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Archive for the ‘In English’ Category

Video of the presentation to the Centre for Global Finance (SOAS, University of London) on 12/5/2021, via webinar.

Summary points:

  • The monetisation of enlarged budget deficits, combined with official support for emergency bank lending to cash-strained corporates, has led to extremely high growth- rates of the quantity of money (broadly defined) in leading economies, which are incompatible with price stability over the medium term. The excess in money balances by financial companies in 2020 has already led to a big bounce-back in financial markets and asset price inflation. In addition, once lockdowns are over and the pandemic is under control, the excess in money holdings by households and non-financial companies will result in higher nominal spending and output, and eventually CPI inflation.
  • In sharp contrast with the aftermath of the Global Financial Crisis, the central banks’ response to Covid-19 crisis has resulted in an expansion of their balance sheets but also critically of bank deposits, and thus of the amount of money in the economy broadly defined (M3 in the USA). It is changes in the latter what explains changes in inflation over the medium term, and central banks should pay more attention in monitoring changes in broad money as effective leading indicators of inflation in 1-2 years.
  • We are already seeing a significant increase in commodity prices, industrial prices and also in CPI prices in the USA. The extremely high growth rates of money seen in the USA since March 2021 (the highest rate in modern peacetime, over 25% year on year in 2020) will end up in an inflationary boom over the next few years. The duration and scale of the boom will be conditioned by the speed of broad money growth in the rest of 2021 and in early 2022; thus, on the reaction of the US Fed to rising CPI inflation in the rest of 2021 and 2022.
  • The quantity theory of money provides a valid theoretical framework which relates trends in money growth to changes in inflation and nominal GDP over the medium and long term. More details on this analysis on the report by myself in collaboration with my colleague T. Congdon (IIMR) (https://iea.org.uk/publications/33536/), published in the spring 2020 by the IEA. More up to date data can be accessed at the IIMR website.

Video available below (on CFG’s YouTube channel) :

With thanks to the CGF for hosting the webinar.

Comments welcome.

Juan Castañeda

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At a time when major central banks are reviewing their policy strategies (the US Fed already did so in September 2020, see George Selgin‘s excellent analysis here), there is always the temptation to call for an extension of the remit of central banks, to go ‘bold’ and ‘modern’, which effectively means to go beyond maintaining price stability. As the leading British economist, Charles Goodhart (LSE), has put it before, if you want to know what major central banks will do in the future, check what the Reserve Bank of New Zealand (RBNZ) is doing now. Well, the RBNZ is already giving us a hint about what’s coming. As announced few days ago, the bank has been instructed by the government to consider ‘how it can contribute to the Government’s housing policy objectives, consistent with its financial stability objective of promoting a sound and efficient financial system.‘ In the reply of the RBNZ to the government’s instructions, the monetary authority makes it clear that this ‘requires the Bank to have regard to the impact of its actions on the Government’s policy of supporting more sustainable house prices, including by dampening investor demand for existing housing stock, which would improve affordability for first-home buyers‘.

Since the very launch of ‘inflation targeting’ as a policy strategy by the RBNZ in 1989, followed by many other central banks in the 1990s, the definition of what price stability means and how to measure it have been at the core of the policy and academic debates and discussions. At the time it was decided to measure price stability in terms of a consumer price index (CPI), which excludes asset prices. Of course, monetary policy decisions do affect asset prices (see a recent paper on it here, by Tim Congdon, IIMR); but adding asset prices to the remit of the central bank would mean that we know in advance what the long term equilibrium of asset prices is, that compatible with macroeconomic and financial stability. In real time, under uncertainty, we can identify trends and changes in asset prices which we may believe are not compatible with financial stability, but we can only know for sure ‘ex post’. Even if such a target for asset prices were easy to identify in real time, having both a CPI target and another one in terms of ‘sustainable house prices’ may become am impossible task for the central banks to achieve when both price indices move in opposite directions. For example, the aggressive response to Covid-19 crisis by major central banks since the Spring 2020 has resulted in an extraordinary increase in the amount of money broadly defined in major economies, indeed led by the USA; which has first affected asset prices, very much on the rise since then. However, CPI prices have not increased much yet (here we explain why CPI inflation will very likely increase later in 2021, particularly in the USA). At this juncture, should a central bank have a dual-price mandate, which prices should be prioritised?

