Will the Euro Survive?

I was a little puzzled last week after reading Wolgang Munchau's column in the FT. He noted that some of the European countries outside the Eurozone--specifically Denmark, Hungary, Iceland--are now wishing they were members and probably will become so in the near future. Based on these developments he argued the global financial crisis should actually lead to an enlargement of the Eurozone. While his argument makes sense in the case of the few countries mentioned above, what about the broader Eurozone? Does not the global financial crisis add more stress to the viability of the Eurozone? In a reply to Munchau, Desmond Lachman says yes:

Sir, Wolfgang Münchau seems to be very wide of the mark in asserting that the present global financial crisis will lead to the early expansion of the eurozone... For, as the marked widening in interest rate spreads on Italian and Spanish government bonds would suggest, the more pressing question raised by the crisis is not so much whether the eurozone will expand but rather whether or not the euro can survive in its present form.

In 1998, when the euro was launched, Milton Friedman famously warned that the euro would be truly tested by the first major global economic recession. He issued this warning in the belief that, lacking labour and product market flexibility, Europe was not an optimum currency area in the sense that was the case of the U.S. economy.

Judging by October's alarming plunge in global equity prices and the virtual freezing up in global credit markets, there can be little doubt that Europe, along with the United States, is at the start of its worst economic recession in the postwar period. And judging by the bursting of Spain's outsized housing market bubble and by the precarious state of Italy's public finances, there can be little doubt that Spain and Italy will be the two major European economies that will be put to the severest of tests as the global recession deepens.

For in order to cope with their respective problems, Spain and Italy will need low interest rates and weak currencies that continued euro membership clearly precludes.

In short, Lachman is questioning whether the Eurozone in its current form is an optimal currency area and, thus, whether it can truly survive. Apparently, so are some investors thinking this way. Over at intrade.come there is a contract on whether "any country using the Euro to announce their intention to drop it on/before December 2010." Here is the latest figure--where price equals probability-- from the contract (click figure to enlarge):


Currently the probablity of say Spain or Italy leaving the Euro is between 30-35%. Although not very high, it is a sizable increase from when the contract was introduced in early 2008. So what is the future of Euro?

Update: Here is a related post from Naked Capitalism. Here are some papers from a conference on the future of the Euro hosted by The Economist magazine and CATO.

The Future of the Eurozone

So we are live at NRO discussing the future of the Eurozone:

Albert Einstein is rumored to have quipped that doing the same thing over and over again and expecting different results is the definition of insanity. If he were alive today, Einstein might say this is the definition of some key euro-zone policymakers.

There I argue hard choices have to made in the Eurozone: further integrate or separate.

So where does this leave the euro zone? For now, euro-zone officials are still kicking the can down the road, but at some point they will face a fork. One path will force further integration upon the euro zone, along the lines of Emmanuel Macron’s proposal and better ECB monetary policy. The other path will lead to the separation of the euro zone. As Ashoka Mody shows in his new book, the 20-year history of the euro zone suggests the latter path is more likely. Breaking up the euro zone, though, need not end the EU. As suggested by Ambrose Evans-Pritchard and Ramesh Ponnuru, the periphery could keep using the euro while the core could exit and adopt their own currency: Call it the Deutschmark 2.0. This approach would minimize the financial stress from the breakup of the currency union.

One chart that did not make it into the final article is below showing the OCA theory. It shows that if a region’s business cycle is similar to the currency union or if there are sufficient shock absorbers in place, or some combination of the two exists, then it makes sense for the region to be in the currency union. If a regional economy does not meet these criteria, like Italy, then it would be inside the OCA frontier curve in the figure and should not join the currency union. 

My conclusion in the article effectively says that Eurozone officials are not willing or able to make the changes needed to push countries like Italy beyond the OCA frontier. Ashoka Mody makes a convincing case in his book that, if anything, the Eurozone is pushing countries like Italy farther inside, away from the OCA frontier. Better to address the inherent tensions of the Eurozone now than to keep kicking the can down the road. 

Is It Time for the Eurozone to Get Rid of Germany?

Back in April 2010 when it first seemed the Eurozone was about to crack up, I did a post on the lessons of the Eurozone crisis.  I argued then that the main lessons were, one, countries joining a currency union should take seriously the optimal area criteria and the real exchange rate and, two, central banks should take seriously the task of stabilizing the growth of nominal spending.  I still think these points are valid,  but I now see a more important lesson from this ongoing crisis: avoid relationships where one party to the relationship is domineering and has a history of abuse.  In short, avoid bad relationships.

In the case of the Eurozone relationship the dominant party is Germany.  Its desires have largely shaped the direction of the Eurozone and continue to do so today, even though it only has historically made up at most about 30% of the Eurozone economy.  This uneven relationship has been very apparent lately as the future of the Eurozone seems to hang on the day-to-day developments in Germany.  For example, the fate of the currency union inched closer to collapse a few weeks ago when German's constitutional court ruled against a supranational fiscal authority and when a German vote of no confidence was effectively issued for the ECB by the resignation of the German representative Jurgen Stark from the ECB's board.  Then, last week the mood improved when German Chancellor Angela Merkel said the Eurozone must stick together.  Now new polls show Merkel loosing influence and the Eurozone's breakup looks more likely.  That these German developments can so easily drive the ups and downs of the Eurozone outlook speaks to dominance of Germany in the Eurozone relationship.

Another way to see the inordinate influence of Germany is to look at the inflation-hawk culture of the ECB inherited from the Germans and its influence on the evolution of ECB monetary policy.  Many studies, such as this 2010 report from Barclays Capital or this one from the WSJ, have shown using Taylor Rule estimates that while ECB monetary policy has been stabilizing for Germany over the past decade it has been destabilizing for the periphery.  In particular, monetary policy was too loose for the periphery when the Eurozone was first formed and more recently have become too tight for them.

This tendency to change ECB monetary in a manner that best serves Germany can be vividly seen by looking at the history of nominal spending for Germany and for the rest of the Eurozone.  The first figure below shows the case of Germany along with a trend.  It shows that not only has Germany's nominal spending returned to trend, but that it is has slightly exceeded it in recent quarters.  This explains why the ECB raised interest rates earlier this year and has failed to cut them despite the severity of the crisis.  The German economy needed some tightening and the ECB delivered it.

