Sunday, June 28, 2015

Was Grexit Invevitable?

So it appears the Eurozone crisis has finally crossed the rubicon. Greece is going to default on Monday and this likely will put in motion its departure from the currency union. The Eurozone as we know it may soon cease to exist.

Was this breakup inevitable? Many observers would say yes. The Eurozone, after all, is not an optimal currency area and therefore likely to create problems. Martin Feldstein, for example, in 1997 wrote this in Foreign Affairs:
Monnet was mistaken... If EMU does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe...What are the reasons for such conflicts? In the beginning there would be important disagreements among the EMU member countries about the goals and methods of monetary policy. These would be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries. These economic disagreements could contribute to a more general distrust among the European nations.
This does seem prescient now as the tension between core and periphery countries in general and the Troika and Greece in particular have shown the inherent tension in the currency union. So maybe this path was preordained. Maybe 'Grexit' was inevitable. 

Or maybe not. Maybe the Eurozone crisis happened when it did because of colossal policy errors rather than being a necessary outcome of a flawed currency union. I make this argument in a new working paper and contend the policy errors were the ECB's two tightening cycles in 2008 and 2010-2011. These tightening cycles were a huge mistake and arguably what set in motion the Eurozone crisis. They helped precipitate the sovereign debt crisis and gave teeth to the austerity imposed on the periphery.

In early 2008 the Eurozone began contracting, as seen in the first panel of the figure below. The growth of total money spending, a broad indicator of monetary conditions, had started declining even earlier. With monetary conditions beginning to tighten and the economy slowing down most central banks would have cut interest rates. The ECB, however, did nothing and kept its target interest rate pegged at 4 percent. Moreover, as seen in the second panel below, the ECB was signalling a rate increase which further intensified the slowdown. Thus began the first tightening cycle of the ECB in early 2008. Finally, in July 2008 the ECB raised its target interest rate to 4.25 percent and kept it there for three months. This tightening cycle was arguably that shock the triggered the Eurozone crisis. 


The second monetary policy tightening cycle began in late 2010 when the ECB began signaling again that it would be raising its policy rate to stem the burgeoning inflation. This too can be seen in second panel of the figure above. This expectation began stemming total money spending growth in early  2011. The ECB followed through on these expectations by raising its policy rate from 1 percent to 1.25 percent in April and then to 1.50 percent in July where it stayed for four months. This second  tightening cycle occurred even though Eurozone was still recovering from the first recession and is  arguably the shock the intensified the crisis in 2011.

As I show in the paper, these tightening cycles preceded the financial panic of late 2008 and sovereign debt problems and appear to have given teeth the austerity programs. How different would the Eurozone look today had the ECB had instead cut rates in 2008 and started its QE program back then? I think the Eurozone would be a lot different. And no, Grexit would not be an inevitable outcome. There would still be problems for the currency union, but they would problems that could be sorted out in an economy not beset by a depression.

The ECB, in other words, bears a lot of the responsibility for the impending breakup of the Eurozone. Keep that in mind this week as the Grexit comes to fruition.

Update: Some observers question whether ECB monetary policy was really too tight during the crisis. The answer is yes. For evidence, see my paper or this earlier post that shows a tight relationship between Taylor Rule gaps--a measure of the stance of monetary policy--and economic growth in the Eurozone. Some are also reminding me that it was Jean Claude Trichet's ECB that made the mess, not Mario Draghi's ECB. Fair enough.

Other folks are pushing back against the monetary origin view altogether saying this crisis is really a balance of payment crisis or a creditor-debtor crisis. As a proximate cause, yes, but as an ultimate cause, no. Too see this, recall that the deflation experienced in the periphery has meant creditor countries like Germany are getting real wealth transfers from the periphery. The ECB could have prevented this outcome had it prevented deflation and the lower-than-expected inflation that followed. Also consider what would have happened had the ECB adopted a price level  target. It would have required a temporary period of higher-than-normal 'catch-up' inflation that would have further moderated the imbalance between creditor-debtor countries in the Eurozone.

