There is No Debt Crisis In Europe

As much I criticize the Fed for its shortcomings, it pales in comparison to the failures of the ECB. Under its watch, aggregate nominal income and broad money growth has faltered in the Eurozone. This, in turn, has created an economic crisis. Note that causality runs from a weakened economy allowed by the ECB to a debt and financial crisis in the Eurozone, not the other way around. This is a point Ramesh Ponnuru and I have stressed before:

[Observers] tend to think of Europe’s current crisis as the result of overspending welfare states. And these states would indeed be better off with lower spending levels and less regulated labor markets. But many of the nations swept up in the euro-zone crisis, such as Spain and France, had spending and tax revenues well aligned before it hit. The true problem has again been monetary. Europe has for a decade had a monetary policy well suited to the circumstances of Germany but not to those of the rest of the euro zone and especially its periphery. Nominal income in Germany has stayed on a fairly steady trend line. In the periphery, however, it first went way up and then crashed. For the euro zone as a whole, nominal spending has fallen far below its previous trend—and has been continuing to fall farther away from it. Monetary policy therefore remains very tight in the euro zone overall. One effect of that drop-off, in Europe and in the U.S., has been to make debt burdens more onerous.

The graph below underscores this point. It shows that below-trend growth in Eurozone NGDP--the NGDP gap--has been matched by a rise in Eurozone government debt. The Eurozone crisis, then, is a nominal GDP crisis, not a debt crisis:

I bring this up because today we learn just how bad conditions are becoming in the Eurozone: unemployment hit 12.1% in March, 2013! Michael Darda of MKM Partners observes that this is the highest unemployment rate in the Eurozone over the past few decades. And on a country-by-country basis the unemployment numbers are even more harrowing, as shown by Ryan Avent. What more will it take for the ECB to act more aggressively? Apparently, intense human suffering is not enough. Maybe the advent of Abenomics in Japan in conjunction with the Fed's ongoing QE3 program will spur the ECB into action out of fear of losing external competitiveness. How ironic it would be if Europe's periphery became the main beneficiary of Abenomics. 

Is Monetary Policy Capable of Offsetting Fiscal Austerity?

Mike Konczal has a new article where he claims there is a great natural experiment unfolding in the U.S. economy, one that Ramesh Ponnuru and I proposed back in 2011:

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

So Mike Konczal's assessment of this experiment is that monetary policy has not been able to offset fiscal austerity. Paul Krugman  agrees as do other observers who question the effectiveness of monetary policy in a liquidity trap. I agree that there is an interesting experiment going on, but Konczal and Krugman (K&K) oversell what it means and ignore other recent developments that shed light on the efficacy of monetary policy.

For starters, this experiment is only measuring whether QE3 is powerful enough to offset fiscal austerity. It is not measuring whether the actual proposal Ramesh and I laid out in 2011, a nominal GDP level target (NGDPLT), is capable of offsetting fiscal austerity. QE3 is a big change in Fed policy, but it is still far from a NGDPLT in terms of efficacy. One way to see this is to note that QE3 constrains asset purchases to a fixed dollar amount of $85 billion per month no matter how fast or slow the economy is converging to the Fed's inflation and unemployment targets. Consequently, if a spate of bad economic shocks--more Eurozone uncertainty, sequestration, China slowdown concerns, etc.--suddenly increased money demand the $85 billion injection may not be enough to offset it. In this case, aggregate demand would slow down and stall the convergence to the Fed's target. 

QE3, then, is like taking a road trip and applying the same pressure to the gas pedal regardless of whether one is driving up a hill, down a hill, or on a flat terrain. The trip's length would depend on the changing terrain of the road (the shocks) and would be hard to know ahead of time even though you know your trip's destination (the target). This is better than taking a QE2 road trip, where you don't know your destination, but there is still much uncertainty about how long the QE3 trip will take. Now imagine you turn on cruise control at 70 MPH so that your car automatically adjusts the amount of gas based on the terrain. There would be much more certainty about the trip and much better expectations management. This would be much closer to a NGDPLT and provide the real test of  whether monetary policy can offset fiscal austerity. It could be operationalized by conditionalizing the size of the QE3 asset purchases each month so that constant progress to the Fed's targets were being maintained. QE3, therefore, is farm from ideal and, as Matt O'Brien observes, it is not even clear the Fed is fully on board with it.

With that said, one can still learn a lot about the potential of monetary policy to offset fiscal austerity by looking at the fiscal consolidation in the United States over the past few years. As I have noted before, fiscal austerity has been happening in the U.S. economy since about mid-2010. And yet, the Fed has kept NGDP growing on a remarkably steady growth path (albeit, below its pre-crisis trend path). This performance is even more remarkable when you consider that there have been other negative AD shocks buffeting the U.S. economy. K&K ignore this achievement and its implications for monetary policy offsetting fiscal austerity.

