How the Eurozone Exports Deflation

Fiscal devaluation without wage growth will trigger bad side effects both at home and abroad.

Mario Draghi
Mario Draghi PHOTO: ALESSIA PIERDOMENICO/BLOOMBERG NEWS

The latest European Commission economic forecasts released Thursday show a disturbing continuation of the recent build up in imbalances within the European Monetary Union. Germany expects a record current-account surplus in excess of 8.5% of gross domestic product for 2015 and 2016, while all the other eurozone countries will continue to chase their tails seeking a bigger share of external demand through internal devaluations. And yet these imbalances are accompanied by a disingenuous narrative suggesting that a current-account surplus is the corollary to export performance and competitiveness.

“Restoring competitiveness via structural reforms,” as the mantra goes, has in practice been a policy not so much geared toward creating productivity gains but rather designed to pursue wage and price reductions to boost exports. When these nominal or real reductions in wages were difficult to secure politically, they were replaced by fiscal devaluations, shifting taxes away from labor toward indirect taxes. It’s a policy that mimics an exchange-rate devaluation by modifying relative prices.

In effect, Europe has replaced the competitive exchange-rate devaluations of the 1970s and 1980s with wage compression and fiscal devaluations within the euro. The result is a policy race to the bottom that spreads deflation inside and outside the euro area. Even a country like Finland, which stands at the top of every competitiveness and ease-of-doing-business indicator, has now convinced itself that the best way to lift itself out of a three-year recession is to restore price competitiveness through a reduction in hourly wages.

The collective effect of this policy weighs heavily on aggregate demand and fuels deflationary forces. It also undermines the European Central Bank’s objective of achieving 2% inflation through low interest rates and purchases of sovereign bonds and other assets.

The European Commission’s macroeconomic-imbalances procedure, which was established during the crisis to allow the better coordination of national economic policies, has so far been a failure. It has proved ineffective for spotting excessive deficits and impotent in confronting excessive surpluses.

The eurozone needs to address its internal and external imbalances more seriously. This can’t be achieved by fiscal consolidation, structural reforms and devaluations. It has to involve not only fiscal expansion in countries that can afford it most, but also a sustained rise in wages across the euro area to boost domestic demand.

The inability to do so is no longer simply a problem for the eurozone itself. It’s a matter of global relevance. The eurozone’s current-account surplus is now 3.7% of GDP, the largest in the world in absolute terms, and it’s expected to remain at such elevated levels over the next few years. A possible new round of monetary accommodation by the ECB could increase it even further.

Indeed, a depreciation of the euro would only be expansionary for the whole world if the effects on domestic demand and financial conditions in the eurozone were greater than the contractionary side-effect of appreciating other currencies in the rest of the world. Yet monetary policy alone, at least in the near term, won’t be able to countervail the demand-suppressing consequences of lower wages and debt deleveraging.

The debate on the degree to which Europe’s policy failure has become a global one hasn’t really started. The International Monetary Fund and the G-20 statements remain too kind and international pressures too limited.

Since the height of the crisis, the matter of global imbalances has receded and international coordination on the matter has declined. The IMF expects the U.S. current-account deficit to have shrunk by nearly half compared to 2007 levels. China’s slow rebalancing has brought the current-account surplus down to 3% of GDP from 10%.

Meanwhile, the U.S. and China seem to have found at least a transitory monetary peace, a pax chimericana: the U.S. government will agree to China’s newly created Asia Infrastructure Investment Bank and entry into the IMF’s special drawing rights basket of currencies, while China will try to maintain a relatively stable currency to prevent another round of rapid appreciation of the dollar.

This policy coordination between the world’s two leading economic powers seems far more developed and effective than what’s happening within the G-20 and surely within the eurozone. And yet, the case against the eurozone’s macroeconomic policy is unlikely to be made effectively at the forthcoming G-20 summit in Turkey because it is politically charged and directly linked to the dysfunctional governance of the monetary union.

In Europe, there hasn’t been a meaningful discussion on macroeconomics since ECB President Mario Draghi’s Jackson Hole speech last year. The fiscal question remains largely taboo, and the policy consensus is that economic reforms and currency devaluation can somehow kick-start and sustain the recovery. Both the empirical and theoretical evidence suggest the opposite.

The eurozone and its member states can’t continue to behave as if they were a small, open economy. It’s a mistake for the G-20 to let the eurozone continue to free ride and undermine the increasingly fragile global recovery.

Mr. Vallée, a former adviser to the French economy minister and the president of the European Council, is a senior economist at Soros Fund Management LLC.

Changes in the Draghi speech at Jackson Hole

Draghi pronounced a pretty major speech at Jackson Hole but the delivery of the speech has been marred by a controversy over changes he would have introduced himself compared to the original version of the speech (which was momentarily posted on the ECB’s website).

There are several interpretations about the origin of these changes: whether they respond to the climate there and the friendly peer pressure he might have received there. Or whether they are part of a more deliberate strategy to go beyond what his services had prepared in order to push both his Executive Board and the Governing Council further.

