Happy 2013

Hi. I haven’t been too active lately here. Been busy doing proper academic work like teaching and research. I may become more active next year, but I will stick to my principle that one doesn’t have to have an opinion, and vent it, about everything. Actually, the day where the news on TV announce that they cut their program short by 15 minutes due to lack of interesting news, or when a newspaper come in a short, cheaper edition during summer due to lack of important stuff to write about, then I will be happy.

Too many just write because they want to write, or have an obligation to write. Irrespective of whether there is anything substantive to write about. Ho-hum.

Nevertheless, next year will be interesting in central banking. We are in the midst of world-wide dire economic times with high unemployment and public debts on both sides of the Atlantic. So far, two basically different approaches have been tried out. The US goes with the academic prescriptions of signaling a commitment about the future policy, while in Europe, the ECB has come out as a fiscal player standing ready to bail out countries with high public debt (all in the name of living up to their monetary policy mandate as the mantra goes again and again).

We are not supposed to pick winners, but irrespective of the results, there will be interesting lessons to be learned. Happy New Year!


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Nobel awarded to Roth and Shapley: Personal nostalgia

Today, the “Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2012” was awarded to Alvin E. Roth and Lloyd S. Shapley “for the theory of stable allocations and the practice of market design”. As always when the Nobel is decided, I realize that I should not be one giving out the prize. Along with many, I try to make clever predictions, which always fail. On the other hand, when the prize is being awarded, I almost always find that the choice is obvious and natural.

This year is no exception. I will spare you for my failed prediction(s), but applaud this year’s choice. Roth and Shapley are both powerhouse scientists, and the research program that is being acknowledged today is really among the very basics of economics: Who trades with whom and why? To answer this, one has to make theories and predictions about how markets work, and to come up with mechanisms to solve allocation problems when the free market does not work.

Here, Shapley made the pure theory foundations (along with Gale) back in the 1960s, which Roth and others since the 1980s have applied to a host of real-life economic issues ranging from allocation of students to colleges to allocation of kidneys. A great lesson on how deep “theory-theory” can be adopted to very hands-on economic issues.

For me, it is a particular joy that Shapley gets the prize. In the 1950s, he developed a cooperative game concept called the Shapley value, which essentially through a single number ranks players’ value of participating in a game. The concept was applied to political decision making together with Martin Shubik in 1954, as the Shapley-Shubik index. It is a simple index that measures the voting power of parties, and, in particular, shows that number of seats in a committee or parliament is not the same as power. It is the power of the coalitions in which a party can be decisive, i.e., pivotal, that matters. Think of a parliament with three parties with 50, 49, and 1 votes, respectively. If only majority coalitions win, the party with 49 is pivotal in as many coalitions as the party with 1. Hence, these parties have the same power as measured by the Shapley-Shubik index. (The 50-vote party is pivotal in all three winning coalitions, and has thereby disproportionately more power than the party with just one vote less.)

I wrote my M.Sc. thesis on this index (and its subsequent derivatives) back in 1988, where I applied my own variant of it to power indices of parties in the Danish parliament in the 1970s and 1980s. Essentially, I just assigned priors to the likelihood of some coalitions to materialize—this contrasts with the derivation of the Shapley-Shubik index where all coalitions are equally likely. For Danes, it should not be surprising that it turned out that the small center party “Radikale Venstre” (which is neither radical, nor left winged) came out as having as much power as the big parties with the bulk of the seats in parliament. It was a slightly odd subject at a time where most wrote about exchange-rate target zones, but now, and particularly today, I am still quite happy about it.

Congratulations to Roth and Shapley!

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The ECB in Slovenia: Transparency about what?

The meeting of the ECB’s Governing Council was last Thursday hosted by Slovenia, but the procedures were the usual. Compared to last month’s meeting, however, where everything was about fiscal policy, the very first question at the press conference actually dealt with monetary policy. Triggered by the (expected by most) decision to keep policy rates unchanged, a reporter asked:

Two short questions, Mr Draghi. The first one: you mentioned downside risks to the economy again. Have there been any discussions today about a possible rate cut in the months to come?

And the second one on Spain: do you find Spanish bond yields appropriate at the moment or are they still hampering your monetary policy transmission?

