• Immediately establish a single, Euro area-wide bank deposit guarantee scheme.  A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany.  That means that retail and commercial deposits in each should be backed by the same guarantee.  I have no firm opinion on how it should be funded.  The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them.  Just get the thing up and running.  Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing.  There are many and varied forms that fiscal union can take; this is the most urgent of them all.  I am shocked that this does not already exist.

• The ECB should switch from targetting current inflation to expected future inflation.  The Bank of England already does this.  Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years.  This is important.  Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%.  On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany.  They will be much lower for the rest of the Euro area.  Monetary policy in the Euro area is much, much too tight at the moment.  At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.

• The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation.  This follows on from my previous point, but is still logically distinct.  The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements.  I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP.  I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.

• The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough.  The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this.  I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral.  I certainly believe (see my second point above) that interest rates should be lowered.  The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.

• A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first).  The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability.  When banks are instead deleveraging, the problem is made worse by waiting.

• Credit Default Swaps must be permitted to trigger.  The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky.  By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better.  Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.

• Every member of the Euro periphery should be in an IMF programme.  Yes, I’m looking at you, Italy.  If the IMF does not have sufficient funds to work with, the ECB should lend to it.  All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity.  These things cannot be fixed in two or three years.  They can, at best, be put on the right path.

• For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it.   If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%.  The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis.  Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere.  Note, too, that a central bank is only meant to be a lender of last resort to banks.  The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation:  Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT.  Any member country would retain the ability to provide benefits above and beyond the minimum.  This will have several benefits:

• Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
• It will help provide pan-European automatic stabilisers in fiscal policy;
• It will provide crucial intra-European stabilisation;
• It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
• It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

———————-

Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks.  This is a good thing. Press releases:

• Bank of England
• Bank of Canada
• ECB
• Bank of Japan
• Swiss National Bank
• Federal Reserve

Here’s the almost-anonymous W.W., writing at The Economist:

This left her in the odd and almost certainly untenable position of advocating a minimal state financed voluntarily. In her essay “Government Financing in a Free Society“, Rand wrote:

“In a fully free society, taxation—or, to be exact, payment for governmental services—would be voluntary. Since the proper services of a government—the police, the armed forces, the law courts—are demonstrably needed by individual citizens and affect their interests directly, the citizens would (and should) be willing to pay for such services, as they pay for insurance.”

This is faintly ridiculous. From one side, the libertarian anarchist will agree that people are willing to pay for these services, but that a government monopoly in their provision will lead only to inefficiency and abuse. From the other side, the liberal statist will defend the government provision of the public goods Rand mentions, but will quite rightly argue that Rand seems not to grasp perhaps the main reason government coercion is needed, especially if one believes, as Rand does, that individuals ought to act in their rational self-interest.

The idea of private goods vs. public goods, I think, is something that Rand would have recognised, if not in the formally defined sense we use today, but I do not think that Rand really knew much about externalities and the ability of carefully-targeted government taxation to improve the allocative efficiency of otherwise free markets.  I think it’s fair to say that she would probably have outright denied the possibility of anything like multiple equilibria and the subsequent possibility of poverty traps.  Furthermore, while she clearly knew about and despised free riders (the moochers  in “Atlas Shrugged“), the idea of their being a problem in her view of voluntarily-financed government apparently never occurred to her.

However, this does give me an excuse to plump for two small ideas of mine:

First, I consider the charitable (i.e. not-for-profit) sector as falling under the same umbrella as the government when I consider how the economy of a country is conceptually divided.  In their expenditure of money, they are essentially the same:  the provision of “public good” services to the country at large, typically under a rubric of helping the most disadvantaged people in society.  It is largely only in they way they raise revenue that they differ.  Rand would simply have preferred that a (far, far) greater fraction of public services be provided through charities.  I suspect, to a fair degree, that the Big Society [official site] push by the Tories in the UK is about a shift in this direction and that, as a corollary, that Mr. Cameron would agree with my characterisation.