The next figure shows nominal spending for the rest of the Eurozone.  The difference between the two figures is shocking.  Not only is nominal spending below trend, but the difference continues to increase.  The ECB is failing miserably here to stabilize nominal spending for the other 70% of the currency union.  This should remove any doubt about the inordinate influence of Germany on the Eurozone.

Finally, it is worth nothing that the Eurozone crisis is not the first time Germany's internal policy goals were promoted at the expense of partner countries.  The European Monetary System (EMS), which tied other European currencies to the German Deutsche Mark, erupted into a crisis in 1992 when the German central bank adopted a tighter monetary policy that was appropriate for Germany but too tight for the other countries in the exchange rate system.  Thus, there is an tendency for Germany to use its inordinate influence over European monetary affairs in a manner not conducive to the overall monetary system.  This suggests to me that maybe the best solution to the Eurozone crisis is not to fix the currency union but for Germany and like-minded countries to leave it.  Ambrose Evans-Pritchard, Ramesh Ponnuru, and others have  made the case for something like a two-tiered EMU where Germany and other austerity-embracing countries adopt a harder currency while letting France lead the Euro block.  Here is Evans-Pritchard's idea:

My solution - like that of Hans-Olaf Henkel, the ex-head of Germany's industry federation (BDI) - is to split EMU into two blocs, with France leading a Latin Union that keeps the euro. This bloc would devalue but not by 60pc, yet uphold its euro debts intact. The risk of default and banking crises would decrease, not increase.

The German bloc could launch their Thaler, recapitalizing banks to cover losses from rump euro debt. Disruptions could be contained by capital controls at first. None of this is beyond the wit of man. My bet is that aggregate losses would be lower than the status quo, and the long term outcome much healthier. The EU might even carry on, unruffled. 

I haven't always held this view, but am becoming increasingly sympathetic to it.  Sometimes it is for the best of all that a bad, abusive relationship gets terminated.  Maybe it is time for Germany to leave the Eurozone.

The Future of the Euro (Part VI)

As readers of this blog know, I have been following the debate on whether the Euro can survive the current economic crisis. Most recently, I noted that this crisis may actually lay the foundation for a real fiscal transfer mechanism in the Euro area, something that is sorely needed to make this currency union a true optimum currency area. Such a development, of course, presumes the current economic crisis makes the Euro-area institutions stronger rather than tearing the region apart. The latest news coming out of out Europe suggest the big fear now is that the financial meltdown in Eastern Europe is making the latter scenario more likely. The Europeans are concerned enough about this development that they have called for an emergency summit. Even the typically Euro-sanguine Wolgang Munchau of the FT is concerned that the "Eastern crisis...could wreck the Eurozone." Back here in the United States the mood is equally gloomy according to this article in Bloomberg:

Feb. 27 (Bloomberg) -- Hayman Advisors LP, the firm that earned $500 million betting on the U.S. subprime mortgage-market collapse, says Europe’s monetary union is about to fall apart.

Richard Howard, a managing director for global markets at Dallas-based Hayman, said Germany may opt to shore up its own economy, Europe’s biggest, rather than bail out fellow euro nations such as Austria, Italy and Spain as their banks sag under the weight of bad debts. That might lead to defaults and compel Germany to renounce the euro, he said.

“People said subprime could never blow up but it did and now they’re saying the exact same thing about the eurozone,” said Howard. “There’s no stopping what is now a downward spiral.” He declined to discuss his investments.

Hayman joins a growing number of investors seeing the possibility of a breakup of the $12 trillion euro bloc, conceived more than 10 years ago to cut unemployment, tame inflation and create a rival to the dollar. Societe Generale SA said this week Germany may refuse a bailout in an election year. ABN Amro Holding NV said Feb. 17 the crisis is “Europe’s subprime.”

[...]

The breakup may occur as investors shun all but the safest government bonds, said Hayman, which in 2006 was among the first to bet against Wall Street’s rush to securitize the debt of the least creditworthy U.S. borrowers, correctly predicting a slump in home values that sparked the global credit crisis.

Investor demand for the lowest-risk securities already drove the difference in yield, or spread, between Greek, Austrian and Spanish 10-year bonds and German bunds, Europe’s benchmark government securities, to the widest since the euro’s debut.

So a "growing number of investors" are seeing a greater likelihood of the Eurozone breaking up. If so, you would think these investors would be adjusting their portfolios accordingly. There is an intrade contract that indicates the probability of a nation dropping its use of the Euro by December 31, 2010 has not change much since July 2008 (see figure below). This contract suggests that a "growing number of investors" may be a bit of an overstatement. Or maybe this contract is to thinly traded to truly reflect the increased fear about the Eurozone. Any thoughts?

Another Look at the Lessons of the Eurozone Crisis

Now that the Eurozone crisis is heating up again, I thought it worthwhile to revisit an earlier post of mine that discussed the key lessons I see from the Eurozone crisis:

(1) The optimal currency area (OCA) criteria should be taken seriously ex-ante. Before any country joins a currency union it should make sure it has met some combination of the OCA criteria. These criteria tells us that members of currency union should (1) share similar business cycles or (2) have in place some combination of economic shock absorbers including flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. In the former case, similar business cycles among the regions mean that a common monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. In the latter case, dissimilar business cycles among the regions make a common monetary policy destabilizing—it will be either too stimulative or too tight—for regions unless they have in place some of the economic shock absorbers. In short, if a region's economy is not in sync with the currency union's business cycle and the above listed shock absorbers are absent then it does not makes sense for a country to be a part of the currency union. Instead, the country should keep its own currency which itself will act as a shock absorber. This understanding can be graphically represented as follows (click to enlarge):

As shown in this recent post of mine and by others, several of the Eurozone countries fell inside the OCA boundary, Greece being one of them. This is not a surprise to most folks including the Euro optimists, but many hoped that these criteria would be met ex-post as the economies integrated. This leads to the second lesson.

(2) Don't hang your hope on becoming a successful currency union by meeting the OCA criteria ex-post. Some observers argued around the time of the Eurozone's inception that looking at the OCA criteria ex-ante was not warranted since the criteria themselves would emerge once a currency union was formed. This "endogenous" view of the OCA gave hope to the Euro optimists and lent support to their cause. Now there is evidence that joining a currency union does stimulate trade as transactions costs are lowered. One study found currency unions more than tripled trade among members. It is apparent now, though, that some of the Eurozone periphery did not integrate enough to justify the cost of being a member in the currency union. It is best not to base the survival of a currency union on hope.

