potentially lead to fiscal transfers between Eurozone members, potentially making it illegal under EU treaties. While writing my latest comment, I noticed it was getting way too long, so let me offer a response as a new post.

The way I see it, the main disagreement between Max and me involves the direction any possible fiscal transfers would go if the ECB would, some day, actually buy bonds under the OMT program. We don’t seem to disagree on the fact that any purchases of government bonds by the ECB would potentially prove legally problematic, but rather on what these purchases would entail economically with regards to possible fiscal transfers within the Union. Max argues that, through sterilization, i.e. the ECBs attempts to remove an equal amount of money from the market as it is injecting by buying government bonds of troubles periphery countries, it is substituting low-risk assets on its balance sheet for high-risk assets, making its entire balance sheet more risky and thus representing a real cost to the core, which gets their share of any interest payments accrued from these assets (and thus potentially stands to loose these due to their increased riskiness). However, it would seem that this is based on an inaccurate description of how the ECB conducts (and would conduct) said sterilization. That no OMT purchases have ever actually taken place does not really make the issue harder – for all intents and purposes, OMT is just a replacement for the Securities Markets Program (SMP) instituted by the ECB in 2010 and under which it has already bought around €200 billion worth of bonds of periphery countries (mostly Italy), most of which it still holds on its books. Although there might be some technical differences, conceptually it would seem to me that the main feature of the “change” is that OMT made this program open-ended (thus also reducing the actual need to buy the bonds in the first place). So we know pretty well how OMT as well as sterilization measures would work – so how would they?

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The ECB Isn’t Allowed To Directly Finance EU Governments – Who Said It Needs To?

A large part of the debate on whether or not the ECB can do quantitative easing revolves around the issue that the ECB statutes prohibit the central bank from “financing” any of the member governments directly (or, depending on what German courts say, indirectly as well). To a certain extent this policy makes sense – it avoids a lot of explicit moral hazard and essentially prevents the EU from ever getting stuck in a hyperinflationary situation where governments issue bonds to raise their spending and the central banks just acquiesces and goes on buying these bonds. Also, the Bundesbank has a price stability fetish because of something that happened over 80 years ago but for some reason they can’t seem to learn the correct lessons from. Somewhere else on this blog I have also argued that introducing Eurobonds would provide an instrument for the ECB to actually engage in straight-forward QE, even though just buying a reasonably weighted basket of national bonds would do the same trick (however, with potentially different fiscal implications). But why should buying government bonds be one of the go-to policy to try and gain traction in a liquidity trap in the first place?

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Could Leaning Against Asset Price Bubbles Exacerbate the Business Cycle?

In my last post I argued that using monetary policy to lean against asset price bubbles would only tend to hurt the real economy in the long-run if for some reason the central banks target is constructed in an asymmetric way, i.e. it reacts to asset price deviations to the upside but ignores them to the downside. If its asset price target, however defined, is correctly chosen and designed in a similar way as its inflation and/or output targets in e.g. a classic Taylor rule, then on average there will be as much leaning against asset prices as there will be propping up asset price. But what effects would such a policy have on the business cycle in general? More precisely, would a central bank that targets asset prices tend to have a stabilizing or destabilizing effect on the overall system?

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Leaning Against Bubbles Hurts the Economy – Except When it Doesn’t

A lot has been written on the so-called lean vs. clean debate in monetary policy that tries to resolve whether central banks should actively try to counter asset price bubbles during their build or just make sure they do everything they can in order to clean up in the aftermath of these bubbles bursting. To recap, there’s decent arguments for both sides of the debate: the clean camp, applying the “Greenspan principle”, generally cites the difficulties in spotting bubbles, often due to efficient market hypothesis concerns, as the main reason for not using the particularly blunt instrument of interest rate policy to deflate potential bubbles – after all, can we ever really know it is one until it bursts? The clean camp, while generally acknowledging the problems involved in bubble-spotting, tend to stress the damage to the real economy that financial asset bubbles can cause, highlight the potential inability of central banks to “clean up” under certain circumstances, such as when the zero lower bound on nominal interest rates is reached, as well as the inconsistency of asymmetrically responding to asset prices – not at all during the build-up of a bubble, yet strongly to its bursting. There are models that supposedly show that both the clean as well as the lean approach is the optimal one (e.g. Bernanke and Gertler on the clean side and Filardo on the lean side, just to name two – both .pdfs).