The answer is very straightforward if central banks were to adopt a simpler and more effective policy strategy. By maintaining a moderate and stable rate of growth of money (broadly defined), central banks will be contributing to both CPI price stability and financial stability, but over the medium to the long term (approx. 2-3 years). Before the outbreak of the Global Financial Crisis in 2008, we observed a higher than 10% annual rate of growth in the amount of money in the Eurozone, while CPI inflation was still quite moderate. My colleague Pedro Schwartz and myself very much raised our concerns about this situation in 2007, in this report for the ECON Committee of the European Parliament. We didn’t know the extent of the crisis that was coming, but we knew that that rate of growth of money from 2004 to 2007 was not compatible with macroeconomic and financial stability. Of course, no one really paid much attention to it. As we estimated it at the time, following a price-stability rule would have meant a much lower rate of growth of money (broadly defined, by M3 in the Eurozone, see the red line below), around 5% – 6% per annum. The actual rate of growth of money in the Eurozone in 2007 (see the blue line below) doubled that benchmark rate compatible with price stability. M3 growth rates in the Eurozone are again in the double-digit territory (see IIMR February 2021 report here) and this can only mean higher inflation once the economy goes back to ‘normal’ (i.e. the demand for money reverts to levels closer to pre-crisis levels) and agents start to get rid of their excess in money holdings. We will see.

Source: Schwartz and Castañeda, 2007. https://www.europarl.europa.eu/cmsdata/178681/20071220ATT16955EN.pdf. You can find more details in the report on the calculations of the benchmark rules we used to assess the rate of growth of M3 in the Eurozone.

Let’s task central banks with what we know they can achieve. Central banks are very powerful policy-makers but they cannot do it all, and they shouldn’t either. Adding more tasks to their remits, be it an extra target in terms of asset prices, jobs creation, or contributing to a more green economy, among others, would put central banks in a very difficult technical and institutional position; one where they wouldn’t be able to achieve their mandate and they will be more exposed to political pressures. Let’s leave all the ‘extras’ for parliaments to deal with, if they like. This arrangement will preserve central bank independence and enhance their effectiveness in achieving monetary stability and financial stability, no more no less. Here you can find more details on this all in a 2020 report I wrote for SUERF on the ECB 2020-21 policy review strategy.

Thank you. Comments welcome.

Juan Castañeda

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Central banks are not just interest rate setters: an introduction to modern central bank roles

This is the online presentation I made at the 2020 Freedom Week (by the Adam Smith Institute and the Institute of Economic Affairs) on August 21st. It is an overview of the major roles undertaken by modern central banks in our economies, which involves much more than setting the policy rate. Actually, since the outbreak of the Global Financial Crisis what leading central banks have been doing is to act as ‘bank of banks’, ‘bank of the government’ and, as regards monetary policy, to engage in asset purchase operations (i.e. Quantitative Easing). Once policy rates were brought down to the effective lower (nominal) bound, central banks have used outright asset purchases to be able to affect macroeconomic outcomes. Contrary to a very popular misperception, in purely fiat monetary systems, central banks cannot run out of ammunition, even when nominal policy rates are zero or close to zero. In this presentation, I briefly discuss (1) what central banks do as providers of services to the banking sector and to the government, as well as (2) the importance of monetary analysis to understand the effects of changes in the amount of money on inflation and output over the medium to the long term. This is at the core of what we do at the Institute of International Monetary Research.

I hope you find it a good introduction to central bank roles in modern economies. As ever, comments welcome.

