Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 4 August 2012

Watching the ECB play chess

Watching Mario Draghi  trying to gradually out manoeuvre some of his colleagues in order to rescue the Eurozone has a certain intellectual fascination, as long as you forget the stakes involved. I’m not an expert on the rules of this game, so I’m happy to leave the blow by blow account to others, such as Storbeck, Fatas, Varoufakis and Whelan.

What I cannot help reflecting on is the intellectual weakness of the position adopted by Draghi’s opponents. These opponents appear obsessed with a particular form of moral hazard: if the ECB intervenes to reduce the interest rates paid by certain governments, this will reduce the pressure on these governments to cut their debt and undertake certain structural reforms. (Alas this concern is often repeated in otherwise more reasonable analysis.) Now one, quite valid, response is to say that in a crisis you have to put moral hazard concerns to one side, as every central bank should know when it comes to a financial crisis. But a difficulty with this line is that it implicitly concedes a false diagnosis of the major problem faced by the Eurozone.

For most Eurozone countries, the crisis was not caused by their governments spending in an unsustainable way, but by their private sectors doing so (for example, Martin Wolf here). The politics are such that the government ends up picking up the tab for imprudent lending by banks. If you want to avoid this happening again, you focus on making sure governments do what they can to prevent excess private sector spending, which means countercyclical fiscal policy, and perhaps breaking the political power that banks have over local politicians.

Trying to do either of these things by forcing excessive austerity on governments is completely counterproductive. You do not encourage countercyclical fiscal policy by making it more pro-cyclical. In addition, creating major recessions in these countries makes it more, not less, likely that banks will be bailed out. Forcing excessive austerity, as well as doing nothing to deal with the underlying causes of the crisis, may even have made the short term problem of default risk worse. Not only have the size of any bank bailouts increased because of domestic recession, but in the case of Greece excessive austerity has generated political instability which also increases default risk.

In a monetary union, a ‘punishment’ for allowing excessive private sector spending (and therefore the incentive to avoid it) is automatic: the economy becomes uncompetitive and must deflate relative to its partners to bring its prices back into line. Adjustment should be painful for creditors and debtors alike. However there are two clear cut reasons why this deflation should be gradual rather than sharp. The first is the Phillips curve: gradual deflation to adjust the price level is much more efficient than rapid deflation. The second is aversion to nominal wage cuts, which makes getting significant negative inflation very costly.

It is in this context that the game of chess being played at the ECB seems so divorced from macroeconomic reality. By delaying intervention, and insisting on conditionality, the ECB is complicit in creating unnecessarily severe recessions in many Eurozone countries, and may even be making the problem of high interest rates on government debt worse. As the interest rate the ECB sets is close to the zero lower bound, it is almost powerless deal with the consequences for aggregate Eurozone activity, so the Eurozone as a whole enters an unnecessary recession.  The OECD is forecasting a -4% output gap for the Euro area in 2013, and only an inflation nutter would call that as a success for the ECB.

It gets worse. By not using its power (which no one doubts) to lower interest rates on government debt, it has allowed a crisis of market confidence to become a distributional struggle between Eurozone countries. So in effect one set of governments started financing another, on terms that make it very difficult for debtors to pay, and so the crisis becomes one that could threaten the cohesion of the Eurozone itself.  The ‘you will have to leave’ threats to Greece are just a particularly nasty manifestation of this.

There is a line that some people take that the current crisis shows that a partial economic union, where fiscal policy remains under the control of nation states, is inevitably flawed, and that the only long term solution for the Euro area is fiscal as well as monetary union. I think that case is unproven. If the ECB had undertaken a programme of Quantitative Easing, directed (as any such programme should be) at markets where high interest rates were damaging the economy, then economies would have been able to focus on restoring competitiveness in a controlled and efficient manner. That was never going to be easy or painless, but it need not have led to the scale of recession, and the political discord, that we are now seeing.

