The primacy of monetary policy in Europe

Last November, I posted a two-part piece on the limits of monetary policy based on a speech by Charles Plosser. The message of Plosser’s speech – and many subsequent speeches – has been that central banks are being called on to do too much. Plosser believes their role should be limited and I agree. But that’s not the world we live in. In fact, right now, the ECB is taking on the all-powerful cyclical role that the Fed has been called upon to take and the question should be: can the ECB fulfill that role? My answer is no. I have more extended commentary explaining why and what the macro implications are below.

Let me start with the macro analysis on why over-reliance on monetary policy doesn’t work. The primary transmission channels of monetary policy act through credit and financial sector channels into the real economy. That means that monetary policy is a vehicle for changing perceptions about the carrying cost and risk of credit. And while monetary agents like the Fed act principally via the short-term government interest rate lever due the position as monopoly supplier of base money, the Fed exerts a dominant influence across the yield curve, not just on the short end.

In terms of how this has worked traditionally, as I wrote in the Plosser post, “ the central bank lowers interest rates to stimulate credit growth. As a result, financial institutions deem a greater number of projects and requests for credit profitable given the risks to capital; they extend more credit. Eventually, the extension of credit becomes excessive. The central bank, worrying about the excess growth in credit leading to inflation, tightens monetary policy by raising rates. And so the economy flags again. And the cycle is then repeated.”

On this front, New Keynesians like Paul Krugman have pushed the idea that we are in a liquidity trap because rates are at zero and the US economy still isn’t firing on all cylinders. The reasoning here relies implicitly on the Knut Wicksell idea that there is a natural rate of interest that puts savings and investment into equilibrium. And what the New Keynesians are saying is that this rate of interest is below zero percent right now. Thus, given the zero lower bound, there will continue to be a surplus of savings over investment, retarding growth, at least until the natural rate creeps above zero.

I don’t like this formulation. First, like the Austrians, I tend to look at monetary policy-induced credit expansions as events which are unbalanced due to multiple and varying project, company and industry discount rates across the economy. The value of equity and the carrying cost of debt is inextricably linked to the discount rates affected by the central bank’s base rate. So the lowering of the base rate to aid credit expansion is a distortion which leads to excess capital formation in projects and investment with longer payback timeframes that benefit most from lower discount rates, whether those projects are financed with debt or equity. This distortion often leads to ‘bubbles’ that get unwound in an ensuing cyclical downturn. Last decade’s mortgage finance bubble is a textbook example of how this distortion plays out in the real world.

Moreover, as Cullen Roche points out, Keynes himself disavowed the utility of the Wicksellian natural rate of interest in his seminal General Theory book.

Keynes wrote:

“I am now no longer of the opinion that [Wicksell’s] concept of a ‘natural’ rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.”

So, the liquidity trap argument promoted by New Keynesians is not ‘Keynesian’ in any sense of the word. And besides, the use of monetary policy to overcome cyclical difficulties is problematic from a credit allocation perspective.

Nevertheless, with rates at zero percent, lowering interest rates is out now. So the Fed and other central banks have come up with new mechanisms to lower risk premia and try to bolster credit growth, with mixed results. And to the degree they intervene in existing markets by buying longer-lived assets, they can have a direct impact on credit conditions and capital allocation in those markets, as evidenced by the Fed’s intervention into the mortgage-backed security arena.

Gavyn Davies is, therefore, bullish on the potential for the ECB’s new asset purchase program. He wrote a piece in the FT on saying private sector QE can work in the euro area . His view is that the Asset Quality Review exercise to bolster bank capital adequacy, combined with the purchase of specific private sector assets will free up capital for lending in the areas where the ECB does buy assets – and in the euro area countries where the QE is conducted. This is very different from buying government bonds across the euro area, including Germany, and in direct proportion to those countries’ GDP.

Personally, I am sceptical about the over-reliance on the ECB to give Europe a boost, when private debt in periphery is high. There will be distortions. And piling on more private debt without concomitant thought to wage growth is not a lasting solution. Now, Italy doesn’t have a private debt problem. So this program is tailor-made for that economy. But the rest of the periphery still has elevated private debt levels. And France is on the cusp of debt deflation becoming a real threat, with its housing market suffering the same downward trajectory we saw in the Netherlands.

The French example highlights the real problem here. The new Jean-Claude Juncker headed-EC is said to be poised on rejecting the French 2015 budget proposal as not sufficiently austere (link in German). This is a key test for Juncker and he plans to show that despite the relaxation in austerity time frames, the EC is only willing to backload austerity so far. The prevailing paradigm, in Euroland, therefore is still one in which the primacy of monetary policy remains. Fiscal policy is restrictive and monetary policy is therefore being used to steer economic policy to deal with cyclical shortfalls.

And against this backdrop, we should see the collapse in Germany industrial orders as bad news. German factory output put in its in biggest fall in five years as industrial orders fell by 5.7% in August. The German order split was as follows: Outside the Eurozone, down -10%; inside Eurozone, down -5.7%; in Germany, down 2%. What that tells you is that Russian sanctions are having a negative impact outside the Eurozone, but that the Eurozone as a whole is hurting. Even domestic orders were down. Manufacturing is a much larger percentage of German output than it is in other advanced economies. So this is not a good harbinger. Commerzbank now believes that the data supports their expectation for a weak second half for the German economy.

I don’t think private sector QE will be enough to end the torpor in the Eurozone given this backdrop. The program is too small and the ECB’s mandate too limited to permit it to have the cyclical firepower to overcome the secular forces bearing down on Europe including demographic challenges, structural deficiencies, fiscal tightening, excessive private sector indebtedness, and bank capital weakness. The baseline has to be for continued weakness i Europe.

While the private sector QE is tailor-made for Italy, this is the country where the next crisis has to be avoided because the public debt trajectory is worrisome given the lack of economic growth and the lack of a specific, explicit and credible backstop from the ECB. Draghi’s “whatever it takes” doctrine is an implicit backstop that has worked for now. But over the longer-term, we will need to see growth in Italy or Mr. Draghi’s resolve will be tested.