Juan Castaneda

PS. If only for enjoying James Gillray‘s caricatures as a means to explain money and central banking, it may well be worth watching.

 

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A rule-based monetary strategy for the European Central Bank: a call for monetary stability

This is the paper I wrote on the current review of the ECB strategy, just published in SUERF Policy Note series (Num. 192, September 2020). As you will see in the summary below, I discuss different alternatives to reform the current strategy of the ECB, including the adoption of a (1) higher inflation target, (2) price level target, (3) average inflation target or (4) a nominal income rate target in line with a stable growth of money. I explain in the paper why I favour number 4, so that the ECB aims at maintaining a stable rate of growth of broad money, compatible with a stable rate of growth of nominal income over the medium term. This strategy would allow the ECB to accommodate to supply shocks much easier and without the need to intervene in the market: in case of a positive supply shock, prices would tend to fall in a growing economy, thus resulting in a more stable rate of growth of nominal income. Under this strategy, the central bank would not need to offset such fall in prices by an increase in the amount of money but to do nothing (G. Selgin explains this point masterly in his pamphlet, ‘Less than Zero’). This means that the amount of money in the economy would not be as pro-cyclical as it has been in the last 15 years; with too much money growth in the expansionary phase of the cycle and too little during recessions. The stability in the rate of growth of money, broadly measured, would become key to maintain a stable nominal income growth throughout the cycle.

The ECB will announce the outcome(s) of the review of its strategy in 2021. The choices made by the ECB will surely shape the bias of monetary policy in the Eurozone for one or two decades. Other major central banks are conducting similar exercises. The US Fed just announced its new strategy (see G. Selgin excellent analysis on it here) and the Bank of England’s strategy is also currently under review.

Clearly, ‘inflation targeting’, at least as applied in the years running up to the Global Financial Crisis, is not the best policy strategy to maintain both monetary stability and financial stability over the long term. Central banks should not just take the ‘easy’ option and adopt a higher inflation target or an (asymmetric and vague) average inflation targeting (AIT) strategy. The latter seems to be the option taken by the Fed. And I say ‘seems’ because it did not make it clear in the announcement made last week. How many years will the Fed use to average inflation around? And will it react equally to long periods of inflation and to long periods of disinflation? If a symmetric AIT, the Fed would both (1) adopt a below target inflation rate after a period of too much inflation, and (2) an above target inflation rate after a period of too little inflation. However, it seems unlikely that the Fed would systematically target a lower rate of inflation (lower than 2%) when inflation has reigned over a long period of time. In the current juncture these options (the outright increase in the inflation target or the average inflation target) may well give central banks room to be more inflationary in the next few years, but they will also likely harm their credibility if they cannot contain the growth of inflation in the future. We will see in the next few months/years how the Fed effectively applies his new AIT strategy. My fear is that, in the absence of enough information communicated to the market to assess its policies over the long term, the Fed has just adopted a strategy to be more inflationary in the next few years.

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Summary of the paper on the ECB strategy review (full paper at https://www.suerf.org/policynotes/16571/a-rule-based-monetary-strategy-for-the-european-central-bank-a-call-for-monetary-stability):

‘The 2020-2021 review of the ECB strategy will shape monetary policy in the Eurozone in the years to come. Crucially, it will also determine the scope and capabilities of the ECB within the ever-evolving architecture of the euro. As in the aftermath of the Global Financial Crisis and the subsequent Euro Crisis, Member States are discussing new mechanisms to enhance economic recovery and further integration which, one way or another, will involve the support of, or the coordination of fiscal policy makers with the ECB. The impact of the new ECB strategy in the current debate about the future direction of the single currency should not be overlooked. In this note, we offer a proposal for the reform of the ECB strategy incorporating the lessons learned in the recent crises. We discuss several options for the ECB and set up a rule-based strategy suitable to operate in an environment of persistently low inflation and near zero interest rates. Under our proposal, monetary stability becomes the guiding principle for providing macroeconomic stability over the medium and long term, as well as for enhancing the transparency of the ECB communication policies.’

