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The world’s biggest book fair is opening its doors soon and, as a native “Frankfurter” working in the publishing industry, it's the time of year that my colleagues start asking me about my hometown. Sadly, the most common thing I hear is that there is little that they know beyond Frankfurt airport and the exhibition centre.
Economists are better at history than forecasting. This explains why financial journalists sound remarkably intelligent explaining yesterday’s stock market activity and, well, less so when predicting tomorrow’s market movements. And why I concentrate on economic and financial history. Since 2015 is now in the history books, this is a good time to summarize a few main economic trends of the preceding year.
Last month, the European Central Bank (ECB) announced its plans to commence a €60 billion (nearly $70 billion) of quantitative easing (QE) through September 2016. In doing so, it is following in the footsteps of American, British, and Japanese central banks all of which have undertaken QE in recent years. Given the ECB’s actions, now is a good time to review quantitative easing. What is it? Why has the ECB decided to adopt this policy now? And what are the likely consequences for Europe and the wider world?
What is quantitative easing (QE)?
Under normal circumstances, central banks undertake monetary policy via open market operations. This typically involves buying (or selling) securities in a short-term money market to lower (or raise) the interest rate prevailing in that market. Central banks are well equipped to do this. They have large inventories of securities that they can easily sell in order withdraw money from the market and push interest rate up. They also have a monopoly on the creation of their particular currency, which they can use to buy securities and push the interest rate down. Open market purchases and sales usually only last for a day or two (through repurchase agreements, or repos), but can be repeated as often as necessary and adjusted in size to achieve the targeted rate.
For an economy that is mired in recession, open market purchases can be a good policy move: buying securities lowers short-term interest rates and increases the money supply. In time, such expansionary monetary policy can also reduce longer-term interest rates, which may stimulate spending on new houses, factories, and equipment, since such investment spending is often made with borrowed money. Expansionary monetary policy will also lead to a decline in the value of the domestic currency on international markets (i.e., depreciation), which will help domestic exports. Too much sustained monetary expansion can lead to inflation, which is one of the main risks of this policy.
In the current economic climate, however, short-term interest rates are already hovering around zero. Although some central banks have flirted with the idea of negative interest rates, there is not much room for conventional expansionary monetary policy to do much good.
Enter quantitative easing. Using quantitative easing, central banks purchase longer-term securities and, unlike open market operations, the purchases are usually permanent instead of for just a few days. This lowers longer-term interest rates. Since individuals and firms that borrow money to invest in homes, factories, and equipment generally do not finance these long-loved assets with overnight borrowing (for mortgages, 15- and 30-year terms are more typical), lowering longer-term interest rates may be a good way to stimulate such long-term investment.
Mario Draghi, President of the ECB, World Economic Forum 2013. CC-BY-SA-2.0 via Wikimedia Commons.
Why now?
The European economy is listless. GDP appears to have grown—just barely—during the year just finished. Although 2014’s performance was an improvement over 2013’s decline in GDP, the EU’s growth forecasts for 2015 and 2016 are far from rosy. The job market is sluggish: EU-wide unemployment was 11.6% in 2014, down slightly from 12.0% in 2013. And a pick-up in inflation, which should accompany growth, was absent in 2014: the authorities have set a 2.0% for inflation; instead prices rose by an anemic 0.4% in 2014. Several countries have made progress toward much-needed structural reform; however, it is not clear that such reforms alone will get the European economy out of the doldrums anytime soon.
Other dangers facing the European economy also argue in favor of quantitative easing. To the east, tensions with Russia could flare at any time. The terrorist attacks in France have given a boost to right-wing parties throughout Europe, another threat to stability. And the election victory of the anti-austerity Syriza party in Greece, suggests that relations between Greece and the EU are about to get rockier.
What are the consequences?
