Quantitative Easing – Getting less from more

The European Central Bank has been late to try quantitative easing and may find that additional euros cannot buy much relief

We all have the tendency to rely on the tried and true tricks we have found helpful in the past even when their usefulness has faded.  This also seems true of central banks who have come to rely on quantitative easing even though its effects show signs of fading.  Even the initial boost provided by the first attempts at quantitative easing was limited and the situation has deteriorated amid its continued application.  As the last major central bank to give it a go, the European Central Bank will not get much return from any extra cash. 

Why more is not always more

Economist should know that repeating the same policies does not always work considering a well-used idea in economic theory known as diminishing returns.  This concept refers to the way in which more of the same often comes with fewer additional benefits.  Economists use this to describe why the second plate of ice cream does not taste as good as the first or why one more cook in a crowded kitchen doesn’t necessarily improve the food. 

Printing more money, which is the basis for quantitative easing, sounds like a sure-fire way to generate economic growth but any economy can only handle so much money.  The world is already awash with cash even before central banks started with quantitative easing.  This means that every additional dollar, euro, or pound printed as part of quantitative easing is being added to an already substantial pile of cash.  With money already being hoarded by many companies and governments not wanting to spend more cash, there is not much use for any more.

No need for more

With the meagre effects of quantitative easing on the wane, it was the earlier versions that would have generated the most bang for each additional buck.  It was the Federal Reserve and the Bank of England that tried out the first rounds of quantitative easing – the goal was to push investors away from government bonds to more risky investments such as corporate bonds or stocks.  The hope was that this would help provide companies with easier access to cash and to perk up investors by boosting share prices. 

Not all of the extra dollars and pounds would have stayed local but also headed overseas to find places to earn more money.  This meant that the effects of quantitative easing would have been felt far beyond the countries where the cash was originally coming from.  It has been helpful in places such as Portugal and Spain with overseas investors buying bonds issued by the Portuguese and Spanish governments as worries about Europe eased.

With the effects of quantitative easing having already spilled across international borders, there is not much more to be gained from even more cash.  As such, the additional euros coming out of the European Central Bank following the recent launch of quantitative easing in Europe may not amount to much.  Any further action may also be limited as the saga over whether or not to implement quantitative easing has highlighted how the European Central Bank only has limited room for manoeuvre when running in opposition to Germany.  Now, more than ever, it is time to try something new.

Monetary Policy – where has the magic gone?

The European Central Bank tries to cast another spell to save the Eurozone but its magic has been stolen

Monetary policy is like magic – you have to use tricks to get people into believing what you want them to believe.  Both magicians and central banks apply various devices to convince their audience that they can pull off amazing feats.  A bit of showmanship can be crucial in creating an aura of the fantastical when your powers are actually rather limited.  Central banks have pulled this off in the past but quantitative easing by the European Central Bank is more likely to show that it does not have any rabbits left to pull out of the hat.

Trying to work magic

Your Neighbourhood Economist likes to look back fondly to an era when central banks had the financial market enthralled with their mastery of all things economic.  This admiration was won the hard way in the 1980s by bringing double-digit inflation back to more manageable levels and ushering in an era where the booms and busts seemed to have past.  But central banks have been taken down a notch by their inability to revive the economy after the global financial crisis. 

Slashing of interest rates has not worked as high levels of debt meant that no one wanted to borrow. Upping the ante, central banks tried pumping money into the financial system through quantitative easing.  The effect on the actual economy due to quantitative easing also looks to be limited at a time when there is already a lot of spare cash in the financial system.  Financial markets were buoyed by quantitative easing but a side effect has been the potential for heightened volatility in the financial markets. 

With few other options seen as viable, quantitative easing has gone from an unconventional measure to the mainstay policy for central banks despite questions over its usefulness.  The European Central Bank has been slow to try its hand at quantitative easing even though the Eurozone economy was struggling more than most.  This was because Germany (who had initially done well despite its neighbours being in crisis) was firmly against the central bank in Europe printing cash to buy government bonds.  It was only after a further considerable deterioration in the prospects for the Eurozone (as well as that of Germany itself) that the European Central Bank to override this opposition.  

No more magic left

The European Central Bank has been put at a disadvantage considering that the other big central banks have already tried to work their magic through quantitative easing.  Investors are becoming harder to impress having already seen central banks pull off similar tricks.  To maintain the wow factor, quantitative easing has needed to get bigger and bigger.  The central bank in Japan pledged to double the money supply within two years but had to offer up even more cash when its initial plans proved to be lacking. 

The European Central Bank cannot compete on scale as it has to perform magic with one hand behind its back due to the political constraints within the Eurozone.  Any extra boost using the element of surprise was also dented by the protracted process as the European Central Bank and Germany squabbled publicly over quantitative easing in the months before the policy was launched. 

The fractious politics in Europe has sapped power from the central bank who had previously been the main shining light in saving the Eurozone.  Political squabbles have highlighted the limited power at the disposal of the European Central Bank.  It is like a magician who is being sabotaged by their own assistant – it will take more than magic to escape this spell.

Monetary Policy – Germany to feel the pinch

A taste of its own medicine may prompt Germany to rethink its tough guy approach to Europe

No one like a bully but that seems to be Germany’s role in Europe.  It makes other countries walk the line in policy terms (for their own good) even amid simmering discontent among its neighbours.  Germany has been mean in terms of pushing for monetary policy to be less expansive as elsewhere in spite of struggling countries needing help.  Yet, things may change as the German economy is starting to suffer from similar problems to those it bullies.  Germany is likely to be stuck with monetary policy that is too harsh for even its own economy and this may result in it softening up its approach to others in Europe.