These are two fundamental questions on monetary policy, and on how the ECB views the monetary transmission mechanism (as its alleged disruption is what made the ECB initiate the OMT). Draghi’s answer was short:

On the first question the answer is no and on the second question, I will not comment.

If the first part of the answer was a way of signaling a commitment to low rates for a long time, it could have been done more elegantly and more transparent. The second part of the answer was strange. Draghi does not say that he does not know, is uncertain, or something else, which would have been understandable. He just refuses to answer.

This does not provide further insights to those who could suspect that the constant talk of a hampered transmission mechanism and the need for “singleness” in monetary policy is a veil needed for engaging in bailouts of countries in fiscal distress.

It was therefore somewhat ironic that the next question (again on monetary policymaking!) dealt about publications of the minutes from the Governing Council meetings; i.e., dealt about the transparency of the ECB. In part to this issue Draghi responded:

What you have to keep in mind is that the ECB is already a very transparent institution; just think about this press conference every month.

Oh, well.

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QE3 and the FED: State-contingency and commitment emphasized

Today the Board of Governors of the Federal Reserve System published its decision to start a new round of quantitative easing and a revised announcement concerning the Federal Funds rate. Both legs of this decision have some interesting new aspects that show a central bank continually trying to expand the toolbox of monetary policy, and to be honest about its limitations when acting in an uncertain world. More specifically, the Fed re-introduces purchases of mortgage-backed securities (MBS) at a rate of $40 billion per month. No end date for the purchases is specified—at the contrary, it is emphasized that it will be extended if the economy does not pick up. Moreover, the 0–0.25% level for the Federal Funds rate is kept at least until mid 2015, but with the new qualifier that it will not be lowered, even when the economy picks up.

At the press-conference with Chairman Ben Bernanke, he elaborated on these aspects (aided by quite insightful questions from the press). Bernanke made it clear that at the lower bound, the Fed’s policy instruments are essentially balance sheet manipulation and communication.

Indeed, the quantitative easing of MBS belongs to the first category. Of course, at the press conference, Bernanke was asked whether this “QE3” will be effective at all. Many seem to acknowledge the effects on interest rates and asset prices, but many doubts that the effects go further. So, as one reported formulated it, will this policy actually go from Wall Street to Main Street? Bernanke emphasized that the role of monetary policy is to affect financial prices and that the Fed was convinced that there would be an effect on the real economy. However, the lack of a numerical target for asset purchases (as under the old MBS programme), is clearly a concession to the uncertainty that prevails about this effect. Bernanke stressed that a general and a sustained improvement of the labor market is needed, and that the Fed did not have a specific number that captures when this would happen. The Fed states it clearly:

“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

Such a state-contingency is new in the recent series of quantitative easing, and it becomes interesting to see whether this will imply an ever-increasing balance sheet of the Fed, or a perhaps more potent result due to the expectation that this time it will work? At least, it is a rather bold policy measure.

As for the second category, communication, the Fed kept the date for when policy rates would be raised imprecise (as it has done previously), but moreover it added a commitment to keep rates low even after recovery starts:

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015”

This comes close to the theoretical concept of optimal monetary policy in forward-looking New-Keynesian models, where history-dependence is optimal since it helps affect expectations about the future, and thereby current conditions directly. The reason is that history dependence implies that actions today will feed into the future, and thus the expectations about this future—given that the policy is credible. In particular, such history dependence of policy implies that an expansive stance should continue beyond the time where a given target is achieved.

Hence, the Fed’s decision comes close in accommodating the general ideas in the recently heavily mentioned paper by Michael Woodford on “Methods of Policy Accommodation at the Interest-Rate Lower Bound“ that was recently presented at the annual Jackson Hole Economic Policy Symposium (it is fantastic that a 95-page academic paper has gotten so much attention outside academia). Woodford has been the main academic economist emphasizing the advantages of history dependence in policy, and in this particular paper he makes the case for a nominal GDP-path target as a means to achieving this history dependence. (Ok, here I must state that originally nominal income growth targeting as a way of attaining history dependence was brought up by myself in a 1999 CEPR Discussion Paper that was published in 2002 as Targeting Nominal Income Growth or Inflation? American Economic Review 92, 928-956. Woodford noted this in his 2000 American Economic Review article on “Pitfalls of Forward-Looking Monetary Policy” which is a nice and brief introduction to the benefits of history dependence for those who are reluctant to dig into 95 pages.)

