The radical transformation of the ECB

Students of my generation will remember what we learned about how the European Central Bank conducts monetary policy: The ECB makes one-week loans to commercial banks against top-rated collateral. This was called “Main Refinancing Operations”. The interest rate charged on these loans was known as the Main Refinancing Rate and was considered the key policy rate of the ECB, like the Fed Funds Rate in the United States. Then we learned something about Marginal Lending Facilities and Long-Term Refinancing Operations, but were told they were relatively unimportant.

This was indeed how the ECB operated – before 2009. Since then the ECB has changed its operations. It seems to me that the radical nature of this change has not been recognized enough by economists – let alone the general public.

Look at the chart below. It shows the assets held by the ECB system for purposes of monetary policy operations. The Main Refinancing Operations (the yellow area) have disappeared. In 2019 they constituted a mere 0.25% of the total monetary-policy related assets! The Long-Term Refinancing Operations (blue area) have replaced them and make up about 20% of the total now.

But the elephant in the room is the grey area that first appears in 2009 and then explodes after 2014. The ECB labels it “Securities held for monetary policy purposes”. What are those securities? Government bonds and a couple of corporate bonds as well. The ECB started to buy them with the “Securities Market Program” in 2009 and hugely expanded the purchases with the “Public Sector Purchase Program” in 2015. Last year, the ECB system held 2.6 trillion of assets in relationship with those programs. That is more than 80% of their total policy-related assets.

This means that the ECB of our old textbooks, the ECB that was envisioned by the founders of the euro, has ceased to exist. It has been replaced by an altogether different beast. The primary way in which the ECB conducts monetary policy these days consists in buying Eurozone government bonds in the open market.

This has made the ECB the single biggest lender to Eurozone governments. As I showed in my last post, 91% of all new government debt issued after 2010 is now being held by the ECB. It resembles a 3.2 trillion euro hedge fund, financed by short-term commercial bank deposits (aka “reserves”), holding a diversified portfolio of Eurozone government bonds. The equity owners of this fund are the Eurozone government themselves: they “own” the ECB, they are responsible for replenishing its equity if and when it is deemed necessary.

One implication of this radical transformation should be immediately obvious: Eurozone governments have in effect mutualized 91% of their post-2009 debt. Whenever a Eurozone government defaults on the bonds held by the ECB, the losses would be absorbed, eventually, by the other Eurozone governments.

I’m not saying that’s a bad thing or a good thing. I’m not saying it is illegal or legal. But nobody should delude themselves or others that this is not what has been happing.

How much monetary financing did the ECB provide to Eurozone governments?

Last week, the German constitutional court ruled that the large-scale purchases of government bonds by the ECB since 2015 fell outside the ECB’s legal competences. But the Court also held that this purchasing program did non violate the “prohibition of monetary financing of Member State budgets” in Art. 123 of the TFEU.

It’s unclear whether the ruling will have any effect in practice, because the Court allowed the ECB to continue its program provided they come up with some kind of explanation of what they are doing in the next few months (I’m simplifying).

I admit that I have no idea if the ECB transgressed its legal authorities. But I’m a little bit shocked by the second aspect of the ruling, the finding that the ECB did not provide monetary financing of Member States budgets.

Because the ECB clearly did.

The figure below shows the change in the aggregate outstanding debt of all Eurozone governments (blue line) as well as the change in the ECB’s holdings of such debt (red line) since 2010.

All Eurozone governments combined have issued 1.845 trillion euros* in new debt since 2010. During the same time, the ECB has increased its holdings of Eurozone government debt by 1.683 trillion euros. Ergo, the ECB has bought 91 cents of every euro of new debt issued by Eurozone governments. Notice also the clear break in the red curve in the year 2015. That’s exactly when the PSPP started.

How can this not be “monetary financing” of Eurozone governments?

*) All debt numbers here refer to face values, not market values, and are not adjusted for inflation.

A New Keynesian toy model

I’ve been keeping a collection of “toy models” on my computer. I do this for two reasons. First, building them is a lot of fun and useful as a kind of intellectual work-out to develop the “model-building” regions of my brain. Second, I think they help clarify my own thinking about economic issues.

I’d like to share one of my favorite toy models with you. I learnt it from Cedric Tille when I was at the IfW Kiel. The purpose of this model is to show the basic intuition behind a strand of literature called “New Keynesian” macroeconomics. The NK approach can be thought of as a combination of the techniques of the “Real Business Cycle”  literature (rational expectations, continuous market clearing, dynamically optimizing agents) with “old” Keynesian economics (monetary policy has real effects, government spending has a multiplier effect, etc.). The model is simple enough to be taught to first-year econ students and at the same time rich enough to provide a basis for discussion of the effects of monetary policy, technology shocks, fiscal policy, the distinction between expected and unexpected shocks and more. It is also much closer to current macroeconomic research than the usual AS-AD model contained in most textbooks. The model has a natural extension to an open economy setting, which is contained in this paper by Corset & Pesenti.