Help wanted

It is a given that the economy in Europe could do with a boost.  Weak demand from consumers and firms means that unemployment remains stubbornly high and inflation for Europe as a whole is not far off zero.  But Germany continues to push its policy of tough love onto Europe.  As with most other developed countries, fiscal stimulus is not an option as governments deal with high levels of public debt.  Germany has gone further in cajoling other governments in Europe to sort out their budget deficits despite the likelihood of adverse economic effects.  

Germany has also not allowed the use of monetary policy as an alternative means of stimulating the economy.  Measures such as quantitative easing have been utilised with some benefits in the US and in Britain but not in Europe even though Europe needs a boost more than anywhere else.  The reasoning behind this approach by Germany is that, by offer laggards in Europe an easy way out, the current problems which are holding them (and Europe as a whole) back will remain in place.  As a result, the European Central Bank has had to be creative and try other measures such as negative interest rates.  But it is difficult for monetary policy to have much effect when its scope is limited.

Turning the tables

Germany may have been able to bully others in Europe but it may be the Germans turn to feel the pain.  The German economy is beginning to flag amid weakening demand for its exports from places such as China.  Forecasts for economic growth in Germany are being cut as its prospects deteriorate while inflation has fallen to below 1%.  The normal response to a weakening economy anywhere else would be for looser monetary policy.  But having not allowed other European countries this option, Germany’s tough stance on others may result it also being tough on itself. 

It is funny to think that the Germans would have likely allowed itself to have more stimulus via monetary policy if there was just a German central bank looking after just the German economy.  But its own actions in influencing monetary policy will mean that Germany may have to endure monetary policy that does not reflect the weak state of its economy (along with most everyone else in Europe).  When framed in this way, Germany must rethink its ideas on economic policy for Europe if just for its own good. 

Continued stubbornness by the Germans would be unconstructive even in comparison to the often dysfunctional politics in Europe.  Deflation is another concern that will only get worse with the current policy measures.  Germany was never going to go easy on others in Europe while its economy was riding high.  It is only a Germany that has been laid low that may soften up and be more willing to help itself by helping others.

Euro as the new Deutsche Mark

Germany practically controls the euro as if it were its own currency but it would gain more being less in charge

Being a big fish in a small pond can have its benefits as Germany is discovering in its dealing with Europe.  Its powerhouse economy means that Germany was one of the few countries left standing after the Eurozone crisis.  Germany has used this position of strength to turn the euro into its own de-facto currency.  It dominates the decisions over monetary policy and has influences spending decisions by politicians outside of its borders.  This level of control is alienating many others in Europe while still being insufficient to keep Germans happy.  As a result, more could be gained by Germany trading away its power to secure a brighter future for Europe as a whole.

Benefits of being the boss

Control over monetary policy is not something that Germany fought for but it came as a by-product of the Eurozone crisis that hobbled the other powers in Europe.  More prudent management of government finances meant that the government has less debt and the economy has been resilient due in part to its exporting prowess.  This left its Chancellor, Angela Merkel, as one of the few politicians who is backed by voters and in a strong position to dominate European politics.

It has allowed Germany to impose its own policy measures over the Eurozone.  Germany has set the tone regarding austerity as well as its concerns over inflation limiting the scope of monetary policy.  Countries such as Spain and Italy would benefit in the short term from more government spending and looser monetary policy.  But Germany has pushed for a range of policies which are a better fit for its own economy than others in Europe where the shortfall in demand is more pronounced.  The aim is to bring others into line in terms of implementing reforms which would improve the outlook for Europe in the future.

Along with setting policies, being the boss of a widely used currency comes with a host of benefits.  For starters, investors looking for the safest place to park their euros will choose Germany over other European countries and this keep down interest rates in Germany.  Worries about a sluggish economy in Europe are a further boost to Germany by keeping the value of the euro weak.  The euro is both too strong considering the economic circumstances of many of the countries in Europe but considerably below what a truly German currency (a new Deutsche Mark) could be valued at. 

Getting more from less

As is often the case, its power has become like a poisoned chalice.  Not only is Germany out of tune with many of its neighbours but the euro is also increasingly unpopular at home.  The rapid rise of an anti-euro party in Germany (called the Alternative for Germany party) suggests that there are many Germans who feel as if they are getting a raw deal from being part of the Eurozone.  This party joins a growing list of populist parties in Europe worried about the level of integration needed to maintain the euro. 

If a position of strength does not come with many rewards, sometimes more can be gained from giving power away.  Germany could soften its strict stance on fiscal and monetary policy as a trade for more reforms in other countries.  This bargain would help deal with the short-term issues of a weak economy needing stimulus as well as concerns about the prospects for Europe over the long term.  Compromise also seems more likely now that deflation is a growing threat and the German economy itself is flagging.  It is time for Germany to cash in now as it may be too late if the situation in Europe gets worse. 

Europe – finding a way out

Europe seems trapped with a sluggish economy but a way out may be close

Getting out of a hole that you have dug for yourself can be tough.  This is what Europe is struggling with as the Eurozone crisis seems to have passed only to be replaced with a slow strangling at the hands of deflation.  Infighting among politicians about the best way to deal with the economic stagnation in Europe has resulted in few reasons for hope of an escape.  Yet, this may change due to recent developments such as a flagging German economy and the rise of reform-minded governments in some countries.  Sometimes things need to get worse before a way out is possible and the situation in Europe may have finally got bad enough for positive change to occur.

An economic escape route…

An economic recovery is typically an automatic progress but may not always be easy.  Companies going bankrupt and workers losing their jobs cause considerable pain but is actually something that is good for the overall health of the economy.  A cull of weaker businesses provides more space for more successful firms to grow and prosper.  This process has the label of “creative destruction” in economic theory due to the idea of the old needing to give way for the new. 

