Update on the Eurozone Crisis

Back on the Eurozone crisis front we find find some great lines from Michael Darda and Marshal Auerback on the latest developments.  Here is Darda from his latest newsletter:

Although there seems to be some optimism in European equity markets that Thursday’s finance ministers’ powwow will bring a “shock and awe”  announcement, we would not wait to exhale. As we’ve argued before, eurozone nominal GDP is about 10% below trend. This has caused tax revenues to collapse and debt burdens to mushroom. Since the ECB has tightened liquidity and raised rates instead of lowering  them and adding liquidity,  we simply  see  no path to  a  recovery in nominal GDP (and solvency) for the European periphery, whose costs and prices are out of whack with the rest  of the eurozone. Rearranging the deckchairs with  alphabet soup bailout schemes and fiscal austerity measures has failed for 14 months and will continue to fail unless accompanied by  a much more  supportive monetary policy by the ECB, in our view...Sterilized interventions -- when a central bank buys an asset but sells another asset so that the money supply remains unchanged -- is like attempting procreation with contraception. It’s set up to fail.

 And here is Auerback in his latest article:

In the past, I have called the euro zone a “roach motel”. But as usual, I’ve been outdone in the metaphor design department by the Italians: Guilio Tremonti, the Italian Finance Minister, last week compared Germany and its small-minded Chancellor Angela Merkel to a first-class passenger on the Titanic. The underlying message is the same: You can be sailing in coach or you can be in the 1st class compartment. But when the ship hits the iceberg, everybody goes down together — Germans, Italians, Greeks, Irish and French alike. All euro zone members have an institutional wide problem of not being able to fund deficits, given that the countries of the euro zone have all acceded to impose gold standard conditions on themselves by forfeiting their fiscal freedom.

To repeat: this is not a problem confined to the periphery. The sovereign risk problem applies to the central core countries, such as Germany and France, as it does to the Mediterranean “profligates”. Once a run on the currency starts and moves into the banking sector, then none of the governments will be able to do anything other than to oversee financial and economic collapse while the fiddlers in Brussels and Frankfurt try to spin some line about “special circumstances” or something without admitting the whole system they imposed on the area is the cause of this crisis. 

I concur with Auerback that the ECB has been fiddling while the Eurozone slowly burns. I just hope it does not turn into an other Lehman-type event.  Should it come to that, here is how I would have the Federal Reserve prepare for such an outcome.

The Inadequacy of the Balance Seet Recession View

Thanks to this David Leonhardt article, the balance sheet recession view is once again getting much discussion.  This view holds that households acquired excessive amount of debt during the housing boom, the value of their assets plummeted during the crash, and now their balance sheet are in need of great repair.  Consequently, the U.S. economy is undergoing a great deleveraging cycle that is slowly restoring household balance sheets.  Some take this view to also mean that only time can heal the wounds of a balance sheet recession. 

I don't like this view for two reasons.  First, it is at best an incomplete story.  For every household debtor deleveraging there is a creditor getting more payments.  Yes, household debtors have cut back on spending, but so have creditors.  The creditors could in principle provide an increase in spending to offset the decrease in  debtors' spending.  They aren't and thus the economic recovery is stalled. In other words, the problem is as much or more about the build up of liquid assets by creditors as it is the deleveraging of debtors.  The balance sheet recession view, however, sees the debtors deleveraging as the main problem.  It completely ignores the creditors buildup of liquid assets and its implications for spending.   

When one begins to focus on the creditors' role, it becomes apparent that the underlying problem is excess money demand.  For if the creditors are not spending their newly acquired dollars there must be an unsatiated demand for money.  Even in the case where banks are the creditor, the excess  money demand problem is present.  For example, if a bank loan is paid down both loans and deposits fall. If those deposits were checkable, saving, small time, or money market accounts–assets used as money–the money supply falls too. For a given demand for money, this drop in the money supply now means there is--if not already--an excess money demand problem. The key issue, then, is to satiate creditors' demand for money and get them to start spending some of their money assets.  This insight is ignored by the balance sheet view of recessions.

The second problem I have with the balance sheet view of recessions is that it leads people to think there is nothing monetary policy can do.  Part of the issue here is the failure to see the underlying excess money demand problem.  If it were widely understood that the fundamental problem was excess money demand, then there would be more faith in using monetary policy.  