But the changes are pretty unequivocal on the assessment but more prudent on the action to take. Indeed, while Draghi qualifies the risk of disanchoring of inflation expectations, which really accelerated only in august. He is more cautious on the policy conclusions where he repeats the agreed language on “all instruments” rather specifically “unconventional instruments”.

You can view the changes in pdf here

ECB Press Statement Comparison between February 2014 and March 2014

Ladies and gentlemen, the Vice-President and I are very pleased to welcome you to our press conference. We will now report on the outcome of today’s meeting of the Governing Council.

Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. Incoming information confirms that the moderate recovery of the euro area economy is proceeding in line with our previous assessment. At the same time, underlying price pressures in the euro area remain weak andlatest ECB staff macroeconomic projections, now covering the period up to the end of 2016, support earlier expectations of a prolonged period of low inflation, to be followed by a gradual upward movement in HICP inflation rates towards levels closer to 2%. In keeping with this picture, monetary and credit dynamics areremain subdued. Inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. As stated previously, we are now experiencing a prolonged period of low inflation, which will be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on.

Regarding the medium-term outlook for prices and growth, furtherthe information and analysis will becomenow available in early March. Recent evidence fully confirmsconfirm our decision to maintain an accommodative stance of monetary policy stance for as long as necessary, which. This will assist the gradual economic recovery in the euro area. We firmly reiterate our forward guidance. We continue to expect the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation is based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy, the high degree of unutilised capacity and subdued monetary dynamics. With regard to recent money market volatility and its potential impact on our monetary policy stance, wecredit creation.

We are monitoring developments on money markets closely and are ready to consider all available instruments available to us. Overall, we remain firmly determined to maintain the high degree of monetary accommodation and to take further decisive action if required.

Let me now explain our assessment in greater detail, starting with the economic analysis. Following two quarters of positive realReal GDP growth, developments in recent data and surveys overall suggest that the moderate recovery continued in the euro area rose by 0.3%, quarter on quarter, in the last quarter of 2013., thereby increasing for three consecutive quarters. Developments in survey-based confidence indicators up to February are consistent with continued moderate growth also in the first quarter of this year. Looking ahead, our previous assessment of economic growth has been confirmed. Output in the euro area the ongoing recovery is expected to recoverproceed, albeit at a slow pace. In particular, some further improvement in domestic demand should materialise, supported by the accommodative monetary policy stance, improving financing conditions and the progress made in fiscal consolidation and structural reformsreform. In addition, real incomes are supported by lower energy price inflationprices. Economic activity is also expected to benefit from a gradual strengthening of demand for euro area exports. At the same time, although unemployment in the euro area is stabilising, it remains high, and the necessary balance sheet adjustments in the public and the private sectorsectors will continue to weigh on the pace of the economic recovery.

This assessment is also broadly reflected in the March 2014 ECB staff macroeconomic projections for the euro area, which foresee annual real GDP increasing by 1.2% in 2014, 1.5% in 2015 and 1.8% in 2016. Compared with the December 2013 Eurosystem staff macroeconomic projections, the projection for real GDP growth for 2014 has been revised slightly upwards.

The risks surrounding the economic outlook for the euro area continue to be on the downside. Developments in global money and financial market conditions and related uncertainties, notably markets and in emerging market economies, as well as geopolitical risks, may have the potential to negatively affect economic conditions negatively. Other downside risks include weaker than expected domestic demand and export growth and slow or insufficient implementation of structural reforms in euro area countries.

According to Eurostat’s flash estimate, euro area annual HICP inflation was 0.7% in January 2014, after 0.8% in December. This decline was mainly due to energy price developments. At the same time, the inflation rate in January 2014 was lower than generally expected.8% in February 2014, unchanged from the (upwardly revised) outcome for January. While energy prices fell more strongly in February than in the previous month, increases in industrial goods and services prices were higher than in January. On the basis of current information and prevailing futures prices for energy, annual HICP inflation rates are expected to remain at around current levels in the coming months. Over the medium term, underlying price pressures in the euro area are expectedThereafter, inflation rates should gradually increase and reach levels closer to remain subdued. Inflation2%, in line with inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%..

BothThis assessment is also broadly reflected in the March 2014 ECB staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.0% in 2014, 1.3% in 2015 and 1.5% in 2016. In the last quarter of 2016, annual HICP inflation is projected to be 1.7%. In comparison with the December 2013 Eurosystem staff macroeconomic projections, the projection for inflation for 2014 has been revised slightly downwards. In view of the first publication of a three-year projection horizon in the March 2014 ECB staff macroeconomic projections, it should be stressed that the projections are conditional on a number of technical assumptions, including unchanged exchange rates and declining oil prices, and that the uncertainty surrounding the projections increases with the length of the projection horizon.