In this way, economic growth returns after a recession as resources such as workers move to more productive uses.  The economy can grow faster as a result but a certain level of economic freedoms are needed to allow this to happen.  In this way, there is a trade-off between economic growth and the potential for instability.  It is not possible to have the former without the latter but any instability can be limited through controlling economic excesses (which often show up in the financial system).

Getting the balance right is not easy.  Companies in finance have been given too much leeway and created havoc as a result.  Yet, in other areas, businesses have been burdened with too many rules.  One example is regulation which makes it difficult for firms to fire workers.  This may seem like a good way of keeping people in jobs but such regulation has an adverse effect in that companies will not want to take on new workers if their employment is almost permanent.

… and the politics to make it happen

Many countries in Europe are in desperate need of policies to free up business from such regulation but implementation is often tricky.  At a time of rapid change, voters often crave stability of bygone eras that are no longer viable.  This does not stop populist parties making false promises to turn back time and dismissing the need for reforms.  It is heartening for the outlook in Europe that some countries such as Spain have made progress with its reforms.  Others such as France and Italy also have governments that are making the right noises in terms of reforms even if not actually putting new policies in place.

The lack of reforms has been preventing the recovery in Europe in other ways.  Germany, who has a firm grip on the reins of power in Europe, has stubbornly refused to offer much help to struggling European countries.  The reasoning behind this is that offering an easy way out would mean that these countries would not deal with the problems within their own economies.  The flip side is that, once reforms begin, Germany may be more accommodating in providing support. 

This opens up the possibility of a grand bargain, such as reforms as a trade for looser monetary policy and less focus on austerity.  More action from the central bank seems likely as the German economy is beginning to falter and genuine fears about deflation in Europe grow.  Its own weak economic growth and low inflation will highlight to the Germans that the problems are plaguing Europe as a whole rather than just individual problem countries.

Your Neighbourhood Economist penned this posting with comments from readers in mind.  Europe and the euro was seen as a lost cause by one reader while others have been annoyed that this blog always had to be so pessimistic.  Hopefully, this post will hopefully prove them wrong (but in a good way).

Quantitative Easing – Waiting while Europe Sinks

As Europe cries out for more action against deflation, the central bank must wait until the situation gets even worse

It would be strange to hold off saving people in a sinking ship until the ship is just about to go under, but this is how monetary policy works in Europe.  The situation in European grows continues to get worse as economic growth stagnates and deflation sets in.  Yet, the central bank cannot help, as it is hamstrung by politics, and must hold off until the cost of inaction is too high.  This means that Europe will have to take on a lot of water until a rescue package can eventually be put in place. 

Politics muddies the water

Monetary policy is tough enough in one country, let along for the 18 countries which use the euro.  The European Central Bank has acted boldly when given the chance.  It took a stand in 2012 stating that it was willing to do “whatever it takes” to save the Eurozone.  This was the lifeboat that saved Europe from collapse at a time when national governments were absorbed riding out wave after waves of turmoil.  But the European Central Bank was only free to jump in once it seemed as if Greece and other countries were about to let go of the euro. 

Despite a temporary reprieve, the economies of Europe have been like a listless ship with leaks.  Reforms have been put off in the hope that the worst is over and economic growth would return without any further encouragement.  Yet it is not a surprise that Europe is close to being sunk again but this time in slow motion.  The problem is the rules and regulations that get in the way of more efficient ways of doing business.  Economic growth cannot be seen as a given and government policies must allow resources to move to more productive uses.   

Such reforms tend to be unpopular as the costs are borne upfront while it takes time for the benefits to show.  So politicians in Europe have put off these measures as pleasing voters is proving tough enough as it is.  Instead, it has been easier to blame others and wait in the hope that economic growth will return.  This wait-and-see approach relies on the central bank to help out with the economy but this is beyond what the European Central Bank can achieve.

The politics behind the European Central Bank is made even more difficult in dealing due to some countries floundering more than others.  Amid all of the concerns about deflation, it is already a fact of life in some countries such as Greece and Spain.  Yet, even Europe as a whole is edging closer to deflation which is typically the symptom of a sluggish economy.  The fear is that deflation will create its own problems if falling prices prompt consumers to hold of spending in the hope for cheaper goods in the future.

Waiting until things get worse

The central bank has already responded to the threat of deflation through a policy of negative interest rates.  Quantitative easing, which has already been used (with limited success) in other countries, is the obvious choice to ramp up monetary policy.  This option has been kept off the table due to its potential to cause inflation which raises hackles among Germans.  Since any measures by the central bank could be deemed to be inflationary, Germany has used its influence to restrict the ability of the central bank to act. 

Yet, even the Germans will eventually have to see deflation as the greater threat.  But, at the same time, it is tough to gauge when too little inflation (or too much deflation) will be enough for a change of tack.  Germany has stuck to its guns since the outbreak of the Eurozone backed by an economy which had until recently remained buoyant.  So Europe is likely to get quantitative easing sometime (soon) and hopefully before the Eurozone is too far under water.

The Economics behind Populist Parties in Europe

Voters kick up a stink in the European elections but mainstream politicians only have themselves to blame

The success of anti-EU parties in the European elections has been in the news over the past week but it is economics that provides much of the backstory.  Voters in Europe have flocked to political parties offering the illusion of a way of opting out of the changes that threaten their livelihoods.  Such frustration is understandable considering that the more established parties have only offered up piecemeal measures as a solution.  Acceptance of the limited options available will be the first step to making real progress.

Going with the flow

The economic prospects of those with few skills are dire.  Many of the sectors that provided jobs for workers in earlier generations have shrunk due to the double whammy of technology and globalization.  Gains in technology have seen a rise in the mechanization or computerization of many tasks.  Globalization has allowed firms to search the world to find the cheapest workers.  These are not trends that are expected to change anytime soon.