As an aside, it is worth nothing that even if a region does endogenously meet the OCA criteria further problems can arise from being a part of the currency union. The increased trade flows and economic activity within the currency union can over time lead to regional specialization that makes the regions more susceptible to economic shocks. Paul Krugman first made this point in 1998 and the idea has become known as the "Krugman Specialization Hypothesis" (KSH). I think the best example of KSH is the United States. Despite being a currency union for many years, the United States did not become an OCA until the 1930s according to Hugh Rockoff. One reason is because there was so much regional specialization and until the New Deal reforms, many of the economic shock absorbers necessary to offset the lack of regional economic diversification were simply missing. So even if the Eurozone were a functioning OCA there is no guarantee it would stay that way.

(3) Take the real exchange rate seriously. A summary measure of a country's external competitiveness is its real exchange rate. If a country's real exchange rate is appreciating then its goods are becoming more expensive to the rest of the world. And, as a result, it will begin losing foreign earnings and the ability to meet external obligations. In a time of crisis for a country dependent on foreign funding this problem becomes more pronounced. As seen in the next figure, most of the Eurozone periphery has had a real appreciation on average since the inception of the Euro!

Now to understand why the periphery has had the real appreciation, one has to look at the three components of the real exchange rate: domestic prices, foreign prices, and the exchange rate. For Greece the problem was twofold. First, because of wage pressures domestic prices rose, more so than in the core Eurozone countries. Second, given its membership in the Eurozone, Greece had a fixed exchange rate and, thus, no chance for its currency to depreciate. To get out of this bind Greece can either have painful deflation or end its use of the Euro. Given where Greece is now, leaving the Euro may seem like lesser of two evils for Greek leaders. (Just to be clear, a depreciation will not solve Greece structural problems, but it make it easier to address them.) Any country joining a currency union should consider the implications of membership on its real exchange rate.

(4.) The central bank contributes most to macroeconomic stability by stabilizing aggregate demand (i.e. total current euro spending). I have made this point before for the United States, but it applies just as well to the Eurozone. And based on the following figure, the European Central Bank (ECB) has not done a very good stabilizing total current euro spending during this crisis:

As Nick Rowe notes, the sharp decline in the Eurozone's aggregate demand was avoidable had the ECB really tried to stabilize it. Instead, the ECB mistakenly looked to low short-term interest rates as an indicator of loose monetary policy and became convinced it was doing enough. A better indicator of the stance of monetary policy I have discussed before is to look at the growth rate of aggregate demand relative to the policy interest rate. Using this metric, the ECB policy rate should not deviate too far from the aggregate demand growth rate otherwise monetary policy is either too loose (the policy rate is significantly below the total spending growth rate) or too tight (the policy rate is significantly above the total spending growth rate). This next figure shows this measure for the Eurozone:

According to this measure, monetary policy in the Eurozone has been rather tight over the last year. The Eurozone's future would have been more secure had the ECB been more vigilant in stabilizing aggregate demand.

Lessons from the Eurozone Crisis

It is increasingly likely that the Eurozone could become the Humpty Dumpty of currency unions. If so, this is a tragedy foretold by many observers. Martin Feldstein, for example, argued back in the late 1990s that there were too many cultural, institutional, and economic differences in the EU nations for a single currency to work. He even claimed that the currency union could lead to more conflict instead of reducing it as many Euro supporters claimed it would do. His skepticism of the Eurozone was shared by many others, particularly American economists, who saw a one-size-fits all monetary policy as destabilizing to the regional economies in the EU. For all these naysayers, though, there were supporters who argued that political gains will trump any economic costs in the monetary union and that over time many, if not most, of these costs would disappear as the regional EU economies converged. Well so much for the Euro optimists. Many folks are now saying that at a minimum there needs to be a "shock and awe" bailout package as high as $1 trillion to keep Eurozone intact. Yikes.

Given the real possibility of the Eurozone ceasing to exist in its current form, it is worth taking stock of important lessons from this experience. Here are what I see as the four big lessons of the Eurozone crisis:

(1) The optimal currency area (OCA) criteria should be taken seriously ex-ante. Before any country joins a currency union it should make sure it has met some combination of the OCA criteria. These criteria tells us that members of currency union should (1) share similar business cycles or (2) have in place some combination of economic shock absorbers including flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. In the former case, similar business cycles among the regions mean that a common monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. In the latter case, dissimilar business cycles among the regions make a common monetary policy destabilizing—it will be either too stimulative or too tight—for regions unless they have in place some of the economic shock absorbers. In short, if a region's economy is not in sync with the currency union's business cycle and the above listed shock absorbers are absent then it does not makes sense for a country to be a part of the currency union. Instead, the country should keep its own currency which itself will act as a shock absorber. This understanding can be graphically represented as follows (click to enlarge):
As shown in this recent post of mine and by others, several of the Eurozone countries fell inside the OCA boundary, Greece being one of them. This is not a surprise to most folks including the Euro optimists, but many hoped that these criteria would be met ex-post as the economies integrated. This leads to the second lesson.

(2) Don't hang your hope on becoming a successful currency union by meeting the OCA criteria ex-post. Some observers argued around the time of the Eurozone's inception that looking at the OCA criteria ex-ante was not warranted since the criteria themselves would emerge once a currency union was formed. This "endogenous" view of the OCA gave hope to the Euro optimists and lent support to their cause. Now there is evidence that joining a currency union does stimulate trade as transactions costs are lowered. One study found currency unions more than tripled trade among members. It is apparent now, though, that some of the Eurozone periphery did not integrate enough to justify the cost of being a member in the currency union. It is best not to base the survival of a currency union on hope.

As an aside, it is worth nothing that even if a region does endogenously meet the OCA criteria further problems can arise from being a part of the currency union. The increased trade flows and economic activity within the currency union can over time lead to regional specialization that makes the regions more susceptible to economic shocks. Paul Krugman first made this point in 1998 and the idea has become known as the "Krugman Specialization Hypothesis" (KSH). I think the best example of KSH is the United States. Despite being a currency union for many years, the United States did not become an OCA until the 1930s according to Hugh Rockoff. One reason is because there was so much regional specialization and until the New Deal reforms, many of the economic shock absorbers necessary to offset the lack of regional economic diversification were simply missing. So even if the Eurozone were a functioning OCA there is no guarantee it would stay that way.

