The non-independent ECB

Imagine that the Scottish National Party (SNP) had won the independence referendum. The SNP starts negotiating with the remaining UK (rUK) government over issues like how to split up national debt. On some issue the negotiations get bogged down. Rumours start circulating that this might mean that rUK will not form a monetary union with Scotland, and that Scotland might have to create its own currency. People in Scotland start withdrawing money from Scottish banks.

Now it is almost the definition of a private bank that if everyone who has an account at the bank wants to withdraw their money, the bank will run out of cash and go bust. That is why bank runs are so dangerous. It is also why one of the key roles of a central bank is to supply an otherwise solvent private bank with all the cash they need, so they will never deny depositors their money. (To be a lender of last resort.) If they did not do this, anyone could start a rumour that a bank was insolvent, and as people withdrew their cash just in case the rumour was true, the bank would run out of money and go bust anyway.

So in my hypothetical story, as people started withdrawing cash from Scottish banks, the Bank of England should supply these banks with all the cash they need. Except suppose it did not. Suppose it put a limit to the amount of cash it would supply. The Scottish banks would protest - you agreed we were solvent before independence, they would say, so why are you rationing our liquidity? The Bank of England replies that although they might have been solvent before independence, if there is no agreement solvency is less clear. The Bank of England says that the limit on cash will remain until the Scottish and rUK government come to an agreement.

This announcement of course leads everyone in Scotland to try and get their money out, and the Scottish Banks have to close. The Scottish economy begins to grind to a halt. The English media report that Scotland is running out of money because the Bank of England will not ‘lend’ any more to the Scottish banks. The Scottish government is forced to agree to the rUK’s terms. The English media say look what happens when you elect a radical government. In Scotland they call it blackmail. What would you call it?

If it sounds to you like the Bank of England is taking sides and putting impossible pressure on Scotland, then you will know what it feels like in Greece right now. When, on 28th June, the ECB stopped providing emergency funding to Greek banks, it took sides. Part of the ECB’s logic is that Greek banks may be insolvent if there is no agreement between the Troika and Greece (even though it is the Central Bank of Greece, and therefore the Greek people, which stands to suffer losses from defaults by commercial banks).

Why should the failure to reach an agreement influence the solvency of the Greek banks? Is it because without an agreement there would be a Greek exit? But Greece does not want to abandon the Euro, and the other Eurozone countries have no formal grounds to expel Greece. Greece will only leave the Eurozone if the ECB stops supplying Euros. We reach exactly the same self-fulfilling logic of a bank run. Is it because without an agreement the Greek government would default on some of its debts, and that might adversely influence the solvency of Greek banks? But the fact that the Greek government will not get money from the Troika to pay back the Troika seems to have no implications for the underlying solvency or either the Greek state or its banks. (Paul De Grauwe discusses this further.) If the Troika can make Greece insolvent by itself withholding money we have another self-fulfilling justification.   

The real explanation for the ECB’s actions is much simpler. Limiting funding on 28th June was the Greek government’s punishment for failing to agree to the Troika's terms and calling a referendum the day before. The ECB was not, and never has been, a neutral actor just following the rules of a good central bank. It has always been part of the Troika, and right now it is the Troika’s enforcer.

As Charles Wyplosz recounts, this is not the first time the ECB has chosen to bow to political pressure. There will be some on the left who will say of course - what else do you expect of a central bank? In response, let me go back to my hypothetical example involving Scotland and the Bank of England. I may be wrong, but I think in that case the Bank of England would have supplied unlimited cash to the Scottish banks. I may be naive, but I believe it would have realised that to do anything else was an overtly partisan political act, and recoiled from doing that. Just as I do not think it was inevitable that the Eurozone committed itself to austerity, I also think it was possible that the ECB could have been a more independent central bank. The really interesting question is why it has turned out not to be such a bank.  

A budget for our next Prime Minister

There is a simple way to read George Osborne’s budgets. Forget the economics, and just think politics.

Take the macroeconomics of aggregate fiscal policy, for example. Many pages have been filled (in some cases by me) about the folly of fiscal austerity while interest rates are near their lower bound. Under the coalition I calculated (with the OBR’s help) that this policy cost the average household the equivalent of at least £4,000 over the last five years. The arguments put forward to support this misguided policy have changed, but they seem to get worse rather than better: I go through the latest in this short piece for today’s Independent. But the focus on the deficit helped Osborne win the last election (admittedly with the help of Labour’s reluctance to challenge what he said), and is on course to lead to a radical reduction in the size of the UK state, as Colin Talbot sets out here.