Despite the large number of those put out by these trends, the benefits for the economy as a whole have been unprecedented.  Technology has brought a wealth of information and possibilities to our fingertips and outsourcing has made the bulk of things we buy much cheaper.  There is no one who has not gained in some way with the overall gains far outweighing the costs.  The problem is that these costs are borne by a relatively limited number.

In an ideal world, some of the wide spread benefits would be used to compensate those missing out due to the rise of technology and globalization.  However, governments in the Western world have been moving in the opposite direction.  People are increasingly left to fend for themselves with few hand-outs from the government.  The affected workers need money during periods without work as well as help with reskilling to move into growing industries.  Yet, unemployment benefits are being trimmed back and education is becoming more expensive. 

Instead, governments look to shield themselves from the blame, and since no one is going to come out against technology, globalization is the obvious fall guy.  The EU takes the blame in Europe as the epitome of the uncontrollable external forces pushing for more open borders.  Rather than admit that they are almost powerless in the face of outside influences which are part of globalization, politicians offer temporary reprieves.  Typical responses include attempts to limit immigration, moves to block factory closures, railing against takeovers by foreign firms, or moaning about a strong currency hurting exports.  The failure of such actions to have any substantive effect leaves governments open to criticism.  Hence, the rise of political parties proposing to do more.

A dose of honesty

The policies of populist parties will not offer any long-term respite.  It is possible for an economy to shut itself off from the global economy.  However, fighting against the tide of history is not a long term option - a faster pace of economic growth in other countries which are more open will inevitably reveal the folly of such isolation.  Instead of being a viable alternative, the anti-immigration political parties tend to function as a form of protest for voters to vent their frustration at the status quo.  But there is still the possibility of one of these protest parties snatching power, likely with dire consequences.

The main remedy might be something as simple as a bit of honesty.   Politicians need to be more open with voters about the limits of their policies.  This would give them the scope needed to deal with the negative effects of technology and globalization which need more than ad hoc measures.  Long term investment in education and infrastructure will be key in terms of both dealing with the negative and reaping the most benefits.  Now is the time for governments to step up and act or else face a more rapid tumbling down the global pecking order.  Politicians and voters need to come to their senses.  And soon.

Greece – On the mend but still broken

The Greek government is selling bonds again but its debts require a further fix

Greece was always broken but it was not obvious until the Eurozone crisis.  With its increasingly shabby façade finally stripped away, Greece's dilapidated economy was shunned by investors and needed to be bailed out - twice.  But, with help from others, Greece is on the mend and recent progress has been rewarded by the Greek government regaining the ability to borrow from financial markets.  While this is a key step in putting the pieces back together again, a big chunk is still missing.

Shoddy foundations

The Greek economy had never been on the firmest footing.  A raft of regulations sapped the dynamism of the economy, making Greece an alluring holiday location but an unattractive place to do business.  To avoid cumbersome rules, companies typically remained small and often hide out in the shadow economy.  This resulted in Greece being mired in low productivity and chronic tax avoidance.

Investors were willing to overlook all of this once Greece joined the euro.  Despite its obvious faults, Greece was treated as if it were the same as any other country using the euro.  This gave Greece access to funds at a lower interest rate, triggering a boom in investment in property among other things.  The government joined in and ramped up spending on the assumption that the good times were here to stay.

Yet, what was seen as a blessing at the time proved to be the wrecking ball that was to bring down the house.  Cheap financing dried up with the onset of the global financial crisis and the weakened economy collapsed under the weight of excessive levels of debt.  The government needed to borrow more and more as the economy sank into recession but investors were no longer forthcoming with their cash. 

With no one willing to lend to the Greek government, the IMF and others stepped in to prevent a default due to fears that other countries in Europe would be put in peril.  The result was a prolonged economic slump as Greece struggled with the aftermath of its borrowing binge as well as with austerity measures needed to shore up the government’s finances.  The situation was so bad that Your Neighbourhood Economist was one of many who thought that the Greeks would leave the Eurozone lured by the illusion of an easy way out.

Major repairs still needed

The economic stagnation in Greece has continued with six consecutive years of recession leaving GDP around 25% lower.  Forecasters are now optimistic enough to predict that the Greek economy will grow slightly in 2014 with austerity measures expected to ease as government finances improve.  Another sign of progress is that investors are again willing to lend the government money.  The Greek government sold 3 billion euros worth of bonds earlier in April offering a yield of just under 5% after yields spiked to over 30% around two years ago.

Investors are keen to snap up debt from other peripheral countries in Europe.  This reflects brighter prospects for some countries such as Ireland and Spain.  Yet, in the case of Greece, it is more a reflection of a dearth of other investment options offering similar returns and of investors being more willing to take on risks.  That Greece can sell bonds again is a sign that the Eurozone crisis is over but the Greeks are still left with the harsh reality of excessive debt.

Exacerbated by the sharp drop in the size of the economy, the debt to GDP ratio is around 175% and still edging upwards.  Considering that the Greek economy is unlikely to generate enough of a surplus to pay off this debt, another bailout has always been on the cards.  The Greek people are also unlikely to be able to live with the burden that this brings.  Until the shackles of debt are removed, the Greek economy will never be properly fixed.

Dysfunctional Politics Needs Economic Reforms

Politics typically operates like a badly run economy with unappetising choices between limited options

Current politics could be compared with the old Soviet economy – consumers frustrated due to few choices between ill-conceived products designed to fit what most people want but ultimately satisfying very few.  Replace “consumers” and “products” with “voters” and “parties” and this is an apt description of many Western democracies.  The analogy is even more appropriate in that the solution in both cases is the same – reforms to make participation easier for newcomers so as to create more competition.

How have things gone wrong?

Public perception of politicians seems worse than ever.  The aftermath of the global financial crisis has further exacerbated this.  Governments showed themselves to be inept in managing their finances before the crisis and misguided in their response to the ensuing economic slump.  Though elected to serve for the good of the country, governments often prove themselves unable or unwilling to do so.