Another part of this problem, though, is a failure to look back to history for other examples of balance sheet recessions.  As Frederick Mishkin has shown, households were also significantly deleveraging during the Great Depression.  This experience would fit the standard definition of a balance sheet recession.  Below is a table from his paper that shows household balance sheets in real terms.  Note that between the 1933 and 1936 U.S. household underwent a cumulative deleveraging  in real terms of 20%. This is far more in percentage terms that has happened over the past few years. And yet between 1933 and 1936 the U.S. economy had a robust recovery.  Real GDP averaged almost 8% growth during these years. 

 

The balance sheet recession view cannot easily reconcile the large deleveraging by households and the rapid real economic growth that occurred between 1933 and 1936.  What can explain it is a more nuanced view that acknowledges creditors with excess money demand were confronted by FDR's original quantitative easing program.  This QE program was far better than recent ones in that FDR clearly signaled a price level target and backed it up by devaluing the gold content of the dollar and allowing unsterilized gold inflows. In otherwords, FDR signaled that he was going to allow a significant and permanent increase in the monetary base and followed through on it.  This change nominal expectations and caused creditors to start spending their money balances.  The same could be done today with something like a nominal GDP level target.

Unfortunately, I fear Edward Harrison is correct in saying Fed has burned up most of its political capital. So it is unlikely to try anything radical like nominal GDP level targeting.  That means the economy will be stuck in stall speed for the time being.

Update I: A quick follow-up point to some of the comments.  Whether consumers default or pay down debt is irrelevant to whether there is an excess money demand problem. If consumers default and hold on to their money balances there is an excess money demand problem.  If consumers pay down their debts and the banks (the creditor) mark down their assets and liabilities accordingly, there is still an excess money demand problem since there is now less money supply for a given level of money demand.(By the way, this New York Fed report shows that many consumers have been paying down their debts, not defaulting.)

Update II: Just to be clear, there are more creditors than just banks so it is a little misleading to focus solely on banks.

Is Weak Aggregate Demand Really the Main Problem?

Or is it the regime uncertainty that many observers attribute to the Obama administration? The answer from several recent surveys say it is weak aggregate demand.  First, a Wall Street Journal survey shows most economists see the lackluster recovery as a the result of weak aggregate demand rather than uncertainty over government policy:  

The main reason U.S. companies are reluctant to step up hiring is scant demand, rather than uncertainty over government policies, according to a majority of economists in a new Wall Street Journal survey...In the survey, conducted July 8-13 and released Monday, 53 economists—not all of whom answer every question—were asked the main reason employers aren't hiring more readily. Of the 51 who responded to the question, 31 cited lack of demand (65%) and 14 (27%) cited uncertainty about government policy. The others said hiring overseas was more appealing.

This conclusion is supported by the findings in the most recent NFIB's survey of small businesses.  This survey has consistently shown, and shows for June, that the number one problem facing small business is not regulation or taxes--though they do matter according to the survey--but weak sales.  Here is a table, for example, from the June, 2011 survey that underscores that it is weak sales more than anything else that is creating stress for small firms. Note that regulatory costs and taxes are captured under the increased costs category (see underlined footnote). 

I suspect regulatory costs become more apparent and seem more important when aggregate demand is persistently weak. Conversely, if firms were flush with growing revenues and expected higher sales the regulatory costs would probably seem less burdensome. This is not trivialize the importance of such regulatory costs, but to point out that some commentators should probably spend more time thinking about the problem of weak aggregate demand and what can be done to fix it.

Update:  Nick Rowe makes a good point in the comments section:

[L]ook at the table on page 20 of the report. Once again, only a very small percentage of firms list "quality of labour" as their most important problem. 5% today, compared to 4% one year ago, 3% as the survey low, and 24% as the survey high.  The fact that labour is so easy to hire is more confirmation that there's generalised excess supply, and the problem is AD.

The Other Four Important Insights From Bernanke's Testimony

Chairman Bernanke's testimony before Congress this week generated much attention because he mentioned the Fed remained open to further monetary easing.  Many observers interpreted this statement as Bernanke opening the door for QE3.  Though this was the big news from Bernanke's visit to Congress, there were four other important insights in his testimony worth mentioning too. 

First, Bernanke affirmed his new-found love for the portfolio channel of monetary policy.  The idea behind this channel is that through its purchases of longer-term securities the Fed can cause investor's to rebalance their portfolios toward riskier but higher yielding assets like stocks and capital.  Eventually, these asset prices would increase and their yields drop providing a boost to consumption and investment spending. Here is Bernanke:

The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program--like more conventional monetary policy--has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy.

