Does the eurozone have a monetary policy transmission mechanism? Or rather a liquidity leak?

by on May 17, 2013 at 2:03 am in Economics, Uncategorized | Permalink

What would happen if the ECB immediately and directly ran a helicopter drop of money to the periphery?  I don’t find that an easy question to answer.  Here is one recent report:

But the indicator [interest rate spreads] has since risen again and reached a record of 3.7 percentage points in January, indicating companies in southern Europe were paying significantly higher interest rates than northern rivals.

“Market segmentation remains, divergence in bank lending rates persists and, as a result, immediate growth prospects in the periphery are bleak,” said Huw Pill, European economist at Goldman Sachs, who was previously a senior monetary policy official at the ECB in Frankfurt.

Or read this update. Here is a more specific story about how small to mid-sized Italian banks are contracting.

Would the new helicopter drop money be kept in periphery banks and lent out to stimulate business investment?  Or does the new money flee say Portugal because Portuguese banks are not safe enough, Portuguese loans are not lucrative and safe enough, and Portuguese mattresses are too cumbersome?

The former scenario implies that monetary policy should be potent.  The latter scenario implies that the helicopter drop will be for naught and the fiscal policy multiplier also will be low, on the upside at the very least (fiscal cuts still might cause a lot of damage on the downside).  I call this the liquidity leak, rather than the liquidity trap.

So which scenario is it?

Does it matter who gets the helicopter drop?  Perhaps a granny gets the money first and sticks it in the local bank.  Alternatively, a financial manager in Lisbon would transfer that same euro rather seamlessly to his second account in Frankfurt.  Under this differential scenario, changes in the distribution of wealth also have nominal and eventually real effects.

Is the flow of marginal deposits the problem or the flow of marginal loans?  Or both?

Ryan Avent suggests allowing banks to swap their risky commercial loans for safer assets.  Other ideas propose running QE on packages of small to mid-sized loans or accepting those loans as collateral at the ECB.  Of course these assets are difficult to price and also moral hazard problems would loom.  If the ECB is not “overpaying” for the small loans, they won’t be encouraged.  If the ECB is overpaying, there are plenty of Sicilian businessmen who have friends at the local bank.  The mere lending isn’t enough, the projects also need to be good ones, because in these cases we are talking about tackling issues in the real economy.  Can a long-distance ECB collateral support operation spur good, growth-inducing projects?  It is easy to see why the Germans might be skeptical.

In some regards these problems will look like liquidity traps, because monetary policy will not always work.  But in the periphery lending rates are high (albeit with restricted credit), and standard liquidity trap models will not in general apply.  Again, I call it the liquidity leak.

Liquidity trap approaches will encourage you to think in terms of raising expectations of inflation (which is indeed the correct question in many settings), but here the geographic distribution of credit and economic activity is instead the crux of the matter.  Our current macroeconomic tools are not well-suited for integration with spatial economics, I am sorry to say.

Addendum: On some related issues, read Scott Sumner.

Tom May 17, 2013 at 2:51 am

Rather than a helo drop of money, it should be 0% interest loan, for 5 years after the first grace year (with possible additional grace months).
To income tax taxpayers.
In an amount equal to last 3 years total tax paid.
Maximum loan is the median annual tax declared income for that country.
ECB gives out the loan; the local country tax authorities distribute the money and, later, make collections.

A “Tax Loan”. For all taxpayers who choose to participate.
More buying/ investment/ prior-loan repayment now, less in the future after other growth has started — fiscal neutral over the business cycle.

This should be an automatic program to start on downturns, and end on upturns. With the main positive increase in consumer/ investment decisions in the down times,
and the milder drag in later years.

Frederic Mari May 17, 2013 at 3:02 am

Eerie. I am trying to write a blog-post on Monetary policy, around the same questions… After all, as opposed to Scott Sumner, I am a monetary stimulus skeptic.

IMHO, Koo’s explanation of ‘balance sheet recession’ answers a lot of the initial question: In a crisis, fearful of the future, people don’t want to consume and companies don’t want to invest. Banks either don’t want to lend or don’t find takers for the kind of risk-reward loans they’re willing to give. Interest rates being zero is nearly irrelevant. It helps people with existing adjustable rates or, at most, with refinancing but that’s it.

Thus, dropping money in Portugal would probably get people to either pay down their debts (that’s still a worthwhile thing as deleveraging can only help) or saving – if possible, outside of the Portuguese system. Basically, effects will be limited, imho.

I don’t see how that translates with a low multiplier for fiscal stimulus such as infrastructure spending (if said infrastructure was needed). But tax cuts probably play relatively similarly to ‘money drops’.

