I woke up today to read the following on the front page of the Financial Times (“Merkel highlights Eurozone divisions with observations on interest rates”).
Angela Merkel underlined the gulf at the heart of the eurozone when she waded into interest-rate policy, arguing that, taken in isolation, Germany would need higher rates, in contrast to southern states that are crying out for looser monetary policy.
The German chancellor’s highly unusual intervention on Thursday, a week before many economists expect the independent European Central Bank to cut its main interest rate, highlights how the economies of the prosperous north and austerity-hit south remain far apart.
What could Mrs. Merkel possibly have meant by this remark? Presumably she means that inflation in Germany is higher than she would like it to be, so that her preference would be that the ECB raise its lending rate, thereby tightening monetary policy for the entire Eurozone in order to bring down the German rate of inflation (which is now less than 2 percent under every measure). The question is why did she bother to say this? My guess is that she is trying to make herself look as if she is being solicitous of the poor unfortunates who constitute the rest of the Eurozone, those now suffering from a widening and deepening recession.
Her message is: “Look, if I had my way, I would raise interest rates, forcing an even deeper recession and even more pain on the rest of you moochers. But, tender-hearted softy that I am, I am not going to do that. I will settle for keeping the ECB lending rate at its current level, or maybe, if you bow and scrape enough, I might, just might, allow the ECB to cut the rate by a quarter of a percent. But don’t think for even a minute that I am going to allow the ECB to follow the Fed and the Bank of Japan in adopting any kind of radical, inflationist quantitative easing.”
So the current German rate of inflation of 1-2% is too high for Mrs. Merkel. The adjustment in relative prices between Germany and the rest of Eurozone requires that prices and wages in the rest of the Eurozone fall relative to prices and wages in Germany. Mrs. Merkel says that she will not allow inflation in Germany to go above 1-2%. What does that say about what must happen to prices and wages in the rest of the Eurozone? Do the math. So if Mrs. Merkel has her way — and she clearly speaks with what Mark Twain once called “the calm confidence of a Christian holding four aces” – things will continue to get worse, probably a lot worse, in the Eurozone before they get any better. Get used to it.
Uneasy Money 
Early this morning a friend had sent me this ‘absurdity’. So much so that afterwards the German economics minister had to issue a declaration that the ECB was still an independent central bank.!!!
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I’m seriously confused as to how some of these economists in Europe got their jobs…do they realize the depression they are causing in Europe?
From the same article:
“…the country’s politicians, reared on the tradition of Bundesbank independence, usually avoid expressing a view on monetary policy. Wolfgang Schäuble, the German finance minister, has also broken the taboo, saying in a recent interview that the ECB should “drain liquidity” from the system.”
Or this story of the Bundesbank criticizing the ECB’s debt-buying policy:
http://www.independent.ie/business/world/bundesbank-confirms-sent-ecb-report-criticising-debtbuying-plans-29223853.html
As a student (in the US for that matter), watching this situation transpire in Europe is terrifying. Just think of the disaster that could occur if Merkel actually gets her way…and all we can do is sit here and “get used to it”.
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So, once again, we are blessed with a stong-willed woman of conviction, a lady who is not for turning…till the rest of us crash the wall.
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I say, “Good for her!”
Why should German taxpayer, savers, and consumers be the sacrificial animals at the feet of other spend-thrift Europeans, who have governments that have taxed and borrowed far beyond their own counties ability to keep all their welfare-statist promises?
They should learn the lesson that, in the long-run, you cannot keep spending more than you produce. That real savings is the only basis for real, sustainable investment. And under the modern welfare state the vast amount of what government spends (on the basis of taxes or borrowing) is economic waste, not “investment.”
What much of Europe is going through is not the “crisis of capitalism,” or the “failure of austerity policies,” but, instead the bankruptcy of the interventionist-welfare state.
The faster “Europe” learns this and accepts it, the quicker “Europeans” can introduce the necessary market-based reforms to set them on a real path of recovery.
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Mr. Ebeling
I think you’re old enough to remember how much the interest rate differential between the USD and DM was a very good proxy to explain movements in the exchange rates before the Euro. A new Deutsche Mark coupled with a ReFi rate 1% higher than the Fed would simply make skyroket the German currency shocking its (huge) export sector and hurting the asset side of its banking system. As Mr. Schauble told Germans don’t pay because they’re good; they pay because it’s worth doing it.