(3) Take the real exchange rate seriously. A summary measure of a country's external competitiveness is its real exchange rate. If a country's real exchange rate is appreciating then its goods are becoming more expensive to the rest of the world. And, as a result, it will begin losing foreign earnings and the ability to meet external obligations. In a time of crisis for a country dependent on foreign funding this problem becomes more pronounced. As seen in the next figure, most of the Eurozone periphery has had a real appreciation on average since the inception of the Euro!

Now to understand why the periphery has had the real appreciation, one has to look at the three components of the real exchange rate: domestic prices, foreign prices, and the exchange rate. For Greece the problem was twofold. First, because of wage pressures domestic prices rose, more so than in the core Eurozone countries. Second, given its membership in the Eurozone, Greece had a fixed exchange rate and, thus, no chance for its currency to depreciate. To get out of this bind Greece can either have painful deflation or end its use of the Euro. Given where Greece is now, leaving the Euro may seem like lesser of two evils for Greek leaders. (Just to be clear, a depreciation will not solve Greece structural problems, but it make it easier to address them.) Any country joining a currency union should consider the implications of membership on its real exchange rate.

(4.) The central bank contributes most to macroeconomic stability by stabilizing aggregate demand (i.e. total cash spending). I have made this point before for the United States, but it applies just as well to the Eurozone. And based on the following figure, the European Central Bank (ECB) has not done a very good stabilizing total cash spending during this crisis:

As Nick Rowe notes, the sharp decline in the Eurozone's aggregate demand was avoidable had the ECB really tried to stabilize it. Instead, the ECB mistakenly looked to low short-term interest rates as an indicator of loose monetary policy and became convinced it was doing enough. A better indicator of the stance of monetary policy I have discussed before is to look at the growth rate of aggregate demand relative to the policy interest rate. Using this metric, the ECB policy rate should not deviate too far from the aggregate demand growth rate otherwise monetary policy is either too loose (the policy rate is significantly below the total spending growth rate) or too tight (the policy rate is significantly above the total spending growth rate). This next figure shows this measure for the Eurozone:

According to this measure, monetary policy in the Eurozone has been rather tight over the last year. The Eurozone's future would have been more secure had the ECB been more vigilant in stabilizing aggregate demand.

So what lessons do you see from the Eurozone crisis?

The Future of the Euro (Part VIII)

It seems Martin Feldstein cannot avoid speculating about the demise of the Euro. Since the late 1990s he has been making the case that there are just too many institutional and economic differences in the EU nations for a single currency to work. In short, Feldstein believes the Euro area falls way short of being an optimal currency area. The past decade of relative success for the ECB has done nothing to change his view. In fact, earlier this year he discounted this period as a "lucky time" for ECB policymakers:

Mr. Feldstein pointed out that the past decade has been, until recently, a lucky time in Europe. European country economies weren’t buffeted by severe economic problems, or big unemployment problems, allowing the European Central Bank to focus on price stability. But now, economic conditions are deteriorating rapidly, and some countries are being much harder hit than others...“In my judgment, the next few years will be an important testing time for the EMU and Europe,” Mr. Feldstein said - one in which the possibility of one or more countries choosing to withdraw from the EMU cannot be ruled out.

That was written in January 2009 when Europe seem poised to implode. Now that ECB has weathered that storm Feldstein still questions the Euro's survivability:

The economic recovery that the euro zone anticipates in 2010 could bring with it new tensions. Indeed, in the extreme, some countries could find themselves considering whether to leave the single currency altogether.

Although the euro simplifies trade, it creates significant problems for monetary policy. Even before it was born, some economists (such as myself) asked whether a single currency would be desirable for such a heterogeneous group of countries. A single currency means a single monetary policy and a single interest rate, even if economic conditions – particularly cyclical conditions – differ substantially among the member countries of the European Economic and Monetary Union (EMU).

[...]

The European Central Bank is now pursuing a very easy monetary policy. But, as the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Those countries whose economies remain relatively weak oppose tighter monetary policy.

Feldstein acknowledges there would be technical and political hurdles to overcome for a country to abandon the Euro. Barry Eichengreen argues these hurdles are probably large enough to prevent a country from leaving the currency union. Obviously, Feldstein is less confident on this point than Eichengreen. Interestingly, Desmond Lachman, who foresaw many of the emerging market crisis of the 1990s, sees a "ticking time bomb" for Spain, Greece, Portugal, and Ireland from the "straightjacket of the Euro-zone membership." He too does not see the hurldes to a breakup of the Eurozone as unsurpassable. As I noted in a previous post, Argentina in the 2001-2002 period provides a good example of a country for which the technical and political hurdles--including a financial crisis, the largest-ever sovereign default, and political chaos--were not enough to prevent it from leaving the dollar zone. Never say never.

The Eurozne: Deja Vu Argentina 2001 & Other Thoughts

The sovereign debt problems in the Eurozone periphery and the implications of this development for the future of the currency union attracted a lot of attention over the weekend. Here is the New York Times on the problems facing Greece and the Eurozone more generally. Carmen Reinhart, meanwhile, tells us that Greece has been in a state of default about 50% of the time since the 1830s (Why then, was it ever allowed to join the Eurozone?). More importantly, she indicates that if some of the Eurozone's periphery goes under then the problems in Eastern Europe become more severe. Here is CNN quipping that Europe's PIGS (i.e. Portugal, Italy, Greece, and Spain) don't fly. Here is Paul Krugman lamenting the monetary stratightjacket that is the Euro. Finally, here is Simon Johnson pulling a Roubini by forecasting these problems, if not addressed, risk causing another global depression. After reading all these pieces, here are some thoughts:

(1) I couldn't help but think of Argentina's crisis in 2001-2002. It too had a sovereign debt problem, an overvalued real exchange rate, and was effectively part of a currency union that did not meet the optimal currency area criteria. It too tried to cut wages and prices but found the deflationary price too high. Ultimately Argentina defaulted and broke the peso-dollar link, even though the currency board linking the two currencies was almost a decade old and considered an important institution. It seems possible some of the PIGS could go the way of Argentina.