How about his bold move of a substantial increase in the minimum wage? At first sight it seems very strange: it is a policy that if introduced by Labour would have much of the press, and most economic journalists, screaming about unnecessary interference with the market and the onset of socialism. Until now the level of the minimum wage has been carefully calculated by the Low Pay Commission to avoid significant job losses. The OBR calculate that Osborne’s proposed hike will lose about 60,000 people their jobs. But as Tim Harford explains, it is not as if Osborne has an alternative economic view. He just needed a dramatic move to give him political cover for his large cuts in tax credits.

Most of those on low earnings will still be worse off - by a lot in some cases, often decreasing work incentives - but he knows from the last election that impressions are more significant than numbers. [1] Probably the most important impact of this budget will be to raise poverty, particularly child poverty. The previous coalition’s policy changes also increased poverty, but their impact on the official statistics was offset by the overall decline in real wages. Over the next five years that will no longer happen, so again the cover is being put in place: change the definition of poverty. The economics is ludicrous, but we should have got used to that by now.

Then there is inheritance tax. It is not often I agree with Janan Ganesh, but he is correct when he wrote just before the budget:

 “George Osborne wants to refurbish the Conservatives as the natural habitation for working people … But the message will always be muffled as long as the tax system favours assets, including those bequeathed, over earned income … the greatest perversity of the system survives and will only worsen if the threshold for inheritance tax is lifted this week.”

But this year, and probably for the next one or two, George Osborne has a more important political goal in mind than confining Labour to opposition (particularly when they are doing just fine without his help). He wants to be sure that when David Cameron steps down, as he has promised to do, it will be George Osborne who is seen as the natural successor. Most of the Conservative base is not devoted to the cause of free markets, but is passionate about their own families’ income and wealth. It also likes high defence spending, so the budget contained a commitment to keep to the 2% Nato target. For those who hope for measures to tackle what Chris Dillow calls the true ‘something for nothing’ culture, the UK housing market, I suspect that too will not happen before the Conservative Party have elected their new leader (if it happens at all).    

If this sounds too cynical to you, all I can say is that I learn from experience. When I wrote this three years ago, Paul Krugman no less said I was getting “remarkably cynical”. Unfortunately, save for one detail, my cynicism proved pretty accurate. When it comes to implementing good (evidence based) economic policy, in both the UK and the rest of Europe, we are living through very depressing times.

[1] Postscript: the reaction of the UK press is outlined here

Austerity is an integral part of the Greek tragedy

Too many people, including many in the Troika, see the Greek struggle as just about transfers from one debtor nation to lots of creditor nations. That is why they perhaps saw the Greek referendum as an unhelpful move, as just inflaming nationalist sentiment. As Dani Rodrik puts it “What the Greeks call democracy comes across in many other – equally democratic – countries as irresponsible unilateralism.”

It is, however, not just about transfers, or what economists call a zero sum game. It is also fundamentally about austerity, as Dani Rodrik, Thomas Picketty, Heiner Flassbeck, Jeffrey Sachs and I say in this letter jointly published in the Guardian, Le Monde, The Nation and Der Tagesspiegel (and thanks to Avaaz for making this happen).

I think many people believe that a debtor country must somehow inevitably suffer large scale unemployment as a result of having to pay back at least some of its debts. But this comes more from a moralistic view than thinking about the macroeconomics. In an open economy, the real exchange rate (competitiveness) will adjust to ensure ‘full employment’ is preserved, whatever primary surplus (taxes less non-interest spending) a government needs to service and pay back its debt.

Under flexible exchange rates this competitiveness adjustment could happen immediately. Things are not quite so simple in a monetary union: competitiveness cannot immediately adjust because of wage and price rigidities. A period of ‘excess unemployment’ will be required to push wages and prices down if the country is uncompetitive in relation to required primary surpluses. However the excess unemployment can be relatively modest. In fact, because of the structure of the standard Phillips curve, it is much more efficient to achieve gains in competitiveness gradually through a measured increase in unemployment than quickly through a rapid rise in unemployment, for reasons I outlined here when talking about Latvia.

To achieve this efficient outcome may well require the government to reduce its primary deficits gradually, because without this fiscal support while competitiveness adjusts output could fall rapidly. This in turn will require more government borrowing, and if the government cannot do this from the markets, the IMF or other governments should step in to ensure this efficient adjustment can take place and avoid the waste and suffering of unnecessary unemployment.

