Friday, June 6, 2014

Tinkering on the Margins: ECB Edition

Has the ECB finally ended its hard-money ways? You know the kind that raises interest rates twice during the crisis, allows aggregate demand in the periphery to stall, and fosters below-trend growth in money supply and money velocity. On Thursday, the ECB said it would be taking bold steps to stabilize the economy. It would start charging banks for the privilege of depositing their funds at the ECB, commence a new long-term lending program of €400 billion, quit sterilizing its bond purchases, and begin preparing for a QE program. That is quite a list, right? Many commentators are making much ado about the first item since it means a major central bank will begin targeting a negative nominal interest rate. Finally, a central bank who does not fear the zero lower bound!

So does this mean the ECB has finally gone all-Abenomics on us and unleashed both barrels of the gun? Sadly, the answer is no. Its new actions will not fundamentally alter the path of aggregate demand in the Eurozone for one key reason: there has been no regime change. The ECB did not change its inflation target. Should the ECB's new programs threaten to push inflation a tad too high expect it to tighten policy like it did in 2011. This point was made very clear by Mario Draghi in the ECB press conference :
“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring."(HT Lars Christensen)
In other words, these policies at best raise inflation from its current low level to somewhere between 1% and 2%. That is not enough to close the aggregate demand shortfall. This is an important point. It means that even if there were further fiscal integration in the Eurozone and more active fiscal policy, such as helicopter drops, it would have little effect on the economy. The ECB would quickly offset any program that began to meaningfully raise inflation. It would cut short any robust recovery.

There has to be, however, a period of catch-up aggregate demand growth and by implication, temporarily higher inflation for a recovery to take hold in the Eurozone. This requires a commitment by the ECB to a permanent, non-sterilized monetary injection, the kind done by Japan under Abenomics and by Israel under Stanley Fisher. (No, the kind done under Ben Bernanke is not expected to be permanent and is a key reason for the sluggish recovery.)

The Germans should understand that were the ECB to allow a temporary period of catch-up inflation it does not mean long-run inflation expectations have to become unmoored. It does mean, though, the ECB would need to do something like a price-level or NGDP-level targeting. Level targeting is the kind of regime change that would fundamentally change the path of Eurozone aggregate demand since it allows for catch-up growth. It seemed to have worked for Israel during the crisis and should do wonders if tried in Europe.

In terms of the specific proposals, it is interesting to see the ECB try negative interest rates. In theory, it makes sense: move market interest rates closer to the negative natural interest rate and markets will begin clearing. And contrary to many observers claims, the mechanism for this process is not just about forcing banks to lend. It is more about incentivizing depositors on the margin to spend their money balance instead of holding them in the bank. The idea is that the banks will pass the ECB's charge on to their customers and spur a recovery in nominal spending.  

That is a compelling theory except for this problem:

Currency holdings have grown dramatically in the Eurozone and would grow even more if individuals started getting charged for their deposits. This is the zero lower bound (ZLB) problem: individuals would rather hold cash and earn 0% than hold bank accounts and earn a negative interest rate. So for all the buzz about the ECB targeting a nominal interest rate, it still has failed to solve the ZLB problem. There are ways to solve this problem without getting rid of currency. But so far the ECB has not been willing to try them.

In short, the ECB's new programs amount to nothing more than tinkering on the margins. Unfortunately, this means more sluggish aggregate demand growth and more human suffering.

P.S. Below is a figure showing currency as a percent of M3 less currency. It reveals a sharp drop in the currency holdings during the transition to the Euro that later returns to trend. Once the Euro crisis starts the ratio starts rising. Expect it to rise more.


  1. Good blogging. The ECB will keep looking through the inflation microscopes. Europe will stagnate.

  2. If inflation is at 2% then AD is growing much faster than AS. Even if inflation grows at a higher rate there is no assurance that GDP will improve. This hope is based solely on the (very iffy) Phillips curve. Friedman taught us (late '60s!) that all it takes is inflation expectations to change to mess up the inflation - unemployment tradeoff. Hope we don't get caught expecting your inflation increase...

    1. Anonymous:

      This categorical claim is wrong: "If inflation is at 2% then AD is growing much faster than AS" See this figure: There are many periods where inflation was 2% and less than real GDP growth. The exact relationship between inflation and real GDP depends on a number of factors.

      Milton Friedman also taught us the Fed failed during the Great Depression and also that the Bank of Japan should be doing more. His Bank of Japan comments were in the late 1990s, early 2000s! Since then he passed away, but now the Bank of Japan is doing more under Abenomics and is doing fairly close to what Friedman prescribed. And guess what? Japan is having a solid recovery. More so than the US and much more than the Eurozone. So if you are going to invoke Friedman, please consider all he had to say.