Regarding the Governing Council’s risk assessment, both upside and downside risks to the outlook for price developments remainare seen as limited, and they continueare considered to be broadly balanced over the medium term.

Turning to the monetary analysis, data for December 2013January 2014 confirm the assessment of subdued underlying growth in broad money (M3) and credit. Annual growth in M3 moderatedincreased to 1.2% in January, from 1.0% in December, from 1.5% in November. Deposit outflows. The monthly inflow to M3 in January was substantial, compensating for the strong outflow in December mirrored the strong sales of government and private sector securities by euro area MFIs, which, in part, could be related to adjustments by banks. The increase in anticipation of the ECB’s comprehensive assessment of banks’ balance sheets. These developments also affectedM3 growth reflected a stronger annual growth inrate of M1, which moderatedrose to 6.2% from 5.87% in December but remained strong. As in previous months, the main factor supporting annual M3 growth was an increase in the MFI net external asset position, which continued to reflect the increased interest of international investors in euro area assets. The annual rate of change of loans to the private sector continued to contract. The annual growth rate of loans to households (adjusted for loan sales and securitisation) stood at 0.3% in December, broadly unchanged since the beginning of 2013. The annual rate of change of loans to non-financial corporations (adjusted for loan sales and securitisation) was -2.9% in December, after -3.1% in November. The January 2014 bank lending survey provides indications of some further stabilisation in credit conditions for firms and households and a smaller net decline in loan demand by enterprises. Overall, weakJanuary, unchanged from December. Weak loan dynamics for non-financial corporations continue to reflect their lagged relationship with the business cycle, credit risk and the ongoing adjustment of financial and non-financial sector balance sheets. The annual growth rate of loans to households (adjusted for loan sales and securitisation) stood at 0.2% in January 2014, broadly unchanged since the beginning of 2013.

Since the summer of 2012 substantial progress has been made in improving the funding situation of banks. In order to ensure an adequate transmission of monetary policy to the financing conditions in euro area countries, it is essential that the fragmentation of euro area credit markets declines further and that the resilience of banks is strengthened where needed. This is the objective of the ECB’songoing comprehensive assessment by the ECB, while thea timely implementation of additional steps to establish a banking union will further help to restore confidence in the financial system.

To sum up, the economic analysis confirms our expectation of a prolonged period of low inflation, to be followed by a gradual upward movement towards levels of inflation rates below, but closecloser to, 2% later on.%. A cross-check with the signals from the monetary analysis confirms the picture of subdued underlying price pressures in the euro area over the medium term.

As regards fiscal policies, the ECB staff macroeconomic projections indicate continued progress in reducing fiscal imbalances in the euro area. The aggregate euro area general government deficit is expected to have declined to 3.2% of GDP in 2013 and is projected to be reduced further to 2.7% of GDP this year. General government debt is projected to peak at 93.5% of GDP in 2014, before declining slightly in 2015. Looking ahead, euro area countries should not unravel past consolidation efforts and should put high government debt ratios on a downward trajectory over the medium term. Fiscal strategies should be in line with the Stability and Growth Pact and should ensure a growth-friendly composition of consolidation which combines improving the quality and efficiency of public services with minimising distortionary effects of taxation. When accompanied by National authorities should also continue with the decisive implementation of structural reforms, these strategies will further support the still fragile economic recovery. Governments must therefore continue with product and labour market reforms. in all euro area countries. These reforms will helpshould aim, in particular, to enhancemake it easier to do business and to boost employment, thus enhancing the euro area’s growth potential and reduce the highreducing unemployment rates in many countriesin the euro area countries. To this end, the Governing Council welcomes the European Commission’s communication of yesterday on the prevention and correction of macroeconomic imbalances and on the Excessive Deficit Procedure. Looking ahead, it is key that the macroeconomic surveillance framework in the euro area, which was significantly strengthened in the wake of the sovereign debt crisis, is implemented fully and in a consistent manner.

We are now at your disposal for questions.

 

January 2014 Governing Council Press Statement Track Changes

Statement Comparison between January 2014 and December 2013

ECBwatchers.org

Ladies and gentlemen, the Vice-President and I am are very pleased to welcome you to our press conference. I will now report on the outcome of today’s meeting of the Governing Council, which was also attended by the Commission Vice-President, Mr Rehn. Let me wish you all a Happy New Year. I would also like to take this opportunity to welcome Latvia as the eighteenth country to adopt the euro as its currency. Accordingly, Mr Rimšēvičs, the Governor of Latvijas Banka, became a member of the Governing Council on 1 January 2014. We will now report on the outcome of today’s meeting of the Governing Council.

