Wednesday, December 14, 2011

...The implications for Eurozone Policy

So here are the implications for the Eurzone situation. As the central bank for the Eurozone, the ECB is in charge of shifting the LM curve so as to reach the IS-LM-FE equilibrium. But now the problem may become apparent to the astute reader. The problem with multiple economies sharing one central bank is that each economy has its own FE curve, its own IS curve, but is expected to share ONE LM curve. And the ECB has happily altered the nominal supply of euros so as to hit an M/P that corresponds to an LM that is at the IS-FE point for Germany. So Germany has recovered from the slump and is enjoying 5.8% unemployment with stable prices. But the LM curve that is at IS-LM-FE for Germany corresponds to an IS-LM that is to the left of FE for Spain. To the left of FE for Italy. To the left of FE for Ireland. (I wish I could create my own damn graphs for this; it would be more clear. Maybe someday.)

Remember before when I said that if IS-LM was to the left of IS-FE, deflation could increase the real money supply (M/P) so as to shift the LM curve to the right? Well that is exactly the solution ECB and German officials have proposed for the periphery countires (they call it "internal devaluation," a term I kind of like). That is fine in principle: if Italian and Spanish and Irish workers would agree to lower nominal wages and firms would slash nominal prices, the real money supplies in those countries would expand; their markets could create their own "monetary expansion" without the ECB creating more nominal money balances.

But the problem here is not theoretical: its practical. Economists since the 1930s have made the observation that in practice, firms are very reluctant to cut nominal prices and workers are very reluctant to accept nominal wage reductions. This is partially explained by the idea that firms and workers have a hard time distinguishing between nominal reductions and real reductions; whatever the reason, the price level is considered "sticky" in the short run. That is why monetary policy that expands the nominal stock of money (the M in M/P) is relied on to shift the LM curve and not reductions in P. So while in theory the periphery should be able to deflate its way to full employment, the reality is that doing so will take an intolerably long time, if it can even be fully achieved.

Plus, there's the issue of debt-deflation...

IS-LM and the Price Level

One criticism that is sometimes made about the IS-LM model is that it neglects the price level. The determinates of the model are the real interest rate and GDP; but the price level IS present in the framework. In the LM function that represents the necessary levels of (r) and (Y) that clear the market for real money balances, the supply function in the market is the real, as opposed to the nominal, money supply.

What this means is that a change in the price level, that is to say deflation or inflation, will shift LM either up or down. The real money supply is defined as M/P, where M is the nominal money supply and P the price level. A fall in P, that is to say deflation, leads to a smaller denominator and hence a larger real money supply. Inflation, that is to say a rise in P, leads to a larger denominator and hence a smaller real money supply. Recall that an increase in the real money supply relative to money demand causes the LM curve to shift to the right; a decrease causes a leftward shift.

This mechanism, where changes in the price level change the real money supply and hence the position of the LM curve, is the mechanism that theoretically allows the LM to reach FE equilibrium without a change in the nominal money supply, that is to say monetary policy. If the IS-LM intersection is left of IS-FE (the interest rate compatible with full employment), a then there will be downward pressure on prices: workers will accept lower nominal wages, and firms will cut nominal prices to move pilled-up inventory. This decrease in P then causes M/P to expand and shift the LM curve to the right until FE is reached. If IS-LM is to the right of IS-FE, then nominal wages and prices will rise (i.e. inflation) and M/P will contract until LM is once again at FE. So the price level does factor into our IS-LM analysis; its just hidden in the LM curve.

But what are the implications for Eurozone policy?