Here goes.

Technology. An economy’s output (Y) is produced by labor (L) alone. The aggregate production function is

Y = A*L,                           (1)

where A is the technology parameter (labor productivity).

Households. Households consume output and supply labor. They trade off the marginal utility from consumption against the marginal disutility of working. Under usual assumptions about the shape of utility functions, consumption will be an increasing function of the real wage. Denoting the nominal wage by W and the price level by P, let household consumption (C) be given by

C = k*(W/P),                 (2)

where k is a positive parameter. The basic intuition behind this consumption function is that a higher real wage induces people to substitute consumption for leisure (substitution effect) and raises their real income (income effect). Both effects act to increase consumption, while the effect on labor supply is ambiguous.*

In order to purchase goods, households must hold money. Money demand (M) is a function of nominal consumption spending:

M = (1/v)*P*C,             (3)

where v is the (exogenous) velocity of money. Note that this is just a versions of the quantity theory of money. The money supply is set by the central bank and exogenous to the model. We will think of M as describing the stance of monetary policy.

Firms. Firms compete in a monopolistic way, i.e. each firm has a monopoly over the specific kind of consumption good it produces, but there is a large number of close substitutes. It can be shown that under this kind of competition, the aggregate price level will be set as a mark-up over marginal costs of production. Nominal marginal costs are equal to W/A — it takes 1/A hours to produce one unit of output and each hour costs W euros.

Crucially, firms must set prices before learning the labor productivity and the monetary policy stance. Hence, they must form expectations about nominal marginal costs. Let z be the mark-up, which indicates the market power of firms (which in turn depends on how “tough’’ competition is in the goods market). Then the price level is given by

P = z*E(W/A),               (4)

where E() denotes the expected value conditional on information available to firms when they set prices.

Closing the model. The model is closed by the goods market clearing condition:

Y = C.                              (5)

This is a model with five endogenous variables (Y, C, L, W, and P) and two exogenous variables (M and A). Let’s find the general equilibrium of this economy. First, combine (2) and (3) to get
W = (v/k)*M.                (6)
Taking expectations and inserting into (4) yields
P = (z*v/k)*E(M/A).               (7)
Next, combine (3), (5) and (6) to get
Y = (k/z)*M/E(M/A).              (8)
Re-inserting this into (1) yields
L = (k/z)*[M/A]/[E(M/A)].   (9)

Equilibrium. Suppose that, in the long run, expected values equal actual values, i.e. E(M/A)=M/A. This is just the rational expectations assumption which in this context means that firms don’t make persistent, systematic mistakes in forming expectations about productivity and monetary policy. With this assumption, (8) reduces to

Yn = (k/z)*A,

which we can call the natural rate of output or full-employment output. It increases in productivity and decreases in the degree of monopolistic distortions. The long-run (“natural”) level of employment is given via (9) by

Ln = k/z.

Using these results in (8) yields

Y/Yn = [M/A]/[E(M/A)].

This equation relates the ratio of actual to natural output (the output gap) to the monetary stance and the state of technology. What exactly does this mean?

  • An unexpected increase in money supply raises output over its natural level. The reason is that an increase in M while P is fixed makes households spend more which raises output and employment.
  • An unexpected increase in labor productivity reduces the output below its natural level. The reason is that a higher A increases potential output, but does nothing to stimulate household spending. Hence output stays the same while labor demand (and therefore employment) falls. So a positive technology shock produces underemployment in the short run.
  • Expected changes in monetary policy or technology have no effect on the output gap. In the long run, money is completely neutral with respect to Y and L.
  • If the central bank has a way of knowing A in advance (for instance, because they employ competent economists who can forecast A perfectly), they could set M in such a way as to completely stabilize the economy at the natural output level. They “simply” have to set M=b*A.

Fiscal policy. How do we get fiscal policy into the model? Easy. Just add government spending into the goods market clearing condition:

Y = C + G                                     (5*)

and assume for simplicity that the government makes spending proportional to total output G=g*Y. (You also must assume that the government finances its expenditure by lump-sum taxes on households only so that firms’ pricing decisions and households’ labor supply are not distorted.) In this case natural output becomes

Yn =(k/z)*A/(1-g),

which increases in g. Government spending doesn’t affect the output gap, though, because it moves actual and potential output by the same amount.