Based on our regular economic and monetary analyses, we decided to keep the key ECB interest rates unchanged. Incoming information and analysis have confirmed continued to confirm our previous assessment and monetary policy decisions of last month.. Underlying price pressures in the euro area are expected to remain subdued over the medium term. In keeping with this picture, monetary and credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be are firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggestscontinues to suggest that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Our monetary policy stance Against this background, the Governing Council strongly emphasises that it will remain maintain an accommodative stance of monetary policy for as long as necessary, and which will thereby continue to assist the gradual economic recovery in the euro area. In this context, the Governing Council confirmed its Accordingly, we firmly reiterate our forward guidance that it continues to we continue to expect the key ECB interest rates to remain at present or lower levels for an extended period of time. This As previously stated, this expectation continues to be is based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy and subdued monetary dynamics. With regard to money market conditions and their potential impact on our monetary policy stance, we are monitoring developments closely and are ready to consider all available instruments. Overall, we remain determined to maintain the high degree of monetary accommodation and to take further decisive action if required.

Let me now explain our assessment in greater detail, starting with the economic analysis. Following a rise of 0.3% in the second quarter of 2013, realReal GDP in the euro area increased rose by 0.1%, quarter on quarter, in the third quarter of 2013, following an increase of 0.3% in the second quarter. Developments in survey-based confidence indicators up to November are consistent with a positive growth rate also in the fourth quarter of the year.While developments in industrial production data for October point to a weak start to the fourth quarter, survey-based confidence indicators up to December have improved further from low levels, overall indicating a continuation of the gradual recovery in economic activity. Looking ahead toat 2014 and 2015, output is expected to recover at a slow pace, in particular owing to some improvement in domestic demand supported by the accommodative monetary policy stance. Euro area economic activity should, in addition, benefit from a gradual strengthening of demand for exports. Furthermore, the overall improvements in financial markets seen since last year the summer of 2012 appear to be working their way through to the real economy, as should the progress made in fiscal consolidation. In addition, real incomes have benefited recently from lower energy price inflation. At the same time, unemployment in the euro area remains high, and the necessary balance sheet adjustments in the public and the private sector will continue to weigh on economic activity.

This assessment is also reflected in the December 2013 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP declining by 0.4% in 2013 before increasing by 1.1% in 2014 and 1.5% in 2015. Compared with the September 2013 ECB staff macroeconomic projections, the projection for real GDP growth for 2013 has remained unchanged and it has been revised upwards by 0.1 percentage point for 2014.

The risks surrounding the economic outlook for the euro area are assessedcontinue to be on the downside. Developments in global money and financial market conditions and related uncertainties may have the potential to negatively affect economic conditions. Other downside risks include higher commodity prices, weaker than expected domestic demand and export growth, and slow or insufficient implementation of structural reforms in euro area countries.

According to Eurostat’s flash estimate, euro area annual HICP inflation increased in November 2013 to was 0.8% in December 2013, compared with 0.9%, from 0.7% in October. The increase November. This outcome was broadly as expected and reflected, in particular, an upward base effect in energy prices and higher lower services price inflation. On the basis of prevailing futures prices for energy, annual inflation rates are expected to remain at around current levels in the coming months. Over the medium term, underlying price pressures in the euro area are expected to remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%.

Broadly in line with this assessment, the December 2013 Eurosystem staff macroeconomic projections for the euro area foresee annual HICP inflation at 1.4% in 2013, at 1.1% in 2014 and at 1.3% in 2015. In comparison with the September 2013 ECB staff macroeconomic projections, the projection for inflation for 2013 has been revised downwards by 0.1 percentage point and for 2014 it has been revised downwards by 0.2 percentage point.

The risks to the outlook for price developments are continue to be seen to beas broadly balanced over the medium term. Upside, with upside risks relaterelating to higher commodity prices and stronger than expected increases in administered prices and indirect taxes, while and downside risks stemstemming from weaker than expected economic activity.

Concerning the staff macroeconomic projections, let me inform you that the Governing Council has decided to publish more details as of December 2013. You will receive this material today after the press conference.

Turning to the monetary analysis, data for October confirmNovember support the assessment ofof continued subdued underlying growth in broad money (M3) and credit. Annual growth in M3 moderated towas broadly unchanged at 1.5% in November, after 1.4% in October, from 2.0%following two consecutive declines in September. This moderation was partly related to a base effect. and August. Annual growth in M1 remained strong at 6.65%, reflecting a preference for liquidity, although it was below the peak of 8.7% observed in April. Net capital inflows into the euro area continued to be 2013. As in previous months, the main factor supporting annual M3 growth, while was an increase in the MFI net external asset position, which continued to reflect the increased interest of international investors in euro area assets. The annual rate of change of loans to the private sector remained weak. The annual growth rate of loans to households (adjusted for loan sales and securitisation) stood at 0.3% in OctoberNovember, broadly unchanged since the beginning of the year.2013. The annual rate of change of loans to non-financial corporations (adjusted for loan sales and securitisation) was –2.9% in October, following -2.8% in September and -2.9% in August.3.1% in November, following -3.0% in October. Overall, weak loan dynamics for non-financial corporations continue to reflect their lagged relationship with the business cycle, credit risk and the ongoing adjustment of financial and non-financial sector balance sheets.