Country-specific developments with the higher inflation growth would have further reinforced this rebalancing. Prices would first grow faster in the regions with the least excess capacity, the core countries. During this time, goods and services from the periphery countries would then become relatively cheaper. Consequently, even though the exchange rate among the regions would not change, there would be a relative change in their price levels making the periphery countries more competitive. 

The Trichet ECB could have done a lot more to prevent the creditor-debtor problems from reaching this tipping point. Instead they behaved like Sadomonetarists, as noted Paul Krugman. There is more on the creditor-debtor point in the paper.

Thursday, June 25, 2015

The Long Unwind of Excess Money Demand

Two years ago I was part of a panel discussion on Fed policy at the American Enterprise Institute. I talked about why money still matters as way to make the case that the economy was still being plagued by excess money demand. This problem occurs when desired money holdings exceed actual money holdings. This imbalance causes a rebalancing of portfolios toward safe assets away from riskier ones and in the process causes a decline in aggregate demand. This is one way to view the long slump.

My argument back then was that even though the excess money demand problem peaked in 2009 it still was being unwound in 2013 and therefore still a drag on the economy. Among other things, I showed as evidence a chart portraying the sharp rise in the share of household assets that were liquid and noted it was still elevated in 2013. You can see it in the video or slides from the panel, but I thought I would update the chart in this post to see how much progress we made on the excess money demand problem.

The figure  below shows the liquid share of household assets and plots it against the U6 unemployment rate. In both the 2001 and 2007-2007 recessions this measure leads unemployment. It appears there may still be some residual excess money demand, but a lot of progress has been made. The most striking observation for me, though, is how long it has taken for household portfolios to return to more normal levels of liquidity. It has taken six years and appears not completely done yet! Remember this the next time someone tells you that the aggregate demand shocks were all were worked out years ago.

This next figure plots the household liquid share against small businesses concerns about sales. The latter measure comes from the following question in the NFIB's Small Business Economic Trends: "What is the single most important problem facing your firm?"  There are nine answers firms can chose, but below I plot just the one about concerns over lack of demand. Here too you see a good fit, a non-surprising result.


The fact that a large portion of the liquid share of household assets has declined over the past six years shows that its elevated rise was not a structural development but a cyclical one. It also suggests that more could have been done to hasten its return to normal levels. That is, more could have been done to satiate the excess demand for money. It should not take this long for a business cycle to unwind.

P.S. This is not to say there were no structural problems over the past six years. There were plenty. But what the above analysis speaks to is that many observers grossly underestimated the size and duration of the aggregate demand shock.

Update: I count cash, checking, saving, time, money market mutual funds, treasuries, and agencies as the liquid portion of household assets. Here is the link to the data in FRED.

Tuesday, June 23, 2015

The Penske View of Macroeconomic Policy


You can learn a lot about macroeconomic policy by driving a Penske truck. I did three years ago when I moved from Texas to Tennessee. The trip began with me driving a 26-foot Penske truck and my wife following in our car. I quickly discovered that Penske had placed a governor on the engine that limited the truck's speed to around 65 miles per hour. This was well below its true potential and made for an incredibly frustrating trip. Hills proved to be especially challenging since I could never generate enough momentum to avoid slowing down as I began ascending them. After the hills it was impossible to make up for lost time because I was prevented from accelerating the truck into catchup speed. There were also the other drivers on the road who got annoyed with my relatively slow speed. One on of those annoyed drivers turned out to be my wife. She decided she could handle the truck better than me so we switched vehicles. She may have done a better job handling the hills and traffic, but only on the margin. Overall, she too faced the same constraint I did: a upper bound on the truck's speed. Reaching our final destination took far longer than we had planned.

There are a lot of similarities between this experience and the use of macroeconomic policy over the past seven years. The U.S. economy, like the truck, has been operating well below its potential. This has meant reaching the final destination of  full employment has taken far longer than anyone expected.

As with the truck, the output gap emerged once the U.S. economy hit a hill called the Great Recession. Unlike the truck, though, this hill was so tough it not only slowed the economy down but caused it to stall and start rolling back down the hill. Fortunately, the brakes were applied, the economy got started again, and the ascent up the hill was made. Since then, the big problem has been the failure of macroeconomic policy to create enough catch-up speed to make up for lost time. More precisely, macroeconomic policy failed to generate enough growth in total dollar spending to close the output gap. 