Which is why I think wealth re-distribution effects and WHO you’re giving the money to matters. And why I was inquiring in a previous reply about the stickiness of consumption by income ranges/archetypal situations…

And these considerations are why I am fundamentally suspicious of monetary stimulus a la Scott Sumner. In his view, AFAICT, raising the specter of inflation credibly will get people to spend… because… well, who wants to hold money when it’s losing value? But I disagree that this is the most likely scenario. People may well INCREASE their saving to achieve post-inflation saving ‘targets’. People may also desperately seek another store of value such as gold or diamonds (gold-bugs would finally be vindicated!)…

You’re right that the geography matters in Europe, given that some areas are doing (relatively) well and some not. I guess the same would be true to some extent of the various US states. But that’s why we got fiscal transfers, targeted spending AND the possibility to vary taxes across areas.

I still don’t understand why you could not get, say, a sales tax (VAT) cut in Germany, to encourage greater consumption in Germany, say. And, say, a payroll tax cut in Southern Europe. Both could be financed by taxing our very wealthy individuals or our big corporations…

Floccina May 17, 2013 at 11:05 am

1. People may also desperately seek another store of value such as gold or diamonds.
If someone buys gold somebody sold gold and now has the money to spend.

2. Both could be financed by taxing our very wealthy individuals or our big corporations.
But they might flee your taxation. Also who consumes less if you tax these corporations and individuals?

Frederic Mari May 17, 2013 at 1:03 pm

1- Yeah, well, prices may well rise as too many people seek to hoard said store of value, thus creating a bubble i.e. you don’t get enough sellers. Yes, those who do sell will have money to spend. I suspect that the end result, if monetary easing does result in nothing but just gold price bubble, will not be enough to power a recovery/super-charge the US present tentative recovery.

2- They can try. There are ways to deal with that issue, tbh. http://theredbanker.blogspot.com/2012/05/taxes-here-comes-great-reaper-part-2.html

Frederic Mari May 17, 2013 at 1:06 pm

Sorry, missed the second bit of your second point.

The issue is that they are not consuming/investing enough at present. If we tax these people with excess cash, their cash position deteriorates, they get mightily pissed off at the evil, confiscatory government and cry a river in the press (they tend to own anyhow) but not much else will occur.

Alex Godofsky May 17, 2013 at 3:11 am

Why is it so crucial that the money stays in Portuguese banks? It’s not impossible for German banks to make loans to Portuguese citizens.

Edward Lambert May 17, 2013 at 4:35 am

I have done an analysis of monetary policy and I conclude that we are in a sub-optimal equilibrium. And the best policy now is to actually raise interest rates, that means the Fed funds rate. It should be raised to over 3%. And then we need to start working on getting back to the old optimal equilibrium.
http://effectivedemand.typepad.com/ed/2013/05/response-to-george-evans-we-need-a-fed-rate-of-4-now.html

meicate May 17, 2013 at 4:35 am

“The latter scenario implies that the helicopter drop will be for naught”

There will not be a helicopetr drop in Europe.
The ECB is keeping inflation at 2%. That is it’s one, only mandate. They do a successful job, no?
They will prevent deflation, but not de-leveraging.

They prefer to lend to businesses not sovereigns.

Merijn Knibbe May 17, 2013 at 5:27 am

Keeping consumer price inflation at 2% (“moins de 2%, proche de 2%”) is the mantra but not the mandate of the ECB. The mandate is to keep inflation low and stable AND, if it does not compromise the first task, to keep prosperity and employment high. The ECB itself has defined what ‘low and stable inflation’ actually is, they can change this definition. And they should sometimes change this definition. For one thing they have to track the broader GDP deflator (which also tracks prices of investments, i.e. includes new houses), which up to 2008 showed the same developments as consumer prices but which after 2008 was considerably smaller for years in a stretch. And they can include prices of existing house (which they should have done right from the beginning – hey, if one price became more important after 1950 it’s this one as (up to about 2000) more and more people owned houses while the very increase of this price made also made it more important. Considering the present level of as well consumer price inflation as well as GDP inflation (just checked the Eurostat data, look at value added in basic prices which excludes increases in VAT) there is ample room as, consdering the second mandata, need for more agressive policies. But indeed – they do want governments to borrow less and they do want (see the recent Peter Praet speech) the private sector to borrow (much) more – despite high private debt levels.

meicate May 17, 2013 at 5:59 am

“The mandate is to keep inflation low and stable AND, if it does not compromise the first task, to keep prosperity and employment high.”

This is perhaps your wish, but not reality (the FED has two mandates not the ECB). The ECB states; “The ECB is the central bank for Europe’s single currency, the euro. Its main task is to maintain the euro’s purchasing power.” If you read what Draghi says he is very serious about this. He has a very different job (and much easier job) than Bernanki or King. No government can bully him or beg with him. Therefore we have what is happening in Greece and similar.

” there is ample room … ”
That room will not be used.