This is what failed to happen in the case of Greece. Whether this was just the result of poor Troika calculations, or a consequence of feeling that creditor bankers were more of a priority (see, for example, Mark Blyth), need not concern us here. Once the mistake became clear, perhaps creditor voter fatigue meant additional loans were not politically possible. But to demand primary surpluses (i.e. to take money out of the country) while unemployment remains so high - as the Troika continues to do - is unforgivable in my view. It clearly makes the unemployment problem worse - see here, footnote [2]. At best it indicates an impatient creditor with no concern for the welfare of the debtor, but given the responsibility the creditor has for the debtor’s current position it is far worse than that.

That is not the only reason Greece’s story is about austerity. Its problems were made worse by the austerity across the Eurozone as a whole, and the deflation which that has brought. Deflation increases the real value of nominal debts. It also makes competitiveness adjustment more difficult because of a well known non-linearity.

Even those that have a great dislike or distrust of Syriza should recognise that Syriza is also a product of acute austerity, a point which the referendum reaffirmed. As economists might say, Syriza is endogenous.

That the Greek economy now lies broken is not the inevitable result of imprudent borrowing a decade ago, or structural weaknesses, or a left wing government elected just a few months ago. It is also the result of the actions of those who effectively ran the economy from 2010 to 2014, and their imposition of draconian austerity. Greece long ago recognised the folly of its borrowing, and has made a start on addressing its structural weaknesses. The Troika has yet to acknowledge its own part in making this tragedy.

Why Germany wants rid of Greece

When I recently visited Berlin, it quickly became clear the extent to which Germany had created a fantasy story about Greece. It was an image of Greeks as a privileged and lazy people, who kept on taking ‘bailouts’ while refusing to do anything to correct their situation. I heard this fantasy from talking to people who were otherwise well informed and knowledgeable about economics.

So powerful has this fantasy become, it is now driving German policy (and policy in a few other countries as well) in totally irrational ways. In particular, Germany refuses to discuss debt relief with Greece, yet seems quite happy to see Greece leave the Eurozone, the inevitable consequence of which would be that Greece would obtain much greater debt relief through default. Talk about cutting off your nose to spite your face. What is driving Germany’s desperate need to rid itself of the Greek problem?

One possible answer is that Germany finds the truth about Greece too upsetting, too challenging. This is because since 2010 Greece has done most of what the Troika asked of it. In particular, changes in its government’s underlying primary budget balance (i.e. the degree of austerity enacted) have been greater, by a long distance, than any other European economy. For many outside Germany what has happened to Greece as a result is hardly surprising: austerity is contractionary, and austerity on steroids is ruinous. Yet Germany is a country where the ideas of Keynes, and therefore mainstream macroeconomics in the rest of the world, are considered profoundly wrong and are described as ‘Anglo-Saxon economics’. Greece then becomes a kind of experiment to see which is right: the German view, or ‘Anglo-Saxon economics’.

The results of the experiment are not to Germany’s liking. Just as ‘Anglo-Saxon economics’ would have predicted, the results for Greece under the Troika have been a disaster. After dutifully taking the medicine for years, and seeing the collapse of their economy, finally the Greek people could take no more. Confronting this reality has been too much for Germany. So instead it has created its fantasy, a fantasy that allows it to cast its failed experiment to one side, blaming the character of the patient.

The only thing particularly German about this process is the minority status of Keynesian economics within German economic policy advice. In the past I have drawn parallels between what is going on here and the much more universal tendency for poverty to be explained in terms of the personal failings of the poor. These attempts to deflect criticism of economic systems are encouraged by political interests and a media that supports them, as we are currently seeing in the UK. So much easier to pretend that the problems of Greece lie with its people, or culture, or politicians, or its resistance to particular ‘structural reforms’, than to admit that Greece’s real problem is of your making. 

After Oxi, what next?

A lot of the commentary on Greece fails to see why the Greek No vote changes anything. This view tends to see the stance of the Eurozone group as simply expressing their own voters’ preferences which will not be changed by what happened yesterday. Here is an alternative reading.

It starts from a simple observation. The Troika will get far less of its money back (if any!) if Greece is forced out of the Eurozone. (I say forced out because Greece does not want to leave, so Greek exit is first and foremost an ECB decision: if you think otherwise read Karl Whelan and Matthew Klein and Paul De Grauwe. [1]) That is why creditors are generally weak in negotiations of this kind. Things are different in this case only because the creditors include the ECB, and Greece wants to stay in the Eurozone. The Troika has played this for all it is worth. They were relying (you could say gambling) on the Greek people, one way or another, deciding that they would agree to the Troika’s demands because they feared Greek exit more.