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Comments and feedback welcome.

Juan Castaneda

 

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On the economic effects of the policy responses to Covid-19

Today the Institute of Economic Affairs (IEA, London) has just published a report by my colleague Tim Congdon and myself (Institute of International Monetary Research and University of Buckingham) on the debate on the expected inflationary vs. deflationary consequences of the current crisis. Of course there are many unknowns yet and we should not claim or have the illusion that we can forecast exactly inflation rates in the next 2-3 years. But what we can attempt is to do ‘pattern predictions’ (see Hayek’s 1974 Nobel lecture speech). Based on the monetary data available and the theoretical body linking changes in the amount of money to price changes over the medium/long term, we have observed in the last two months an extraordinary increase in the amount of money in most leading economies (certainly in the USA, with a rate of growth of money, M3, of 25% in April 2020). This comes from the implementation of quite significant asset purchases programmes (i.e. Quantitative Easing) and the (partial) monetisation of very much enlarged government deficits; a trend that will most likely continue for the rest of the year. It is both the extraordinary money growth rates seen recently, along with the expected persistence in monetary growth in 2020 what support our forecast of an inflationary cycle in the US (and in other leading economies, though to a lesser extent) in the next 2-3 years. The diagram below from the report says it all (see page 8).
More details in the report (IEA Covid-19 Briefing 7, June 2020) at:
https://iea.org.uk/themencode-pdf-viewer-sc/?file=/wp-content/uploads/2020/06/Inflation_the-new-threat25787FINAL.pdf. Also, the webinar presentation of the report with my colleagues Geoffrey Wood and Tim Congdon will be available soon at the IEA’s website/YouTube channel.
Money growth (M£) in the USA
Juan Castañeda
Summary of the report (in pages 4-5):
  • The policy reaction to the Covid-19 pandemic will increase budget deficits massively in all the world’s leading countries. The deficits will to a significant extent be monetised, with heavy state borrowing from both national central banks and commercial banks.
  • The monetisation of budget deficits, combined with official support for emergency bank lending to cash-strained corporates, is leading – and will continue to lead for several months – to extremely high growth rates of the quantity of money.
  • The crisis has shown again that, under fiat monetary systems, the state can create as much as money as it wants. There is virtually no limit to money creation. The frequently alleged claim that ‘monetary policy is exhausted at low (if not zero) interest rates’ has no theoretical or empirical basis.
  • By mid- or late 2021 the pandemic should be under control, and a big bounce-back in financial markets, and in aggregate demand and output, is to be envisaged. The extremely high growth rates of money now being seen – often into the double digits at an annual percentage rate – will instigate an inflationary boom. The scale of the boom will be conditioned by the speed of money growth in the rest of 2020 and in early 2021. Money growth in the USA has reached the highest-ever levels in peacetime, suggesting that consumer inflation may move into double digits at some point in the next two or three years.
  • Central banks seem heedless of the inflation risks inherent in monetary financing of the much-enlarged government deficits. Following the so-called ‘New Keynesian Model’ consensus, their economists ignore changes in the quantity of money. Too many of these economists believe that monetary policy is defined exclusively by interest rates, with a narrow focus on the central bank policy rate, long-term interest rates and the yield curve. The quantity theory of money today provides – as it always has done – a theoretical framework which relates trends in money growth to changes in inflation and nominal GDP over the medium and long term. A condition for the return of inflation to current target levels is that the rate of money growth is reduced back towards annual rates of increase of about 6 per cent or less.