This issue was also brought up at the press conference, where the notion of credibility of the Fed was discussed. Whether the Fed has the necessary credibility is ultimately an empirical issue, and Bernanke found that empirics indicated good credibility—the aforementioned Jackson Hole paper by Woodford shows that announcements by the Fed affects bond yields almost immediately, indicating that communication matters. Nevertheless, it will be interesting to see whether the Fed (perhaps under another chairman) will keep rates low in an economy where inflation is picking up. This is a type of commitment that is hard to live up to, and one that cannot be assured from empirics on intra-day asset price movements following policy news.

Nevertheless, this meeting of the Board of Governors introduced an emphasis on state-contingency and commitment which is refreshing and goes nicely with academic literature (Bernanke is an ex-colleague of Woodford and has co-authored papers with him). Additionally, it was refreshing to see that these new policies are honest attempts to do something. Attempts that given their novelty by nature have no solid empirical support. Bernanke therefore also said that these measures offered no solution as such, but that the Fed thought that they will “nudge the economy in the right direction”. It will be interesting to follow.

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From SMP to OMT: ECB commits to destroy monetary transmission

This is not a humorous title, and this is not a funny post. A couple of days ago, the ECB announced after its Governing Council meeting that it would initiate a new program of sovereign debt purchases. The program is named Outright Monetary Transactions, which adds OMT to the endless list of acronyms that has emerged after the onset of the financial crisis. The program replaces the Securities Markets Programme (SMP), or, rather, extends it in a number of directions.

As mentioned in my post on the last ECB policy meeting, its need for emphasizing that what it does is not illegal strikes me as odd if not suspicious. At least I think it gives an impression that there is some bad consciousness involved. Or perhaps it is just a preemptive strike to silence those who think government bond purchases by the ECB are a violation of the Treaty of the European Union (or maybe it is done to cater the one country who cast a dissenting vote regarding the OMT). In any case, just as under the SMP, bond purchases will be conducted on secondary markets, and not directly from governments. The label “outright” otherwise does, according to some dictionaries, mean “direct”, “openly”, “without reservation or qualification” inter alia. But according to the Treaty, the market on which you acquire government debt sems of essence when it comes to aiding governments in fiscal trouble. I never understood this, but it is a distinction that enables the ECB to sidestep all issues about an independent central bank not being allowed to help out governments with their finances. It is like a situation where buying drugs from a drug producer is illegal, but going out on the streets to buy drugs is legal.

However, these legislative details appear entirely unimportant to the ECB, as its rationale for introducing the program is action towards restoring the monetary transmission mechanism in the Euro area—just as the SMP was. The argument is that the divergence in government bond yields are hampering monetary transmission in the Euro area, and thereby hampering the ECB’s efforts at attaining price stability—their primary mandate. I have still not understood this argument entirely (if at all), but Mario Draghi gave some explanation at the press conference to which I return shortly.

First, however, I should mention the main differences between the OMT and SMP. The main difference is that purchases under the OMT come with conditionality. Countries whose bonds the ECB buy, must meet relevant requirements set up by the European Financial Stability Facility/European Stability Mechanism (the IMF will also become a player of the game to the extent that it can monitor whether countries satisfy to conditions). Moreover, there are no limits to how much can be bought, but the purchases stop whenever the ECB’s objectives of “securing appropriate monetary transmission and the singleness of the monetary policy” are achieved. Alternatively, they stop if the country in question does not satisfy the conditions. Due to this conditionality, it is obviously not possible to hide which countries the ECB buys bonds from (even on secondary markets). Hence, both the amount of holdings and the nationality will now be disclosed (and ECB tries to score a “Transparency Point” on that fact). As with the SMP, purchases are going to be fully sterilized. So this is not quantitative easing, but the German member of the Governing council, Jens Weidman, who in all likelihood cast the dissenting vote, has nevertheless been stating that bond purchases were “too close to state financing via the money press for me”. Finally, the ECB gives up on its seniority status on bonds.