A number of examples spring to mind.  The United States came to the brink of defaulting over its debt and almost triggered another global financial crisis due to a reluctance on the part of its politicians to compromise.  The nation states of Europe almost destroyed more than half a century of integration and spreading democracy across the continent by refusing to band together to help out the weaker EU members until the central bank stepped in.  The economic recoveries in many countries have also struggled to gain traction as government policies have been more of a hindrance than a help.

The argument could be made that this is not the Soviet Union and democracy gives us a choice of government.  But this choice is often an illusion and often times boils down to selecting the least worst option.  To take a more pessimistic view, the most common political strategy appears to be to make voters dislike the other party more than your own.  This only works when the electorate is faced with limited options as is typically the case in countries where two parties dominate.

Outflank the other party on a few key issues and the voters have no other choice but to tolerate your policies.  The UK Labour Party lost the public trust by overspending in the lead-up to the global financial crisis, thus giving the current Tory-led government a freer rein on its economic policy.  As a result, the British have been lumped with austerity despite the need for measures to boost aggregate demand.  In the US, the Tea Party has infiltrated the Republican Party making it unpalatable for most voters resulting in a second term for an Obama administration which has been slow to act and disappointing in delivering on its promises of change.  The results of the European elections in May 2014 are yet another example of how mainstream parties are failing voters.

Change is possible

An economy with such poor products on offer would collapse but our political system continues to stumble on with voters choosing to tune out instead.  Reforms more typical in economics provide an option for changing this – more competition.

One key area would be changes to the voting system.  Elections using the first-past-the-post format hamper change by ensuring a large number of safe seats for each party while preventing smaller parties from getting into power.  New political parties would shake up politics by bringing in ideas in contrast to the stale left and right divide that still dominates politics.  Coalition governments do not always work (such as in Italy), but are not a recipe for sclerosis in politics as the experiences of the UK government have shown over the past few years.

Such changes may not bring about anything as profound as the fall of the Berlin Wall, but any change from the status quo is likely to be an improvement.

Another New Policy - Negative Interest Rates

Another unconventional policy measure may be trialled in Europe as its central bank struggles to revive the moribund economy

The on-going economic troubles have been demanding in many ways – including having to learn the meanings of an ever-increasing range of new economic terms.  This is due to central banks implementing a range of practices to breathe life into an economy which seems impervious to their best efforts at resuscitation.  The list of unconventional policies started with quantitative easing, which was soon followed with forward guidance.  The next piece of headline-grabbing jargon may be negative interest rates.  This latest innovation is expected to come from the European Central Bank (ECB) even as other central banks look to wind down their operations.

The What, How, and Why of Negative Interest Rates

The policy of negative interest rates is just as simple as it sounds – paying someone to hold money instead of receiving interest on any deposits of cash.  Fortunately, the humble blogger on the street will not be required to pay negative interest rates by his or her retail bank; instead, the banks themselves will be charged for their holdings at the central bank.  Banks tend to park any surplus funds with the central bank so the idea of negative interest rates is to spur banks into making better use of their reserves.  In particular, the policy is intended to boost lending by banks which has remained sluggish despite record low interest rates.

The policy is all about creating the right incentives.  The actual payments themselves would be small.  For example, the ECB is said to be considering an interest rate of -0.1% in place of its current rate of 0.25%.  Central banks have been frustrated by the failure of low interest rates to generate the desired result – more lending.  Both forward guidance and negative interest rates are policies aimed at achieving this.  

Timing – why now?

Now we understand the basics of negative interest rates, the final question is one of timing – why now?  The ECB is driven by two key factors – the changes to monetary policy in the US and fears about deflation in Europe.

The effects of the Federal Reserve printing money to buy bonds (known as quantitative easing) have reached far beyond the US borders with some of the money also finding its way to Europe.  Less loot leaving the US will likely lead to less liquidity in the European banking system.  Low levels of inflation (0.7% in January) have led to fears about consumer prices starting to fall, something already happening in places like Greece.  There are concerns that such deflation could further undermine demand and result in debts increasing in size relative to the economy.

The potential adverse consequences of these developments have pushed the ECB to act and negative interest rates are one of the few options available.  This is because the actions of the ECB are restrained by divergent views among the member countries of the European Union.  In particular, Germany has been adamant in upholding rules that limit the ability of the ECB to purchase bonds. 

Negative interest rates would also bring their own complications.  European banks may struggle to deal with negative interest rates which are not the norm.  The extra costs may weaken banks by lowering their profits, making them more cautious lenders and exacerbating the problem.  Low lending rates have had only a muted effect so the benefits of going negative may be limited.  Even if the policy is seen to be effective, Germany would be loath to offer more help to struggling countries in the periphery of Europe as it may encourage them to put off crucial reforms.

It is too early to say whether negative interest rates will ever make it into our everyday lingo.  Either way, we can only hope that it does not take many more new policies until we can shake off the current economic stupor.

Your Neighbourhood Economist turns 100

Not much cheer considering how little progress in dealing with economic stagnation has been made since the blog began

There has not been much to celebrate of late but Your Neighbourhood Economist is happy to have reached a satisfying milestone – 100 blogs (not years).  This blog started by asking “so what is going on?” back in November 2011, lamenting weak growth in the global economy.  Little did Your Neighbourhood Economist (or many others) know that there would still be few signs of improvement over two years later.

Perhaps the only consolation is that things could be worse.  At least the Eurozone has not self destructed (yet) thanks to the European Central Bank stepping in.  US politicians also showed some surprising good sense despite all expectations to the contrary.  But the positives are few and far between.