*) A utility function which gives rise to such a consumption function is U(C,L) = log(C) — (1/k)*L.

Draghis Nullzinspolitik, Friedmans Regel und die deutsche Presse

Die deutsche Presse ist völlig aus dem Häuschen. Nein, nicht wegen der andauernden Flüchtlingskrise, auch nicht wegen Griechenland, nicht einmal Fußball ist der Grund des Aufruhrs. Der Grund ist die jüngste Entscheidung der Europäischen Zentralbank den Hauptrefinanzierungssatz (vulgo Leitzins) von 0,05% auf 0,00% zu senken.

Na mehr brauchst’ nicht.

Die Süddeutsche Zeitung titelt „Draghi kennt keinen halt mehr“, die Welt legt noch eins drauf: „Mario Draghi raubt der Welt des Geldes das Fundament“, „Ist das Mario Draghis letzte Schlacht?“ fragt Spiegel-Online und die FAZ raunt: „Wie geht es weiter mit dem Euro?“

Nun, wie ich auf diesem Blog schon früher einmal festgestellt habe, macht Geld eben verrückt – sogar die biedere deutsche Wirtschaftspresse. Aber hier scheint mir das Maß der monetären Manie neue Höchststände zu erreichen. Nehmen wir den „Welt“-Artikel her. Dieser wirft Draghi vor Inflationserwartungen zu schüren – in deutschen Augen die schlimmste Sünde für einen Geldpolitiker – und erklärt ohne jeden Anschein von Ironie nur wenige Zeilen davor, dass die Niedrigzinspolitik weitgehend wirkungslos gewesen sei. Er beklagt, dass die EZB den Banken jetzt kostenlos Geld leiht, und wirft ihr gleichzeitig vor, dass sie die „Profitabilität der Geldhäuser massiv unter Druck“ bringe. Die Nullzinspolitik, so die „Welt“, setze alle Regeln des Marktes außer Kraft.

Wie reagiert der gute Ökonom auf solchen Unsinn? Ein guter Anfang ist wie immer bei Milton Friedman zu finden.

Jeder weiß, dass Friedman den Monetarismus begründet hat. Das ist jene Doktrin, der zufolge die Zentralbank für ein möglichst konstantes Wachstum der Geldmenge zu sorgen hat. Wenige wissen, dass Friedmans Monetarismus eine einfache Regel für den optimalen Nominalzins impliziert. Das optimale Zinsniveau beträgt – die Spannung steigt – null.

Das Argument, warum der Nullzins optimal ist, sollte nicht schwer zu verstehen sein. Die Regel für die optimale Bereitstellung von Geld ist dieselbe wie die für die optimale Bereitstellung von Wiener Schnitzeln. Die privaten Grenzkosten des Schnitzelkonsums (also die Menge an anderen Gütern, auf die die einzelne Konsumentin verzichten muss, wenn sie ein zusätzliches Schnitzel isst) muss gleich sein den sozialen Grenzkosten der Schnitzelproduktion (die Menge an anderen Gütern, auf die die Gesellschaft verzichten muss, wenn sie ein zusätzliches Schnitzel produziert). Die optimale Geldmenge ist erreicht, wenn die privaten Kosten der Geldhaltung gleich den sozialen Kosten der Geldproduktion sind. Die privaten Kosten der Geldhaltung sind die nominalen Zinserträge, auf die ich verzichte, wenn ich mein Vermögen in Form von Geld halte anstatt in Anleihen und andere Wertpapiere zu investieren. Die sozialen Kosten der Geldproduktion sind praktisch null. Euroscheine zu drucken kostet fast nichts, digitales Buchgeld zu schaffen genau nichts. Ergo sollte die Zentralbank genau so viel Geld bereitstellen, dass der Nominalzins auf null sinkt.

Aber was ist mit Inflation? Heizt eine Nullzinspolitik nicht die Preissteigerung an? Nein. Die Inflation wird, zumindest langfristig, vom Wachstum der Geldmenge bestimmt und nicht von ihrem Niveau. Eine Nullzinspolitik ist vereinbar mit einer wachsenden, fallenden oder gleichbleibenden Geldmenge und daher mit Inflation, Deflation oder perfekter Preisstabilität. (Friedmans ursprüngliche Analyse verlangt im Optimum eine leichte Deflation.)