All in all, it appears as a further step away from the intentions of the Treaty on the European Union which in letter states that

“Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments (Article 123)”

It clearly represents an upgrade in the efforts of affecting government financing conditions. I mean, if it is not a scheme that represents a credit facility on favor of a union central government, which is prohibited, then I don’t know.  (The fact that the ECB is not in conflict with the second part of the Article doesn’t nullify this.) The conditionality aspect may comfort some, but to me it just makes it looks even more as a fiscal policy action. But still, the ECB maintains it is for monetary policy purposes only. At the press conference, there was one question in particular, which created important food for thought, and also allowed Draghi to explain this monetary policy aspect in more detail.

The question, posed by a reporter Draghi clearly respects, is the second part of a two-part question starting at 26:21 in the press-conference clip below:

The first part is a clarifying question on the announced maturities of the bonds eligible for purchase (up to 3 years to maturity). The second part is on the conditionality part and goes:

 “Now you mentioned that the OMT would be suspended, if countries didn’t fulfill the necessary conditions set out in the MoU. Now, given that these purchases are explicitly for monetary policy purposes, does this mean that you will suspend the ECB’s independence if the countries don’t fulfill the conditions? I don’t quite understand this contradiction. Maybe you could elaborate that for me?”

Draghi answers:

“On conditionality  . . . The assessment of the Governing Council is that we are in a situation now where you have large parts of the Euro area in what we call a bad equilibrium. Namely, an equilibrium where you have self-fulfilling expectations, you may have self-fulfilling expectations, that generate, they feed upon themselves, and generate adverse, very adverse, scenarios. So there is a case for intervening through, in a sense break these expectations, which by the way don’t only concerns the specific countries, but the whole Euro area as such. But then, and this would justify the intervention of the central bank, but then we should not forget why countries have found themselves in a bad equilibrium to start with. And this is because of policy mistakes. That’s why we need both legs to fix, in a sense, this situation: to move from a bad equilibrium into a good equilibrium. If the central bank were to intervene without any action on the government side, without any conditionality, it would not be effective. It would not be effective, and it would loose its independence. At the same time we see that we are in a bad equilibrium, and therefore policy actions, though convincing doesn’t seem to produce, or [inaudible] to produce, in a relatively medium term, the results for which it is geared. So that’s why we need both legs, for this action, and I think, hope, this answers your question”

The question hints to a contradiction that Draghi never gets to. Perhaps the question is not formulated entirely clear on this issue, so Draghi spends time explaining conditionality and why it is necessary. During this, he clearly states that the high yields on some government bonds are not fundamentally based. They are a result of a “bad equilibrium” brought about by self-fulfilling expectations, e.g., due to “unwarranted” expectations about the disruption of the Euro area. As it affects the whole Euro area, it is of concern for the ECB (by the Treaty, the ECB must not care particularly about single countries, so it is important for the ECB to emphasize that the debt crises in some countries hamper all countries).

The rest that follows is strange. Draghi concedes that the bad equilibrium is triggered by bad fiscal policy in some countries. Does this mean that the excess yields are partly a country-specific fiscally-based risk premium and an “unwarranted” Euro-break-down premium? Or is it only an unwarranted Euro-break-down premium triggered by bad fiscal policy? This is not spelled out and will leave market unsure as to when the ECB will “pull” out of a given country’s bonds. In either case, why is conditionality then needed to eliminate the self-fulfilling expectations? This can only be because it is believed that an improvement in fiscal performance is a necessary condition for the elimination of self-fulfilling expectations. This is consistent with Draghi stating that without conditionality, ECB purchases will have no effect, and ECB’s independence would be lost. So he is effectively admitting that the SMP was an ineffective construct, and even one that gave away ECB independence. However, improvement in fiscal performance is not considered sufficient to eliminate the bad equilibrium, so that is why the OMT must be implemented to bring about a good equilibrium. And presumably if it works, then the ECB does not loose its independence.