Another way of saying this that is that Fed's asset purchasing program is simply moving down the list of assets--i.e.it is going from buying treasury bills to buying treasury notes and bonds--whose yields also affect money demand.  When the zero bound on short-term interest rates is hit and money demand still remains elevated it is time to start lowering yields on other longer-term securities until money demand drops and nominal spending is fully restored. (See Edward Nelson for a more on this channel and see here for evidence that money demand still remains highly elevated.)  

I am glad to see Bernanke get behind the portfolio channel, though the lack of a robust recovery means this channel's potential hasn't been fully utilized.  An important part of this channel is shaping the expected path of nominal spending and interest rates so that investors start rebalancing their portfolios on their own.  The Fed shouldn't have to do the heavy lifting if it sets expectations correctly. But since the Fed has yet to commit to a level target this has not happened.  

Second, Bernanke implicitly acknowledges that interest rates would be low even in the absence of the Fed.  This is an important point that many commentators miss.  Interest rates are low now mainly because the economy is weak, not because of Fed policy.  The weak economy has pushed the equilibrium or neutral interest rate down and the Fed at best has only marginally lowered it. Again, here is Bernanke:

Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points. 

To put this in perspective, the 10-year treasury yield reached a low of about 2.5% in October 2010.  Add the upper-end estimate of 30 basis point to this and the 10-year yield is still only 2.8%, a low number relative to its value over the past decade. Interest rates will rise once the economy begins to really recover, not before.  What is frustrating for me is to see many otherwise thoughtful folks, including some Fed officials, failing to understand this point and calling for higher interest rates. This has the causality completely backwards.  At least the folks at the Swedish central bank get it right.

Third, Bernanke acknowledges the Fed still has plenty of ammunition in its monetary arsenal.  Bernanke, therefore, disagrees with the David Brooks of the world who say there is no magic lever or the Richard Koos of the world who say a central bank can do nothing in a balance sheet recession. Here is Bernanke on what else the Fed can do:

Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.

So the Fed can better shape expectations (which would happen if the Fed would just set a level target!), buy up more longer-term securities, and lower the interest payment on excess reserves. Of these options, I see the first as being the most effective.  In fact, the first option is more or less what Bernanke told Japan to do in the 1990s.  If it is good for Japan, why not the United States?

Fourth, Bernanke reiterated the Fed's desire to slouch on the job and ignore the aggregate demand shortfall.  Okay, he did not exactly say that, but it was implied by the fact the Fed is doing nothing despite the ongoing elevated demand for money and money-like assets.  Bernanke, himself, has recently said that monetary policy can be passively tightened by doing nothing. (He was referring to the Fed's balance sheet passively shrinking by not reinvesting its mortgage earnings.)  As Ryan Avent notes, it is amazing to see Bernanke list all the things  the Fed could still do to help the economy, but chose not to act.  

Chairman Bernanke vs. Governor Bernanke

I was looking at the official transcript of Ben Bernanke's last press conference in June and found this exchange interesting:

AKIHIRO OKADA.  Mr. Chairman, I am Akihiro Okada with Yomiuri Shimbun, a Japanese newspaper.  During the Japanese lost decade in the 1990s, you strongly criticized Japan’s lack of policies.  Recently Larry Summers suggested in his column that the U.S. is in the middle of its own lost decade.  Based on those points with QE2 ending, what do you think of Japan’s experience and the reality facing the U.S.?  Are there any historical lessons that we should be reminded about?  Thank you.

CHAIRMAN BERNANKE.  Well, I’m a little bit more sympathetic to central bankers now than I was 10 years ago.  I think it’s very important to understand that in my comments—both in my comment in the published comment a decade ago as well as in my speech in 2002 about deflation—my main point was that a determined central bank can always do something about deflation.  After all, inflation is a monetary phenomenon, a central bank can always create money, and so on.  I also argued—and I think it’s well understood that deflation, persistent deflation can be a very debilitating factor in—in growth and employment in an economy.  So we acted on that advice here in the United States, as I just described, in August, September of last year.  We could infer from, say, TIPS prices—inflation index bond prices—that investors saw something on the order of a one-third chance of outright deflation going forward.  So there was a significant risk there.  The securities purchases that we did were intended, in part, to end that risk of deflation.  And I think it’s widely agreed that we succeeded in ending that deflation risk.  I think also that our policies were constructive on the employment side.  This, I realize, is a bit more controversial.  And we’ve been consistent with that—with that approach.  But we did take actions as needed, even though we were at the zero lower bound of interest rates, to address deflation.  So that was the thrust of my remarks 10 years ago.  And we’ve been consistent with that—with that approach.