Combining the Models: IS-LM

So now we have two seemingly unrelated markets that are both cleared by the same thing: the interest rate. The IS-LM model, developed by John Hicks in 1936, combines the two. The model relates the interest rate (r) to GDP (or income on a national level) (Y). The two functions are not supply and demand but a downward sloping function representing cominbations of Investment and Saving corresponding to each combination of (Y) and (r). It's downward sloping because as income increases, saving increases relative to investment leading to a lower interest rate. The upward-sloping function is the Liquidity-preference and Money supply function which is upward sloping with relation to income because as income grows, money-demand increases due to the fact that more money is required to carry out more transactions in a larger economy; this causes money demand to grow relative to money supply, causing rates to rise. Yes, this is potentially the most obtuse collection of concepts in macroeconomics and the most convuluted framework ever. It makes more sense to see it put together piece by piece, but I don't have the ability to make the graphs I need myself and Google has failed me yet again.
As you can see, IS and LM intersect at FE, or the Full Employment level of GDP. This graph represents an economy in equilbrium, where the central bank has set the money supply relative to money demand in such a way as to set the LM curve along the IS curve so as to reach full employment and stable prices. If the central bank were to contract the money supply, the LM curve would shift to the left along IS, resulting in a new Y below Y*; in other words, a recession. If the central bank expanded the money supply relative to money demand, LM would move to the right of the current IS-FE point; that would mean an equilibrium point on Y above the FE level, which is to say an inflationary gap.

This brings us to the price-level aspect of IS-LM, and then onto its implicaitons for Eurozone policy. I can hardly wait.

Tuesday, December 13, 2011

Why Monetary Policy Matters Anyway (part 2): Liquidity Preference and the Real Money Supply

So we have established that Saving and Investment are determined by the real interest rate (r) which adjusts to equilibrate the two. However, in an economy in which money is used as a store of value, a complication arises. The rate of interest on a bond is the inverse of the price of that bond: bond prices and interest rates move in opposite directions. In an economy is which the only store of value was bonds, any increase in saving would automatically translate into an increased demand for bonds and hence lower interest rates, like the loanable funds model from before indicates.

But once we introduce money into the picture, things become complicated. Savings can be held in the form of either bonds OR money; bonds earn interest, but money has two advantages. The first is that by holding money balances, savers can speculate that the price of bonds is about to fall, i.e. that interest rates are about to rise (no one would buy an asset that's about to decline in value). The other and more important motive for holding money is the transactions motive: households and firms hold money balances to make short-term purchases and meet short-term expenses. You can't pay the contractor in Treasury bills. 

So money-demand is a function of both the interest rate and income, so that we write Md=f(r, Y). Money-supply is not a function of the interest rate, its a perfectly inelastic line indicating the fact that the supply of money is fixed by the central bank at any given moment. Given that, as in all markets, quantity supplied must equal quantity demanded, we can write MS=md (r, Y). Income and the interest rate adjust to equate the money supply with money demand. This market is described in the below chart. 
As you can see, the central bank moves the interest rate up or down by increasing or decreasing the money supply along the money demand curve. 

So we have two markets, the market for loanable funds and the market for money balances, that are both cleared by the same variable: the interest rate. Whats left to be done is to combine them. 

Why Monetary Policy Matters Anyway (part 1): Loanable Funds

As I've demonstrated earlier, I'm a euroskeptic (I didn't invent the term) primarily because of what I see as the disasterous experience of the ECB: the periphery countries of Europe have been saddled with a monetary policy that has been tailor-made for Germany and Germany alone; the result has been stable prices and full employment for Germany; unemployment and depressed incomes for Italy, Spain, Ireland, and others. Now I want to delve into why that is: why does the monetary policy of the ECB have an effect on the economic performance of European economies at all?

Monetary policy affects the economy by affecting interest rates: monetary easing lowers rates, while tightening raises them. Lower interest rates entice firms to borrow for investment projects and encourgae households to save less. Higher interest rates discourage borrowing for investment and encourage household saving. The market for loanable funds thus determines what the equilibrum rate of interest will be for the economy: the the graph below, savings is the upward-sloping function of the interest rate (r) and investment is the downward sloping function. This is known as the loanable-funds model.