Since the summer of 2012 substantial progress has been made in improving the funding situation of banks. In order to ensure an adequate transmission of monetary policy to the financing conditions in euro area countries, it is essential that the fragmentation of euro area credit markets declines further and that the resilience of banks is strengthened where needed. The ECB’sforthcoming comprehensive assessment before it adopts its supervisory role underby the single supervisory mechanism ECB will further support this confidence-building process. It will enhance the quality of information available on the condition of banks and result in the identification and implementation of necessary corrective actions. Further decisive A timely implementation of further steps to establish a banking union will help to restore confidence in the financial system.

To sum up, the economic analysis indicates that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. A cross-check with the signals from the monetary analysis confirms this picture.

As regards fiscal policies, the Governing Council welcomes the European Commission’s assessment of the 2014 draft budgetary plans which were submitted in October for the first time under the “two-pack” regulations. This new surveillance exercise needs to be fully effective. In order to put high public debt ratios on a downward path, governments should not unravel their efforts to reduce deficits and sustain fiscal adjustment over the medium term. In particular, consolidation measures should be growth-friendly and have a medium-term perspective, so as both to improve public services and minimise the distortionary effects of taxation. At the same time, there is a need to push ahead with product and labour market reforms, in order to improve competitiveness, raise potential growth, generate employment opportunities and foster the adaptability of our economies.

As regards fiscal policies, it is important not to unravel past efforts but to sustain fiscal consolidation over the medium term. Fiscal strategies should be in line with the fiscal compact and should ensure a growth-friendly composition of consolidation, which combines improving the quality and efficiency of public services with minimising distortionary effects of taxation. When accompanied by the decisive implementation of structural reforms, this will further support the gradual economic recovery in the euro area and have a positive impact on public finances. Reforms in product and labour markets and a rigorous enactment of Single Market policies warrant particular focus to improve the outlook for economic growth and to foster job creation in an environment of high unemployment.

We are now at your disposal for questions.

See the pdf here.

ECB and the treatment of sovereign debt

Peter Praet gave an interview to the Financial Times this morning where he made a very important point about sovereign debt holdings (full transcript without the paywall courtesy of the ECB here):

The worst case, to say it very bluntly, is of a central bank providing liquidity to banks just to buy or carry legacy assets, and the banking sector doesn’t restructure. This was typically the Japanese situation in the early 2000s.

Perhaps paradoxically, a rigorous AQR and stress test helps monetary policy. Appropriately treating banks’ holdings of sovereign debt according to the risk that they pose to banks’ capital makes it unlikely that the banks will use central bank liquidity to excessively increase their exposure to sovereign debt. This is because banks will be wary of the constraints placed on sovereign debt by the stress tests to which they are subject at the same time.

The ECB had expressed dissatisfaction about the fact that the previous round of LTRO had been used to buy sovereign bonds and offered banks with an easy carry trade which in turn contributed to increase financial fragmentation and the sovereign-banks nexus as banks hoarded domestic government bonds. This is now described as an unintended consequence that needs to be addressed. This was a critical point made by Jens Weidmann in a recent OpEd in the FT and it is also something that has been at the heart of discussions in the context of the AQR and the ESRB.

There are two very different problems here that should be distinguished.

The first is the increase in sovereign debt holdings in aggregate and this is hardly an unintended consequences, this was actually precisely the point of the LTRO. Get banks to hold assets because their liquidity risks were taken care of. The LTRO were designed both to stabilize sovereign debt markets and loosen monetary conditions, in that sense they have worked pretty well, driving government funding pressures and affected yields across the credit spectrum.

The second is the concentration of domestic debt, (ie. the renationalisation of debt holdings). This is the real unintended consequence. The ECB probably didn’t anticipated so much national hoarding. But this can easily be controlled by diversification/concentration caps on sovereign debt holdings. This is actually something the ECB could impose as a single supervisor, via the European Systemic Risk Board or in the context of the AQR but this is very different from imposing capital surcharges or haircuts on sovereign debt in repo operations.

Conclusion

It is critical that the ECB differentiates the problem of large holdings of sovereign debt (quite normal in high risk aversion environment) from high domestic concentration of sovereign debt holdings. These are two different issues. Confusing both will lead the ECB to:

  • tighten monetary condition at the worse possible moment
  • weaken the transmission channels via the refinancing operations of      government debt
  • destabilise government debt markets by exacerbating already      challenging funding conditions for sovereigns
  • weaken banks’ profitability and increase risks to financial      stability

PREs, VSPs and the ECB: a response to Paul Krugman

 

In a response to one of our recent posts on Peter Praet’s speech, Paul Krugman argued that there was indeed a fight inside the ECB between the PRE (pretty reasonable economists) and the VSP (very serious people).  We disagree.

Our understanding of what is going on at the ECB is different and somewhat more troubling. We think these categories are not relevant because there isn’t an actual debate between PREs and VSPs but rather a common defensive stance in support of a defunct monetary policy doctrine.