I think one can construct a consistent story behind the multiple equilibrium theory and the corresponding fiscal-monetary program needed to bring down yields, but how that in any way relates to the ECB’s independence is vague. It seems that Draghi is simply saying that if purchases are effective, then the ECB has maintained its independence!

The reporter’s question may have had a different connotation—one that really fleshes out a contradiction in the OTM scheme. At least for me, this particular Q/A triggered the following question: If a country does not live up to the conditions, will the ECB accordingly abandon it, and thus accept the resulting disruption of the monetary transmission; i.e., accept that the whole Euro area will be left in a bad equilibrium? By letter of the OMT scheme, to which the ECB have committed, it should. But in reality it ultimately depends on the credibility of this “threat strategy”;  i.e., of whether the ECB is really willing to abandon a country. As is well known, a commitment is only as good as the credibility of its support. I.e., the actions taken when some breaks the rules (in game theory, this is what is meant with credibility of “off-equilibrium” strategies, or, perfect Nash equilibrium strategies).

Here I see the contradiction: On the one hand, the OMT is emphasized to be initiated for the sake of monetary policy transmission purposes only, but it will be stopped vis-a-vis countries that violates the associated conditions. But by the ECB’s own logic such a violation will ruin the very same transmission mechanism, as it will trigger a bad (or, worse) equilibrium. Hence, if the ECB should obtain credibility about its commitment to this program, it must be willing in some circumstances to ruin the monetary transmission mechanism, send the entire Euro area into a bad equilibrium, and thereby be willing to make it hard for them (by their own logic) to fulfill its objective of price stability. So to be in accordance with the Treaty and its own objectives, the ECB has committed to a scheme where the “threat strategy” that will give credence the its commitment will make it impossible to live up to the Treaty! Talk about setting up traps for yourself!

So not only have the ECB embarked on a program that is the most blatant fiscal rescue plan ever seen by an independent central bank, it has also done it in a way that is bound to create insurmountable challenges for itself down the road. I honestly think that the ECB should have stuck with monetary policy, and left the fiscal problems where they belong: in the hands of governments. This was indeed the idea behind the Treaty in the first place as I understand it from Article 123.

Oh, and at the press conference, there was actually one, yes one, question about monetary policy, more specifically the interest-rate decision. It was on whether the ECB had thought of a change, and we were told it had not. Nobody seemed to care one bit.

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White Paper, Great Economists and (really) Bad Science

In Denmark, where I come from, academic economists are often used in the media. Whenever there is a political debate on an economic issue or policy proposal, TV and newspapers call out for economists to get their views and analyses. The norm is that journalists try to cover most views on a given issue, and that the economists in question try to be as balanced as possible. Ideally, the economists act as a sort of independent “expert witnesses”. Of course, personal opinions will to some extent color what a given economist will focus on, but one line is never crossed: An academic economist never endorses a given politician or party publicly. If that happens, the credibility of the economist as a reliable source for journalists drops to zero and the scientific reputation among peers drops to a low. When crossing the line, the economist effectively becomes a politician, which is a completely different trade. (As universities are state funded, one is obliged to make it very clear that if one makes a political statement, which of course is not illegal, then it is in the capacity as a private individual and not as an academic economist.)

The reason why I write this, is that in the US things work very differently on these matters. As is well known, a presidential election is coming up in November where President Barack Obama will take on Republican Mitt Romney. As seen here from a list of Mitt Romney supporters, academic economists of all vintages and qualities are not afraid of making an official endorsement. To me, this in itself is a cross of a line, which hampers these economists’ future statements in terms of the scientific objectivity many would ideally see academic economists live up to (their employers are often not the state, so they may not care?). As N. Gregory Mankiw indeed writes in the Introduction to one of the editions to his undergraduate text “Principles of Economics”:

“Economists try to address their subject with a scientist’s objectivity. They approach the subject of the economy in much the same way as a physicist approaches the study of matter and a biologist approaches the study of life: They device theories, collect data, and then analyze these data in an attempt to verify their theories”

However, the endorsement per se is only the beginning of a story of scientific objectivity that is currently stirring the debate. The core is the publication of a “White Paper” by economists R. Glenn Hubbard, N. Gregory Mankiw, John B. Taylor and Kevin A. Hassett. This White Paper is called “The Romney Program for Economic Recovery, Growth, and Jobs” and is thus an unconditional endorsement of Mitt Romney as new president and, in particular, of his proposed changes in economic policy. What is particularly remarkable in this paper is that the authors use academic references to back up their affirmative views on Romney’s policy proposals. I.e., they have not only crossed the line in terms of showing their colors, but they use the methods of their economic profession in the process of being politicians. The result is a horrible mess, which has received strong criticism.