If you claim the opposite you should explaing why the Swiss Central Bank is “so stupid” to not allow CHF appreciate more 1.20 vs EUR.
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Perhaps it’s all a diabolical plant to bring back fascism in Europe!
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should be “plan” not “plant”
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Mrs Merkel and the german government obviously either don’t know nor don’t care about the very concept of money ( not a bank account but “money”).
Obviously they don’t know about anything related to Balance -of – payments, a subject every german should understand since the Treaty of Versailles imposed suffering on Germany and Europe because of the same ununderstanding.
They obviously don’t know anything about currency area and their consequences. In fact, they don’t know and care even less about anything macroeconomics discussed, discovered, taught and applied for the last 80 years.
And worse, they don’t even know and care even less about the consequences on Europe and Germany of their actions.
And no amount of sanctimony will have them forgiven by history. A century from now, no more people will remember the names of greek ministers anymore than we remember the board of directors of the KreditAnstalt. But we will remember Angela Merkel the way we remember Heinrich Bruning.
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“Silvano,”
Europe’s problem, in my view, is not a currency problem, per se.
It is a fiscal and institutional structural set of problem. Their fiscal problem arises from the lack of any “hard budget” discipline. As James Buchansn and Richard Wagner argued a long time ago in their book, “Democracy in Deficit” (1977), it is the real-world political reality of the Keynesian theory of balancing
budgets over the “business cycle,” rather than on an annual basis.
Once freed from the discipline of having to tell taxpayers and voters the truth of what government spending will actually cost by linking it dollar-for-dollar (or Euro-for-Euro) with the taxes to pay for it, politicians have been able to create the fiscal illusion that people could have something for nothing (or at least for less than the real full cost) by covering part of the promises with borrowed funds.
The cost was hidden away by implicitly saying, well, the money borrowed “today” will be covered by taxes in an undefined “tomorrow” by some equally unspecified taxpayer.
Well, “tomorrow” has come. And Europeans are discovering that the “piper has to be paid,” if they are not going to crush their economies with growth-destroying taxes, they must accept that the government “horn-of-plenty” is empty, and live within their personal means without a welfare state anything like they are used to.
If you say, “But how can they?” It has been done before, in the years immediately after the war. Ludwig Earhard went on post-war German radio and told the German people that no one was going to “bail them out” of the state of total destruction that Germany was in.
Only work, saving and investment in the fairly free market environment that Erhard helped to establish in post-war Germany would enable the German’s to redeem themselves and restore the country’s prosperity.
The next ten years generated what is now called the “Germsn miracle.” If you say, but many Europeans can’t and won’t face that reality and that path to longer-run sustainable stability and growth, you are just saying that the “Dependency State” has done its work in undermining the spirit of self-reliance and real private enterprise.
It will not be restored by having the Germany of today bailout these bankrupt or near bankrupt parts of the European Union. To do so will only delay real recovery by reinforcing the “moral hazard” — having others cover the costs of one’s own mistakes.
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One size does not fit all, in prophylactics or monetary policy. What is just right for Merkel is too tight for Greece.
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The “profligate spending, lack of fiscal discipline” story may be true for Greece, but it certainly isn’t true for the rest of the peripheral countries. Pre-crisis, Spain had a better debt-to-GDP and smaller deficit than Germany. The real story is massive capital inflows inflating a housing bubbles — inflows largely funded by German banks. The bubble increased demand for workers, and this raised wages above levels competitive with the core countries.
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Richard Ebeling,
You don’t seem like the sort of guy who lets reality get in the way of a good story, but you might want to know that the likes of Spain and Ireland were balancing their budgets and paying down their debts before Germany decided to tighten the noose around them.
Also – there’s a thing called “aggregate demand”. When there’s not enough of it, it causes a recession – due to another thing called “sticky wages”.
Any of this ring a bell ?
