Article 123.1 and the ECB

123.1. 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.

This post will not be about the the legal interpretation of this article of the European Union Treaty. Ashok Mody does a much better job of that than I ever could, and he comes to the conclusion that the European Court of Justice (ECJ) could well decide that this Article, combined with other parts of the Treaty, makes OMT illegal. As OMT is widely credited with ending the debt funding crisis in the Eurozone, this would represent an existential threat.

The same treaty article may be crucial in deciding whether the ECB institutes a programme of Quantitative Easing (QE) to help revive the Eurozone economy. As Willem Buiter reminds us (in a paper which I discussed an earlier version of before in a different context) a combination of fiscal expansion and QE is a certain way to boost demand and raise inflation. He writes: “there always exists a combined monetary and fiscal policy action that boosts private demand—in principle without limit. Deflation, 'lowflation' and secular stagnation are therefore unnecessary.” He goes on to say that if the Eurozone Treaty prevents this policy, yet the Eurozone wants to avoid the kind of deflationary trap it is currently in, then the Treaty should be changed.

Ashok Mody’s view is nicely summarised in these two paragraphs.

“In highlighting the tensions between the TFEU and the OMT, the German Court is basically concerned that the OMT is a fiscal union by the backdoor. The ECJ could validate the current design of the OMT— locating the fiscal union in the central bank—in which case the nature of the eurozone will be fundamentally altered and the ECB will become a more political institution. Alternatively, if the ECJ were to determine that the German Court’s concerns need to be addressed by changes to the OMT—by imposing serious limits on purchases of sovereign bonds and requiring the ECB to claim seniority to private creditors—the OMT will be rendered ineffective. 

There is a third option. And that would be to agree that the OMT is needed as temporary support because an incomplete monetary union creates intolerable risks. The ECJ would ask the political actors to meet their responsibility by providing a transparent and legitimate mandate for a permanent OMT. They would do so by jointly guaranteeing the ECB against losses incurred if a particular transaction ends in a default. That guarantee may never be needed. But it would focus the minds and clarify who bears the cost. Then Europe would have taken a real step forward.”

I have a lot of sympathy for that view. I have argued that for the Eurozone to survive in something like its current form (and not to have to become a fiscal and political union), the decision about whether to implement OMT must never be automatic (default must be possible), and should be based on transparent and informed advice. However it also seems sensible that the ultimate responsibility for such a momentous decision should lie with member states and their elected representatives.

The issue I want to highlight here is the position of the ECB. At present, as I understand it, the ECB would have the right not to implement OMT, even if governments were happy with it. It also has complete authority about whether to introduce QE - member states get no say. The reasoning behind this is that the ECB’s control over inflation is absolute. As OMT could in theory compromise this control, it must be allowed a say in whether it goes ahead. Article 123 is designed to protect that control, and ensure that the ECB cannot be subject to fiscal dominance. The same mentality can explain why the ECB feels so free to tell member states what they should be doing with fiscal policy. Fiscal policy has a bearing on inflation, so the ECB has a right - indeed a duty - to speak out.

Discussion about the ECB often focuses on the difficulties it faces because its decisions may or may not lead to redistribution among member states. These difficulties would disappear, of course, if the Eurozone became a political union. However, as Ashok Mody points out, the ECJ seems content with this kind of redistribution if it is sanctioned by the democratic representatives of the member states involved. This could happen with OMT, or QE. But this cannot happen if the ECB is designed to be independent of any democratic control. If the ECB can take decisions independently of member states, and those decisions can redistribute income among member states, then the ECJ may say those decisions are illegal and cannot be made. We have a problem, because the ECB is beyond democratic control.

When economists extolled the virtues of central bank independence, did they really have this in mind? Should governments really have no say in what monetary policy’s targets should be, and what mechanisms it should or should not use to achieve them? If the monetary policy institution is completely autonomous, how do we guard against incompetence? Perhaps the perceived need to outlaw inflation using the constitution or by treaty is an attempt to solve a problem of the past, which is stopping us dealing with the problems of today.

Economics, Politics and Naivety

I’m no fan of UK Chancellor George Osborne’s economics, but he is a pretty good politician. He pulled out all the stops a few weeks ago when he ruled out a monetary union if Scotland became independent. (For the background, see here.) Not only did he get his Labour opposite number Ed Balls to agree, but he also had the Treasury’s Permanent Secretary take the highly unusual step of publishing personal advice that monetary union was unwise.

What has rather amused me since has been the reaction of some that this is only a bluff. Incredulous indignation brimmed over from Kevin McKenna in the Observer: “Is a UK chancellor of the exchequer seriously asking us to believe that he is contemplating damaging the entire UK economy following a yes vote?” The chair of the Scottish government's fiscal commission working group, Crawford Beveridge, whose other members are Professors Andrew Hughes Hallett, Sir Jim Mirrlees, Frances Ruane and Joseph Stiglitz, said that none of them believed "for a minute" that chancellor George Osborne was serious.

Why was I amused at the idea that George Osborne could not possibly plan to do something that would be damaging to the economic interests of the UK economy? Just yesterday in opposite pages of the FT were two news items that gave clear examples of where for the Conservatives politics trumps economics. First, the chief executive of the engineering company GKN warned that the possibility of Britain leaving the EU following the proposed referendum was harmful to UK companies and was already being used by competitors against them. The second was on a report that migrants to the UK set up one in seven new UK companies.