Paul Krugman notes that the authors are trying to “destroy their own reputations”, while Brad DeLong meticulously, and very critically, dissects the paper and its particular use of references to back up its claims. (Note to Brad’s sports analogy: He observes that dishonest referencing sends you to the showers in the US but earns you four red cards in Europe; well, one red card sends you to the showers in Europe!) Ezra Klein has interviewed many of the researchers who are being cited and find that they mostly think that their research lends no support to Romney’s politics. John Taylor has a rebuttal where he notes that

“But the research papers and books that are cited are quoted correctly and do provide supporting evidence. As Scott Sumner reports ‘when I looked at the paper I couldn’t find a single place where they had misquoted anyone.’ ”

(N. Gregory Mankiw on his blog, which nowadays is mostly a link hub, just links to, well, a few links.)

I have no doubts that the white paper does not contain any misquotes as such. Sure, there is a simulation in Altig, Auerbach, Kotlikoff, Smetters and Walliser which shows that some tax reform gives a gain in GDP of up to 1%. This is, however, not inconsistent with the cited authors being in disagreement with the conclusions of the white paper (in the example, according to Ezra Klein, Auerbach did not think the simulation had much to do which the Romney tax plan as that plan is not sufficiently spelled out). As long as researches share their work with the public, it is an occupational hazard to be cited, as well as to be cited in a way that backs conclusions you may not agree with.

This is not the problem either. The problem is that the white paper is written with a political premise, and that the academic evidence is picked selectively to back up the premise. Gone is the objectivity that Mankiw elsewhere states is a goal to strive for. Gone is therefore science. What is left is Bad Science. Bad science is not illegal, it is not even malpractice—bad science is made by many economists all the time. It is just particularly disturbing when highly regarded economists (some of whose work I admire a lot) engage in bad science. It does indeed tear their reputation to pieces, and makes you suspicious whether their next NBER working paper or text book has a gist of “Paid for by Romney for President, Inc.”

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May in August at the ECB

After the recent meeting at the ECB’s Governing Council, it was decided to keep the policy rate fixed at its record-low level of 0.75%. As the (bleak) economic outlook has not changed markedly since the last meeting, it seems a sensible decision given the ECB’s mandate.

Many, however, forget that the mandate of the ECB is to secure stable prices in the Euro area, which by the ECB is defined as a HICP inflation rate close to, but not above, 2%. It is currently at 2.4%, so it is difficult to accuse the ECB for being particularly hawkish. But the policy rate setting, and how it was aligned with the mandates of the ECB, were not what made the headlines.

Instead, most focus was on how the ECB could possible help saving the European debt crisis. To be clear, it is not the job of the ECB, and it is not within is legal mandates. It is supposed to act independent of fiscal matters. Nevertheless, many commentators and market participants criticized the ECB for not laying out any firm strategy for helping fiscally distressed countries (like, e.g., Spain). Well, I would say that the ECB itself is to blame for this de jure unwarranted focus on fiscal policy measures. It has earlier been running a Securities Markets Programme (SMP) where they have bought up public debt on a massive scale (thereby violating the intent of the Treaty on European Union). So the ECB has been acting in a way that clearly has undermined its credibility as a central bank independent of governmental preferences and pressure. (How this can generate excessive debt issuance and fiscal relaxation I have noted before.)

To make matters worse, Mario Draghi made a sequence of openings for fiscal action in his introductory statement to the press conference following the meeting of the council. Here are a couple of central passages (coming way before the analyses leading to the policy rate decision!):

“Exceptionally high risk premia are observed in government bond prices in several countries and financial fragmentation hinders the effective working of monetary policy. Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible. (…) The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.”