So far this strategy has failed. First they pushed Tsipras further than he could possibly go, hoping perhaps that Syriza would collapse in recriminations. Tsipras’s response was a unifying referendum. They then gambled that Greece would say no, and they lost that too. Tsipras continues to offer the Troika the chance to be more reasonable. He followed the referendum not with triumphalism but by removing his finance minister. This was both a signal - I really want a deal, even though it will in all probability inflict further (unnecessary) pain on Greece - and a lifeline, because the Troika can now say that an important obstacle to a deal has been removed. (An obstacle, because Varoufakis was too open - something politicians and much of the press hate - and too honest about the other side’s lack of economics.)

Now the Troika seem to face a simple choice. Agree a deal and get a little more heat from your political opponents at home for ‘giving in’, or force Greek exit with the risk that you will get a lot more heat when Greece defaults and people realise you have lost all their money. If they are really just interested in getting as much of their money back as possible, it would seem crazy to throw away their best card by forcing Greece out of the Eurozone.

Of course rationality may not prevail, or interests may be rather different. The IMF may continue to be an unhelpful nuisance. (If you think my criticism of their role was harsh, read this from Peter Doyle.) Some within the Troika will be happy to go for Greek exit because they think nationalist sentiment can overcome any kickback from the subsequent Greek default. Others may fear a deal may encourage anti-austerity sentiment in their own indebted countries.

Unfortunately there is a third possibility, which is probably the worst possible outcome. To prevent any loss of face, the Troika may continue to gamble, waiting for days or even weeks, and watch ECB pressure, together with reluctance by Tsipras to introduce a new currency, gradually bring chaos to the Greek economy. Only then will it negotiate, allowing any deal to be portrayed as the result of desperation by the Greek government. In which case, recent European politics will have reached a new all time low.    

[1] Postscript: Martin Sandbu provides a very clear account.

Greece and the political capture of the IMF

When governments borrow too much, and cannot repay, it generally falls to the IMF to sort things out. In playing this role, the IMF should be pretty tough on creditors. As Interfluidity so lucidly points out, this is where real moral hazard lies.

So what went wrong with Greece? Remember the Troika made a huge mistake in using their citizens’ money to lend to Greece so Greece could partially repay these private sector creditors - that is where most of the Troika’s rescue package went. The IMF’s own internal analysis was deeply flawed (being predictably wrong in how austerity would impact on the Greek economy), and even then the deal failed its own tests, so special dispensation had to be made.

The IMF should have been very worried about motivations here. After all, many of these creditors were banks from European countries, so the motivations of those bailing out these creditors were conflicted to say the least. They were nevertheless persuaded to go along because of fears of contagion. If the worry was contagion to other countries governments that was an obvious mistake, because it happened anyway but could have been solved ‘at a stroke’ by the ECB (as it eventually was). If the worry was a collapse in the European banking system, then that was the responsibility of the governments concerned, and not the Greek people.

To the present, and the negotiations that failed. Forget all the fluff you read in most papers about this. What is quite clear is the following. A deal could have been done if the Troika had allowed debt restructuring to be part of the package. The IMF agrees that debt needs to be restructured, as do most economists. It has made no secret of this, yet it has consistently soft pedalled when it came to dealing with the rest of the Troika. So it was allowed to be kept off the table in the current negotiations by the Troika: vague promises to look at this after a deal had been agreed would never be enough for Syriza to sell the deal. There are two reasons why Germany might have wanted it to remain off the table. One is that it never wanted a deal; the other is that to include it would have been politically embarrassing for German politicians.

What seems abundantly clear is that the IMF should have had no truck with either concern. It has to be tough on creditors, and in this case the creditors were the European institutions. It clearly had the political power to face down European governments on this issue, and if it had done so a deal could have been achieved. The only conclusion I can come to is that the IMF on this occasion has been captured by the rest of the Troika. [1] [2] [3] As Ashoka Mody puts it, it has become trapped by the priorities of [selective] shareholders, including in recent years the U.K. and Germany.

The following are not really true footnotes - they are too important for that - but I wanted to keep the main text crystal clear.

[1] Peter Doyle has also noted how dubious the IMF’s interventions on essential ‘reforms’ are both in economic and political terms. (If this report is true, it is even worse.) While other parts of the IMF seem to understand multipliers (see [2] below), those in charge of the negotiations seem to take a more German view. [Postscript: Ashoka Mody's verdict on this IMF analysis is restrained but blunt.]