This is probably a stretch but what is clear is that there isn’t at the ECB a culture of economic debate, of disagreements and dissent as much as there is at the Federal Reserve. This is problematic because by pretending to be consensual, governing council members are impeding an intellectual process that is very necessary in difficult times. As a result, this is creating a profound intellectual drag that undermines new thinking about the crisis, about monetary policy and about the monetary union precisely at a moment where disagreements are part and parcel of a necessary process to come to grips with the situation at hands.

Instead, the ECB prefers to paint itself into an academic and policy corner by referring constantly to a fragile doctrine. If anything the discussion about publishing the minutes of the governing council meetings (which was meant to be closed by the end of the year and on which a decision has been postponed) is likely to exacerbate this state of affairs even more by pushing Governing Council members to be more cautious about their communication even inside the secrecy of the Governing Council rather than embrace their respective viewpoints and differences.

The more recent example of this fact is the last speech by Benoit Coeuré (arguably one of the most progressive and intellectually savvy member of the Executive Board) who still managed to pronounce one of the most conservative and incongruous speeches in recent memory.

There are at least three reasons for such a speech:

  • The first one is office politics. Peter Praet, the Head of Research at the ECB, is most probably going to be appointed Vice Chair of the Supervisory Board (despite Vitor Constancio and Yves Mersch fighting for the job), which means that the job of Head of Research of ECB is up for grabs. This is an important job because the Head of Research makes the interest rate proposal to be discussed and approved by the Governing Council. Coeuré is arguably the most qualified of all board members to land the job. He was the chief economist of the French Treasury and has a strong academic pedigree (by ECB standards). Since Coeuré would have to run DG economics, also known as the guardians of the temple, he certainly felt compelled to pay his respect to the ordoliberal throne.
  • The second is European politics. Given the rise in Germans’ concerns about inflation risks, ECB board members need to appear hawkish to assuage German anxieties in order to remain credible and audible in the biggest economy of the monetary union. This pandering to German misconceptions forces the board to “talk the talk”. But “events my dear boy, events” and the economic situation don’t allow the ECB to “walk the walk” which creates very serious communication hazards.
  • The last one is intellectual short sightedness. The sad fact is that the ECB refuses to engage seriously in the debate over modern monetary policy that is raging across academia and the central banking community globally. This is even more regrettable coming from Coeuré who, by virtue of being in charge of market operations, should be more equipped than anybody else on the board to think about modern monetary policy.

The gist of the latest speech by Benoit Coeuré betrays a concerning reluctance to think openly and critically about the conduct of monetary policy and the institutional set-up of the monetary union

On the monetary policy framework, the Panglossian view is basically that: 

We know what has worked in the euro area: an allocation of tasks based on the primacy of price stability. And we know what has not worked: a lack of stability orientation in other policy areas. We have been successful in delivering price stability because we have a clear alignment of objectives and instruments – what is called by economists the “Tinbergen principle”.

First, even by this restrictive metric, this is incorrect since the ECB is forecasting inflation to remain below its own definition of price stability trough to 2015.

Second, it betrays a real neglect for the flaws in the conduct of monetary policy in the first decade of the euro, which have produced price stability but also credit and asset bubbles and contributed to the crisis we know. This is worrying because it partly explains why so little progress has been made on the design of a clear and effective macro prudential policy framework.

On the institutional set-up of the monetary union.

First, Coeuré basically undermines more than a year of intense work for creating a full fledged banking union with a strong fiscal backstop precisely at the time when European governments are negotiating one such backstop arrangement in the context of the Single Resolution Mechanism.

And let me be clear: [the ongoing process of building a banking union] will not be achieved by mutualising risks. On the contrary, banking union reduces risks for taxpayers.

Second, and contrary to what the ECB (from Trichet to Draghi) has been arguing for a long time, Coeuré tries to make the case that the monetary union can be rebuilt without further steps in the way of greater European integration thereby defending a form of institutional status quo:

This does not require a quantum leap in integration. I do not see a strong case today for further fiscal centralisation (…) adjustment can and should take place via flexible markets.

Conclusion

The culture of dissent that is so present at the Federal Reserve and which Paul Krugman often refers to as the conflict with the VSP and the PRE doesn’t really apply at the ECB. In this sense, there is no Manichean fight between the doves and the hawks but rather a generalized intellectual paralysis about monetary policy at the zero lower bound. This lack of internal intellectual debates and even arguments about monetary policy doctrines, instruments, and transmission channels is probably the biggest danger for the ECB and for the euro area as a whole.

 

December 2013 Governing Council Press Statement Track Changes

We are just writing a longer post about monetary policy options at this stage to counter the narrative that the ECB cannot do much at this stage. But in the meantime, here is a very short summary of the gist of the press conference today. The governing council decision today brought very little new information to the table. The new ECB staff projections continue to see improvements in the economic outlook but have started to bring inflation projections lower.