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Richard Ebeling, you’re conveniently forgetting that German debts were largely forgiven after WWII in an effort to avoid the disaster that followed WWI and ultimately led to a fascist Europe. The “German Miracle” had a lot to do with this debt forgiveness. Debts that can’t be repaid won’t be. It seems the German government has forgotten this bit of history too.
Also, the idea of comparing a sovereign nation’s budget to a household budget is preposterous. Sovereign nations which control their own currency cannot become insolvent unless they have a suicidal political structure. Eurozone countries have given up this sovereignty. The US, UK, Canada, China, Japan, Brazil, … pretty much all the rest of the world, hasn’t! If the Germans continue to insist on austerity for everyone else, it will be the end of the Euro.
Practically what constrains a sovereign nation’s spending is inflation. It’s completely different that a household, business, local, or state government which must budget knowing it ultimately does NOT control its own currency. That’s the nature of a sovereign state which controls it’s own currency. It works as a natural check on foreign trade imbalances as well. As a nation’s currency is devalued, foreign goods become less attractive, and their own exports become more attractive to other nations. Eurozone countries have deprived themselves of this mechanism by adopting the Euro.
In the US, the states are roughly equivalent, in a budget sense, to Eurozone nations (i.e. the states don’t control their own currencies). But in the US there is a flow of Federal funds from net producer states (California, New York, Pennsylvania, Washington, New Jersey, Massachusetts, Illinois, Texas), to net taker states (Mississippi, Alabama, Montana, Georgia, Tennessee, Missouri). Europe lacks this political unity. They have a unified currency without the mechanism to ensure stability in place politically. If it keeps on this course the Euro is doomed.
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Cullen Roche expresses these thoughts a lot more clearly than I have in this recent post in which he comments on another post by P. Krugman:
http://brown-blog-5.blogspot.com/
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Richard, Cullen Roche expresses these ideas a lot more clearly than I have in this recent post of his:
http://pragcap.com/oversimplifying-the-ignoramus-strategy
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Precisely because debtor countries in the Euro-Zone no longer can inflate their respective country’s debts out of existence — diluting the value of that debt held by both domestic and foreign lenders (some of us would call this theft via price inflation) — the only answer, other than repudiation, is to make one’s economy more globally competitive to earn the needed revenues to meet one’s debt payments.
How does a country do that? Through lower prices and wages.
Am I suggesting (oh, no!) price deflation? Yes. I think we need to get over our fear of the word and the practice. I’d be happy to buy more Greek goat cheese at half the price!! I might even think of buying a condo in Athens at half the price. Why, at the right price, I know some people who might be willing to buy an entire Greek island !
The reality is the Greeks are a lot poorer than they thought they were or want to be. But that’s reality. They need to live with it. Rather than expect their German uncle, Otto, to pay off their national credit card debt.
What if this might lead to a break-up of the Euro-Zone? It is an artificial political creation, anyway, that should never have imposed on people to begin with.
Do my views seen out-of-step with much current thinking? Well, sometimes the truth hurts, when you tell the emperor that he has no clothes.
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Tom Brown: Excellent commentary. By the way, this fellow below has done serious work on the the states that are dayglo pink with federal funds, and North Dakota is one of the winners. Mostly red states, btw.
http://www.udel.edu/johnmack/data_library/
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One if the great remaining Keynesian myths is that there is something called “aggregate demand.”
Who is this “demander” and what is this thing called “output as a whole” that “he” buys?
There are only individual demanders who demand individual, specific goods, at individual, specific market prices. Sure, I can add up my expenditures and estimate how many total dollars I spent on “goods.”
But the summing of expenditures and the goods I bought “as a whole” do not exist independent of the individual specific dollars expenditures on each of these particular goods at their individual market prices. To think otherwise is to suffer from an accounting sleight-of-hand in thinking that the totals at the bottom of the ledger book exist independently of the individual entries on each line.
Are markets, throughout the “micro” structures of relative demands, supplies, and prices, interconnected and interdependent? Of course, and they can and do have spillover effects on each other that can have “cumulative” consequences.
But to understand how and why these cumulative impacts occur requires a “micro process” analysis they looks beneath the illusionary “macro” surface.