Quantitative easing will strengthen Europe’s wobbly recovery. The announcement quickly lifted European stock markets—the Euro Stoxx 50-share index rose 1.6% on the news. Lower longer-term interest rates should encourage more borrowing and investment spending. And QE will lead to a continued depreciation in the value of the euro, already at a decade-low against the US dollar, which will make European exports more competitive in world markets. The results will not be so pleasant for American exports, since the euro’s depreciation will cut into recent American export growth, which has benefitted from three rounds of American QE, the last of which ended a few months ago.
Quantitative easing will not sit well with all Euro-zone countries. Germany, which is economically far more robust than its European partners, is not a fan of QE. Memories of a destructive hyperinflation in the 1920s still linger in the national consciousness, lead Germans to be far more skeptical of a potentially inflationary policy that they see as bailing out their more profligate neighbors at their expense.
Finally, the European Central Bank has not said exactly which bonds it will buy. When the US Federal Reserve undertook QE, it had a wide variety of Treasury securities to purchase. Given the high credit-worthiness of the US government and the fact that the market for US Treasury securities is the most liquid market in the world, it was not difficult to find suitable securities to purchase. Will the ECB buy the debt of the fiscally weak euro-zone nations and put their balance sheet at risk? Or will it restrict its purchases to only the most credit worthy countries and risk the ire of the citizens from less well-heeled nations?
Despite these legitimate concerns, Europe’s weak economic performance requires bold action. Quantitative easing is an important step in the right direction.
Featured image credit: Growing Euros, by Images_of_money. CC-BY-2.0 via Flickr.
Dystopias are trending in contemporary popular culture. Novels and movies abound that deal with fictional societies within which humans, individually and collectively, have to cope with repressive, technologically powerful states that do not usually care for the well-being or safety of their citizens, but instead focus on their control and extortion. The latest resounding dystopian success is The Hunger Games—a box-office hit located in a nation known as Panem, which consists of 12 poor districts, starved for resources, under the absolute control of a wealthy centre called the Capitol. In the story, competitive struggle is carried to its brutal extreme, as poor young adults in a reality TV show must fight to death in an outdoor arena controlled by an authoritarian Gamemaker, until only one individual remains. The poverty and starvation, combined with terror, create an atmosphere of fear and helplessness that pre-empts any resistance based on hope for a better world.
We fear that part of the popularity of this science fiction action-drama, in Europe at least, lies in the fact that it has a real-life analogue: the Spectacle—in Debord’s (1967) meaning of the term—of the current ‘competitiveness game’ in which the Eurozone economies are fighting for their survival. Its Gamemaker is the European Central Bank (ECB), which—completely stuck to Berlin’s hard line that fiscal profligacy in combination with rigid, over-regulated labour markets has created a deep crisis of labour cost competitiveness—has been keeping the pressure on Eurozone countries so as to let them pay for their alleged fiscal sins. The ECB insists that there will be ‘no gain without pain’ and that the more one is prepared to suffer, the more one is expected to prosper later on.
The contestants in the game are the Eurozone members—each one trying to bootstrap its economy out of the throes of the most severe crisis in living memory. The audience judging each country’s performance is not made up of reality TV watchers but of financial (bond) markets and credit rating agencies, whose supposedly rational views can make or break any economy. The name of the game is boosting cost-competitiveness and exports—and its rules are carved into stone in March 2011 in a Euro Plus ‘Competitiveness Pact’ (Gros, 2011).
The Hunger Games, by Kendra Miller. CC-BY-2.0 via Flickr.
Raising competitiveness here means reducing costs, and more specifically cutting labour costs, which means lowering the wage share by means of reducing employment protection, lowering minimum wages, raising retirement ages, lowering pensions and, last but not least, cutting real wages. Economic inequality, poverty and social exclusion will all initially increase, but don’t worry: structural reforms hurt in the beginning, but their negative effects will be offset over time by changes in ‘confidence,’ boosting spending and exports. But it will not work, and the damage done by austerity and structural reforms is enormous; sadly, most of it was and is avoidable. The wrong policies follow from ‘design faults’ built into the Euro project right from the start—the creation of an ‘independent’ European Central Bank being the biggest ‘fault’, as it precluded the necessary co-ordination of fiscal and monetary policy and disabled the central banking system from providing support to national governments (Arestis and Sawyer, 2011). But as Palma (2009) reminds us, it is wrong to think about these ‘faults’ as being caused by perpetual incompetence—the monetarist Euro project should instead be read as a purposeful ‘technology of power’ to transform capitalism into a rentiers’ paradise. This way, one can understand why policy makers persist in abandoning the unemployed.