The current crisis certainly reveals shortcomings in the original design of the Euro. In my view these shortcomings could have been (and still could be) solved, if those in charge had looked at what was actually happening and applied basic macroeconomic principles and ideas. We have perpetual crisis today because too many European policymakers (and, with politicians’ encouragement, perhaps also voters) are looking at events through a kind of Ordoliberal and anti-Keynesian prism. If the current crisis reveals anything, it is how misguided this ideological perspective is.  


  1. I don't really follow this, particularly the claim that
    private sector spending (capital misallocation?) has "caused" the crisis - by which you mean AD collapse?

    How do you identify the "sustainability" of private sector (or indeed public sector) spending, ex ante?

    Investment spending always looks unsustainable ex post, if there is an unanticipated AD collapse.

    1. It is not true that investment spending always looks unsustainable ex post. But it is true that, aside from con men who can sniff out opportunity, it is not easy to tell when booms have gone too far. The danger of taking away the punch bowl too soon is less than the danger of financial crisis, recession, and depression. Waiting until the problem is obvious means that it will be too late to take effective action.

    2. Its easy to tell when a boom has gone too far. Just as its easy to tell when a recession hurts too much. I'm not going to tell economists how they should improve their game because when I finally do I want to make sure I get every ounce of credit.

      I absolutely and categorically knew a huge recession was imminent before it happened in the UK as I really could see it brewing in 2007. It doesn't take a lot of brains what I could see and sense and why I knew it was coming. The only unfortunate aspect is that I did know how deep and how long it would last for.

  2. "Adjustment should be painful for creditors and debtors alike."

    What? The world must be made safe for creditors. Especially foreign creditors. That is the mantra of the World Bank, the IMF, and central banks everywhere.

  3. If this is a chess game then its clear that neither side can agree on the rules of the game. And that the banks must be the king, since all the other pieces are expendable to protect them

  4. Would "playing chicken" be a more appropriate metaphor?

  5. Prof Simon, I can’t fault your ECONOMICS. But I think you’ve missed the POLITICAL dimension.

    That is, the power behind the ECB throne is Germany. I.e. Germany is a a major shareholder in the ECB. And it’s not in Germany’s interests to buy periphery debt that might turn out to be worthless.

    If Germans saw periphery countries in the same light as West Germans saw East Germans just after unification (i.e. if Europe was politically united) there wouldn’t be so much of a problem.

    1. Ralph. I suspect they would lose nothing, because the ECB would never have to buy anything. The moment they announced their policy, interest rates would immediately fall.

    2. The ECB has to be willing to risk losing the money, even if, by having this will, it is not likely to lose money ex-post.

      Thinking that it never will need to lose money requires certain rationality and coordination assumptions that you cannot assume will always arise out of aggregate market behavior -- i.e. sometimes you do need to fire the bazooka. Having a bazooka only if you never need to use it is not the same as having the bazooka unconditionally.

      This means the member governments need to be willing to accept a contingent off-balance sheet liability that will, every once in a while, be put on the balance sheet. That's a political commitment, the lack of which is a real obstacle.

    3. But is it clear it will lose more by the ECB intervening than it might under the current approach?

    4. No, it is not clear, but I think this is the wrong question.

      It's not like there is a 70% that if the ECB spends $1 to purchase risky asset A, it will make $1, and a 30% chance it will lose $1, so the ECB should go ahead and load up.

      The member nations, at least the ones that count, don't want the ECB to lose any money at all. Neither do any governments, which is why central banks are extremely conservative in which assets they purchase.

      That means that the ECB, and central banks generally, do not possess bazookas that can be fired at risk assets.

      But unlike other central banks, no EMU debtor can issue riskless liabilities. Therefore the ECB does not have a bazooka at all. It is much more fearful of markets than other central banks.

  6. ''...then economies would have been able to focus on restoring competitiveness in a controlled and efficient manner. ''

    and here lies the problem: where is the proof these countries would actually adopt policies that would restore ''competitiveness in a controlled and efficient manner''?
    They don't have a history doing so.

    1. If this is a concern, then Eurozone fiscal rules would be of the following kind: if country X has inflation above the Eurozone average, it should decrease government spending. That would make much more sense than the current fiscal rules. Its called countercyclical fiscal policy.


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