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Mr, Ebeling
Well, if it’s so painful as you say why are they keeping spending money? Everyone of us can agree on one thing: Mrs Merkel isn’t elected in Greece, nor in Spain and so on. Mr Schauble told it quite clearly: not because they’re good, but because benefits outweight costs. Indeed, that’s basic Public Choice.
And why do benefits outweight costs? I) Because their banks lended poorly and in such they can try to get their money back as much as they can in a safe way: private debts became public and refunded by peripheral taxpayers, II) Real Effective Exchange Rates matters: they can keep ongoing an export led growth model both inside and outside EZ.
Anyway, if you think there is no such thing like AD and BoP inbalancies are irrelevant (pretty weird, you can find them or a currency peg in all the financial crisis of the last 30 years) and theories about OCA have nothing to say, why talking about macro issues?
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Perhaps Mrs. Merkel is diluded into thinking that the European Central bank sets a real rate of interest instead of a nominal one.
“Look, if I had my way, I would raise interest rates, forcing an even deeper recession and even more pain on the rest of you moochers.”
The only moochers are government bondholders that receive a guaranteed income for no productive effort. And how exactly does higher interest rates punish them?
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@Frank Resty “The only moochers are government bondholders….how exactly does higher interest rates punish them?”. Seriously? So somebody saves some money (refrains from consumption), purchases a government bond (lends governement money) and receives interest payments. They are moochers? Are all lenders “moochers”? And to answer your question, higher interest rates lower the value of those moochers’ holdings.
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Marcus, I don’t know about you Marcus, but I would put my money (no pun intended) on Mrs. Merkel as against her economics minister, whoever he is.
ACB, If Merkel gets her way?
Jacques, Disasters come in all shapes and sizes, and all ideological persuasions, whether principled or unprincipled.
Richard, Whether countries have the ability to keep their promises is not unrelated, as I think you would acknowledge, to how what percentage of the country’s available productive resources are being used. If monetary policy is causing unemployment of productive resources, then the problem (or at least part of the problem) is with monetary policy not (or at least not just) the tax and spending policies of the politicians. I am all in favor of reforms to make countries more productive and use their resources more wisely and more efficiently, but monetary policy may be sabotaging those reforms not promoting them.
Tom, I don’t believe in diabolical plans. And, much as I deplore Mrs. Merkel’s policies, I would not ascribe to her any authoritarian motives.
Jacques, I agree that she carries a huge responsibility for the European crisis. I cannot believe that it will end as badly as the crisis eighty years ago did.
Richard, The one point that you are missing is that the German miracle was helped along by having the d-mark pegged at a rate that undervalued it against the dollar, giving the Germans the ability to rebuild their industrial base by exporting to the rest of the world and especially the US. The German economy has been benefitting from a euro exchange rate that relative to Germany’s prices and wages is undervalued, but is overvalued relative to prices and wages elsewhere in the Eurozone. So the best way out of the crisis would be for the rest of the Eurozone to kick Germany out and force the Germans back into the deutchmark, allowing the deutchmark to appreciate and the euro to depreciate. Mrs. Merkel would not like that, but it would serve her right.
Benjamin, And too tight for about 14 of the other 15 eurozone economies.
David, Good point.
Tom, It is not the euro that’s doomed. I don’t think there is any feasible way to undo the euro, except maybe to kick Germany out, but even that may be a non-starter even in theory.
Richard, You may think that price deflation is not so bad, but it really depends on the circumstances. Price deflation in the context of economic growth that is increasing the supply of goods faster than the total spending is increasing is probably not a bad thing at all, and maybe it is a good thing. But price deflation as a way to stop an economic contraction is a disaster, a catastrophe, because that creates an unstable disequilibrium that results in a downward spiral of prices and wages that may have no stopping point until the economy is decimated. And would you mind explaining why transferring wealth from creditors by price inflation (actually by inflation greater than expected) is theft, but transferring it from debtors by price deflation (actually by inflation less than expected) is not theft?
Concerning aggregate demand, I would say that it is a theoretical concept that does not correspond to any real world object. But is an individual demand any more real than aggregate demand. Does anyone out there really have a schedule of desired purchases at hypothetical prices for any individual product? I doubt it. So the concept of aggregate demand is just a way of subsuming certain theoretical relationships in a convenient way. Macro relationships presume micro relationships but micro relationships also abstract from reality, and part of the abstraction process involves a ceteris paribus assumption, and the ceteris paribus assumption involves something akin to assuming that aggregate demand is constant. Normal micro relationships don’t necessarily obtain in a world of rapidly falling or rapidly rising prices or high rates of unemployment.