Und die Banken? Werden die durch die Nullzinspolitik nicht zu immer riskanteren Investitionen gedrängt? Wieder daneben. Ich bin eine Bank. Investition A garantiert eine Rendite von 4% jährlich. Investition B bringt 10% oder 0% mit gleichen Wahrscheinlichkeiten. Wenn ich, solange der Leitzins bei 1% lag, Investition A gegenüber Investition B bevorzugt habe, warum sollte ich meine Präferenz ändern wenn der Leitzinssatz auf 0% sinkt?

Damit hier kein falscher Eindruck entsteht sollte ich vielleicht darauf hinweisen, dass Friedmans Regel eher wenig mit der jüngsten Zinsentscheidung der EZB zu tun hat. Mario Draghi weiß bestimmt, dass diese Regel, obwohl hilfreich als eine erste Annäherung an gute Geldpolitik, in unserer komplexen Realität nicht ganz optimal ist.

Wenn er an eine Regel denkt, dann wohl eher an die Taylor-Regel, die grob besagt, dass der Nominalzinssatz sich an der Inflation und der „Outputlücke“ (Differenz zwischen tatsächlichem BIP und seinem „natürlichen“, d.h. idealen Niveau) orientieren sollte. Gemäß der Taylor-Regel sollte der Leitzinssatz schon seit geraumer Zeit nicht null, sondern negativ sein. Weil aber der Nominalzins nicht negativ sein kann (der Beweis dieser Aussage ist dem geneigten Leser überlassen!), ist null die nächstbeste Alternative.

Wie dem auch sei, die EZB-Politik der Nullzinsen steht durchaus im Einklang mit der ökonomischen Lehrmeinung. Das heißt selbstverständlich nicht automatisch, dass sie auch richtig ist. Aber die Hysterie, mit der sie in deutschen Medien diskutiert wird, basiert weitgehend auf ökonomischem Analphabetismus.

(Die andere geldpolitische Entscheidung der EZB, den Aufkauf von Staatsanleihen auszuweiten, steht auf wesentlich dünnerem Eis – aber davon ein andermal.)

How is NGDP targeting different from inflation targeting?

This is basically a note to myself, but may be of interest to some of you. I have been thinking lately about nominal GDP targeting. The idea in itself is old, but it has received a lot of attention in the blogosphere post 2009. I want to know under which conditions NGDP targeting produces different results than an inflation targeting regime.

So, to get a first intuition about this, I took the standard ASAD model from the shelf. I transformed everything into growth rates or, if you want to look at it differently, into deviations from the steady state equilibrium. Then I plugged in simple characterizations of the two different policy regimes. And the result is this: A minimalist ASAD analysis of NGDP targeting.

The basic insight is that NGDP targeting requires that any shock to aggregate demand (positive or negative) be completely offset by monetary policy while supply side shocks be neglected. In other words, NGDP targeting fixes the position of the AD curve and doesn’t worry about the position of the AS curve. Inflation targeting, on the other hand, demands that monetary policy takes into account both AD and AS shocks. As my little modelling exercise shows, there is a tight correspondence between the two regimes in the sense that for every given NGDP target there is an inflation target that produces the exact same path of real output and inflation as the NGDP target, and vice versa. I also show that if there were no supply side shocks, only demand shocks, the two regimes are equivalent. The difference between the regimes lies only in how they react to AS shocks: an inflation target tends to amplify the effects of AS shocks on output, the NGDP target doesn’t. Hence NGDP targeting tends to produce smaller fluctuations in real output growth than an inflation target.

So, if you believe macroeconomic shocks are mainly due to aggregate demand, you should be indifferent between the two regimes.

The Bank of England on money creation

Money creation makes people go nuts. Everyone can verify that claim by searching youtube for “money creation” or “money multiplier”, which will turn out a long list of clips telling you the SHOCKING TRUTH about our FRACTIONAL RESERVE BANKING system. Interestingly the money creation craze can be found on both ends of the political spectrum. To socialists, the fact that banks create money out of thin air proves that they are the ultimate force of evil in the world, designed to enslave the working class in a never-ending spiral of debt and compound interest. Libertarians, on the other hand, go “Money out of thin air! Inflation! Theft!”.

Introductory economics textbooks are partly to blame for this confusion. Most of them present an oversimplified model of money creation that goes something like this: there is an initial deposit of $100 with bank A. Bank A keeps 10% (say) as reserves and lends out the remaining $90. This new loan ends up as a deposit with bank B. Bank B keeps 10% of it as reserves and lends out $81, which will end up in bank C, and so on. By the magic of infinite series, the initial deposit of $100 creates new money in the amount of $1000; it gets multiplied by a factor equal to the inverse of the reserve ratio.

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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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