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A model of parallel currencies under free exchange rates

Money is one of the most studied and truly complex phenomena in Economics. How money is created? And how is it destroyed? ‘What constitutes money and what doesn’t? Is money only the means of payment sanctioned by law, by the State? In our current monetary systems, can we ‘create’ as much as money as we like? If so, wouldn’t it be inflationary? These are some of the questions Economics students frequently ask at the start their degrees. Today I am only going to focus, if only timidly, on one of them; the absence of competition in the national currencies markets in our days. Of course, the absence of competition in this market is not the result of the application of the conventional laws of Economics; quite the opposite, as masterly explained by Vera Smith in her ‘Rationale of Central Banking and the Free Banking Alternative’ in 1936, the granting of the legal tender clause to a single currency, that issued by the State, has been an explicit decision made by the government (the relation between the State and the central bank has always been problematic to say the least, you can find more details on it here). F. Hayek also explains marvellously the abolishment of the laws of Economics as regards money in his ‘Denationalisation of Money’ in 1976. More recently, my colleague from the Institute of International Monetary Research (IIMR), Tim Congdon, discussed this issue in his ‘Money in a Free Society’ in 2009 and makes the case for a privatised and truly independent central bank, detached from the political agenda or the economic needs of the government.

Following this debate, two colleagues of mine, Pedro Schwartz and Sebastian Damrich, and myself have reflected on these issues in a working paper just published by the Applied Economics Centre of the John Hopkins University (‘A model of parallel currencies under free floating exchange rates’. In Studies in Applied Economics, Num. 160, June 2020). In the paper we assess the feasibility of a parallel currency system under different macroeconomic scenarios. We first offer the rationale for the introduction of more competition in this market and then develop a model to see wether (and under which conditions) a parallel currency system ends up in the running of a single currency economy, or rather in two currencies competing for the market. We draw policy implications and use the the eurozone as a case-study, but the model could well be applied to any other set of countries sharing a currency or willing to access a different currency area. In a nutshell, what we show in the model is the conditions for the issuer of each currency to gain a higher market share and benefit from it. We make a distinction between (1) a macroeconomic stable scenario, defined in the paper ‘as one in which the sensitivity of the market share of the currencies to changes in prices in both currencies is not high (as we presume changes in inflation in both currencies will be rather small)’ (see page 25). In this scenario, it is ultimately the supply of each currency what determines their market share (the less inflationary currency will gain more market share over time); and (2) a highly unstable macroeconomic scenario, ‘where agents’ demand of each currency is very sensitive to changes in relative prices in both currencies. In this high price sensitive scenario, an increase in the switching costs to favour the use of one of the currencies (i.e. the government’s preferred currency) would only lead to inflation in that favoured currency and very quickly to its expulsion from the market’ (see page 25). The model can thus be applied to well-established economies, where both the national currency and the common currency circulate in the economy and to highly inflationary economies, where the government favours the use of its currency and uses the currency as a source of revenues (i.e. seigniorage).

This is the abstract of the paper, which you will be able to access in full here:

‘The production of good money seems to be out of reach for most countries. The aim of this paper is to examine how a country can attain monetary stability by granting legal tender to two freely tradable currencies circulating in parallel. Then we examine how such a system of parallel currencies could be used for any Member State of the Eurozone, with both the euro and a national currency accepted as legal tender, which we argue is a desirable monetary arrangement particularly but not only in times of crisis. The necessary condition for this parallel system to function properly is confidence in the good behaviour of the monetary authorities in charge of each currency. A fully floating exchange rate between the two would keep the issuers of the new local currency in check. This bottom-up solution based on currency choice could also be applied
in countries aspiring to enter the Eurozone, instead of the top-down once and for all imposition of the euro as a single currency that has turned out to be very stringent and has shown institutional flaws during the recent Eurozone crisis of 2009 – 2013. Our scheme would have alleviated the plight of Greece and Cyprus. It could also ease the entry of the eight Member States still missing from the Eurozone.’

All comments welcome. We still have to work more on the paper and suggestions for change and further references will be most appreciated.

 

Juan E. Castañeda

PS. A previous study on parallel currencies by P. Schwartz, F. Cabrillo and myself can be found here; where we put it forward as a solution to ease and expedite the adjustments needed to apply to the Greek economy in the midst of the so-called euro crisis.

 

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It’s not all about interest rates!