Philanthropy UK gives the following figures for the size of the charitable sectors in the UK, USA, Germany and The Netherlands in 2006:

Source: CAF Charity Trends, Giving USA, Then & Spengler (2005 data), Geven in Nederland (2005 data)

Combining this with the total tax revenue as a share of GDP for that same year (2006), we get:

Source: OECD for the tax data, Philanthropy UK for the giving data

Which achieves nothing other than to go some small way towards showing that there’s not quite as much variation in “public” spending across countries as we might think.  I’d be interested to see a breakdown of what services are offered by charities across countries (and what share of expenditure they represent).

Second, I occasionally toy with the idea of people being able to allocate some (not all!) of their tax to specific government spending areas.  Think of it being an optional extra page of questions on your tax return.  Sure, money being the fungible thing that it is, the government would be able to shift the remaining funds around and keep spending in the proportions that they wanted to, but it would introduce a great deal more democratic transparency into the process.  I wonder what Ms. Rand (or other modern day libertarians) would make of the idea …

Anyway … let me finish by quoting Will Wilkinson again, in his quoting of Lincoln:

As Abraham Lincoln said so well,

“The legitimate object of government, is to do for a community of people, whatever they need to have done, but can not do, at all, or can not, so well do, for themselves—in their separate, and individual capacities.”

Citizens reasonably resent a government that milks them to feed programmes that fail Lincoln’s test. The inevitable problem in a democracy is that we disagree about which programmes those are. Some economists are fond of saying that “economics is not a morality play”, but like it or not, our attitudes toward taxation are inevitably laden with moral assumptions. It doesn’t help to ignore or casually dismiss them. It seems to me the quality and utility of our public discourse might improve were we to do a better job of making these assumptions explicit.

That last point — of making the moral assumptions of fiscal proposals explicit — would be great, but it is probably (and sadly) a pipe dream.

Here are the stories at the FT, the WSJ, the Economist (in their blogs) and for a won’t-somebody-think-of-the-children perspective, the Guardian [1].

There are plenty of arguments against the increase.  You could argue that there’s a sizeable output gap, so any inflation now is unlikely to be persistent.  You could argue that core inflation is low and that it’s only the headline rate that’s high.  You could argue that with the periphery countries facing fiscal crises, they need desperately to grow in order to avoid a default or, worse, a breakup of the Euro area.  You could argue that a period of above-average inflation in Europe’s core economies and below-average inflation in the periphery would allow the latter to (slowly) achieve what a currency devaluation would normally do:  make them more competitive, attract business and allow them to grow in the long run (above and beyond the short-run stimulus of low interest rates).

On that last point, though, it’s worth looking at the data.  It’s a great idea, in principle, but unfortunately and despite all the austerity packages, the data show exactly the opposite picture at present.  Here’s the current year-over-year inflation rate broken down by country, from Eurostat (HICP and Labour Costs):

For some reason Ireland doesn’t seem to be included in the Labour Cost data.  Look at Greece and Spain.  They’re getting more expensive to do business in relative to Germany and France.  Portugal is in the right area, but with Germany’s growth rate in Labour Costs so low, they’re still coming out worse.  The same story is painted in consumer inflation.  It looks like Ireland is doing what it needs to, but Greece, Portugal and Spain are all getting even less competitive.

Here’s my theory:  The ECB hates the fact that they’re temporarily funding these governments, but can’t avoid that fact.  Furthermore, they reckon that Greece, Ireland and Portugal are eventually going to restructure their debt.  Given that they cannot shove the temporary funding off onto some other European institution, the ECB either doesn’t care whether it’s in 2013 or today (they’ve already got the emergency liquidity out there and it can just stay there until the mess is cleaned up) or quietly wants them to do it now and get it over with.  Either way, the ECB is going to conduct policy conditional on the assumption that it’s as good as done.

[1]  Just kidding, Guardian readers.  You know I love you.  Mind you, the writing in that article could have been better — it says that inflation has gone above the ECB’s target of 2% and never mentions what it actually is, but later mentions the current British inflation rate (4.4%) without explaining that it is for Britain and not the Euro area.

Let me quote Ryan at Free Exchange:

The minimum common equity requirement has been increased from 2% to 4.5%. Common equilty is what is called “core” Tier 1 capital. Regulators have agreed on an additional 2.5% “conservation buffer”. Most large banks will likely maintain such a buffer, as falling below it will lead to additional regulatory scrutiny. The likely impact, then, is a pretty substantial increase in the common equity reserves banks need to hold.