This assessment is also reflected in the December 2013 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP declining by 0.4% in 2013 before increasing by 1.1% in 2014 and 1.5% in 2015. Compared with the September 2013 ECB staff macroeconomic projections, the projection for real GDP growth for 2013 has remained unchanged and it has been revised upwards by 0.1 percentage point for 2014.

Projections for the euro area foresee annual HICP inflation at 1.4% in 2013, at 1.1% in 2014 and at 1.3% in 2015. In comparison with the September 2013 ECB staff macroeconomic projections, the projection for inflation for 2013 has been revised downwards by 0.1 percentage point and for 2014 it has been revised downwards by 0.2 percentage point.

With a marginally better activity outlook, the ECB foresees more downward price pressures and inflation to remain below its target for more than 2 years. The reason why that is, isn’t very clear.

However no action seems to be on the card, in particular, there was no upgrading of the forward guidance language which was simply confirmed and not even reviewed as it was last month. There is in the statement a slight opening to a more active monetary policy stance but only in related to money market conditions rather than monetary conditions in general:

With regard to money market conditions and their potential impact on our monetary policy stance, we are monitoring developments closely and are ready to consider all available instruments.

 

See our tracking of the changes in the statement below or here  for the PDF file.

Statement Comparison between November and December

ECBwatchers.org

 

Ladies and gentlemen, I am very pleased to welcome you to our press conference. I will now report on the outcome of today’s meeting of the Governing Council, during which we took a number of decisions on key ECB interest rates, forward guidance and liquidity provisionwhich was also attended by the Commission Vice-President, Mr Rehn.

First, basedBased on our regular economic and monetary analyses, we decided to lowerkeep the key ECB interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25% and the rate on the marginal lending facility by 25 basis points to 0.75%. The rate on the deposit facility will remain rates unchanged at 0.00%. These. Incoming information and analysis have confirmed our assessment and monetary policy decisions are in line with our forward guidance of July 2013, given the latest indications of further diminishing underlyingof last month. Underlying price pressures in the euro area are expected to remain subdued over the medium term, starting from currently low annual inflation rates of below 1%.. In keeping with this picture, monetary and, in particular, credit dynamics remain subdued. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. Accordingly, ourOur monetary policy stance will remain accommodative for as long as necessary. It, and will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October.

Second, following today’s rate cutin the euro area. In this context, the Governing Council reviewed theconfirmed its forward guidance provided in July and confirmed that it continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time. This expectation continues to be based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy and subdued monetary dynamics. With regard to money market conditions and their potential impact on our monetary policy stance, we are monitoring developments closely and are ready to consider all available instruments.

Third, we continue to monitor closely money market conditions and their potential impact on our monetary policy stance. We are ready to consider all available instruments and, in this context, we decided today to continue conducting the main refinancing operations (MROs) as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the 6th maintenance period of 2015 on 7 July 2015. This procedure will also remain in use for the Eurosystem’s special-term refinancing operations with a maturity of one maintenance period, which will continue to be conducted for as long as needed, and at least until the end of the second quarter of 2015. The fixed rate in these special-term refinancing operations will be the same as the MRO rate prevailing at the time. Furthermore, we decided to conduct the three-month longer-term refinancing operations (LTROs) to be allotted until the end of the second quarter of 2015 as fixed rate tender procedures with full allotment. The rates in these three-month operations will be fixed at the average rate of the MROs over the life of the respective LTRO.

Let me now explain our assessment in greater detail, starting with the economic analysis. Real GDP in the euro area rose by 0.Following a rise of 0.3%, quarter on quarter,% in the second quarter of 2013, following six quarters of falling output.real GDP in the euro area increased by 0.1%, quarter on quarter, in the third quarter. Developments in survey-based confidence indicators up to OctoberNovember are consistent with continued, albeit modest,a positive growth rate also in the second halffourth quarter of the year. Looking ahead to 2014 and 2015, output is expected to continue to recover at a slow pace, in particular owing to a gradualsome improvement in domestic demand supported by the accommodative monetary policy stance. Euro area economic activity should, in addition, benefit from a gradual strengthening of demand for exports. Furthermore, the overall improvements in financial markets seen since last year appear to be gradually working their way through to the real economy, as should the progress made in fiscal consolidation. In addition, real incomes have benefited recently from generally lower energy price inflation. This being saidAt the same time, unemployment in the euro area remains high, and the necessary balance sheet adjustments in the public and the private sectorssector will continue to weigh on economic activity.

This assessment is also reflected in the December 2013 Eurosystem staff macroeconomic projections for the euro area, which foresee annual real GDP declining by 0.4% in 2013 before increasing by 1.1% in 2014 and 1.5% in 2015. Compared with the September 2013 ECB staff macroeconomic projections, the projection for real GDP growth for 2013 has remained unchanged and it has been revised upwards by 0.1 percentage point for 2014.