In a piece published by CityAM on 12/11/2019 (‘Interest rates aren’t central banks’ only ammunition to defend against recession‘), I criticised the view apparently shared by most policy commentators about the alleged lack of ammunition of central banks to tackle the next crisis; they claim that this is because policy rates have reached either zero or close to zero levels and therefore there is no more room for monetary expansion. As I put in the article, this is wrong:

But interest rate change is not the only policy tool available to create money. Indeed, nor is it the most effective in times of crisis. In modern economies, where monetary systems are purely based on fiat currencies, money can be created “out of thin air”. As shocking as it may sound, this means that central banks can always increase the amount of money in the economy.

Since 2008 central bank (main policy) rates had been cut down to zero or near zero territory, and for many years it was mainly by changes in the amount of money how central banks managed to stabilise spending (through unconventional policy measures or QE). The outcome in the US, the UK but also in the Eurozone (though achieved much later), has been the stabilisation of the rate of growth of broad money in these economies followed by a period of a relatively stable overall macroeconomic picture (i.e. broad money growth in the US around 4% – 5% for a long period of time).

 

Broad money growth, US

 

The fundamentals to understand how monetary policy decisions are made in modern monetary systems, particularly in times of a financial crisis, where commercial banks struggle to expand deposits, can be summarised as follows:

  • In the absence of a truly binding anchor (such a metallic standard under the gold or silver standards) central banks can always create money ‘out of thin air’, with no limit.
  • In modern monetary systems both commercial banks and central banks create money; actually the bulk of the means of payments used are created by commercial banks in the form of deposits and the extension of overdrafts (see the seminal paper on this, Money creation in the modern economy , by McLead, Radia and Thomas, 2014).
  • The announcement and later application of tighter bank regulation in the midst of the Global Financial Crisis (2009 – 2010) increased bank capital requirements by approx. 60%, thus limiting the ability of banks to give loans and create deposits (i.e. money) in an already recessive economy. In the absence of the creation of money by markets (i.e. banks), central banks had no choice but to step in and buy assets from the market (from non-financial institutions), the so-called QE operations. Otherwise, money supply would have contracted very severely, with the harm it would have inflicted on the economy (this time, central bankers were determined to avoid the mistakes they made in the Great Depression years as Ben Bernanke had famously put it back in 2002, when deposits contracted by more than 30% in four years in the USA, therefore aggravating and prolonging the recession).

I argue in the article that, for better or worse, the ‘monetary weaponry’ in modern monetary systems can never be exhausted (Venezuela today is a dramatic example of it, when the printing press is heavily exploited by the government). Under purely fiat monetary systems, we need to tie the hands of the central banks so they abide by a rule in order to maintain a moderate and stable rate of growth of money; a rule that does not result in excessive money growth during the expansion of the economy, nor in a strong decline or even a fall in money growth during recessions. My colleague from the University of Buckingham and the Institute of International Monetary Research, Professor Geoffrey Wood, explains masterly and in few minutes how to define and adopt such a monetary rule in the Eurozone in this video.

 

Juan Castañeda

PS. You can have access to the CityAM article in full at https://www.cityam.com/interest-rates-arent-central-banks-only-ammunition-to-defend-against-recession/

 

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On the performance of the Euro vs. the US dollar (video presentation)

Those who follow this blog will know that I have already published an entry on the index of performance of the euro (1999 – 2018); I commented on the outcomes of an overall index of macroeconomic dispersion among the Eurozone Members States, which can be split up into four (sub) indices: business cycle, competitiveness, public finance and monetary dispersion. I have also reported on the same metrics calculated for the US, so we could compare then with those of the Eurozone. The results are somehow expected, but nevertheless very revealing.

  • Overall macroeconomic dispersion in the US is much smaller than in the Eurozone.
  • Macroeconomic asymmetries within the US states did exacerbate in the crisis years and also in the pre-crisis years, but in the US have quickly returned to pre-crisis levels and remained fairly stable since 2010; whereas in the Eurozone we still have a long way to go.