Not a very firm statement. “May” appears twice, so you can’t blame them for making commitments in this respect. Nevertheless, it doesn’t take much intelligence to acknowledge that when somebody has to emphasize that they contemplate actions that will actually satisfy the laws, then they are in the business of trying to bend the laws to the limit.

Under the SMP, the loophole that carried the ECB through was that they did not buy up government debt directly from governments, but on the secondary markets. In other areas of economic exchange such activity are sometimes referred to as money laundering. Now, the loophole seems to be that the financial markets are mispricing government bonds. It is interesting that an institution which otherwise operates under a free markets doctrine has the power to determine the “right” price on a bond. But since lots of the risk premia arise from investors’ putting a positive probability on a collapse of the Eurosystem, then the ECB can apparently deem the price wrong as “the euro is irreversible”.

Hence, conditional on its axiom that the euro is irreversible, the ECB has now opened the way for any action it desires in a fiscal direction, as this will be interpreted as consistent with central bank independence and attaining its objective of price stability.

It is an amazing play with words and an amazing way of toying around with letters of a Treaty. It appears that in Europe, no Treaty can withstand the shortsightedness of politicians and (some) central bankers.

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A week of records in Euroland, Denmark and Wimbledon

Last week saw the ECB lower its policy rate to the lowest level in its history. A meager 0,75 % is the rate on main financing operations. Not much, not surprising, and probably not what will make much of a difference for the dire straits of the European economies.

The rate cut was the impetus for a record in Denmark as well in last week. Apart from Frederik Løchte Nielsen’s unbelievable feat of becoming the first ever Danish Wimbledon champion (in doubles with English Jonathan Marray), the central bank of Denmark also cut rates thereby introducing a negative deposit rate (for 7-day deposits) for the first time in history. Denmark has therefore essentially hit the zero lower bound of interest rates with the overnight rates at precisely zero, and a loans rate of 0,2 %.

In the figure below one sees the Euro policy rate and Danish policy rate since the inception of the Euro. As Denmark in 1999 continued its fixed nominal exchange rate policy, now with the Euro replacing the D-Mark as the anchor, the policy rate has more or less followed the Euro rate. This is to be expected for a small open economy where credibility of the policy is only disrupted in times of turmoil, leading to occasional upwards deviations in the Danish policy rate so as to defend the parity.

This has also been the picture ever since this policy was firmly adhered to in the mid 1980s. The rule of thumb was that the Danish central bank followed any movement in the German or, now Euro, interest rate. A small interest-rate differential, however, was to be expected as a “price” of being outside the Euro; e.g., one could see it as a combination of a liquidity and risk premium on the Danish currency.

This differential is seen in the figure below. In times of turmoil, like in the fall of 2008, the Danish central bank has had to defend the parity by keeping rates above the Euro rate for a period. But as the ECB in late 2011 lowered rates again (after two increases) mainly in light of the European debt crises, something happened that gave new meaning to the term “defending your currency”. Suddenly, investors did not find bonds of Euro countries particularly attractive, and they started to invest in Danish bonds, driving the yields on short-term bonds into (slightly) negative territory.

This caused pressure on the parity in upwards direction. So to defend it, i.e., to avoid an appreciation, the Danish policy rate was lowered further than the Euro rate, bringing forth a negative interest-rate spread.

The spread in policy rates is currently -0,55 %, but the policy actions last week did not cause that. Rates were simply adjusted by the same amount as the ECB. So, Denmark is currently experiencing times where to defend our currency we have to be more expansive than the record-breaking ECB. If the ECB should lower rates further, the zero lower bound on loans rates may bind, but this should be a minor problem: You can always avoid an appreciation of your currency by creating more of it.

Even though this expansive stance is beneficial for the struggling Danish economy per se, the backdrop of this situation (which was unthinkable when I was “raised” as an economist); however, is a sheer horror story. The Euro area is bleeding as politicians have repeatedly and consistently ignored the rules and regulations they have created to make up for the bad fiscal incentives a currency union creates. Adding new rules (like the new fiscal compact) is probably too much too late, as it is hard to be convinced that politicians should suddenly stop thinking and acting in a shortsighted and selfish manner.

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