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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On the Fears of Bubbles

Katharina recently posted some of her thoughts on the developments in asset markets since the start of the FED’s different unconventional monetary policy programs. I honestly do not know how to go about answering the post, as I personally am unable to get much out of the FT report. But let me give it a try. A couple of months back I posted something dubbed “How destructive are asset bubbles really?”, which I find myself still mostly agreeing with. Of course a lot of that argument is based on monetary policy being able to be effective, which might be somewhat limited given we’re up against the ZLB, but right now is not the place to go into that discussion again. When it comes to identifying whether a bubble is indeed forming or not, I shared some of my thoughts in this post on “The Science of Bubble Spotting”, which probably provides a decent starting point to build on. So let’s get into it.

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A Financial Times Special Report and Some Thoughts on the Ineffectiveness of Monetary Policy

Let me start this by saying that I am reluctant to post about monetary policy. I read Florian’s posts with great interest and some reverence, due to his enormous knowledge on the issue. However, at the moment there is an interesting special report series going on in the Financial Times Video section. John Authers is interviewing a number of interesting people and showing different charts that support his hypothesis that the current US “recovery” is the direct result of monetary policy and, more importantly, completely unstable. I found his figures so interesting, that I decided to share them with you. Unfortunately the ft content is restricted to subscribers (you could get a four weeks for 4€ digital test-subscription though), which is why I’ll give you a brief summary of what he is showing. [Edit: I just saw that the ft has made the videos available on youtube. I added the links below]

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The ECB and its Options at the Zero Lower Bound

Following up on my last post on what easy money actually means I would like to offer some options the ECB could, and in my opinion should, pursue to achieve its mandate of getting inflation back in the vicinity of 2%. Whether doing that is enough is another topic, but it would at least be a start. In general, the consensus is that central banks have three types of tools at their disposal once the zero lower bound is reached: first, they can try to shape public expectations about future monetary policy (e.g. forward guidance), second they can expand the size of central banks balance sheets (e.g. quantitative easing) and third they can change the composition of those balance sheets (e.g. operation twist).

All of these measures have, in the vast majority of studies, shown to be able to affect the economy. The view that economic policy is ineffective at influencing the economy at the ZLB is therefore not correct – it might be less effective, and most importantly probably shows decreasing returns, but it does not become impossible. As Bernanke et al. for instance have argued, we should try to avoid such a situation in the first place, but once there we do have options. So let me offer some more concrete ideas on what the ECB might do in particular.

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Another reason the Fed is better than the ECB

I would argue the Fed has proved, all things considered, to be led one of the most capable central bankers in history. Of the major central banks in the world, it has also shown that it understands how the economy works and what role it is supposed to play in it a great deal better than most others. I really enjoy reading about the thinking that goes on inside smaller central banks like the Swedish Riksbank, and some of the most creative thinking-out-loud by people actually wielding any power in the matter arguably comes out of those smaller central banks. But deciding how to run monetary policy for a small country like Sweden is, needless to say, something completely different than doing the same for the two largest economies in the world, the United States and the Eurozone.

Yet the Fed did not pass all tests presented to it with flying colors – quite the opposite. As I have mentioned before, the housing bubble crashed in 2006, and the real effects throughout the economy were not felt until the Fed decided to let NGDP growth collapse almost 2 years later. And by basically all conventional measures, monetary policy in the United States was also too tight compared to what was needed in the aftermath of the crisis. But it’s nothing compared to the colossal policy failure that the ECB represents. And what’s even more impressive is that the people in charge at the Fed are not ashamed of admitting their past failures. Over at Bloomberg we have William Dudley, the vice chairman of the Fed’s Open Market Committee, admitting that

“With the benefit of hindsight, we did not provide enough stimulus. Perhaps, if we had paid more attention to the persistent divergence between growth forecasts and outturns in Japan in the 1990s, we might have been more skeptical about the prospects for a strong economic recovery, even with a more aggressive monetary policy regime.”

Glad we cleared that up. Let’s not do it again. Again.

The Incompetent Central Bank Case for Fiscal Stimulus

Keynesianism has made a roaring comeback in the aftermath of the Great Recession. No matter what ideological leaning different world leaders had at the time the crisis struck, they all threw their ideologies out of the window and implemented massive fiscal stimulus measures. A big reason Keynesianism was brushed aside in the past couple of decades is that the contractionary part of it more often than not simply does not happen, mainly for political reasons. And as far as the expansionary side of the coin is concerned, opponents of Keynesianism rightly point out that it is unnecessary and even counterproductive in times where our economies are running at something close to full employment. Even without fully rational expectations, the effects expansionary policy can have on the Philips curve are very real. Yet the whole edifice of Keynesian stimulus actually working at least in bad times is built on shaky ground as well – it is made under the assumption that a country’s central bank simply drops the ball when it is needed the most.

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