Of course, some caveats apply in this instance: the US dollar has been a single monetary area for more than 150 years, and indeed a banking union and a fiscal union (with a meaningful federal-central budget) for a long time too. Even with these caveats in mind, what it is very revealing is not that the size of macroeconomic dispersion or internal asymmetries are much larger in the Eurozone, but how differently macroeconomic dispersion has evolved after the crisis: In the case of the Eurozone, particularly as regards monetary and competitiveness dispersion trends, they  show a very strong persistence, revealing (among other things) a more rigid functioning of the price system in goods and services and labour markets as compared to those in the US. The caveats mentioned above may well explain the difference in levels of dispersions, but the changes in trends reveal underlying/structural problems in the way in which markets adjust to crisis in the Eurozone.

We are now extending the results of the project to include the index of dispersion among regions and nations within the UK sterling area, and the (provisional) results confirm the same pattern: the poorer performance of the Eurozone (as measured by internal dispersion) as compared to both the US dollar monetary area and the UK sterling one. We may disagree on the solutions to this problem but we should not simple ignore the facts. ‘All and sundry’ claim that a fiscal union and a pan-EU central budget should be adopted, so counter-cyclical policies can diminish the negative effects of ‘lateral shocks’ (those affecting some MSs considerably more than others) in the future. I do advocate for a different solution, one that requires no further integration, but the devolution of fiscal discipline to the national level. Here it is a the report with my proposal for the re-balancing of the Eurozone.

Here you will find the video to the presentation of the index of the Euro performance (2019) at the European Parliament, in an event organised by the Institute of International Monetary Research in Brussels (29/10/2019). Feedback most welcome.

Juan Castañeda

 

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An optimality index of the single currency: internal asymmetries within the Eurozone and the USA since 1999

We have measured the macroeconomic dispersion within the Eurozone (see further details here on the indicators we have used) and this is in a nutshell how the euro (12 and 19) has performed since its launched in 1999.

 

As shown in the chart above we have added Target2 balances in the calculation of the (overall) index of internal dispersion; which is in fact an index of divergence within the Eurozone. The empirical conclusions are quite revealing, and somehow the expected ones: (1) in the good years (1999-2007), overall dispersion increased quite notably (it doubled!); (2) after the 2008-09 crisis, divergence deteriorated much more sharply and, leaving Target2 balances aside, the trend has been reversed and the index shows signs of improvement (though at a very slow pace).

We have also calculated an index of macroeconomic dispersion for the (mainland US) dollar area, using the same methodology. The chart below shows the trends in dispersion/internal asymmetries in this two major monetary areas:

 

There are many questions to discuss on this issue: among others, I will just mention three: (1) should we or should we not add Target2 balances to the calculation of the index of dispersion? (effectively, do Target2 balances matter?); (2) since the US is indeed a banking union, should we factor in monetary dispersion across States?; and (3) do the charts above suggest that the policies implemented during the recent crisis are the right ones in order to achieve a greater degree of convergence in the Eurozone?

We will discuss these questions and the charts above, and what they mean for the interpretation of convergence trends in the Eurozone, in a two-day conference at the University of Buckingham this week (21-22 February): The Economics of Monetary Unions. Past Experiences and the Eurozone. If you cannot make it, you will be able to follow the presentations live online. More information on the full programme here and how to follow it at the Institute of International Monetary Research social media.

All welcome.

