By Pater Tenebrarum at Acting Man blog
While the ECB keeps talking about what it might possibly do, its actual policy choice is a rather odd mixture, as Sharmila Whelan of Asianomics recently pointed out. On the one hand, it is evident that a policy of internal deflation has been embarked upon in the euro area.
However, on the other hand, this is combined with a policy of “pain avoidance”, which we can see by the frequent reactive ECB decisions to temporarily inject liquidity again with instruments such as its LTROs (and their new bastard child TLTRO) and keeping administered rates at ridiculously low levels, as well as by the continued increase in government debt. As we have previously noted in these pages, to the extent that credit expansion has taken place in the euro area in recent years, it has been focused almost exclusively on the funding of more government spending.
The private sector by contrast continues to slowly deleverage (see our previous article “Euro Area Credit and Money Supply”, which contains a recent update of the most important data points in this context).
Naturally, this combination of policies makes little sense, as it simply serves to prolong the pain of the adjustment. If the ECB and other policymakers in Europe were to let market forces make short shrift of the remaining bubble activities in the euro area, there would be a sharp, but short recession. This would indeed be quite painful, but it would also lay the foundation for a sustainable upswing. However, one would have to be politically prepared to endure the considerable short term pain associated with this approach, and a great many impediments to price and wage adjustments would have to be removed beforehand.
The current period of relative calm is likely to soon give way to a more “interesting” time period again, in the Chinese curse sense. This is so, because money supply growth in the euro area is recently decelerating significantly.
Another Armchair Planner Chimes In
Numerous armchair planners are lately generously dispensing valuable advice to the ECB via the financial media. We discussed one of them recently, namely former ECB board member Lorenzo Bini-Smaghi.
Another armchair planner of considerable prominence is Wolfgang Münchau, who regularly writes for the heavily pro-interventionist Financial Times. A friend pointed us to a recent editorial of his, entitled “Draghi is running out of legal ways to fix the euro”. As the headline indicates, not only can the euro can be “fixed”, but Mr. Münchau actually knows how and is willing to share his “better plan” with Mr. Draghi. If only the latter will listen, everything will be fine and the euro will finally begin to “work”. So what is Mr. Münchau's advice? What is his secret sauce? You probably guessed it already, it is the printing press of course. The ECB, so Münchau, uses a “bad economic model”. He has a better one.
Euro Not Debased Fast Enough
Here are a few excerpts regarding what Mr. Münchau thinks the ECB's failures consist of, as well as his proposals to remedy these failures (which he admits may not be entirely “legal”, but if you want to make an omelet…). Let's start with Mr. Münchau's list of mistakes though:
“The ECB is failing to deliver on its inflation target not because it has run out of instruments but because it has based its policy on a poorly performing economic model. The ECB never expects inflation to deviate from the target of just under 2 per cent. Yet each month inflation undershoots, and the ECB is apparently taken by surprise. Because it relies on inaccurate intelligence, the ECB has committed three errors over the years.
First, the ECB should have embarked on large asset purchases and cut interest rates to zero early on in the financial crisis. It did neither. This level of support was needed even more urgently in the eurozone than in the US, because fiscal policy in Europe was much tougher. This was compounded by the decision to raise interest rates briefly in 2008 and in 2011, when the ECB governing council expected a recovery that never happened.
The second mistake was Mr Draghi’s promise to buy eurozone government debt in the secondary markets, known by the official name of outright monetary transactions. This surely helped the bond market to recover, and took the heat out of the eurozone crisis. But it was at best a partial victory because it made everybody, including the ECB itself, complacent. OMT ended all crisis resolution.
The third mistake was to misjudge the dynamics of the fall in inflation rates late last year. Core inflation, which excludes volatile items such as food and energy, has been fluctuating around 0.8 per cent since November. Yet each month at his press conferencesand in speeches Mr Draghi repeats the mantra that “inflation expectations are firmly anchored” at close to 2 per cent.”
In short, the ECB's biggest failing according to Mr. Münchau is that it hasn't debased the euro “fast enough”.
We wager that almost 500 million consumers in the euro area would beg to disagree vehemently with this assessment. We just cannot imagine that they would deem themselves better off if prices had risen faster than they have.
Euro area HICP (harmonized index of consumer prices). Mr. Münchau believes the euro isn't debased with sufficient fervor – click to enlarge.
The HICP's annual change rate. Shouldn't people in the euro area be glad it has slowed down a lot? Not according to Mr. Münchau – click to enlarge.
What Should be Done?
This brings us to Mr. Münchau's proposed remedies for these alleged mistakes. Hold on to your hat.
“Almost a year ago I argued in this column that the ECB should buy government bonds in proportion to the member states’ share in the central bank’s capital. I no longer think this would work. Sovereign yields are converging to zero in anticipation of deflation; they cannot fall much further. This policy would have been far more potent had it been applied at a time when inflation was still close to the target. By pussyfooting around with liquidity policies instead of acting on inflation, the ECB has signalled that it is safe to bet against the inflation target. That is what German bond yields are telling us.
To undo this would take some heavy lifting – much heavier than anything we have seen from the US Federal Reserve, the Bank of Japan or the Bank of England. I am not sure that the legal and political room for manoeuvre allows such an extreme response. Still, it is worth considering what this would entail.
The ECB should start by ditching the inflation target and replacing it with a price-level target. This would signal to investors that if inflation is too low in one year, the ECB will make up for it by overshooting in the opposite direction the next.
The ECB should starting buying equities and junk bonds. It should subsidize mortgages and consumer credit. It could fund an investment programme in transport infrastructure, energy networks and scientific research, by buying debt to fund such projects at zero interest rates. All these measures would be effective. Most would be illegal.
Legal, shmegal! Who cares, right? There is an emergency on! Our comment to our friend upon reading this list of proposals was as follows:
“So to “save the euro” and “rescue the economy”, the ECB should massively distort prices across multiple markets by means of injecting untold amounts of money from thin air into them.
Right, that is going to work, for sure. Real wealth will magically appear from the 5th dimension as a side effect. Frogs will become princes. Stones will turn into bread.”
We don't have much to add to this assessment actually, except to say that according to Mr. Münchau, the bazooka below, which we showed a short while ago already, is evidently too timid a weapon:
This mini-bazooka will no longer do …
(Illustration via slopeofhope.com / Author unknown)
Instead is is to be replaced with a weapon worthy of Lobo:
The new Lobo-bazooka for Mr. Draghi. Yes, this looks like an illegal weapon …
Our armchair planners are inhabiting an even higher plane of crazy than the real ones.