The savings function is an upward-sloping function of the real interest rate because households want to save more when the reward for doing so it higher. The amount of saving, however, is determined by both the interest rate (r) AND the level of income (Y) so that we write S= f(r, Y). Investment is a downward sloping function of the real interest because more investment takes place when borrowing to do so is cheaper. Since S=I in equilbrium, holding (Y) constant, (r) adjusts until the quantity saved = quantity invested; the market for loanable funds clears like any other.

Sunday, December 11, 2011

Whats the matter with Europe (part 4)

This brings us to David Cameron, and what his veto represented on Friday. The proposed EU treaty that Cameron rejected would have imposed another set of "one-size fits one" policies on Europe. Specifically, it would have put in place rules- binding rules, mind you, for the fiscal policies of member states. Here are some excerpts:

"General government budgets shall be balanced or in surplus; this principle shall be deemed 
respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP. Such a rule will also be introduced in Member States' national legal systems at constitutional or equivalent level. The rule will contain an automatic correction mechanism that shall be triggered in the event of deviation."

"A mechanism will be put in place for the ex ante reporting by Member States of their 
national debt issuance plans."

"As soon as a Member State is recognised to be in breach of the 3% ceiling by the Commission, there will be automatic consequences unless a qualified majority of euro area Member States is opposed. Steps and sanctions proposed or 
recommended by the Commission will be adopted unless a qualified majority of the euro area Member States is opposed."

And the consequences of these requirement would be real. If you think I'm wrong, check this out.

"Why did Irish Budget Plans end up in Berlin?" is the headline, if you didn't click the link.

Some might not see a problem with this step toward European fiscal integration; why shouldn't European governments coordinate budget deficits and spending plans? Why shouldn't budget guidelines be put in place for a series of such interdependent economies? There is a compelling arguement to be made. But if the experience of the ECB is to be taken seriously, and experience suggests that it should, then it is not difficult to predict where this will lead: inappropriate budget deficit constraints in nations that, for demographic, security, or other reasons need to run a moderate structural deficit for a time. And just what would that "automatic correction mechanism" be if a country DID run a deficit of greater than 3% of GDP?

The lesson needs to be that asymetric economies, like those of Europe, are going to experience asymetric shocks- and that locking in binding and symetrical fiscal and monetary policies is only going to lead to policies that work for a few, and hurt many more. The Italians deserve better than that. The Spanish deserve better than that. The Irish deserve better than that. Hell, even the Greeks deserve better than that.

So David Cameron, probably without realizing it, took an important step on Friday when he stood up for his country's interest: he stood up to a German Chancellor who was attempting to impose a series of inappropriate constraints and mandates on a fractured and helpless Europe. And at the end of the day, isn't that what being the British Prime Minister is all about?

Whats the matter with Europe (part 3)

To demonstrate the point that its the ECB's actions that are responsible for the punative interest rates being faced by the European periphery, let us examine some statistics (puts on cherry-picking gloves). In 2010, the sovereign debt of the United Kingdom was 77% of GDP and the annual deficit was 11% of GDP. For Spain, debt was 61% of GDP and the deficit was 9% of GDP. By any sane evaluation, the fiscal posistion of the United Kingdom is far worse than that of Spain; any rational bond investor would certainly price British bonds lower than Spanish. Yet as of Dec 11 British 10 year bonds are selling at a 3.75% coupon rate; the Spanish 10 year rate was 5.75%. The Spanish government must pay an interest rate that is 53% higher than the British government faces even though it is running far smaller budget deficits and has a much smaller national debt. Why? Because the bond market knows that the Bank of England will set interest rate policy in a way conducive to future British growth, so investors are more confident about future British tax revenues being available to pay them back. Meanwhile, Spanish monetary policy is set by an oblivious central bank in Frankfurt who's only concern seems to be German unemployment and German inflation, a monetary policy that Nobel laureate Paul Krugman has dubbed the "one size fits one" approach to monetary policy.