The standard arguments against monetary policy responding to asset prices are the claims that it is not feasible to identify asset price bubbles in real time, and that the use of interest rates to restrain asset prices would have big adverse effects on real economic activity. So what happened with central banks and house prices prior to the financial crisis of 2007-2008?
Looking in detail at what the Federal Reserve Board (Fed), the European Central Bank (ECB) and the Bank of England (BoE) thought and said about house prices from the beginning of the 2000s, it appears that the Fed was so convinced of the standard line (monetary policy should not respond to asset prices but just stand ready to mop up if a bubble bursts) that it did not allocate much time or resources to discussing what was happening.
The BoE, on the other hand, while equally committed to that orthodoxy, felt the need to argue it out, at least up till 2005, and a number of speeches by Steve Nickell and others explained why they believed that the rises in house prices were a response to changes in the fundamentals (notably, the much lower levels of inflation and interest rates from the mid-1990s) and were therefore not a cause for concern. But after 2005 the BoE seems to have lost interest in the issue even to that extent.
Bank of England headquarters, London
The ECB was in principle more willing to consider the issue and to think about a response, but developments were very different between euro area countries (with Spain and Ireland experiencing strong house price booms but Germany and Austria seeing almost no change in house prices), and this would seem to be the main reason why the ECB never raised interest rates to restrain the house price booms in the former (which it correctly identified).
Since the crisis the Fed and the BoE have produced analyses suggesting that monetary policy bore almost no responsibility for the house price rises, on the one hand, and that using interest rates to restrain them would have caused sharp downward pressures on income and employment, on the other. The trouble with these analyses is that they consider only the effect of interest rates being a little higher before the crisis, with everything else equal. But of course the advocates of ‘leaning against the wind’ (the minority view which has favoured using interest rates to head off large asset price booms) have always emphasised that the existence of such a policy needs to be known in advance, so that it feeds into the public’s expectations of asset prices and helps to stabilise them. The absence of any such expectations effect in these analyses means that they are wide open to the Lucas Critique, and their results cannot be taken as an argument against leaning against the wind in this case.
What this all amounts to is our conclusion that the failure to adequately monitor developments in the housing markets means that the central banks of the United States and the United Kingdom, in particular, cannot reasonably claim to have done all they could have done to mitigate the house price movements that were crucial to the incidence and depth of the financial crisis.
The main outcome of the crisis for the operations and strategy of monetary policy so far has been the creation of instruments and arrangements for ‘macro-prudential’ policies, which will indeed offer central banks some additional ways of addressing problems in asset markets. However, central banks need to take some responsibility for the debacle of 2007-2008 and its effects. And they need to find some way in the future to incorporate an element of leaning against the wind into their inflation targeting strategies, in case macro-prudential policies turn out to be inadequate.
It is not beyond the wit of man or woman to establish a central bank remit which has a primary focus on price stability but allows the central bank to react to other developments in extreme situations, as long as it makes clear publicly that this is what it is doing, and why, and for how long it expects to be doing it.
Such a revised remit would and should incorporate useful expectations-stabilising effects for asset markets. The transparency and accountability involved would also help to shore up the independence of the central banks (particularly the BoE) at a time when there is so much pressure on them from the political authorities to ensure economic recovery.
Oxford Journals has published a special issue on the topic of Monetary Policy, with free papers until the end of March 2014.
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Image credit: Bank of England, Threadneedle Street, London. By Eluveitie. CC-BY-SA-3.0 via Wikimedia Commons