Frank, Even bondholders are only guaranteed a nominal return not a real return. TIPS are no guaranteeing a negative return.
gofx, The question is whether bondholders have a right to earn a minimum rate of interest just as workers have a right to earn a minimum wage. Politicians of a certain ideological persuasion seem to think that savers do have a right (though not yet enforceable, but at least a moral right that should be respected by the Fed) to earn a minimum rate of interest on their bond holdings.
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David, you write
“Tom, I don’t believe in diabolical plans. And, much as I deplore Mrs. Merkel’s policies, I would not ascribe to her any authoritarian motives.”
I guess I should have ended that with a 😉
I don’t ascribe to her any authoritarian motives either. That was a joke. Although with youth unemployment as high as it is in the PIIGS, and entities like Greece’s “Golden Dawn” neo-Nazi party gaining ground, perhaps it’s not a very good joke. Don’t underestimate the power of desperate people… like the rest of the world did the German population in the completely avoidable aftermath of WWI. If nothing else, fascists (or other extremists) will definitely bring desperate people change they’re not getting from the endless austerity they’re getting form their governments now.
Also, regarding the end of the Euro… perhaps you are correct. I’ll defer to your more schooled opinion in this case… with the caveat of the attraction of extremist political parties I mention above… and the case of Cyprus… aren’t there effectively two Euros now? The Cyprus one, which can’t leave the Island, and the real one, which is free to come and go here and there… as long as it doesn’t go to Cyprus? That seems like a crack in the Euro that might bring its undoing.
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David, also you write in response to Richard:
“And would you mind explaining why transferring wealth from creditors by price inflation (actually by inflation greater than expected) is theft, but transferring it from debtors by price deflation (actually by inflation less than expected) is not theft?”
That’s a GREAT question! The all too prevalent unspoken assumption by “tough sounding” types is that creditors are somehow supposed to have a risk free existence. The fact is they made an investment, and all investments have a degree of risk. Especially bonds in peripheral Eurozone countries!… Perhaps they should have taken the time to consider that Eurozone nations are currency users… not currency issuers. I’m not inclined to shed many tears for these thoughtless investors should they eventually be forced to take a haircut.
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Gofx,
“And to answer your question, higher interest rates lower the value of those moochers’ holdings.”
Higher interest rates lower the market value of those moocher holdings. Higher interest rates do not lower the realizable value of those holdings (held to maturity).
“Are all lenders moochers?”
In the sense that the act of lending is not a productive enterprise in and of itself – yes. Obviously, private enterprise involved in the production of goods and services may rely on some combination of debt and equity issuance to fund that production – very few companies operate on a cash flow basis only. Also, with private enterprise there is a default risk that must be accounted for – all loans may not be paid back in full – and so interest is one way that lenders are compensated for the risk that they take. With government bonds there is no default risk.
In addition, because the federal government takes pains not to compete with private enterprise in the production of goods, neither the lender (government bond holder) nor the borrower (federal government) have any incentive to produce anything.
David,
“Politicians of a certain ideological persuasion seem to think that savers do have a right though not yet enforceable, but at least a moral right that should be respected by the Fed to earn a minimum rate of interest on their bond holdings.”
I have not personally talked to any of these politicians and so you may be right. But let me say this, the “Federal Reserve Act” was actually two acts. The first in 1913 established federal reserve notes as legal tender, set up the federal reserve banks, and allowed the federal reserve to set interest rates on interbank lending. The second federal act in the 1930’s established the federal open market committee that buys and sells government debt.
Most politicians that I have talked to are unaware of this. And so are the politicians “of certain ideological persuasion” upset that the FOMC has set market interest rates on government debt too low or are they upset that the federal reserve has set the interbank lending rate too low?
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Gofx,
“So somebody saves some money (refrains from consumption), purchases a government bond (lends governement money) and receives interest payments.”