Now you could argue that planning a referendum on leaving the EU and curbs on immigration are not ‘true’ Conservative policies, but are being forced on the party by the rise of UKIP. I’m not sure about that, but it is not the point. Both policies are clearly harmful to the economy as a whole (don’t forget the damage that the current immigration policy is doing to one of our more successful export industries, higher education), yet are being adopted for political reasons. Politics is dominating economic interests.

And then there is the small matter of fiscal austerity, which the OBR estimates has reduced UK GDP by a total of over 5% of annual output up to last year. That is a large economic price for the political goal of a smaller state.

Perhaps the bluff idea comes from the perception that once the Scots have voted yes, the political incentive to say no to monetary union disappears. That seems naive. Losing Scotland will be deeply humiliating for this government, and unpopular among remaining UK voters. The political imperative after a Yes vote will be to make it appear as if the Scots have made a mistake. In that situation, are politicians likely to quickly turn around and say they have changed their minds on monetary union?

The incentives of the Scottish government after a Yes vote are more interesting. Without a monetary union, will they continue to use sterling or will they create their own currency? While keeping sterling will be the least disruptive option, in political terms it would vindicate Osborne’s strategy, because the remaining UK would get most of the benefits of monetary union without the costs. [1] A new currency would give Scotland more independence, which would seem to be where the Scottish National Party’s heart is, particularly if they could say that this is an option they had been forced to take by the ‘auld enemy’. So I think my money is still on a new currency if there is a Yes vote. 

[1] (Postscript) This option has clear economic costs for Scotland, as this post by Angus Armstrong makes clear. 

Multipliers in a monetary union and at the ZLB

For macroeconomists

My recent post reminded me that I had earlier promised to talk about a paper by Farhi and Werning. Its an excellent and very rich paper, but this in my area which means I’m biased, so let me single out one point that should be of general interest to macroeconomists. We all should know, from Woodford for example, that in a closed economy at the zero lower bound (ZLB) the (temporary) government spending multiplier is greater than one. It is tempting to apply the same logic to a member of a monetary union, because if they are small relative to the union as a whole they too face a fixed nominal interest rate. What Farhi and Werning show is that this is incorrect, and I’ll try and explain why. (The authors also focus on this point in their paper, so the first best option is to read their paper, particularly as their intuition for the result is a little different - although I believe quite consistent - with the one I give here.)

Let me first recap on Woodford’s closed economy result. If real interest rates are constant, consumption smoothing ties current consumption to its steady state value, and the temporary increase in government spending has no impact on the steady state. So current consumption is unchanged, and we get an output multiplier of one. (I make the same point in a related two period setup here.) With intertemporal consumption, income effects really do not matter, so we can ignore them. [1] At the ZLB nominal interest rates are fixed, so any increase in output will generate some inflation, reducing real interest rates. Lower real rates will increase current consumption relative to its steady state, so the multiplier exceeds one.

Now why does the same logic not work in a monetary union? The key point is that nominal exchange rates are fixed, which implies that in steady state the price level has to return to its original level to keep competitiveness unchanged. So if inflation rises today, it must fall (relative to the base case) later. With fixed nominal rates, we now have lower real rates followed by a matching period of higher real rates. Working backwards from the steady state, we have a period of rising consumption, preceded by a period of falling consumption, with the impact effect being zero. So in a monetary union, consumption gradually falls, and then rises again, but is always below its initial and steady state level.

Neat isn’t it! Now to relate this to the real world we would want to add lots more things, and the paper does show that with credit constrained consumers the monetary union multiplier can exceed one. But this key difference between a monetary union and a closed economy remains. And of course we are assuming here that consumers realise that in a monetary union higher inflation today will be offset by lower inflation later on, a presumption which some in periphery countries in particular might want to question.

Yet if you think about the logic here, it depends crucially on prices being allowed to rise in the long run in the closed economy case. Suppose instead that the monetary authorities operated a long run price level targeting regime. Now any inflation generated by higher government spending today would require a later period in which inflation was below base to offset it. So lower real interest rates at the ZLB would be offset by higher (than steady state) real interest rates later on as the central bank reduced the price level back to target. We would get something more like the monetary union result. [2]

So the closed economy multiplier is lower with price level targeting. Of course price level targeting (or its equivalent) in itself does help at the ZLB, for exactly the same reason. At the ZLB it is generally assumed that inflation is below steady state, so real interest rates are high, which with inflation targeting just depresses consumption. But with price level targeting, low inflation today will be matched by high inflation and low real rates after the ZLB constraint is lifted, which supports current consumption. Just as price level targeting dampens the impact of a negative demand shock at the ZLB, so it dampens the impact of a positive demand shock like fiscal expansion at the ZLB. The government spending multiplier is still positive, but now below rather than above one. Fiscal stimulus at the ZLB is also beneficial because it reduces the extent inflation has to rise after the ZLB constraint has lifted under a price targeting type regime.

So this is another example of why you cannot assess the potency of fiscal policy without taking into account the monetary policy regime. The other crucial implication for Eurozone policymakers is that in standard state of the art models countercyclical fiscal policy is effective. (I also think its desirable, but I agree effectiveness is a necessary but not sufficient condition for desirability.) But of course they all know that, don’t they! 

[1] Note, however, that the multiplier of one means that human wealth has not changed anyway, because the additional output=income exactly offsets the higher tax bill.

[2] It is not exactly the same, because a monetary union involves forever fixed nominal rates: inflation falls later through competitiveness effects. In a closed economy with a price level target inflation falls, and real interest rates rise, because the central bank puts up nominal interest rates.