(2) On the other hand, Tyler Cowen reminds us that there would be a great cost for Greece's banking system if the nation chose to leave the Eurozone. Barry Eichengreen lists other costly barriers any Euro nation would face in such a move. Maybe this is why the intrade.com contract on any country leaving the Eurozone in 2010 is hovering around 15% (down from a high of 40% in late 2008). Still, Argentina faced similar costs and it abandoned the dollar peg. Never say never.

(3) This New York Times article makes the case the ECB president, Jean-Claude Trichet, has more power because of this crisis. Since there is no EU Treasury to help Greece, the only institution capable of bailing out the PIGS is the ECB. According to the NYT, this makes Trichet the de facto president of Eurozone. Given all the animosity the Federal Reserve has generated for itself in the financial crisis from the new public awareness of its power, I wonder if something similar could happen to the ECB if it chooses to use its power for the PIGS. The U.S. public has always had some aversion to centralized monetary power (e.g. Andrew Jackson's Second Bank War, the hatred of Paul Volker in the early 1980s). Europe may be more open to such uses of monetary power given their longer history with central banking.

(4) Ultimately, this crisis speaks to the importance of a monetary union meeting the optimal currency area to be viable. I have made this point before, but will leave it with Paul Krugman to make the case here:

Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

If Spain had its own currency, this would be a good time to devalue; but it doesn’t.On the other hand, if Spain were like Florida, its problems wouldn’t be as severe. The budget deficit wouldn’t be as large, because social insurance payments would be coming from Brussels, just as Social Security and Medicare come from Washington. And there would be a safety valve for unemployment, as many workers would migrate to regions with better prospects. (Wages wouldn’t have gone up as much in the first place, because of in-migration)... what’s happening to Spain reflects the inherent problems with the euro, which now more than ever looks like a monetary union too far.

Q&A on Dollar's Reserve Status

Stephen Jen at Morgan Stanely's Global Economic Forum weighs in on this ongoing discussion:

Question 1. Are Central Banks Aggressively Diversifying from USD Assets?
There are different ways of thinking about this question. The most popular data that investors refer to are the IMF’s COFER quarterly data on the currency composition of the world’s reserve holdings... According to these data, the USD’s share in total world foreign reserves has declined from 72.7% in 2001 to 63.9% as of end-December 2007, with developed economies having a higher (69.4%) concentration of USD holdings than developing countries (60.7%). During the same period, EUR’s share rose from 17.6% to 26.5%, with developing economies having a higher exposure to the EUR (29.0%) than developed countries (22.2%). Thus, the short answer to this question is ‘yes’, there has indeed been a decline in the USD’s share in the world’s official reserve holdings in the past few years.

While this may be the short answer, it is not a complete answer. First, to conclude that the world’s central banks have been diversifying out of USD, one would also need to address the question of how the swings in the exchange rates may have affected the COFER currency shares... more than 100% of the change in the currency composition of reserves reported by the COFER database can be explained by changes in the exchange rate...The USD’s share seems low mainly because of the weak dollar, and its share was high in 2002, similarly, due to the strong dollar then...

Second, while at 63.8%, the USD’s share in total reserve holdings may be low, certainly lower than the 72.7% registered in 2001, the dollar’s share actually declined to below 50% in the early 1990s. Thus, the decline in the USD’s share is unremarkable, from a longer-term perspective, despite the angst.

Question 2. Will the Euro Challenge the Dollar’s Hegemonic Reserve Currency Status?
Again, the answer to this question is not straightforward. There are several considerations in thinking about this question. Some academic works on this matter have taken a quantitative approach to calculating the currency share of official reserves that can be explained by fundamental variables such as the size of the economy in question, the rate of return and the liquidity in the financial markets of the reserve currency. On these measures, the EUR seems to be a very serious challenger to the dollar. Further, if the UK joins the EMU, many of the liquidity and market size measures for the EMU could surpass the size of the capital markets of the US. For example, the combined market capitalisation (bonds and equities) of the EMU and the UK in 2007 was US$37.4 trillion, representing 30% of the world. The same metrics for the US would be US$43.5 trillion and 35%.

Having said the above, there are two reasons to believe that the EUR will not be able to supplant the USD’s hegemonic reserve currency role, even though the former can take some market share away from the USD. (Similar to car racing, it may be easy to catch up to another car. Passing it is another story.)

First and foremost is the advantage of being the incumbent. Increasing returns to scale are immensely powerful. In our previous writings on this topic, we have used the analogy of languages, that English is the preferred international language not necessarily because it is superior to other languages, but because it is ‘in the lead’ as the most widely spoken foreign language in the world, and so it will most likely remain in the lead as more people around the world learn English in order to communicate with the rest of the world. The positive characteristics of other currencies will need to be much superior to those of the dollar to offset this ‘incumbent advantage’...

The second consideration is related to the first, that the issue is really not the US versus Euroland. Rather, we need to ask what currency standard the rest of the world (that does not have a reserve currency) will have. Specifically, Asia, in our view, will likely remain on a dollar standard for a very long time to come. Even though few Asian currencies are now pegged to the dollar, most of the international transactions are still conducted in USD, reflecting the less-than-full convertibility of most currencies and the preference of Asian countries for invoicing and settling trade and transactions with each other in US dollars rather than each other’s currencies. For example, we hear people comment that Asia now trades as much, if not more, with Euroland than with the US. Statements like this one miss the point, because Asia trades with itself in dollars, and 43% of Asia’s trade is with other Asian countries.

Question 3. What Is the Prospect of the CNY as a Challenger to the US Dollar?
It is a probable, not just a possible, scenario that China’s economy will exceed the size of the US economy in our generation. This makes the CNY, or a form of Asian currency unit centred on the CNY, a much likelier challenger to the USD. [Hey Stephen, you really did not do justice to this last question!]

Bottom Line
We maintain our view that the dollar will likely remain the dominant international currency for the foreseeable future. Available data do not unambiguously support the view that central banks in the world have been aggressively diversifying from the USD. While assets denominated in EUR have experienced a sharp improvement in liquidity and depth since the establishment of the EMU, Asia and other parts of the world continue to rely on the USD as the medium of exchange and unit of account. The ‘incumbent advantages’ that the dollar enjoys will be difficult to overcome. The most likely challenger to the USD will be the CNY or an Asian currency unit centred on the CNY. But the key precondition is that Asia manages to develop its financial markets.