Governments in many countries have too much debt to be able to boost spending which is leaving monetary policy as the main route out of the current weak economic growth.  However, expansive monetary policy has not been enough to generate much economic stimulus despite record low interest rates and loads of newly printed cash in the global financial system.  In fact, monetary policy may be doing more harm than good.  

Movements of surplus funds are creating havoc in emerging markets.  Uncertainty over the direction of monetary policy is a major obstacle in the way of a return to economic growth.  The costs of such policies are becoming more evident as the benefits are increasingly being called into question.

Central banks have struggled as the traditional tools of monetary policy have failed to have much of an effect.  New ideas have been tried (such as forward guidance) but the desired results have proved elusive.  Policy makers are getting side-tracked as new problems, such as concerns about deflation in Europe, draw their attention away from more pressing issues such as reforms.

Chances to celebrate may be a long way off so Your Neighbourhood Economist is glad for reasons to be cheerful (such as reaching 100 blogs) whenever possible.

Good Deflation better than Bad Inflation

Central banks seem to be keen on avoiding deflation at any costs but inflation for its own sake is likely to be worse  

Inflation is on the retreat in much of the world giving rise to concerns about deflation.  Economic theory along with the experiences of Japan makes deflation one of the most feared outcomes in economics.  The central bank in Japan is planning to double its money supply as part of its battle to end deflation while the European Central Bank cut interest rates after inflation figures in October were too low for comfort.  The fears about deflation have resulted in policies which suggest that inflation in any form is better than deflation.  But deflation is a symptom of bigger problems and the prescribed cure may do more harm than good.

Economics textbooks paint a grim picture when it comes to deflation – lower prices translate to less money to pay off debts for both businesses and governments with consumers holding off on purchases if today’s prices are likely to be lower tomorrow.  Japan has been a case study of the damage done by deflation –the bursting of a gigantic financial bubble in 1989 resulted in around two decades of falling prices seen as sapping the life out of the Japanese economy while government debt has reached around 230% of GDP.  The years of deflation reinforced the notion of deflation feeding upon itself to reduce demand for goods and services and further drive down prices.

However, according to this rationale, deflation is the cause of the problem rather than simply a sign of a sluggish economy.  The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past.  We can see an example of how this works in that stock prices in Japan are still less than half their peak value, highlighting the extent to which prices can be massively overinflated.  Prices for consumer goods are not subject to the same price pressures as in the stock market but the example illustrates the consequences of economic overheating.

There are parts of Europe with similar issues but nowhere is close to being on the same scale.  So, while Japan shows what can happen, its relevance to Europe is likely to be limited.  The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs.  The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone.

The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem.  A weaker currency increases the price of imports and is tantamount to paying foreigners more to buy stuff just to create inflation for its own sake.  However, higher prices are more likely to result in consumers tightening their belts as their purchasing power diminishes.  The idea that low inflation requires more of the same approach misses the fact that these monetary policies bring their own costs with little benefit.  Deflation doesn't seem so bad in comparison.

Monetary Policy – via the currency market

With the banking system clogged up, the European Central Bank is looking for other ways to make monetary policy work

Unconventional - this is a term currently used to describe many new elements of monetary policy such as quantitative easing.  It could also be employed in relation to the manner in which monetary policy works nowadays.  The European Central Bank (ECB) cut interest rates in November 2013 due to concerns about deflation (for more info, see previous blog) but the effects are not expected to work through the banking sector as would normally be the case.  Instead, the unspoken target of the policy change was the value of the euro.  This is stuff that you won’t find in any economics textbook, so how does it work and why is the ECB having to rely on such disingenuous tactics for its policies?

The normal result of a cut in interest rates would be a boost to the economy through an increase in lending with lower borrowing costs convincing more households and businesses to take out loans.  The extra spending that this generates would spur on the economy.  But this policy route is not working at the moment as demand for new loans is weak irrespective of how low interest rates are.  The fall in inflation has prompted growing concerns about deflation and the ECB felt the need for further action to signal its intent to prevent this.

Accordingly, the ECB is targeting another avenue (without stating it outright) to achieve the desired results – the currency market.  Europe has been burdened with a currency which reached a two-year high against the US dollar in October.  This is relevant to the fight against deflation in two ways – a stronger currency hurts the economy by making exports more expensive (and harder to sell overseas) as well as reducing the prices of imports (which adds to downward pressure on prices).  A reversal of this trend, that is, a weaker currency, would then work in Europe’s favour and is one of the few levers available to the ECB.

A lower interest rate helps to drag down the value of a currency by reducing the benefits of holding cash in that currency and providing an extra incentive to sell.  This effect is further magnified by the large amount of cash sloshing around in the global financial system at present.   But it is not so easy - some other central banks (namely the Bank of Japan) are keen on achieving the same results through similar policies and not all countries can have weak currencies.  This has resulted in the coining of the term "currency wars" as countries battle to drive down the value of their currencies.  It all sounds rather dramatic but it is evidence of how things in the system of finance are far from normal.

ECB Rate Cut – what's the point?

The European Central Bank set itself apart with looser monetary policy but how is this likely to make any difference to the economy?

Central banks have been busy recently, whether it be talk of forward guidance from the Bank of England or the tapering of bond purchases by the Federal Reserve.  The exception had been the European Central Bank (ECB) which had been going through a quiet period after monetary policy helped to put paid to the Eurozone crisis in 2012.  Worries about deflation jolted the ECB back into action following data showing that inflation was down to 0.7% in October.  The ECB decided to respond last week by cutting its benchmark interest rate from 0.5% to 0.25%.  But, with interest rates already low, will a further reduction make much of a difference to the economy?