Evan Soltas notes that further insights about monetary policy's ability to offset fiscal austerity can be gleaned by comparing the U.S. economy to the Eurozone economy over the past few years. Below are some figures that make this comparison. The first one compares government spending in both regions in absolute dollar and euro amounts. The figure shows that both regions experienced a similar flattening of government spending beginning around 2010. (Total federal expenditures actually decline in the United States. I couldn't find a similar measure for the Eurozone.)

If we now look at government spending as a percent of NGDP, we see that government spending's share has been falling in both regions. The U.S. decline has been the sharpest. 

So we have two large economies experiencing fiscal austerity as seen above. Both are receiving the fiscal austerity 'treatment'. What effect is that treatment having on their NGDPs?  The figure below shows the respective NGDP growth rates in both regions:

The U.S. series shows a stable NGDP growth rate of about 4%, consistent with the NGDP level figure linked to above. The Eurozone NGDP, however, shows a pronounced decline starting in 2010. So both regions have fiscal austerity, but only the United States has stable aggregate demand growth. The easiest explanation for the difference is monetary policies: the Fed has been far more aggressive than the ECB in responding to the slump. Yes, this is not definitive evidence, but it certainly is suggestive that monetary policy makes a big difference in offsetting fiscal austerity. 

P.S. Scott Sumner, Ryan Avent, Marcus Nunes, and Matt Yglesias reply as well. 

Update: A commentator correctly notes my first few graphs ignore the fiscal drag created by tax changes. So I grabbed the IMF's estimate of structural budget balances as a % of potential GDP and made the following figure:

While it does show a higher level of fiscal austerity for the Eurozone, it also indicates the rate of fiscal tightening is very similar in both regions. In other words, fiscal consolidation is happening at a similar pace across the two regions though they start from different points. Given this similarity, one would expect to see some similarity in the NGDP growth rate graph since the tightening began in 2010. But there is none. The gap, then, can still be explained by the differences in monetary policy.

The Ongoing Dereliction of Duty

Last year I made the case that the Fed's failure to keep nominal income growth expectations stable was a dereliction of duty:

[We] have long made the case that a nominal GDP (NGDP) level target would firmly anchor the expected growth path of nominal income.  Doing so, in turn, would stabilize current nominal spending since households and firms are forward looking in their decision making.  For example, holding wealth constant, households generally will put off purchasing a new car or renovating their homes if they expect their nominal incomes to fall and vice versa.  This is why Scott Sumner likes to say monetary policy works with long and variable leads. This understanding implies, therefore, that the reason for nominal spending remaining below is its pre-crisis trend is that the Fed has failed to restore expected nominal income to its pre-crisis path. This failure amounts to a passive tightening of  monetary policy.

Since then, the Fed has improved its management of expectations by introducing the conditional asset purchasing program of QE3. While this program is progress, it is still far from adequate. This can be easily seen by looking at data from a question on the University of Michigan/Thompson Reuters Survey of Consumers where households are asked how much their dollar (i.e. nominal) family incomes are expected to change over the next 12 months. The figure below shows the average response for this question up through March, 2013:

The fall of household dollar income expectations and its failure to fully recover is stunning. It suggests that the now lower expected future income growth is depressing current household spending, a point forcefully made by Mariacristina De Nardi, Eric French, and David Benson of the Chicago Fed. Digging into the data, they find that expected nominal income growth deteriorates across all age groups, educational levels, and income levels over the past few years. This is not some sectoral-specific development, it is a systemic nominal problem. They also find that the collapse in expected dollar income growth explains much of the decline in aggregate consumption since the crisis erupted.

But there is more. The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the 'Great Moderation' period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happened. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households.

This is something that the Fed could correct. QE3 is a step in the right direction, but more needs to be done with this program to raise expected nominal income growth. One way to do this is to make the size of the asset purchases conditional. That is, instead of conducting fixed $85 billion purchases every month until the economic targets are hit, vary the size of the purchases depending on the progress of the recovery. For example, if inflation and unemployment are not moving fast enough to their target, then increase the dollar size of the of asset purchase and vice versa. For if $85 billion is not enough for the nominal economy to gain traction, then it must be the case that money demand is rising enough to offset the benefits of the $85 billion injection. If this conditionality were added and widely understood, QE3 would better manage expectations and pack a larger punch. No more dereliction of duty.

Update I: Per Nick Rowe's request I have added the following two figures.  The first one shows expected household dollar income growth plotted along side NGDP growth over the past year. The former does seem lead the latter.  

 

The second figure shows the mean and the median expected household dollar income growth. Interestingly, the gap between the two series is relatively stable until the crisis, after which it narrows.