What he said. Anyway …

The asterisk on the countercyclical buffer has this note against it: “Common equity or other fully loss absorbing capital”.  Here’s some more detail, from the press release itself:

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

In other words, the countercyclical buffer is expressly designed to allow for different rates of credit expansion across different countries.  This is excellent news for the Euro area, because (as I mentioned previously) it explicitly allows — heck, even encourages! — individual member countries to re-assert some control over monetary policy.  Remember that the level of credit in an economy is not just affected by demand for the stuff (which is itself influenced largely through interest rates), but also through the supply of the stuff, which falls under the umbrella of macro-prudential regulation (since, it is assumed, banks will generally supply all the credit they can subject to the restrictions of capital adequacy regulations).  The former may remain the remit of the ECB, but the latter can be economy-specific.

This is arguably desirable because, since the Euro-area economies are not perfectly synchronised, we have for many years seen monetary policy be overly tight for low-inflation countries like Germany and overly lax for high-inflation countries like Spain.

To some extent, one might view Germany’s reluctance to accept tighter capital requirements as evidence that they have been tacitly using this logic all along:  that is, they were already compensating for the (to them) overly-high interest rate with relatively lenient policies on the supply side.  To a German’s mind, it may therefore appear that with these higher minimum ratios, a neutral position for the German economy will require lower interest rates on average than previously prevailed.

The risk, from the Germans’ point of view, is that in a Eurozone world with higher capital ratios but lower interest rates, countries like Spain may be tempted to avoid making use of the countercyclical buffer and so may still end up with faster-than-ideal credit expansion.  How to convince the central banks and/or regulatory authorities in Mediterranean countries to be financially conservative, even when their governments aren’t, is clearly the next challenge.

It reminded me that I’d meant to write a post on two things I think ought to be done in improving the long-term outlook for the single currency.  None of this is particularly innovative, but I needed to put it down somewhere, so here it is.

First, a European Fiscal Institution (EFI)

At the start of February, when Greece and her public debt was dominating the news, I wrote:

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment. Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment. The latter is difficult in Europe with it’s multitude of languages, but not impossible.

Let me hang some meat on those not-even-bones.  I like the idea of a partially shared, European Fiscal Institution (EFI) that can conduct counter-cyclical spending, subject to strict limits on its mandate.  I am deliberately avoiding calling it an “authority” because that implies a certain freedom of action, which I oppose.  Instead, I think that an EFI should:

• be limited to implementing commonly-agreed automatic stabilisers (in particular, a universally-agreed-upon minimum level of unemployment benefits);
• be able to issue its own “Euro bonds”;
• have a mandate to retain the very highest regard for the safety of its borrowing; and
• be funded (and its bonds be guaranteed) by member countries in a manner part way between proportionate to population and proportionate to GDP.

I do not think that membership of such an institution should be required of any European country.  If a non-Euro country wants to be in it, fine.  If a Euro country wants to not be in it, fine.

The unemployment benefits provided would be the absolute minimum that everyone could agree on.  I want to emphasise that this should be extremely conservative.  If it ends up being just €100/week for the first month of unemployment, so be it; so long as it is something.  Member countries would provide additional support above the minimum as they see fit.

This will have several benefits:

• It will help provide pan-European automatic stabilisation in fiscal policy.
• It will provide crucial intra-European stabilisation.
• It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high.
• It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

Second, country-specific lending standards

A crucial problem with a single currency is that it imposes a one-size-fits-all monetary policy on all member states, even when those states’ economies are not perfectly synchronised.  Synchronisation was, and is, one of the requirements for accession to the Euro, but perfect synchronisation is impossible.  In particular, inflation rates have varied significantly across the Euro-area, meaning that the common-to-all interest rates set by the ECB have been, by necessity, too low for those economies with the highest rates of inflation (e.g. Spain) and too high for those with the lowest rates of inflation (e.g. Germany).

But the (causal) link from interest rates to inflation travels via the extension of credit to the private sector, and the level of credit is determined not just from the demand side (with agents responding to changes in interest rates), but also from the supply side (with banks deciding to whom and under what conditions they will grant credit).  Monetary authorities in individual member countries therefore retain the ability to influence the level of credit through regulatory influence on the supply of the same.