Merijn Knibbe May 17, 2013 at 12:54 pm

This blogpost contains quite some discussion of the articles in the EU treaties which stipulate that the ECB has more than one mandata: http://cedarlounge.wordpress.com/2013/05/15/austerity-and-human-rights-ii/

See also this one: http://rwer.wordpress.com/2013/03/31/the-three-mandates-of-the-european-central-bank-the-price-level-employment-and-stability/

jason (the commenter) May 17, 2013 at 4:35 am

It would make sense to invest in businesses on the periphery of the EU if they had looser labor laws (and other regulations), but those types of structural reforms never happened and were most resisted in those same countries. Furthermore, the EU has been trying to harmonize regulations over the continent, wiping out any natural advantages peripheral economies might have for investors.

ThomasH May 17, 2013 at 5:36 am

But even if the dropped money mainly “leaked,” it would create higher growth or inflation in the “leaked to” economies and so help to adjust relative price levels as a devaluation of the periphery economies would. The policy works to raise NGDP either way.

Merijn Knibbe May 17, 2013 at 5:37 am

It’s entirely possible to devise a debt-voucher system. Vouchers are printed by national central banks and can be supplied to ‘under water’ house owners who sell or sold their house in an amount equal to the remaining debt.The vouchers can be used to pay off the debt and are accepted in change for bank reserves by the ECB. This has the additional advantage that using money to pay off debts to ‘MFI’s’ (banks with ‘a licence to print’) leads to a decline of the amount of M-3 money; the voucher system will prevent this. It will of course lead to much more sales of houses and much lower house prices: good.

Bill May 17, 2013 at 7:17 am

Before the drop, you need to know whether the banks you are giving it too are now well regulated, and whether they will do anything more than increase their deficient capital (and therefore not lend) to reduce risks to their bondholders and owners.

European banking is different than US banking: it is less regulated across the EU, they regulate by primarily state (rather than by a single EU regulatory authority which imposes capital requirements across all banks), some banks are really nothing more than finance arms of conglomerates and finance those conglomerates, or are depository institutions for wealthy owners who dip into the institutions for loans when they need them.

Proceed first with EU banking reform, and, in fact, use the promise of money conditioned on putting the reform in place first.

Luis Pedro Coelho May 17, 2013 at 8:31 am

There are two separate scenarios being confused here:

1) A helicopter drop in the periphery that is compensated by less money to the core. Then, the effects are minimal as the money will soon find its way to its “right” place in a bank in Luxembourg (although, you might have good positive effects: http://econlog.econlib.org/archives/2012/01/an_answer_to_a.html many portuguese firms are owed and owe a lot of money).

It is hard to monetarily move money in a currency union.

2) A true monetary expansion. Then, it actually matters little whether the drop is in the PIGS or in Germany. Rising German wages will eventually push some of the demand towards PIGS.

The big win-win situation is ECB printing money and handing it to Germany.

Neal May 17, 2013 at 9:55 am

In one sense, the problem right now is that money can’t flow out of the periphery fast enough. A helicopter drop anywhere in the eurozone would fix that.

Floccina May 17, 2013 at 10:51 am

The only solution that I can see is to lower income (relative to the north) and debt in the south. The way to do that would be through inflation. So the helicopter drop would work only if it caused sufficient inflation in the north.

Of course I think that diversity is strength and so I think that a breakup of the Euro would be a better way to go. The countries in the south could start paying government employees with and accepting taxes in their own money. They could then let their banks fail doing some sort of speed bankruptcy and let banks from the north operate in their countries.

Joe Smith May 17, 2013 at 11:33 am

Anyone lending to, for example, an Italian business has to make some allowance for the possibility that Italy will exit the Euro and the loan will be converted by law to one denominated in new lira. Given all of the other risks facing a loan in Southern Europe, I am surprised the total premium is only 3.7%

Philo May 17, 2013 at 11:46 am

Don’t frame the issue in black-and-white terms, as if either all the money helicopter-dropped in Portugal would stay in Portugal (strongly stimulating the Portuguese economy) or it would all flee to Northern Europe (having negligible effect on the Portuguese economy). If, say, half stayed in Portugal and half fled, then the stimulative effect in Portugal would be half of what the helicopter advocates were hoping for, and doubling the size of the drop would produce just the desired effect. Come on, ECB, give it a try (and make it *big*)!

Robert Searle May 18, 2013 at 8:28 am

There is a very advanced new economic system of the “highest” possible order. It would be able where necessary to create new money mainly as non-repayable grants which could be tracked electronically where necessary to help prevent fraud. Such capital could come from special Smart Banks, and/or from Governments. Moreover, in its advanced form this new economic system would be able to monitor inflation, 24/7 via transactions of most goods, and services. Special direct electronic controls could be used instaneously to help “cap” the levels of inflation. This is more fully explained by the new economic system which ofcourse, has a name. It is called Transfinancial Economics, and a “simplistic” presentation of it can be found at the p2pfoundation site.

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Eli Rabett May 20, 2013 at 8:02 am

Why not follow the US example with parades of helicopters moving money from the northeast and west coast to the South?

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