Macroeconomic policy should have a significant, if not perfect, influence on the growth of total dollar spending through the use of monetary and fiscal policy. The absence of temporarily faster-than-normal catch-up growth in aggregate demand indicates that like the Penske truck there has been a governor placed on macroeconomic policy.

So what is this governor? It is the Fed's 2 percent inflation target. It prevents monetary policy and fiscal policy from generating temporary periods of rapid catch-up growth in aggregate demand because doing so will raise inflation above its target.

For example, imagine that in the third quarter of 2009 the Fed had been able to raise and keep the annualized growth rate of total dollar spending at 7.5 percent until it reached its previous trend (which is near the CBO's full employment level for NGDP). That would be fairly rapid catch-up growth since total nominal expenditures grew on average around 5 percent during the Great Moderation period. Based on historical relationships, this temporary surge in aggregate demand growth would also translate into a temporary surge in inflation.1 As seen below, this inflation surge would last just over two years.


The temporary inflation surge can never occur with a 2 percent inflation target. Yet, as demonstrated by Israel, it was probably needed after the crisis. In terms of the truck analogy, the deceleration of speed on the hill needed to be offset by temporarily faster speed after the hill to maintain  a stable growth path for total dollar spending.

The Penske truck experience also sheds light on two questions that still vex many observers. The first question is why did the Fed's QE programs fail to spur a robust recovery? George Selgin, for example, recently raised this question. The answer is not that these programs are inherently unable to do so. Rather, they were subject to the inflation target governor. Just like I was limited to 65  miles per hour in the truck, the 2 percent inflation target put a limit on how much aggregate demand growth can be generated by the QE programs. Put differently, the 2 percent inflation target meant that the monetary injections created by the QE programs were expected to be temporary. What was needed to spur rapid total dollar spending growth, though, was an expectation that some portion of those monetary injections would be permanent.

To be clear, the inflation target was an upper bound on how much total dollar spending growth could be created by the QE programs. It did not prevent the Fed from using QE programs to prevent a slow down. In fact, it appears 2 percent is actually an upper bound on an inflation target range of 1-2 percent. If so, the QE programs put a floor under the economy even though they were muzzled from spurring rapid aggregate demand growth.

The second question is whether more aggressive fiscal policy could have made a meaningful difference since the crisis. This question is akin to asking whether my wife made a difference when she tried driving the truck. She may have made a difference on the margin, but was ultimately still bound by the governor. Fiscal policy, like monetary policy, is also bound by a governor. It can only create aggregate demand growth up to the point it pushes inflation to the Fed's 2% target. The Fed's preferred inflation measure, the PCE deflator, averaged 1.4% since 2009. That means fiscal policy would have had 60 basis points on average with which to work over the past seven years in closing the output gap. That is not much and nowhere near the two-year run of over 2 percent inflation required to create the catch-up growth in aggregate demand seen in the figure above.2

What policymakers needed after 2009 was a new governor that would have allowed temporary catch-up growth in aggregate demand. The easiest way to have done this is to have  introduced a NGDP level target. Doing so would be similar to replacing the governor on the Penske truck with cruise control. The growth path of total dollar spending would be set and any deviations around that path would be corrected as needed with slowdown or catch up growth in aggregate demand. No matter what your view of the optimal monetary-fiscal policy mix may be, it will be challenging to implement without a NGDP level target. Moving forward,then, this reform is sorely needed. 

I never again want to drive cross country in a truck that has the governor turned on. Similarly, we should never again want to encounter a sharp recession without a NGDP level target.3

1The historical relationship is estimated by regressing the current and two lagged values of nominal GDP growth on the GDP deflator growth.  
2  If you, like Paul Krugman, believe that the Fed actually targets a1-2 percent inflation range then fiscal policy is even more limited since the 60 basis points are gone. 
3There are other reasons to favor a NGDP level target including minimizing the change of hitting a sharp recession in the first place.