A cut to interest rates is something of an anomaly as the ECB is the only major central bank which has not already lowered interest rates as much as possible.  The recent trimming of its key interest rate follows cuts in July 2012 and May 2013 with the ECB using this drip-feeding of interest rate changes to respond to new data on the economy in Europe.  The focus of policy has shifted from saving the Eurozone from collapse, which was achieved by the ECB taking a stand pledging to do “whatever it takes” to save the euro. Instead, the ECB is looking to boost growth with the hope of staving off deflation.

Lower prices may sound like a blessing to consumers but this fall has the effect of making debt tougher to pay back as selling the same amount of goods generates less money for firms which also means that the government misses out on tax revenues.  Not exactly what a heavily indebted Europe needs at the moment.  This is the reason why central banks will typically adjust policy to achieve inflation of around 2% - better to have a small amount of inflation than succumb to deflation.  Inflation has been decreasing elsewhere as well such as in the UK (see previous blog) due to weak growth combined with a fall in global commodity prices (see Inflation – then and now for more on how inflation works).

The interest rate cut in itself will actually have little effect with households and businesses in Europe not keen on borrowing while the economy is so weak.  Rather it is a signal of intent – the ECB will continue to loosen monetary policy while some central banks elsewhere (the US and, to a lesser extent, the UK) are approaching the beginning of the end of their loose monetary policy.  The key mechanism by which this will be fed through into the economy is likely to be the exchange rate but more on this later…

Eurozone crisis: Still bubbling away

The debt crisis in Europe seems a long time ago but a political hiccup in Italy shows that its revival may not be that far off.

Around this time last year, weeks would go by without this blog commenting on anything but the Eurozone crisis.  The turning point came near the end of 2012 with a bit of imaginative policy making by the European Central Banks who said they were willing to do “whatever it takes” to save the euro.  By the start of 2013, the worst seemed to be over (Good and Bad in 2013), but many of the problems still had to be fixed.  This year has seen the economic problems in Europe simmering away in the background rather than being likely to erupt as in 2012.  However, the turmoil in Italy at the moment shows that it does not take much for things to heat up again.  Europe may not dominate the headlines as in the recent past but it is never too far from the front pages and here is a look into why.

Politics in Italy are tricky at the best of times but an election earlier this year left the country with a fragile coalition.  A fresh saga was triggered as the constant distraction that is Silvio Berlusconi looked to pull his support from the government after being convicted of tax fraud in August.  Yet it was Berlusconi who suffered from his latest attempt at meddling as he was forced into a dramatic U-turn which involved providing support to the government in order to avoid seeing his own party rebel against him.  After a jump in the interest rate on Italian government bonds, the weakening of Berlusconi cheered investors as he had held sway over Italian politics for a long time despite Italy having not benefited much from his time in power.

Although Italy has avoided the unwelcome prospect of another round of elections, the problems that the country faces are greater than the immediate political woes (for some background, see Bigger than Berlusconi).  This year, the government budget deficit is expected to top 3%, which is the upper limit for EU countries, with government debt approaching 130% of GDP.  The coalition government lacks the political capital to push through the necessary reforms to get the economy moving ahead to help generate the tax revenues needed to reduce the shortfall in the government’s finances.

Italy is hampered by a problem which is typical for countries in Europe feeling the strain in the aftermath of the Eurozone crisis – voters weary of austerity measures with little to show for their perseverance.  Mainstream political parties who have been pushing government cuts have seen their support eroded by fringe parties which promise relief through policies which will have negative long term effects.  The democratic process has struggled to deal with the consequences of the economic slump and mounting debts following the global financial crisis.  Voters have been stuck with two unappetizing options – enduring the hardship of austerity with scant rewards or repelling against spending restrictions but becoming an outcast in the financial system.

The same themes can be seen being played out in Portugal and Greece among others.  Greece has witnessed the rise of the far-right extremist Golden Dawn party which has fed off the frustration of Greek voters.  Local elections in Portugal resulted in heavy losses for the ruling party who had pushed through austerity measures.  Despite all the hardship endured in these two countries, further bailouts are seen as necessary to deal with the stubbornly high levels of government debt.  The economic stagnation in Europe continues with countries like Greece still suffering with GDP down by 6.4% in 2013.  Portugal, Italy, and Spain among others also ended 2012 with lower GDP. 

While the European Central Bank has staved off the immediate threat of crisis, the flipside is that the pressure for reforms has eased.  As such, politicians can no longer blame the financial markets for their unpopular policies.  Leadership in Europe has also been lacking with the national elections in Germany drawing the attention of Angela Merkel away from Europe.  Coalition negotiations in Germany following the elections in September will leave Europe seemingly leaderless for a few more months.  The Eurozone crisis may have been put on the back burner but it could still boil over at any point if not watched.

What Europe has to teach Japan

As the Japanese government mulls a higher sales tax to improve its finances, what do the experiences of Europe over the past few years suggest?

When thinking about the problems with the economy in Europe – feeble economic growth, high levels of debt, and banks shackled with bad debts – Japan has been seen as a lesson of what not to do.  Europe had the luxury of learning from Japan’s mistakes – Japan tried to ride out the problems while Europe has been more proactive in sorting out the mess following the global financial crisis.  It could be argued that Europe has come further in a few years than Japan has come over the past two decades, and with Japan considering a move to improve its dire finances through higher sales tax, it seems a good time to see whether Japan has anything it can learn from the experiences of Europe.

Talk of crisis in Europe is significantly more muted these days with the worst of the Eurozone debt troubles having been left behind in 2012 (for more, refer to Both good news and bad news for Europe).  Recent data showed that the economy in Europe grew marginally in the second quarter of this year giving rise to hopes that a brighter future awaits.  A key element of Europe’s gradual return to health has been its austerity.  Japan has been saved from the forced cut backs imposed by some governments in Europe as domestic savers in Japan are reliable buyers of government bonds there.  But the absence of any pressure to rein in spending has a downside as well in the form of more and more debt.  

