What should the ECB do?

In the comments, Gareth writes:

Target nominal GDP growth of at least 5% for all EU countries, and back it with a threat of unlimited QE. Italy needs a primary surplus of 6%+ with current yields. That drops to around 3% if NGDP growth rate goes up from predicted 2.5% to 5%.

And back in reality, they could at least raise the inflation target to 4%.

I don’t think he and I disagree on the underlying economic theory, but I suspect this would be too little.  At zero growth, that means five percent price inflation a year and basically an open fire hose to the Italian Treasury.  That also means they never reform, noting that I accept the Keynesian point that at this time horizon fiscal reform is counterproductive.  But “no reform” is counterproductive too!

In my view, the growth simply isn’t there, not now, not even with looser monetary policy.  Eurozone inflation is already about three percent, and while I understand the Sumneresque credibility point at current margins nothing seems credible for the eurozone, there is only the present.  Why should another two percent inflation a year turn the tide?  The inability to implement any kind of credible rule means that the “in the moment” solution has to be all the stronger.  So the “answer,” if that is the right word, is ten percent inflation a year for the eurozone — plus the firehose to Rome — to get the real value of those debts down and quickly.  Maybe twelve.

I don’t feel like debating whether this would be better or worse than the status quo; I am content to suggest it probably won’t happen, not even if German and French leaders understand the gravity of the situation, which I suspect they do.  (The Germans, believe it or not, “do gravity well” and have for some time.)  It’s a common meme these days that the German leaders “don’t get it,” but I view it in reverse: they’re the ones who understand how grave a problem it is, and how truly hard to fix it would be, which is why they are not doing more.  They don’t see the point in pulling out the peashooter against the elephant, and the blunderbuss is not yet available, if it ever will be.

Addendum: Kevin Drum comments.


Crawl up its own ass and die?


Financial engineering will not solve Italy's problems, we need proper incentives here. ECB should do nothing, unless there are deep structural reforms in Italy. Italians should suffer, in order to understand what is at stake. When they start reforms, they can get financing from EFSF, IMF, World bank, privatization, etc (even from ECB). But no money commitment before reforms.

I prefer ‘conditionality’ to ‘incentives’ in present context. Starting from the base of so-called Washington Consensus. I think Germany understands this and would trade money for it, but consensus will not be forthcoming until the precipice.

Speaking of measured inflation rates, but now in the US, I'm confused as to why the TIPS spread keeps falling and predicting much lower inflation than the other measures, if I'm reading the data correctly.

1) Because the central banks are manipulating the TIPS spread.
2) There is a /massive/ liquidity premium on treasury debt but not on TIPS.

Wrong Wrong Wrong!!! More conspiracy theorists claiming gov't manipulation when markets don't behave according to their wishes!

TIPs spreads keep dropping because commodity prices are expected to fall when the economy falls to pieces!!!

The German leaders understand the problem now and it is a hard to fix problem. At some point in the past the problem was presumably easier to fix? When was this point of no return. If say, we were back in 2009, or even 2006 was the Italian problem fixable? How far back do we have to go in history to see a vibrant Italy. Should the Germans have acted then and why didn't they. Did they not "get" it then?

Plainly, the "fix" that might have been implemented in the past was not to break things in the first place. That is: don't do the Euro. And plenty of people said so at the time, with good and potent arguments.

So the German appreciation of gravity was not what it should have been back in 1992. Perhaps they truly have a grasp of the problem in front of them today--but the history of the common currency gives little ground for thinking so.

I think the Germans appreciated it then, too, but weren't strong enough to stand against the tide of Euro-optimism. I don't remember majorities of Germans supporting the loss of the Deutchmark.

Its the EU, its not like its democratic or that majorities or public opinion mean anything at all.

I am reminded of the Lisbon treaty and how it doesn't fails referendums, but somehow gets adopted by the countries anyway.

The U.S. should invade Europe and give it a proper monetary policy. This will not only save the Europeans from themselves, but provide some Keynesian stimulus back home, as I suspect it will take hundreds of bullets to beat back the European hordes.

Hundreds, sir! I say HUNDREDS!

"We must make the world safe for Loose Monetary Policy."

They won't be able to fight at all unless the USAF agrees to transport them to the battle.

I don't disagree with you, but the DAX was up 1% yesterday, and the DOW is up this morning.

So, the question of the day then must be, what do equity markets see that the econosphere does not? And vice versa, End of the (Financial) World And Equities Feel Fine?