 

Juan Castañeda

 

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A proposal for Target2 reform and a capped mutualisation debt scheme in Europe

‘Under a monetary union, fiscal and monetary discipline have to go hand in hand if macroeconomic stability is to be maintained. The question is how to set up the right institutions to achieve this stability in a credible manner. This policy brief proposes a new institutional arrangement for the euro area to restore fiscal discipline. It places the responsibility for compliance entirely on the shoulders of the member states. It also provides for the mutualisation of 30% of the member states’ debt-to-GDP ratio.
This would help to maintain a stable currency and to limit the risk of contagion should another crisis occur in the future. However, this comes at a cost. Under the fiscal scheme proposed, member states, which would be fully fiscally sovereign, would need to run long-term sound fiscal policies to benefit from euro membership. In addition, this brief proposes a reform of Target2 under which overspending economies would have to pay the financial cost of accessing extra euros, which would deter the accumulation of internal imbalances within the euro area. All this is expected to change the current fragility of the architecture of the euro, provide member states with the right incentives to abide by sounder economic principles and make them fully responsible for the policies they adopt.’

The above is the abstract of a research report I have just written on the reforms needed to undertake to re-balance the eurozone economy, published by the Wilfried Martens Centre for European Studies. As you will read in the report, I don’t favour more centralisation of fiscal competences to the ‘federal’ level (be it Brussels or Frankfurt), but instead to abide by the subsidiarity principle as much as possible; and thus to make Member States (MSs) fully responsible for their own macroeconomic policies and public finances. The euro is a sort of a ‘monetary club’ (some will claim, and quite rightly, that it is much more than that) with benefits and costs of membership. As to the benefits, these are particularly evident for those economies with a poor inflation record in the running of their own national currencies in the past; for which the euro has provided a strong monetary anchor and therefore greater  price stability and lower borrowing costs. As to the costs, these were more subtle before the Eurozone crisis (and indeed less publicised at the time of the launch of the euro), and have become much more evident since then: simply put, MSs do not have access to their own (national) monetary policy anymore in order to ‘alleviate’ the costs of adjustment to a crisis, and also have limited sovereignty over their fiscal policy.

The reforms introduced during and after the recent crisis have confirmed the direction of change in the eurozone towards ever more co-ordination of macro policies; and therefore more and more conditions and criteria are now in place to closely monitor and eventually fine MSs for the running of (severe) fiscal and also macroeconomic imbalances (see the the new ‘Fiscal Compact’ and the new ‘Macroeconomic Imbalances Procedure’ for more details). If anything, the experience of how the excessive public deficits and public debt by different MSs were handled by the eurozone institutions before the crisis is not very promising; even less so now that the complexity and degree of macroeconomic integration and regulation are even greater. The approach I adopt in this report is quite different.

In a nutshell:

(1) I put forward a (capped) debt mutualisation scheme, so those MSs running sound fiscal policies and sustainable budgets can benefit from it; and those in excess of the annual debt threshold will have to issue their own bonds, backed only by their own national revenues and credibility. The scheme, once launched, is communicated to the MS and it is not negotiable; the scheme also decreases in the coverage of the MSs public debt for the current levels down to a 30% ratio of the GDP in ten years. With this scheme, the MSs will have the incentives to meet the pre-announced annual targets, as their debt will be covered under the debt mutualisation programme, and thus will benefit from much lower borrowing costs. And, crucially, there is no need to monitor nor regulate further the fiscal or macroeconomic performance of the MSs.

(2) I also propose a major reform of Target2, which has accumulated (particularly since 2008) enormous imbalances among MSs (see the latest balances across MSs at the ECB website here): On the one hand, Italy holds a debit position amounting to approx. 30% of its GDP while Spain’s is 25% of its GDP; on the other hand, Germany holds a credit position close for the value of nearly 30% of its GDP. The reform proposed in the report would consist of setting a price for access to credit (if only the ECB policy rate), so overspending economies find it more and more costly to keep on borrowing and thus accumulate further imbalances. A way to settle the existing balances cross MSs must be also addressed.

(3) There are other key elements in the report for the proposals above to be effective, such as the return to the ‘no bailout clause’ of MSs, and the possibility of an errant economy to leave the eurozone (or be temporarily suspended). More details in the report.

 

Juan Castañeda

Full text of the report at: https://www.martenscentre.eu/publications/rebalancing-euro-area-proposal-future-reform

Feedback most welcome.

 

 

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