      Here is a post that references his 2000 speech:

      Here is a WSJ article from 1999:

  3. Sorry, you're misinterpreting. I said nothing about which was rising faster than the other. What is being said is that there is more than enough money/velocity in the economy to accommodate all of the extra growth as provided by AS, plus more provided by AD, which then drives up the price level. That's inflation.
    Japan has had deflation for about 10 out of the past 20 years and only had more than 1% inflation once or twice in that time. Likewise, during the Great Depression the price level fell very heavily as well. We haven't had anything like that in the US or Europe in the past 20 years including during this Great Recession. Every year has been positive inflation. I think the Depression and Japan's funk are improper comparisons to what's been happening in the US and Europe.
    I just don't think it's an aggregate demand failure if price levels are always rising. And I'm not sure a 'good dose' of inflation will make it better. The main way that process works is through falling real wages (at least at first). And it doesn't even work at all if the Phillips curve you're counting on shifts in expectation.
    It appears to me that much of this very stubborn downturn is supply-side oriented.
    I'll take a look at your two links, but that's what I'm thinking before I check.

    1. Anonymous, you do not need outright deflation--though it happened in 2009--for there to be AD problems. All that is needed is lower than expected inflation and that happened over the past few years. This point can be generalized to lower than expected nominal income growth. Think of all the long-term debt contracts that were signed with the implicit belief that nominal income would continue to grow near trend growth. It has fallen well short and is a big reason for the rising burden of nominal debt.

      This is not about exploiting a Phillips curve. It is about resolving an excess money demand problem. The money supply--properly defined to include both retail and institutional money assets--is well below trend and below optimal fitted values given potential GDP and trend velocity. Household portfolios share of liquid assets is down but still highly elevated relative to the pre-crisis trends. These are nominal problems that persist to today.

      Another way of saying this is that the market clearing equilibrium or 'natural' interestrate fell to negative territory and policy rates have not been able to reach it because of the ZLB. Essentially, market rates have been above the natural interest rate for several years and this is keeping the economy depressed.

      Worrying about unmooring inflation expectations when there is an excess money demand problem/ZLB problem is fighting the last war. That is why Friedman's comments about the Philips curve were so context specific. He never worried about in the Great Depression or Japan.

      As you note Japan had a depressed economy with many years of low inflation and the US had inflation between mid-1933 and 1937 and was still in a slump. So yes, you can have large output gaps with inflation. All this goes to show that an economy can have a AD shortfall without deflation. What happened in the US is very similar to Japan except that Fed has been better (sort of) than the Bank of Japan did back then.

      It is worth noting that now the Bank of Japan is dong better than the Fed with Abenomics. Growth is picking up faster there with the very policies advocated above. The Fed's performance, though better than the Bank of Japan in the past, still falls well short. See here:

      This is not to say there are no structural problems. I see many, but I also see a large AD problem that is only slowing working itself out.

  4. "The money supply--properly defined to include both retail and institutional money assets"

    Besides the obvious error in Anderson’s & Barnett’s definition, money flows exhibit a much higher correlation coefficient. And sweep accounts still clear thru demand deposits. Whomever wrote the G.6's obituary didn’t understand it. Even using a surrogate (legal reserves) provides a much more accurate measure.

  5. Only in the frictionless world created by the mathematical model builders are the asked prices in equilibrium with consumer spendable income. In the real world, there is always a purchasing power deficiency gap of varying proportions. This is just another way of saying that to have high levels of production and employment, we need not only a vastly more competitive price structure, we also need a steady but slightly inflationary monetary policy (prices increase c. 2-3 percent annually), and a tax policy that contains some elements of compulsory income redistribution - downward.

    I.e., it's simple, unless money expands at least at the rate prices are being pushed up, output can't be sold and jobs will be cut..

  6. David, isn't it a good thing if people increase their cash holdings due to negative deposit rates? Seems like it's the exact same concept as a helicopter drop. The only difference is we're helicopter dropping out of demand deposits. People pull out cash, and cash is risky to hold in large quantities, so people will either A) buy stuff or B) buy assets and drive up asset prices.

    Seems like it can only be a good thing compared to keeping the money as excess reserves, yes?

    1. Anonymous, negative rates is a step in the right direction. But even if it causes households to pull out cash--and I am not sure negative 0.10 is enough to do it---why would they start spending the cash instead of holding it? The outlook hasn't improved and most likely they will hold the cash as precautionary money balances. Based on what we know about the ECB, it is not going to allow household spending to take off at a pace needed for recovery. Doing so would push inflation too high and the ECB would tighten. This understanding is why negative rates by themselves will not spark a recovery in my view.

    2. Yeah, I did understand the major point of your post, which is that the specific technical methods are irrelevant. So long as the ECB is inflation-phobic, then the moment things improve they will backtrack. I was just curious about the potential power of negative interest rates, in theory, assuming an expansionary regime. (I've heard a lot of people speak dismissively about them)

      thanks for answering, David