The Economist Magazine Forgot This Global Institution in Its Leader

The Economist has an interesting leader on the future of global institutions such as the G8, the IMF, and the UN Security Council. The article, however, makes a glaring omission when it comes to its list of important global institutions. This oversight, though, may be a good thing since there is no point in reminding the world about a highly influential global institution that is largely indifferent to the needs of the world yet highly concerned about the one country that runs it.

So what is this global institution? Let us turn to the Financial Times for the answer:

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed sets interest rates for Asian [and many Middle Eastern] countries because, explicitly or not, they manage their exchange rates against the dollar. If US interest rates are low, countries targeting the dollar are obliged to follow, because otherwise investors will sell dollars to buy their currency.

So the Fed is a monetary hegemon and its current accommodative stance, while arguably appropriate for the United States, is way too stimulative for the dollar block, those countries whose currencies are tied to the dollar. This is creating some geopolitical angst and is why the Fed should be added to the list of important global institutions.* The global reach of the Fed is something I have discussed before, but recent commentary on this issue by Brad Sester started me thinking more about the fundamental problem with this arrangement. Here is Brad Sester's take on these developments:

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

...Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US — and the world — would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Brad's point is that this arrangement is the one of the main reasons for the global economic imbalances--the large, ongoing U.S. current account deficits and the financing for them from Asia and the Gulf region--and is therefore unsustainable. I agree with Brad's conclusions, but have started thinking about this problem from a different perspective: the dollar bloc an optimum currency area (OCA). Consider the standard criteria of an OCA: similar business cycles, mobile labor, flexible prices/wages, fiscal transfers, diversified economy. The main regions of the dollar block--U.S., Asia, and the Gulf region--fail to meet the OCA criteria on most counts. For example, the U.S. economy is slowing down while the rest of the dollar block is overheating. Or, when was the last time you saw a mass exodus of former Rustbelt workers moving to China or heard of a fiscal transfer from the Gulf region to the Rustbelt? By my reckoning, then, the OCA criteria also indicates the dollar block countries should abandon their pegs and take on more monetary policy autonomy.

With that said, I am fearful of what would happen to the U.S. economy if the dollar block countries abandoned their dollar pegs anytime soon. The Fed's job would certainly be made more challenging and potentially there could be a run on the dollar. In the near term, then, it may be more sensible for the Fed to acknowledge its role as a monetary hegemon and take the lead in fighting global inflation. (Actually, I would have the Fed stabilize global nominal spending, but I digress). This may have some domestic economic consequences, but it would (1) help reign in global inflation and (2) give more time to dollar block to hammer out a coordinated plan of separation.

*According to Ken Rogoff, these countries make up about 60% of the global economy so the Fed's influence is significant.

Obstfeld and Rogoff's New Paper

Mark Thoma directs us to a new paper by Maurice Obstfeld and Kenneth Rogoff titled Global Imbalances and the Financial Crisis: Products of Common Causes. In this paper the authors acknowledge that highly accommodative U.S. monetary policy in the early-to-mid 2000s in conjunction with other developments played an important role in the build up of global economic imbalances. In their discussion of U.S monetary policy, interest rates, and global liquidity conditions they miss, however, some important points on the issues of (1) productivity growth and (2) the monetary superpower status of the Federal Reserve. Let me take each point in turn.

The first point comes up when Obstfeld and Rogoff criticize the saving glut explanation for the decline in long-term interest rates that began in the early 2000s. They rightly expose the holes in the saving glut story but then turn to a less-than-convincing explanation for the decline in the long-term interest rates. Here are the key excerpts:

[T]he data do not support a claim that the proximate cause of the fall in global real interest rates starting in 2000 was a contemporaneous increase in desired global saving (an outward shift of the world saving schedule)... according to IMF data, global saving (like global investment, of course), fell between 2000 and 2002 by about 1.8 percent of world GDP... [A]n end to the sharp productivity boom of the 1990s, rather than the global saving glut of the 2000s, is a much more likely explanation of the general level of low [long-term] real interest rates.

So their story is that the productivity surge of the 1990s ended and pulled down long-term interest rates. This is a plausible story since productivity growth is a key determinant of interest rates, but the data does not fit the story. Below is a figure showing the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed (Click on figure to enlarge):


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. Rather than pushing interest rates down this indicates they should have gone up. That still leaves the question of why long-term interest rates declined during this time. My tentative answer is that it was some combination of (1) a drop in the term premium that itself was the result of a false sense of security created by the Great Moderation and (2) and expectations of future short-term interest rates being low because of accommodative monetary policy.

The productivity point, however, does not end there. It becomes important in understanding why the Fed continued to keep interest rates so low for so long. As the authors note in the paper:

In early 2003 concern over economic uncertainties related to the Iraq war played a dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first time that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Deflation was viewed as a real threat, especially in view of Japan’s concurrent struggle with actual deflation, and the Fed intended to fight it by promising to maintain interest rates at low levels over a long period. The Fed did not increase its target rate until nearly a year later.

In other words, the fear of deflation is what motivated Fed officials to keep interest rate low for so long. As I have noted many times before, though, the Fed's fear of deflation at this time was misplaced. Deflationary pressures emerged not because the economy was weak, but because TFP growth was surging as shown above. The Fed saw deflationary pressures and thought weak aggregate demand when in it fact it meant surging aggregate supply. Making this distinction is important if monetary policy wishes to fulfill its mandate of maintaining full employment. Not making this distinction in 2003-2004 meant an economy already buffeted by positive aggregate supply shocks (i.e. productivity surge) got simultaneously juiced-up with positive aggregate demand shocks (i.e. historically low interest rate policy). This was a sure recipe for economic imbalances to emerge somewhere.

The second point with the Obsteld and Rogoff's paper is that it fails to appreciate how important is the Fed's monetary superpower status. As I have explained before

the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Obstfeld and Rogoff actually hint at this possibility briefly when they say the following:

the dollar’s vehicle-currency role in the world economy makes it plausible that U.S. monetary ease had an effect on global credit conditions more than proportionate to the U.S. economy’s size.

But then they go on to say

While we do not disagree entirely with Taylor [who believes the Fed was too accommodative in the early 2000s], we argue below that it was the interaction among the Fed’s monetary stance, global real interest rates, credit market distortions, and financial innovation that created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis.