Update II: The first two figures above use a three quarter center moving average to smooth the series. The last figure--the one directly above showing the mean and median--shows the raw, unsmoothed series.

Fed Panel Discussion at the AEI

Friday, I will be participating in a panel discussion on Fed policy at the American Enterprise Institute. Along with me will be Scott Sumner, Ryan Avent, and Jim Pethokoukis. If you are in DC and can make it, I hope to see you there. 

Update: Here is the video of the panel discussion and here is a link to my PowerPoint file.

Missing the Forest For the Trees: Cyprus Edition

The Cyprus bank heist has received a lot of coverage, but in most cases the analysis is missing the forest for the trees. The real problem facing Cyprus and the rest of the Eurozone periphery is more fundamental than who will be bailed out, who will be bailed in, and how it will happen. For these concerns are the result of a flawed monetary union--a currency area that does not meet the optimum currency area criteria--that if not fixed will continue to haunt the Eurozone.  Figuring out how to deal with Cyprus without addressing the flawed nature of the Eurozone is just kicking the can the down road. More radical reforms are needed. 

One reform is to alter ECB policy so that it actually tries to stabilize nominal spending for the entire Eurozone, not just Germany. Since it inception, ECB monetary policy has been biased toward Germany at the cost of destabilizing the Eurozone periphery. This could be fixed by having the ECB abandoned its flexible inflation target and adopt a NGDP level target. Another complementary reform, would be to create meaningful fiscal transfers in the Eurozone similar in scale and scope to the United States. Both of these options, however, would face stiff opposition from Germany. For the former would require temporarily higher inflation than Germany desires and the former would require large fiscal commitments for the Eurozone from Germany. Neither is likely to happen.

That leaves the final reform option: break up the Eurozone into austere and non-austere currency unions. This ideas has been suggested before by Ramesh Ponnuru and Ambrose Evans-Pritchard. Here is Pritchard:

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.

This reform is very radical, but there really is no other viable alternative. The German response over this crisis has given us no reason to believe the other options of improving the existing Eurozone monetary and fiscal structures will ever happen. So why keep pretending otherwise? The current Eurozone approach is the equivalent of an economic whack-a-mole game that never truly solves the problem. The Cyprus crisis is just the latest mole to stick up its head.

Fortunately, Matthew C. Klein reports that there already is some movement in Germany to create two new currency blocks. This is a start. But there is a long way to go and there needs to be a greater sense of urgency. Who knows how long the whack-a-mole game can continue before it turns ugly. Martin Feldstein warned in 1997 that the EMU could lead to conflict. I hope he is wrong. 

P.S. Matthew Yglesias is one observer that does consider the larger Eurozone context behind the Cyprus crisis.  

P.P.S. Just how big are fiscal transfers in the United States? Here is one data point from Paul Krugman: 

[I]f Florida suffers an asymmetric adverse shock, it will receive an automatic compensating transfer from the rest of the country: it pays less into the national budget, but this has no impact on the benefits it receives, and may even increase its benefits if they come from programs like unemployment benefits, food stamps, and Medicaid that expand in the face of economic distress.

How big is this automatic transfer? Table 2 shows some indicative numbers about Florida’s financial relations with Washington in 2007, the year before the crisis, and 2010, in the depths of crisis. Florida’s tax payments to DC fell some $33 billion; meanwhile, special federally funded unemployment insurance programs contributed some $3 billion, food stamp payments rose almost $4 billion. That’s about $40 billion in de facto transfers, some 5 percent of Florida’s GDP – and that’s surely an understatement, since there were also crisis-related increases in Medicaid and even Social Security, as more people took early retirement or applied for disability payments.

Echoes of 1933: the Cyprus Heist

Bank depositors in Cyprus learned today of a planned heist on their funds. It was a well organized one that will take 6.75% of all small deposit accounts and 9.90% of all large depositor accounts. What is truly shocking about this heist is that it was planned by the EU and IMF and applied to funds, at least for the small depositors, that were supposedly government insured (i.e. risk free). This is what we call a major shock to expectations.

Now the depositors do get bank equity in exchange and some observers note this heist is not as bad it could be--the alternative could have been a complete financial collapse--but from a broader perspective these excuses miss the mark. The very reason the crisis has got to the point that bailouts or "bail-ins" are needed is because the Eurozone was a flawed monetary union from the start. It never met the criteria of an optimum currency area and its monetary policy has effectively been geared toward Germany. Thus, at the advent of the Euro, the ECB policy interest rate was close to what a Taylor rule would predict for Germany, but far too low for the periphery. Likewise, since the crisis the policy rate has been close to what a Taylor rule would predict for Germany, but too high for the periphery. In both cases, ECB policy has been destabilizing to the periphery. That is why, despite being in the midst of a crisis, the ECB explicitly tightened monetary policy in 2011 by twice raising its policy rate. It is also why the ECB has implicitly (or passively) tightened policy over the past few years as evidenced by the flatlining of the broad money supply and nominal GDP. In short, the boom-bust cycle of the Eurozone periphery that helped make the Cyprus financial crisis is largely the result of a flawed monetary system biased toward Germany.