How does receiving interest payments cause a person from refraining from consumption? Currently the US federal government sells coupon securities – interest payments are made on a semi-annual basis. At high enough interest rates – there is no difference between you buying a bond and funding consumption out of the interest payments and you spending the money directly.
It is only when the federal government sells accrual securities (interest and principle are repaid at maturity) that the spending / saving incentives change with interest rates.
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Frank Resty. Of course there is a difference. If you buy a bond for $1000, you don’t get to spend that money on consumption. You can spend the coupon payment of say $40 per year, but that is not the same as spending $1000. You must wait for maturity or sell in the secondary market to consume. This is not “mooching”. Mooching would be receiving $40/yr from the government without lending to the government or doing anything else. You fail to keep in mind how someone obtains a bond in the first place: they must pay for it.
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David: In Isaac Asimov’s Foundation Trilogy, a character says ( from memory) “Don’t let your morality principle stand in the way of doing right.” Unfortunately, what we are seeing now is morality worsening the situation..
No. It won’t end as badly, overall, as in the ’30’s. Lots of circumstances are different. Though nobody foresaw in 1930 what would happen later as it was unconceivable.
The german government didn’t cause the crisis( except by being actively complicit with the French in designing a bad monetary system).Little people way below them are directly responsible.
But to whom much is given, much is asked. The big people, as a part of their status, are also responsible for bringing back order and tranquility. And there are not doing it. And don’t want.
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Gofx,
You didn’t answer the original question:
“The only moochers are government bondholders….how exactly does higher interest rates punish them?”
How exactly does higher interest rates punish someone who lends to the federal government?
Your answer:
“So somebody saves some money refrains from consumption, purchases a government bond lends governement money and receives interest payments.”
I will ask again, how do higher coupon interest payments result in less consumption?
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Frank, my main point is that you are in error calling lenders,”moochers”. In my first response responded to you interest rate claim. Higher interest rates lower the value of existing bonds. Typically the supply of existing bonds is way larger than new issuance. How the impact on existing and new bondholders nets out in terms of consumption is indeterminate. Even if you hold to maturity, interest rate increases are likely accompanied by price level increases resulting in lower real returns to holding to maturity. We’ve been through this before. Think 1970s. I really am not that concerned about the fate of investors in government bonds. They know the risks. But they are not moochers.
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Gofx,
My definition of “moocher” differs from yours. I define a “moocher” as someone who obtains an income via a means that requires no productive effort. That income can be nominal or inflation adjusted.
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Tom, Thanks for the clarification. And I should have detected your ironic tone even without the visual aid. Good point about Cyprus. It’s somewhat reminiscent of the gold standard in World War I, which was never formally suspended, but ceased to function very soon after the outbreak of hostilities.
Frank, I think that distinction is way too subtle for most of the politicians under discussion.
Jacques, Thanks for that wonderful Asimov quote.
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David,
Let me try to address the distinction.
The interbank lending rate is an interest rate set by decree at the federal reserve. There is no buying or selling of assets, the federal reserve simply says that is what it is going to be. And so, the federal reserve sets an interest rate for money that may be borrowed some time in the future.
The FOMC buys existing debt at a premium or sells existing debt at a discount. In this case the money was already borrowed in the open market by the federal government. The interest rate on the debt was set at an auction.
In the first case the federal reserve sets a nominal interest rate for money that may be borrowed in the future. In the second case the FOMC is setting the price of existing debt where the funds obtained have already begun to circulate through the economy and affect the price level.
In either case does the federal reserve or FOMC set a real interest rate? In the first case they don’t. I don’t believe they could in the second place, but I am not sure.
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Honestly, I notice everything getting more expensive. The only thing that is not happening is that our wages do not increase. Sooner or later this effect will bring huge demonstrations which equals huge damage to the economy as a whole.
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Frank, The controls the interbank lending rate only by buying and selling assets in sufficient quantities to provide enough bank reserves so that the market clears at the targeted interest rate. The announcement of a target, by itself, would not establish the target rate as the market rate if the Fed was not controlling the total supply of bank reserves.
Tas, Prices go up and down, so most products will occasionally rise in price. People tend to focus more on the stuff that they buy that is going up in price than on the stuff that is staying the same or going down.
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