So Chairman Bernanke is claiming the "thrust" of his remarks about Japan were on its need to address deflation.  And since the Fed did just that with QE2, he believes the Fed under his leadership has been consistent with this approach.  Sorry Chairman Bernanke, but I don't think Governor Bernanke of 2002-2005 would completely agree with that assessment  nor do I think it gets to what Mr. Okada was asking.  For what Governor Bernanke originally advocated was more than just eliminating deflation.  He advocated the adoption of a price level target.  Here is Governor Bernanke in a 2003 speech:

For Japan, given the recent history of costly deflation, however, an inflation target may not go far enough. A better strategy for Japanese monetary policy might be a publicly announced, gradually rising price-level target.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred... Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter.² Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap (Bernanke, 2000). The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.

The key difference, then, between Governor Bernanke and Chairman Bernanke is that the former advocated for Japan an explicit price level target that allowed for catch-up inflation whereas Chairman Bernanke at best has advocated for the United States a vague inflation target that does not close the price level gap.  That is a big difference.  And note what Governor Bernanke says the closing of the price level gap would entail:

A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation.

In other words, Governor Bernanke believed inflation should be allowed to temporarily rise above normal inflation rates until the previous price level trend was reached. He believed in a "reflation phase." One reason for doing so would be to reverse unexpected wealth transfers that occurred between creditors and debtors because of the unexpected deflation.  A second, related, reason is that it would help restore financial intermediation by improving balance sheets.  A third reason is that it would mean nominal spending is recovering as well.  Now contrast that with Chairman Bernanke who panders to the common view that any surge in inflation should be avoided; there is no room for nuance on this issue. 

Now maybe Chairman Bernanke believes that everything the Fed has done to date has returned the price level to its pre-crisis trend.  If so, then Chairman Bernanke can justifiably claim he is being consistent with his former self.  Some would challenge such a belief.  I would reply that even if the price level has been successfully reflated, at the end of the day it is only indicator of what really matters, nominal GDP (i.e. total current dollar spending) and its return to an appropriate trend level.  

I Hate to Keep Making This Point, But It Needs to Be Said

The anemic economic recovery can be tied to the ongoing elevated demand for safe and liquid assets.  Paul Krugman and Brad DeLong refer to this phenomenon as a liquidity trap; I like to call it an excess money demand problem.  Either way the key problem is that there are households, firms, and financial institutions who are sitting on an unusually large share of money and money-like assets and continue to add to them.  This elevated demand for such assets keeps aggregate demand low and, in turn, keeps the entire term structure of neutral interest rates depressed too.  (Note, that since term structure of neutral interest rates is currently low, it makes no sense to talk about raising interest rates soon.  That would push interest rates above their neutral level and further choke off the recovery.)  

As Scott Sumner notes, the weak aggregate demand also makes structural problems more pronounced.   Many observers, for example, claim that firms are not hiring because of all the regulatory uncertainty--e.g. Obamacare--coming from the federal government.  This may be true, but consider how firms would be acting if their sales were rapidly growing. At some point, the marginal benefit of another employee would exceed the elevated marginal cost of that worker coming from the regulatory uncertainty.  Firms flush with growing revenues and expected higher sales would feel less constrained by the regulatory changes when hiring workers.  To the extent, then, that regulatory changes are causing problems for the labor market, it is highly exacerbated by the low level of aggregate demand. 

Again, the weak aggregate demand can be traced back to the elevated demand for money and money like assets.  Here is one figure that is consistent with that claim.  This figure shows monthly job openings for the U.S. economy along with monthly money velocity, an indicator of the demand for money.  The relationship is surprisingly strong and is consistent with the implications of the figures shown in my previous post. 

Source: Macroadvisers, FRED, BLS

The question then is how to change the dreary economic outlook that is causing households, firms, and financial institutions to hold relatively large shares of money and money-like assets.  The best way to do it would be for the Fed to adopt a level target, such as a nominal GDP level target.  It would go a long ways in appropriately shaping nominal expectations and in bringing aggregate demand back to a more robust level.   Finally, ignore all those naysayers who say it cannot be done in a balance sheet recession or who say there is no magic lever that can revive the economy.  They don't know their history.  It worked for FDR in 1933-1936 and could work now too. 

Update:  Here and here are some posts that explain how a nominal GDP level target could restore aggregate demand to a robust level.

The Employment Report Shouldn't Be a Surprise

The demand for money and money-like assets remains elevated as indicated in the figure below.  This means nominal spending remains depressed.  Until this changes we shouldn't be surprised by employment reports like the one we got today.