Altering reserve requirements for banks operating in one’s country would be the crudest version of this mechanism. A more modern equivalent would be changes to the minimum level for banks’ capital adequacy ratios.  Imagine if the Spanish banking regulators had imposed a requirement of 10% deposits on all mortgages from 2005.

I suspect that the new “macro-prudential” role of the Bank of England, in addition to its role of more conventional — and, with Q.E., unconventional — monetary policy will grant them the ability to engage this sort of control.  I think it will become more important over time, too, as the British economy continues its (to my mind inevitable) decline relative to the Euro-area, the UK moves closer to the textbook definition of a “small, open economy” and the BoE thus finds itself more constricted in their choice of interest rates.

Update 13 September 2010:

The new Basel III capital adequacy requirements are out and they appear to enable exactly this second idea.  Good!

The European Commission said on Tuesday it would endorse Athens’ plan to bring back under control the public sector deficit, which last year reached almost 13 per cent of gross domestic product.
…
Under a three-year plan, the Greek government seeks to cut the national budget deficit to less than 3 per cent of GDP by the end of 2012.

and:

In response to criticism that earlier plans had not included sufficient spending cuts, Mr Papandreou also announced an across-the-board freeze in public sector wages which, together with cuts in allowances, would reduce the public sector wage bill by 4 per cent. The government has also pledged to raise the retirement age.

If the Greek government can achieve this without massive, nation-wide strikes, I’ll be terrifically impressed.  Megan’s comments:

Everyone is expressing optimism. But while this sort of belt-tightening is necessary for Greece to stay in the EU, it’s going to come at a huge cost. Greece is already in recession–that’s why its budget problems loom so large–and the fiscal contraction will only make them deeper. Meanwhile, the EU will be setting its interest rates to meet the needs of larger, healthier members (and inflation-hawk bondholders). Tight fiscal and monetary policy means a long, painful period ahead for the Greeks.

This is the dilemma that faced Argentina with its monetary peg to the dollar; ultimately, it led to devaluation and default. We will see if Greece can whether [sic] it better.

I don’t think that this sort of belt-tightening is strictly necessary in the near term.  Germany will, again, fund a bail-out if it really comes down to it because, if nothing else, the loss to Germany of a member of the EU dropping the currency is greater than the loss to Germany of paying for Greece’s debt.

It’s clearly necessary in the long term that Greece get it’s fiscal house in order, but since they’re in such a severe recession, this isn’t really the time to do it (financial market pressure aside).  This is, in essence, the same debate that is gripping America, although there the pressure to address the deficit is coming from a successful political strategy of the opposition rather than, much as that same opposition might like, pressure from the markets.

Ultimately, what the EU needs is individual states to be long-term fiscally stable and to have pan-Europe automatic stabilisers so that areas with low unemployment essentially subsidise those with high unemployment.  Ideally it would avoid straight inter-government transfers and instead take the form of either encouraging businesses to locate themselves in the areas with high unemployment, or encouraging individuals to move to areas of low unemployment.  The latter is difficult in Europe with it’s multitude of languages, but not impossible.

In a perfect world where all regions of the EU currency zone were equally developed, this would simply replace the EU development grants.  But this isn’t a perfectly world …

Nevertheless, people do seem to be wondering about China as an engine of global growth in demand.  The reason is simple:  Despite a near catastrophic collapse in world trade, China’s economy is still growing while those of  other export-oriented countries like Japan or Germany are falling precipitously.

Clearly part of the reason for the continued Chinese growth, like in Australia, is the successful use of a fiscal stimulus to boost local demand (the Australian rebound was also helped by the fact that, by not manufacturing much, their decline in investment was offset by a fall in imports and (price) changes in natural resource exports occur with a significant lag).

Brad Setser has explored the Chinese stimulus a little.  He writes:

I initially underestimated the magnitude of China’s stimulus by focusing on the (fairly modest) change in the government’s fiscal balance. It is now clear that the majority of China’s stimulus has been off-budget: the huge increase in lending by state owned banks mattered far more than the change in the budget of the central government. The expected loss on these loans can be considered a form of fiscal stimulus.

Which is a fascinating way to conduct government business.