I agree that there were many factors at work, but if you accept that the Fed is a monetary super power and therefore helped generate the global liquidity glut then it could have also tightened global liquidity conditions and helped pushed the global interest rates toward a more neutral stance. And without the global liquidity glut it seems that many of the other credit market distortions that arose at the time would have been far less pronounced.

The Future of the Euro (Part VII)

Speaking of optimal currency areas, Barry Eichengreen has a new article on whether some Euro countries may abandon the currency union:

Although housing prices have fallen euro area wide, they have fallen more dramatically in some countries than others. Although the crisis has meant large losses for banks throughout the euro area—often on those same housing-related investments—it has produced larger losses in some countries than others. It has led to rising unemployment throughout the euro area, but more in some countries than others. The result is more deflationary pressure, actual or potential, in some euro area countries than others. There are also more strains on the public finances of some euro area countries, as reflected in the widening of spreads on sovereign bonds and their associated credit default swaps.

Under these circumstances, different euro area countries presumably would prefer a different monetary policy response. But the members of the euro area are necessarily subject to a one-size-fits-all policy, such being the intrinsic nature of monetary union. This tension has revived the pre-1999 debate over whether monetary union in Europe is a good idea. It has also given rise to chatter and speculation about the possibility that one or more euro area countries might now choose to abandon the euro. This article weighs the implications of such a move and, although finding it risky, costly, and complicated, concludes that it is not inconceivable.

Read the rest of the article here. Here is the intrade contract on whether "any country currently using the Euro to announce their intention to drop it on/before 31 Dec 2010." (Click on figure to enlarge.)

This figure indicates the probability is only about 15% now, a big drop from the 40% high last year.

Brexit, Euroskepticism, and ECB Policy

The Brexit vote is upon us and most polls show a race that is too close to call. Much ink has been spilled debating this historic vote as well as trying to explain why it emerged in the first place. Most of the analysis on the latter point has been good, but I do think there is something that has been missing in these discussions. And that is the role the ECB's monetary policy played in helping bring about this referendum on Great Britain's future in the European Union (EU).

  

Most discussions on the causes of the Brexit vote point to concerns over immigration, burdensome EU regulations, and a general desire for more British sovereignty. These issues are important and confirmed by polling, but I see them as a proximate cause rather than the ultimate reason for the Brexit referendum. For, as The Economist notes, the UK has always been a "semi-detached member of the EU" and never has fully bought into it. This tendency was seen way back in the 1950s when the UK was reluctant to negotiate with the precursor to the EU. It was also evident in its decision to hold onto its own currency when the Euro was introduced in 1999. 

So why has this natural British skepticism toward the EU only now risen to the point of a Brexit vote? I submit that this timing is the consequence of the tragic policy mistakes by the ECB that culminated in the Eurozone crisis. Recall that the ECB signaled and followed through with monetary policy tightening in 2008 and 2011. As I show in a new working paper, it was this tightening by the ECB that sparked the sovereign debt crisis, strained inter-European creditor-debtor relationships, and gave teeth to fiscal austerity. Had the ECB instead eased in 2008 and 2011 and began QE sooner, the Eurozone recession would have been much milder and the recovery more brisk. 

Instead, the weight of the Eurozone crisis made what would have been minor irritations over immigration and regulations into something far more painful. Just like a healthy person can easily handle a minor cut or a cold, a healthy economy in Europe could have more easily handled the challenges of immigration and regulations.  

There is evidence supporting this view. The Pew Research Center conducted a multi-nation survey this month on how Europeans view the EU. Below is a chart from this report that summarizes what they found: increasing skepticism towards EU from most countries surveyed. The rise in this EU skepticism coincides with the Eurozone crisis.

While the above chart maps the overall favorability scores of the EU, another question in the survey (50a) more narrowly asks whether the respondents approved or disapproved of the EU's handling of economic issues. In the figure below I plotted the disapproval rate for each country found in this question against their output gap (as measured by the OECD). 

Since the output gap is economic slack induced by the business cycle, the clear implication is that better macroeconomic policy would lead to a more favorable view of the EU. And, again, the biggest failure of macroeconomic policy has been the ECB's policy mistakes in 2008 and 2011 for which the Eurozone is still suffering today. 

So the Brexit vote can, in part, be laid at the feet of ECB policy makers in 2008 and 2011. These mistakes led to the Eurozone crisis which greatly accelerated the distrust of the EU and intensified concerns over immigration. Add this to the existing British skepticism toward the EU and the Brexit vote becomes a reality.

Now one could argue that these ECB's policy mistakes were the inevitable outcome of a poorly-designed currency union. The Eurozone was never an optimal currency area and therefore a one-size-fits all monetary policy applied to very different economies in Europe was going to end badly at some point in time. Maybe so, but as I argue in my working paper the ECB's mistakes of 2008 and 2011 were not inevitable. They were the result of the ECB overreacting to temporary inflation surges that should have been ignored. Until we better appreciate the ECB's errors of that time, we have failed to learn from the mistakes of the past.

Update: Now the Brexit is a reality, let me share my immediate concern with it: the further strengthening of the dollar. The global economy is already weighed down by the rise of the dollar that started in mid-2014. This is because (1) a sizable share of the global economy has their currency tied in some form to the dollar and (2) there has been a surge in dollar debt outside the United States.  As I said on twitter, the strong dollar noose that is choking emerging economies has now had the trap door released via Brexit to make the strangulation of global economy complete. Strap yourself in for a very bumpy ride.

Related Links

The Monetary Policy Origins of the Eurozone Crisis

The Treasury Yield Curve Blues

The Fed needs to start worrying more about the flattening treasury yield curve.  Bloomberg is reporting that bond traders are getting ready for a yield curve inversion as soon as next week.  One fixed income manager quoted in the article had this to say: 

If the Fed decides to move more this year, I think it’s inevitable that the curve inverts and I think it will be a mistake,” said Colin Robertson, managing director of fixed income at Northern Trust Asset Management... He sees greater than a 50 percent chance of the 2- to 10-year spread inverting if the Fed raises rates once more this year, and if the central bank follows its projections and hikes twice more, Robertson sees inversion as a lock.