Normally, gradual and mild rises in interest rates act as a warning signal as in Europe when buyers of bonds shun the debt of any country that seems likely to default.  So even without any signs of trouble being on its way, debt in Japan could all of a sudden reach a point where a large chunk of the holders of its debt decide to jump ship resulting in financial meltdown.  The lack of urgency has meant that austerity has never taken off in the same way that it has been embraced by leaders in Europe. 

Japan is trying a different tack as a means to sort out its finances – a higher sales tax.  This option has long been thrown around as a possibility in Japanese politics and has dominated headlines in Japan with the Abe government considering a two stage rise in sales tax from 5% to 10% by October 2015.  The two different approaches – to cut spending or raise revenues – are both plausible solutions but it seems strange that Japan and Europe have chosen different routes to solve similar problems.  Europe has had more success with its way of doing things but that may be a sign of great resolve instilled through higher interest rates.  Some countries in Europe have adopted measures to increase their income but it begs the question – why has the Japanese government not made more of an effort to rein in its spending?

Government spending in Japan was 15% higher in 2012 compared with 2007 before the global financial crisis but government revenues have fallen by over 8% over the same period.  One of the key reasons behind Japanese politicians’ aversion to cutting spending is its patronage style of government.  Political leader divvy up the resources that come with the levers of power in the same way that traditional community bonds would dictate.  Support of those in power comes through rewarding your followers, and even though this old-style source of power is on the wane, it is where the current ruling party has a reliable support base in rural districts which are overrepresented in the Japanese parliament.  So the reasoning behind the approach of the Japanese government would be that higher taxes will spread the pain whereas cuts to spending will hurt your supporters.

The Abe government in Japan has been trying lots of other tricks including even greater increases in spending in 2013 through a fiscal stimulus package (see When Keynesian policies won't work for why this is not likely to work) along with expansionary monetary policy (which is unlikely to do much good either – see Don't hold your breath).  Yet, spending seems to have passed being useful considering the countryside in Japan is already covered with roads and bridges that see little traffic as well as a multitude of small plots of land farmed by the elderly with government support.  This seems even more incongruous considering that the population in Japanese is declining which will see further falls in revenue and higher spending on pensions and medical bills for the elderly.  This means that the reforms proposed by the Abe government are even more crucial in order to make the falling number of workers even more productive.  Or else, Japan might have to resort to another policy option used in Europe – default…

The perils of doing too much

Central banks have been recruited to stave off economic disaster but they may have been forced into overplaying their hand.

The global financial crisis has propelled central banks into prominent roles in fighting off recession while politicians have been slow to act.  Being the last remaining stalwart against economic disaster, central banks had to go further and do more than would have ever been previously conceivable due to their limited range of policies.  Even though the efforts of central banks have some effect in keeping the global economy afloat, the jury is still out with regard to the distortions left behind by the actions of central banks as well as their new roles as backstops for the global economy.

Most central banks have been given independence over the past few decades due to the notion that this will aid them in their central goal of reigning in inflation.  The theory behind this is that politicians would be tempted to use the tools of monetary policy – setting interest rates and the level of money supply – to boost economic growth and their re-election chances to the long term detriment of the economy.  So independent economists at central banks were given the reigns of monetary policy and a target for inflation of typically around 2% to ensure that a safe pair of hands would be in charge.  The typical cycle of monetary policy involved interest rates rising during periods of strong economic expansion to keep lending in check while a weaker economy prompted cuts to interest rates in order to make borrowing easier. 

The global financial crisis that struck in 2008 involved what could be deemed to be a perfect storm.  Politicians had got caught up in the bubbly state of the economy and government spending got out of hand backed by tax revenues that were later found to be just a temporary fill-up.  This was not just confined to a few countries but the Bush administration in the US, the Labour government in Britain, and many countries in Europe were running large budget deficits at a time when common sense would have suggested putting money away during the good times.  So when the banks got themselves into trouble and required help from tax payers, government finances were already stretched and there was nothing left in the coffers to bail out the economy. 

A crisis of confidence hit the global economy with spending by consumers and investment by companies being cut back due to the chronic uncertainty of whether the banking sector was going to collapse.  Your Neighbourhood Economist would argue, with a good dose of hindsight, that the typical Keynesian policies of an increase in government spending would have been the best response to the global slowdown with government making up for the shortfall in demand from elsewhere.  Government spending could have made up for the shortfall in demand, but the mismanagement of government finances meant that this option was not available.

Monetary policy was always going to be a struggle (a bit of hindsight coming in useful here too) as the activities of the central banks during recessions, such as boosting lending, are generally transmitted through the financial system.  Yet, banks everywhere were fighting for their own survival instead of being concerned about the tinkering of central banks in the background.  The weak translation of monetary policy into positive effects on the actual economy has resulted in the extent of the actions of the central banks having to be ramped up to have an effect.  The most obvious example of this is the recent announcement by the Japanese central bank that it plans to double the money supply in Japan which would be beyond belief even just a few years ago (for more, see All bets are ON). 

Even though the worst seems to be over, central banks are still in a difficult situation in terms of getting out of the role of being the guarantors of the economy.  The massive scale of their involvement in the economy will make an orderly retreat fiendishly difficult due to possible economic hiccups in the future and uncertainty over how the economy will respond.  Even if this Herculean task is pulled off with minimal problems, a new precedent has been set where central banks will now ride to the rescue if the economy goes bad. 

This situation is made worse by politicians who have shown themselves to only look short-term in their focus when dealing with such problems as the Eurozone crisis in Europe or the fiscal cliff in the US.  The expanding responsibilities of central banks may find them overextending themselves to the detriment of the good work they have achieved so far such as keeping a lid on inflation.  Central banks have overachieved during the global financial crisis considering their initial remit but should not have to be relied on to save the day.  Economists are not meant to be super heroes.

Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.