The risks surrounding the economic outlook for the euro area continueare assessed to be on the downside. Developments in global money and financial market conditions and related uncertainties may have the potential to negatively affect economic conditions. Other downside risks include higher commodity prices, weaker than expected domestic demand and export growth, and slow or insufficient implementation of structural reforms in euro area countries.

According to Eurostat’s flash estimate, euro area annual HICP inflation decreasedincreased in OctoberNovember 2013 to 0.79%, from 1.10.7% in September. This declineOctober. The increase was stronger thanbroadly as expected and reflected, in particular, lower food price inflation, a larger fallan upward base effect in energy prices and some weakening inhigher services price inflation. On the basis of currentprevailing futures prices for energy, annual inflation rates are expected to remain at low around current levels in the coming months. UnderlyingOver the medium term, underlying price pressures in the euro area are expected to remain subdued over the medium term. At the same time, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Such a constellation suggests that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below but close to 2% later on.

Taking into account today’s decisionsBroadly in line with this assessment, the December 2013 Eurosystem staff macroeconomic projections for the euro area foresee annual HICP inflation at 1.4% in 2013, at 1.1% in 2014 and at 1.3% in 2015. In comparison with the September 2013 ECB staff macroeconomic projections, the projection for inflation for 2013 has been revised downwards by 0.1 percentage point and for 2014 it has been revised downwards by 0.2 percentage point.

The risks to the outlook for price developments are seen to be broadly balanced over the medium term. Upside risks relate in particular to higher commodity prices as well asand stronger than expected increases in administered prices and indirect taxes, andwhile downside risks stem from weaker than expected economic activity.

Concerning the staff macroeconomic projections, let me inform you that the Governing Council has decided to publish more details as of December 2013. You will receive this material today after the press conference.

Turning to the monetary analysis, data for SeptemberOctober confirm the assessment of subdued underlying growth ofin broad money (M3) and, in particular, credit. Annual growth in M3 moderated to 2.11.4% in October, from 2.0% in September, from 2.3% in August. This moderation was partly related to a base effect. Annual growth in M1 remained strong at 6.6%, reflecting a preference for liquidity, although it was below the peak of 8.7% observed in April. Net capital inflows into the euro area continued to be the main factor supporting annual M3 growth, while the annual rate of change of loans to the private sector remained weak. The annual growth rate of loans to households (adjusted for loan sales and securitisation) stood at 0.3% in SeptemberOctober, broadly unchanged since the turnbeginning of the year. The annual rate of change of loans to non-financial corporations (adjusted for loan sales and securitisation) was -2.79% in October, following -2.8% in September, compared with and -2.9% in August. Overall, weak loan dynamics for non-financial corporations continue to reflect primarily their lagged relationship with the business cycle, credit risk and the ongoing adjustment of financial and non-financial sector balance sheets. At the same time, the October 2013 bank lending survey tentatively signals a stabilisation in credit conditions for firms and households, in the context of still weak loan demand.

Since the summer of 2012 substantial progress has been made in improving the funding situation of banks. In order to ensure an adequate transmission of monetary policy to the financing conditions in euro area countries, it is essential that the fragmentation of euro area credit markets declines further and that the resilience of banks is strengthened where needed. The ECB’s comprehensive assessment before it adopts its supervisory role under the single supervisory mechanism will further support this confidence-building process. It will enhance the quality of information available on the condition of banks and result in the identification and implementation of necessary corrective actions. Further decisive steps to establish a banking union will help to restore confidence in the financial system.

To sum up, taking into account today’s decisions, the economic analysis indicates that we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on. A cross-check with the signals from the monetary analysis confirms this picture.

As regards fiscal policies, the euro area budget deficit is projected to decline further from 3.1% of GDP in 2013 to 2.5% in 2014, according to the European Commission’s autumn 2013 economic forecast. At the same time, the euro area government debt ratio is expected to rise from 95.5% of GDP in 2013 to 95.9% in 2014.Governing Council welcomes the European Commission’s assessment of the 2014 draft budgetary plans which were submitted in October for the first time under the “two-pack” regulations. This new surveillance exercise needs to be fully effective. In order to put high public debt ratios on a downward path, governments should not unravel their efforts to reduce deficits and sustain fiscal adjustment over the medium term. The composition of fiscalIn particular, consolidation measures should be geared towards growth-friendly measures which and have a medium-term perspective and combine improving the quality and efficiency of , so as both to improve public services with minimising and minimise the distortionary effects of taxation. Governments must also decisively strengthen efforts to implementAt the needed structural reforms in same time, there is a need to push ahead with product and labour markets. Progress has been made in reducing current account deficits and unit labour cost differentials, but substantial efforts still need to be undertaken with a viewmarket reforms, in order to further improvingimprove competitiveness, supporting rebalancing within the euro area and creating more flexible and dynamic economies that in turnraise potential growth, generate sustainable economic growth and employment. opportunities and foster the adaptability of our economies.

We are now at your disposal for questions.