[2] One of the reasons that it is part of the IMF’s job to be tough on creditors is that creditors have no concern for social welfare, by which I mean the aggregate welfare of both creditors and debtors combined. (Although, as Interfluidity says, you might have hoped differently on this occasion.) As this point is hardly ever made in the media let me set it out here (the numbers are based on a FT piece by Martin Sandbu). To achieve a primary surplus of 1% of GDP to transfer to the Troika, the Greek government needs to undertake austerity that will reduce Greek GDP by 3% (assuming a multiplier of 1.5, and a tax/transfer loss from lower GDP of a third). That reduction in GDP is a social loss (the loss to the Greek economy is 3% plus the 1% transfer) - at best pure waste, and probably for some the cause of much suffering.

[3] Here is the former head of the IMF's European department, on the need for both debt restructuring and the dangers of demanding larger primary surpluses.       

The ideologues of the Eurozone

It was all going so well. True, Greek GDP did shrink by 25% over 4 years, unemployment rose to 25% and youth unemployment to 50%, but before Syriza’s election Greek GDP had actually stopped falling. Further austerity was planned so that Greece could start to pay interest on its enormous debts, together with various ‘reforms’ that were so obviously in the interests of the Greek economy, and the consensus forecast was that the Greek economy might start to grow at a pace that would also stop unemployment rising. Who knows, in a decade or so it might even fall below 20%.

 

But then disaster struck. The Greek people went and spoilt everything by electing a government that suggested that there might be an alternative to all this. Of course the Greek people are not really to blame: how can they be expected to understand there was no alternative to their suffering. The real blame must lie with the ‘populist’ politicians who pretended there could be an alternative. The ever patient and understanding Troika negotiators then had to deal with ‘adolescent ideologues’ who were prepared to use the suffering of the Greek people as a means to achieve their own political ends. They were cheered on by pundits and economists on the left in the UK and US who wanted nothing more than to use Greece as part of a ‘proxy war’ to get more Keynesian policies in their own countries.

If you think the above parody is over the top, click on the two links. The hypocrisy of some of the commentary on Greece is amazing. When the ‘adolescent ideologue’ Mr Tsipras shows a statesman-like maturity in being prepared to compromise in an effort to get a deal, he is accused of inconsistency and not being able to make up his mind. When those who he is negotiating with push him further than he is prepared to go, he is accused of ‘taking Greece to the brink’ by having the temerity to ask the Greek people to choose. (Any mature politician knows that in modern Europe you only call a referendum when you know you will get the answer you want, and when that does not happen you ignore the result and call another one.) Mr Tsipras is accused of failing to grasp that other nations too have democracies, as if the Troika had shown huge respect for democracy by acting as if nothing was changed by Syriza’s election.

The OECD estimate that the output gap in Greece is currently well over 10%. In plain English that means that those currently unemployed could be producing something useful and GDP could easily expand by at least 10% without generating any increase in inflation. (Greek inflation is currently around -2%.) That would not only be in the interests of Greece, but also in the interests of Greece’s creditors. It is a way of achieving the primary surpluses that the Troika wants without inflicting more pain. It is also absolutely undeniable that further austerity would tend to reduce GDP, just as past austerity has done. So everyone can be made better off by giving Greece the breathing space so that its economy can recover. But apparently it is childish to try and negotiate for such an outcome.

Why is it impossible for the Troika to agree to such a deal? They say their own democracies would not allow it, but it is part of being a good politician that you can afford to compromise when that compromise is in everyone’s interest. I suspect that in at least some cases this argument is a smokescreen, particularly when you see what Mr Tsipras is being told he should do. There is a pattern here. For the ECB to act as a lender of last resort was impossible, and the only answer was yet more austerity - until that austerity had been put in place and OMT became possible. When the French government tried to meet deficit targets by raising taxes rather than cutting spending, they were told that this was the wrong kind of austerity. When it came to Quantitative Easing (QE) some were quite explicit - a problem with QE is that it might take some pressure off governments to undertake austerity and ‘reforms’. So perhaps only when the Syriza government has fallen and their successor agreed to more austerity and reforms will it turn out that the Troika can after all be flexible about restructuring debt.

One of the charges frequently made against opponents of austerity in the Eurozone is that we are really seeking the failure of the whole Euro project. The opposite is nearer the truth. The problem for the Euro project is that it has become captured by an economic ideology, and austerity is that ideology’s principle weapon. A self-confident and mature Eurozone would be able to tolerate diversity, rather than trying to crush any dissent. A Eurozone captured by an ideology will insist there is but one path, and that the imperative of austerity is too important to accommodate democratic wishes. Pursuing that ideology has brought the Eurozone to the brink, where it is prepared to force out one of its uncooperative members. Critics of austerity are not trying to destroy to Eurozone, but save it from the grip of this self-destructive ideology.