Whats the matter with Europe? (part 2)

(continued from below)
So now the Eurozone is faced with a situation where all members share one monetary policy, set by the ECB in Frankfurt, but NOT one economic performance. German unemployment peaked at about 8% in June of 2009, and fell below 7% by the summer of 2011. Over that same summer, the ECB raised its target interest rate three times, tripiling it from 0.5% to 1.5%. In other words, the EUROPEAN central bank has acted as if it is the GERMAN central bank and nothing more. With the rest of the continent still mired in unemployment, the issuing authority of the euro declared the slump over and raised rates.

At the time of this writing, the Italian unemployment rate was 8.3%. The Irish unemployment rate was 14.2%. The Portuguese unemployment rate was 12.5%. The Spanish unemployment rate was a whopping 22.6%. And the folks at the ECB could not care less, because the German unemployment rate is at comfortable 5.8%. Mission accomplished, they say.

And that leads us to the current looming sovereign debt crisis.

For it is this patent disregard on the part of the ECB for the economic success of the periphery countries that has made the creditors of those countries relucant to hold their sovereign debt at anything less than punative interest rates. In order for investors to lend money to a government on reasonable terms (i.e. low interest rates), they must feel confident that the issuing government will have the capacity (i.e. tax revenues) to pay them principle + interest when the debt comes to maturity. But what the ECB has demonstrated is that Spain does not have a central bank that will stand by its economy. Italy does not have a central bank that will stand by its economy. Ireland does not have a central bank that will stand by its economy. As a result, the economic prospects of these nations is proportionally diminished in the evaluating eyes of the international bond market. And it's completely unecessary. (continued)

Whats the matter with Europe? part 1

I would like to put what David Cameron did yesterday into the wider perspective of what's going on in the Eurozone; for his veto of the the proposed Treaty flew in the face of a deeply pernicious agenda being advanced by Germany's Angela Merkel and her finance minister Wolfgang Schauble.

The story so far: In 2002, most of the countries of Western Europe did away with their individual central banks and the individual currencies issued by those banks in favor of adopting the euro as a common currency. With this adoption, the memeber countries effectively signed over their ability to make monetary policy to one central bank, the ECB, located in Frankfurt. 
Normally, each country's central bank would set an interest rate target appropriate to the economic condtions of that country; if unemployment was running high and inflation running low, the central bank would "cut" rates by easing monetary policy; if the reverse was true, the central bank would tighten. Because each nation's economy behaved differently at different times, the multiple currency system allowed for each country to set its own policy as it saw fit. 
But since 2002, there has been effectively ONE monetary policy setting the SAME interest rate policy for the entire eurozone. And this little problem has created the set-up for the sovereign debt crisis that is threatening to break-up the euro area. From 2008-2009 the entire eurozone, much like the rest of the world, was in a recession- as a result, the ECB did what central banks always do: it lowered rates and kept them low. But while the downturn was symetrical, effecting the entire eurzone equally, the recovery has been anything but. To be specific, Germany has experienced a strong recovery on the back of its persistent current account surpluses, while the periphery- Spain, Italy, Portugal, and Ireland, remain deeply depressed. (to be continued)

Saturday, December 10, 2011

David Cameron to Continent: Drop Dead

David Cameron, the British Prime Minister, issued the sole veto to the proposed EU Treaty yesterday; the nations of the Eurozone may yet thank him. The treaty in question would have imposed a mandated limit on deficit of 3% of nominal GDP per annum and would have paved the way to a fiscal union for Europe. A fiscal union, in light of the ongoing implosion of the MONETARY union (the euro).

"Mr Cameron told a news conference that the deal on the table was not in Britain's interest "so I didn't sign up to it".
"We want the eurozone countries to come together and solve their problems. But we should only allow that to happen within the EU treaties if there are proper protections for the single market, for other key British interests" he said.
"Without those safeguards it is better not to have a treaty within a treaty, but have those countries make their arrangements separately.
"It was a tough decision but the right one."

The Eurocrats in Brussels are intent to strike our further and further into the sovereign functions of the EU member states. But this time the Empire struck back.