But that part is not new. What is new is the unexpected seizing of depositors funds. As Lars Seier Christensen, Ed Conway, Felix Salmon, and Frances Coppola note, this sets a dangerous precedent for all Eurozone bank deposits.  Here is Coppola:

[T]he fact is that deposit insurance everywhere in the EU has now been undermined. The precedent has been set for insured depositors to suffer losses in order to protect Russian oligarchs and reckless banks. If the Eurogroup can impose this on Cyprus, it can do so elsewhere too.

Yes, EU leadership promised this action was a one-off event, but the fact that they had to make this promise is a sign that they no longer can be trusted. Just imagine what you would be thinking now if you were a resident of troubled periphery economy and had funds in your bank account. I suspect it would be whether my bank was next and whether I needed to get my funds out ASAP. It is almost as if the EU and IMF were trying to create a banking panic in Europe.

What the EU and IMF did to Cyprus today is poised to be a repeat of what happened to U.S. banking in 1933. In February of that year, the governor of Michigan declared a statewide banking holiday as a means to resolve an impasse on how to wind down an important bank in Detroit. Like the Cyprus action today, the governor's actions back then sent chill waves across a continent, as depositors in other states began to wonder if their governors would also call bank holidays to prevent withdrawal of funds. The fear was so poignant, that the Ohio governor made it a point to declare the bank holiday would not happen in Ohio. But it was too late, the die had been cast. By March 1933, 48 states had declared some form of bank withdrawal restrictions as the bank panic spread and fed upon itself. Only with FDR's national bank holiday and the advent of national deposit insurance in March, 1933 was the bank panic stopped.

What is crazy about the Cyprus heist today is that it has the potential to create the same self-fulfilling bank panics across Europe, but without the benefits of a unified treasury to credibly commit to Eurozone deposit insurance. I can't help but hear the echoes of 1933 now unfolding in Europe. 

Update I: Our friend Lars Christiensen, the Market Monetarist one, also weighs in with good thoughts.
Update II:  A fitting picture on the Cyprus heist:

Why Inflation with a Large Output Gap?

This is a question that observers, particularly those who are skeptical of the aggregate demand-shortfall view, often raise. Ryan Avent and Paul Krugman both answer this question in recent posts. Here is Avent:

The answer to the question of why deflation in, say, America hasn't been sustained despite little progress closing the output gap is extremely simple: the Fed has been determined not to allow that to happen...What the record shows is that disinflation below 2% inflation prompts aggressive Fed reactions, which are generally successful at reversing inflation expectations. The critical difference between the Depression and the Great Recession was that Great-Recession-era central banks were determined to avert deflation and where willing to prop up the financial system, drop rates to zero, and engage in unconventional policy in order to keep inflation positive.

I think that assessment is largely correct. The only part I would add is that once FDR took the reins of monetary policy in 1933 (by breaking the link between the dollar and gold and not sterilizing gold inflows) inflation emerged and coincided with a large output. Though the Fed didn't cause this inflation, the Fed tolerated it until 1937 as seen in the figure below:

 

 As Paul Krugman notes, this bout of inflation between 1933 and 1937 was not that different from what we have today as seen in the chart below.

Below is a table that compares the output gaps and inflation rates that occurred after the troughs of 1933 and 2009.  Again, we see that inflation rates were not that different. 

The only big difference between the periods is the output gaps. The mid-1930s output gap was far larger than the current one and yet that period had a similarly-sized rate of inflation. For me, then, the interesting question is why has inflation during the last two largest U.S. economic crisis been similar? Why were they both gravitating around 2%? Ryan Avent has an answer that I suspect is true to some extent for both periods:

[T]he Fed's observed success in averting deflation should lead one to ask whether its control over inflation expectations suddenly evaporates once those expectations hit 2%. My view is that it does not—why should it, after all?—and that the main constraint on a faster economic recovery is the Fed's reluctance to push inflation over 2%.

This makes a lot of sense for the 1930s too since it is well documented the Fed was concerned about inflation getting too high during this time. There were a few years of higher-than-normal inflation, but the average inflation rate was kept in line by the Fed. Even at the expense of creating a recession in 1937-1938. History repeats itself.

P.S. Yes, I said in my last post the next one will be Bernanke's Friday Night Special II, but it had to wait.  I hope to get it up later this week.