Here is what the 10-year minus 2-year spread currently looks like: 

The yield curve spread is definitely heading down, but is it truly on the cusp of an inversion? It is hard to know for sure, but there are two big clues suggesting the answer is yes. First, as noted by Robert Burgess, yield curve inversions are already happening overseas:

For much of the past year or so, investors and economists have anxiously watched the relentless shrinkage of the gap between short- and long-term U.S. bond yields to the narrowest levels since 2007. After all, an inversion —  when long-term yields fall below short term ones — preceded each of the last seven recessions. But while everyone has been so focused on the U.S, they seemed to have missed the global yield-curve inversion.   

Within the past two months, the yield on an ICE Bank of America index of government bonds due in seven to 10 years has fallen below the yield on an index of bonds due in one to three years for the first time since the first half of 2007. The strategists at JPMorgan Chase & Co. said they were seeing the same thing in indexes they manage. Although the U.S. economy is in solid shape, there have been signs of weakness in the euro zone, China and emerging markets over the past month.

Given the global integration of capital markets, it is not hard to imagine the overseas inversions working their way into the U.S. treasury yield curve. Some Fed officials are paying close attention to this possibility like Atlanta Fed President Raphael Bostic:

“I have had extended conversations with my colleagues about a flattening yield curve” and the risks of it inverting, he said at a moderated forum in Augusta, Georgia on Wednesday. “We are aware of it. So it is my job to make sure that doesn’t happen... Hopefully we won’t get to that inversion.”

That is good to know. Unfortunately, others on the FOMC are more sanguine about the flattening yield curve. From the May FOMC meeting minutes we learn the following:

[P]articipants also discussed the recent flatter profile of the term structure of interest rates. Participants pointed to a number of factors contributing to the flattening of the yield curve, including the expected gradual rise of the federal funds rate (and) the downward pressure on term premiums... A few participants noted that such factors could make the slope of the yield curve a less reliable signal of future economic activity. 

So not everyone at the FOMC is equally concerned about an inversion. This complacency may be one reason why the FOMC, as a whole, is predicting an inverted yield curve of its own making. 

The FOMC currently plans to have its short-term interest rate target range at 3.00% - 3.25% by the end of the 2019. Meanwhile the 10-year treasury yield has been bouncing between 2.80% and 3.00%, close to FOMC's long-run federal funds rate estimate of 2.90%. The FOMC, in other words, sees itself raising its short-term interest rate target such that the yield curve spread will become negative or inverted over the course of the next year and a half. This prediction is our second big clue that the yield curve is likely to invert.

But no big deal, says the FOMC, because this time it is different. Yes, the FOMC will be raising short-term interest rates, but the term premium is the real villain in this story. For it will not allow long-term interest rates to rise above short-term interest rates. So despite appearances, the term premium will be the real cause of the inversion per the FOMC. 

Former Fed chair Ben Bernanke similarly thought it would be different back in 2006. He said not to worry about the flatting yield curve at that time. Bernanke pointed to the term premium as the culprit even as the Fed was raising its interest rate target. But the standard yield curve recession predictions were borne out and we got the Great Recession. This recent experience should give today's FOMC pause. 

Moreover, as Michael Bauer and Thomas Mertens recently show, a negative yield-curve spread still does an amazing job predicting recessions. Consequently, the FOMC should not be aiming to raise short-term interest rates above long-term interest rates. The last thing the Fed should want to do is sing the treasury yield curve blues.  Better to play it safe than to risk choking off the expansion.

Update: I got into a twitter conversation regarding this post and my critique of Ben Bernanke's speech in 2006. As a result, I constructed the following figure using the New York Fed's estimates of term premiums. It shows the 10 year minus 1 year treasury spread decomposed into (1) an expected rate path spread and (2) a term premium spread. These two component add up to the overall spread.

The figure reveals that while Bernanke was right about a declining term premium in 2006 it was also the case that the expected path of short-term rates was declining. It was signaling recession. What this implies for today is that the FOMC should tread cautiously in interpreting the flattening of the yield curve. There may be more to the story than term premiums.

The Fed Gets Schooled Again: Swiss Central Bank Edition

I once argued that all incoming Fed officials should spend six months interning at the Swedish central bank given their relative success in stabilizing nominal GDP.  I was wrong.  What I should have said is that all incoming Fed officials should spend six months interning at the Swiss central bank.  Lars Christensen explains why:

Here is from The Street Light:

“You may recall that in September the Swiss National Bank (SNB) announced that it was going to intervene as necessary in the currency markets to ensure that the Swiss Franc (CHF) stayed above a minimum exchange rate with the euro of 1.20 CHF/EUR. How has that been working out for them?

It turns out that it has been working extremely well. Today the SNB released data on its balance sheet for the end of September. During the month of August the SNB had to spend almost CHF 100 billion to buy foreign currency assets to keep the exchange rate at a reasonable level. But in September — most of which was after the announcement of the exchange rate minimum — the SNB’s foreign currency assets only grew by about CHF 25 billion. Furthermore, this increase in the CHF value of the SNB’s foreign currency assets likely includes substantial capital gains that the SNB reaped on its euro portfolio (which was valued at about €130 bn at the end of September), as the CHF was almost 10% weaker against the euro in September than in August. Given that, it seems likely that the SNB’s purchases of new euro assets in September after the announcement of the exchange rate floor almost completely stopped.”

This is a very strong demonstration of the power of monetary policy when the central bank is credible. This is the Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target. (Nick Rowe and I like this sort of thing…) And now to the (not so) crazy idea – if the SNB can ease monetary policy by announcing a devaluation why can’t the Federal Reserve and the ECB do it?

Exactly. Instead of having a central bank that sets an explicit target and commits to doing whatever is necessary to hit it, we have a central bank that at best has a fuzzy inflation target and operates in a manner that does little to create certainty about the future path of monetary policy.  This lack of clarity was on display yesterday at the post-FOMC news conference when journalist pointed out to Bernanke that the Fed's forecast is worsening yet the Fed wants to wait for further information before acting.  These journalists wanted to know what would trigger the Fed to act and Bernanke could not give a clear answer.  This is because he is simply unable to make a conditional forecast of future monetary policy with no explicit target.  This is crazy.  Here we have the most powerful central bank in the world stumbling, tripping, and occasionally getting lost as it moves forward because it chooses not to set a clear, explicit path of where it wants to go.  If only we could learn from the Swiss...