Update: Here is the household sector's money and money-like assets as a percent of total household assets plotted against the same civilian-employment population ratio. The money and money-like assets include the following: cash, checking account funds, time and saving account funds, money market funds, and treasury securities.

How Should the Fed Prepare for the Eurozone Fallout?

Nick Rowe is concerned that the collapse of the Eurozone could lead to another Lehman-type event for the global financial system.  He is also wondering what central banks should be doing in preparation for such an event.  Nick is not the only one concerned.  Others have expressed concerned that financial contagion could arise from credit default swaps on Greek bonds or U.S. money market funds that are indirectly linked to the Greek economy through investments in the core Eurozone countries.  Even Fed Chairman Ben Bernanke expressed concern in his last press conference about the indirect exposure the U.S. economy has to Greek crisis:

 Answering a question during Wednesday's press conference about the U.S. financial system's exposure to Greece's problems, Bernanke went to great lengths to explain how U.S. institutions had very little "direct exposure" to Greece but considerable "indirect exposure" via their loans to European banks that have loaned to Greece. He drew attention to U.S. money market funds' "very substantial" holdings of European bank-issued commercial paper, which others have estimated to represent a whopping 40% of their assets
 ...
[M]emories of the chaos that followed the demise of Lehman Brothers in 2008 are strong and tend to color how investors, including U.S. money funds, respond to troubling events, such as the Greek crisis...The fear is that a default by Greece or a disorderly restructuring of the nation's debt could create contagion in the bond markets of other troubled sovereigns, thereby doing damage to the balance sheets of banks that have loaned to those governments. This could then raise fears about counterparty credit risks in short-term lending markets and, in a worst-case scenario, the paralysis of this vital source of bank funding. 

So what can the Fed do? Here is a suggestion: the Fed could say if total current dollar spending begins to plummet because concerns about the financial system are causing investors to rapidly buy up safe money-like assets (time and saving accounts, money market accounts, treasuries, etc.) then the Fed would begin buying up less-safe and less-liquid assets until the investors' demand for money-like assets is satiated such that they return total current dollar spending to its previous level. The Fed would need to stress the "until" part means it would purchase as many trillions of dollars of assets as necessary to restore total current dollar spending. Since this  process would take place over time, the Fed would also want to set a target growth rate for where it wanted the level of total current dollar spending to go.    

If the above sounds reasonable to you, then you should be a fan of nominal GDP level targeting.  It is exactly what the U.S. economy needed in early 2008 when inflation expectations and velocity started falling.  And it is exactly what the  U.S. economy needs now.  

One Interest Rate Hike Closer to Eurogeddon

The ECB today followed through on it plans to tighten monetary policy, the second time it has done so since April.  As I have noted before, tightening monetary policy is the worst thing the ECB could be doing right now if it truly cares about preserving the Eurozone in its current form.  If the ECB does care it should be easing monetary policy to help bring about a real appreciation in the core countries and real depreciation in the periphery.  Even if the ECB is indifferent there is still no justification for tightening monetary policy based on its objectives.  For, as Rebecca Wilder notes, inflation expectations are down and the growth in the ECB's targeted monetary supply is tapering off.  So this tightening cycle is truly bewildering.  Maybe the tightening cycle is to provide cover to the ECB buying up debt from the periphery or maybe the ECB is trying to hasten what seems to many the inevitable downsizing of the Eurozone. Either way, the band Europe has the right diagnosis of what all this really means.

How Long Until Employment Recovers?

Colin Barr awhile back had an article where he discussed the discouraging outlook for the U.S. labor market.  It got me wondering how long it would take employment to return to the level where the number of jobs created each month had kept up all along with the population growth rate.  Conventional wisdom says that the U.S. economy needs to create 125,000 jobs per month to keep up with population growth.   Growing jobs at this rate each month since the start of the recession and assuming the economy starts generating 200K, 300K, and 400K jobs per month produced the following chart: (Click to enlarge)

Sigh.  And to think most of this could have been avoided with more aggressive but systematic monetary policy.  

Market Share of Mortgage Debt Outstanding

Mark Thoma is frustrated to see some commentators once again push the view that Fannie and Freddie caused the economic crisis. When this issue arose back in late 2008, Richard Green's figure on the share of mortgage debt outstanding held by type of institution settled the debate for me.  That figure showed the GSE's share declined during the housing boom while the asset-back security issuers' share increased.  Here is an updated and slightly modified version of that figure: (Click on figure to enlarge.)

Source

The data is unambiguous here: Fannie and Freddie were not the immediate cause of the housing boom.   They may be guilty of a number of things, but directly causing the housing boom is not one of them.