Policy Paralysis and/or Secular Stagnation?

Some Talking Points from Fall 2014:

I never turned this into a proper piece…

At some deep level, the overwhelming problem is that Eurocrat elites–and, to a remarkably and unhealthy degree, American elites and not just republican legislators–believe that:

  1. Something called “structural reform” is essential for future economic prosperity.
  2. “Structural reform” cannot be accomplished during a time of prosperity and full employment, but requires deep and visible pain to get politicians to do what must be done.
  3. The remarkable failure of austerity to produce either a successful structural rebalancing or political pressures that lead to meaningful “structural reform” since 2007 means only that austerity has not been austere enough.

We are indeed trapped in the sewer of Romulus…

  1. “Secular stagnation” is a misleading phrase. It was coined by Alvin Hanson in the 1930s to describe a fear that an exhaustion of technological opportunities in a world monetary system that still possessed a nominal anchor to gold would generate a sub-zero full-employment Wicksellian natural rate of interest. But we don’t have an exhaustion of technological opportunities. We don’t have a monetary system with a nominal anchor to gold.

  2. What we do have are rates of inflation in developed market economies that expose us to severe downside macroeconomic risks, and a lack of risk tolerance and risk-bearing capacity even here in the United States that keeps even the lowest of attainable safe interest rates from producing high enough equity and capital valuations to make it profitable to boost investment enough to push the developed market economies to anything like full employment.

  3. There have not yet been any convincing stories of how a trend growth drop would have emerged in the absence of the investment shortfall, the labor skills atrophy, and the other channels of “hysteresis” that have been in operation since 2008.

  4. The only major supply shock in the past decade has been a positive one: the unexpected emergence of new hydrocarbon-extraction technologies like tracking.

  5. We could have a large adverse hydrocarbon-supply shock from political turmoil at the borders of Muscovy. But we have not yet.

  6. What to expect from interest rates? They will, of course, fluctuate. The modal scenario I see in the United States is one in which the Federal Reserve begins raising interest rates too early–a la Sweden at the start of this decade–and then has to return to the ZLB in a year or two as the economy weakens. The optimistic scenario is that that of the smooth glide-path to the normalized, Goldilocks economy. The pessimistic scenario is another adverse shock hits demand while the Federal Reserve is still too close to the ZLB to effectively respond, and political gridlock gives the United States another lost decade.

  7. What to expect from interest rates? They will, of course, fluctuate. The modal scenario I see in the Eurozone is one of continued waves of crisis as Eurozone breakup fears cause spikes in interest rates in the European periphery, as the ECB then does enough to calm markets but not enough to generate recovery, that Germany makes covert fiscal transfers to keep the pain low enough to keep the Eurozone together–and winds up spending much much more than if it had bit the bullet back in 2000–and that German growth over the medium term remains adequate as the chronic Eurozone crisis keeps German exports competitive. The pessimistic scenario is one of Eurozone breakup–with German interest rates even lower than they are, and peripheral European interest rates high with redoubled risk premium. The optimistic scenario is that somehow, some way, the Confidence Fairy appears and the Eurozone has a smooth glide-path to a normalized, Goldilocks economy.

  8. Back in 1829, the young British economist John Stuart Mill was the first to argue that the market monetary economy there would not be enough spending to employ everyone who could be profitably employed at the wages they demanded if and only if the economy lacked enough cash and cash-like assets to make households, businesses, and savers as a group happy with their holdings of means of payment and potential collateral.

  9. The provision of those cash and cash-like assets has to be the business of the national or currency-area government–if not of a super-continental monetary and financial hegemon–because no private entity has the power to make its liabilities legal tender and thus the ability to guarantee their acceptance in transactions and as collateral.

  10. The ECB is tasked with this Millian objective of providing the eurozone economy with the means of payment and stores of value–cash and potential collateral–that the economy needs. The ECB is failing.

  11. Fourth quarter-to-fourth quarter real GDP growth in the eurozone in 2013 was 0.5%. Fourth quarter-to-fourth quarter real GDP growth in the eurozone in 2013 looks to be 0.4%. December-to-December inflation in the eurozone in 2013 was 0.9%. December-to-December inflation in the eurozone in 2014 looks to be 0.0%. The ECB’s annual inflation target is 1.75%. Given the potential for catchup in the European periphery to higher productivity standards, that can only be attained via nominal eurozone GDP growth of 4%-5%/year. The 1.4% nominal GDP growth we saw in 2013 and the 0.4% nominal GDP growth it appears we will see in 2014 tell us that the ECB has fallen further behind the curve than it was at the end of 2012: 7.2%-points further behind the curve than it was then.

  12. One possibility is that the ECB is failing because it cannot do so, for every time it creates a reserve deposit it does so by withdrawing a high-quality liquid asset from the private market place, and so to first-order leaves the stock of cash plus potential collateral unchanged. Perhaps the ECB cannot carry out its million objective without engaging in what would be regarded as fiscal policy.

  13. Another possibility is the ECB is failing because financial Germany believes that the ECB’s target must be not a 1.75%/year inflation target for the eurozone, but a 1.5%/year or less inflation target for Germany–and that Mario Draghi is not powerful enough to overrule financial Germany in the corridors of power in the ECB and hence cannot do whatever it takes.

  14. In this context, I am reminded of Ludger Schuknecht’s exchange with Martin Wolf back in 2012, in which Schuknecht said, among others things: “Mr Wolf’s solution… is risk transfer via eurobonds… and demand stimulation via cheaper money and less fiscal consolidation in Germany. But the public and markets have been led to believe in short- term measures for far too long….” “expansionary policies and weak fiscal positions… created the current problems…” “fiscal consolidation and structural reforms… have invariably succeeded wherever they have been implemented…” “any decision to disregard the rules or introduce ill -suited tools such as eurobonds could undermine… confidence…” “Germany must not undermine its role as an anchor of stability via inappropriate and ineffective fiscal stimuli…” “German and European interests are indeed very much aligned and they are reflected in the jointly agreed strategy…”: the policies that the eurozone has undertaken over the past 2.5 years were, to his eyes back in 2012, already dangerously radical and already pushing the utmost of the envelope that Germany could allow. Yet now we clearly need more…

July 15, 2015

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