The answer is probably: you can think Italy, Greece, and Portugal are hosed but believe it won't harm the U.S. and Germany that much.

They see a money hose. You might as well ask what gold sees, too.

An alternative solution is a debt jubilee. It sounds much nicer than "default". Neutralise all existing government debt with freshly printed money from the ECB. Then institute a rule banning any more government deficits outright. From now on all governments in the Eurozone, national and municipal, must balance their budgets. If they fail to do so, suppliers and/or employees and/or welfare recipients simply go unpaid until the next financial year.
In a default situation, interest rates might shoot so high that borrowing would effectively be impossible anyway. At least a planned debt jubilee would give the authorities a chance of making it work.

Good assessment. Simple question for you: if the ECB cure isn't going to happen, will it be possible for the world economy to grow at a healthy level "without the Eurozone"?

A very human course of action would be for the ECB to:

1. Announce it will buy all eurozone country bonds at a fixed price (say, 200 basis points over German).
2. Hope to hang on until the Singularity.

In the long run we're all dead anyway, and maybe the horse will learn to sing.

Looks like a banker will be running Greece, we are all saved!

The real issue is the real economy: will Euro banks be able to lend. And if that is the question, then obviously the Ecb will print money to loan to banks directly or indirectly. The only question is how do you spell zombie bank in French and German.

So the “answer,” if that is the right word, is ten percent inflation a year for the eurozone

What would Von Mises say to that!

The eurozone is headed into recession, so 10% is probably right for a target. Euro heads to parity with the U.S. dollar, killing China's largest export market. China devalues against U.S. dollar to stay competitive and keep the housing market from imploding, leading Congress to pass retaliatory tariffs during the election year. And nobody is watching Japan, the country that goes up like a roman candle if interest rates hit 4%. If everyone's devaluing, rates have to go up. Japan can't let rates rise though, so they have to let the yen appreciate to attract foreign capital, since their demographics mean they now need external capital to finance their debt. At what point does that party end, with the yen at 60 to $1, 40 to $1, on it's way to 200 or even 400 to $1?

The game is over. Sometimes you screw up so bad, there is no solution. Weekend At Bernie's ends when the body starts to smell.

"And nobody is watching Japan, the country that goes up like a roman candle if interest rates hit 4%."

Great line -- especially since Rome is going up like a Roman candle with interest rates > 6.5%.

Why use QE? At the present level of interests of italian, french and spanish debt, there is a good way to bring it down, using conventional monetary policy.

You don't need QE, just a credible threat to use QE or whatever tools you have to get 5% NGDP. If printing money doesn't get you inflation you fire all the economists because everything they know is wrong.

How does one issue a credible threat?

There's the rub.

"Credible threats" do not solve debt crises. Only following through on such threats does. If you threaten sufficient QE to get 5% (or more) inflation, nominal interest rates will shift accordingly. In order to cap the nominal rate (which you have to do in order to affect a real devaluation of the debt over time, since a fifth of it is getting rolled every year), the ECB would have to then actually go and buy all those bonds, because the entire private sector would dump bonds of a crappy credit risk like Italy if the real interest rate on them was negative. Why hold a term asset with a negative real yield when a central bank will buy it at par and let you put your money elsewhere?

If you threaten QE, you will end up with at least half the stock of Italian debt finding its way onto the ECB's balance sheet. If you make the threat "credibly" (i.e the market really does expect 5% inflation) and then don't follow through, you'll end up with Italian nominal yields in the teens and a default within a year

The problem is the PIIGS have no credibility. No one really believes even now that they will get their house in order.

The Germans are not going to give them a license to essentially print euros, with Germany bearing the inflation.

Yes they are.

For a year, maybe two or three. After that, they will abandon the euro.

If we have a couple more of these Mishandled Financial Crises in the next few years we might get used to them.

Europe is beating about the bush in the throat of a bad fit of the cognitive dissonance syndrome, an acute form of denial or "don't confuse me with reality, I know the truth ".
Growth? What growth?
Inflation? Which one?, The real one or "the one" we need?
The whole thing is a mess starting with a public sector which keeps growing in bureaucracy and structure.

Remember a few days ago, the EU ban on children under eight forbidden to inflate balloons if not supervised by a sober adult.
They're beyond repair.

These countries have been happily paying their mortgage without difficulty and on time for the last sixty years. Suddenly the markets decide that those same countries are at immediate risk of default.

The market is always right, so give 'em what they want - a default.

Beware what you wish for, because you might get it.

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