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Goodhart’s Law – in Good Times and in Bad

A large part of the success of central banks all around the world during what became known as the Great Moderation is often attributed to the successful anchoring of inflation expectations to the levels that central banks would like to see – generally defined as 2% in most of the industrialized world. In basic theory this is awesome: if the inflation rate, through some kind of phillips curve or any other structural relationship you prefer, is linked to the aggregate level of economic activity in a stable way, than a stable inflation rate also leads to a stable level of economic activity.

In comes Charles Goodhart, former member of the Bank of England’s Monetary Policy Committee, who stated something as profound as at the same time similar to the famous Lucas Critique: Goodhart’s Law. In it’s most common version it says that “when a measure becomes a target, it ceases to be a good measure”. In other words, once a central bank (or in theory indeed any institution with enough clout to consistently affect the economy) states that it will do whatever it needs to in order to keep a given indicator at a level it so desires, the market structure will be affected by this, expectations of market agents will adapt, and the target will be achieved, even if the central bank does not really even do much – it just has to credibly promise that it would.

First of all, and on a very deep level, this of course could be seen as qualifying the very success of central banks in “anchoring” inflation rates. Has inflation in the past two decades been so tame because central banks have become better, or simply because they somehow managed to credibly make everyone believe that they have become better? In the end, the answer doesn’t matter much – it is outcomes that we want, who cares about how we get there. However, while the upside to this stable inflation anchoring in good times is enormous, it seems to have come back to haunt us at a time when we most need our monetary authorities to act. Even though inflation both in the US as well as in the Eurozone is considerably below target, inflation expectations are awkwardly close to those targets over the near-term (e.g. here for the Eurozone). Given most central banks nowadays target the forecast, they might interpret this as signalling that there is no real big need to act, and thus not act in the first place. I personally find this to be one of the most compelling explanations as to why the ECB continues to fail to do its job. As Draghi stated, “inflation expectations are firmly anchored in line with price stability“. Exactly. That’s the problem.

The Fed is in a somewhat better position since it does not only target inflation but also full employment – even if inflation sticks to 2%, as long as unemployment is above target it will (or should) ease monetary policy. The ECB, on the other hand, focuses essentially solely on inflation, and at the moment there are great doubts as to whether inflation (particularly inflation expectations) are of any use at all as a signal for what it should be doing. This monthly bulletin by the ECB (dating back to 2011, .pdf), for example, states that “well anchored expectations have contributed to enhancing the effectiveness of monetary policy and will assist the ongoing economic recovery”. Sure, stable inflation expectations also prevent us from falling into outright deflation in a scneario were we assume the central bank to be asleep. Further, as Clarida states (.pdf), “inflation inertia is the enemy of reflation once deflation set in”. However, I would state that somewhat differently: inflation inertia (in the context of this post in terms of expectations) is the enemy of reflation – period. At the moment it mostly provides a convenient excuse for central banks to do less than they should. Currently, it would seem that those well-anchored inflation expectations are part of what’s preventing effective monetary policy in the first place.

The Mystery of the Falling Natural Real Rate of Interest

A couple of weeks ago Larry Summers held a widely praised speech on the difficulties ahead for economic stabilization policy. As far as I can tell, not much of it was really new, as also pointed out by e.g. Krugman, but that does not mean it wasn’t a great speech, and one that seems to have had considerable influence on the policy debate. In essence it boils down to the problems we face due to the zero lower bound on nominal interest rates, and what happens in a world where the real interest rate required to establish full employment, sometimes also called the natural real interest rate, is negative, as it almost certainly is right now.  Yet from the regression’s I have been running, it would seem that the equilibrium real interest rate was already considerably lower than in previous periods even before the crisis started. In other words, even before the crisis struck, monetary policy already had considerably less room to maneuver than in the decades preceding the the 2000s. To recap, let’s again take a look at a fairly simple Taylor rule one might use to describe Fed policy in the 2000s, more precisely from the first quarter of 2000 to the second quarter of 2009, which is roughly around the time when the zero lower bound started binding.

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