Meet the New Cold War, Same as the Old Cold War

Taking a break from the macroeconomic implosion of Europe, I'd like to point out this interesting headline pertaining to the about-to-ensue civil war in Syria:

http://www.canada.com/news/China+Russia+slam+West+Syria+sanctions/6214711/story.html

Is seems Russia and China are drawing a hard line of distinction between their position and that of the United States and the European Union, who seem to be in lockstep with each other. This especially matters  given the very fluid situation in the Middle East since the Arab Spring last year.

Not to mention this:

http://www.reuters.com/article/2012/02/14/us-usa-iran-hormuz-idUSTRE81D1PE20120214

A world in which the United States and Europe are battling with Russia and China on issues pertaining to the Middle East will a volatile one. But certainly not an unfamiliar one.

Draghi Answers the Call

The other day the ECB ended its bond-buying program, and I was bearish on the future of the eurozone economy in light of it. But I am more than pleased to see this today:

http://www.guardian.co.uk/business/2012/feb/28/european-central-bank-euro-eurozone?newsfeed=true

Mario Draghi has committed the ECB to another round of aggressive bond-buying, or "quantitative easing." This is highly expansionary policy at work, and I could not be more pleased.

It seems the ECB may have a chairman who is committed to stabilizing Europes economy and understands the critical role monetary policy has to play in the soverign debt crisis of the periphery. Well done Draghi, and keep up the good work.

I've been saving this picture for a special occassion. This certainly qualifies.

Eurozone Economy on Verge of Second Recession

As predicted, the Eurozone economy seems poised for another contraction. Check it out.


http://www.reuters.com/article/2012/02/22/us-economy-europe-idUSTRE81L0R020120222


France and Germany, the bloc's two biggest economies and drivers of growth, failed to grow at all last quarter; overall eurzone unemployment is at 10.4%, with core inflation running at 1.9%.


I especially like this quote: "The euro zone economy contracted 0.3 percent in the dying months of 2011 so a second quarter of contraction would meet the technical definition of recession."


Recession is looming and inflation is low; now it the textbook time for expansionary policies. The message everyone European should be sending to their policy makers is this: Expansionary Policies Now!

Mario Draghi, you're on deck. 

Spanish Unemployment Rises

In other news, Spanish unemployment rises above 22%. Check out the link.


http://www.bloomberg.com/news/2012-01-27/spanish-unemployment-rises-to-22-9-.html


I mean seriously, 22%? In any sane economic regime, that would be unacceptable. There would be outcry to use monetary and fiscal expansion to grow GDP and create jobs in the way outlined in the two models outlined previously. But the ECB ENDED its expansionary program yesterday, and the periphery countries are all, as is well known, debt constrained. There seems to be no light at the end of this tunnel. And the global economy will suffer for it.

The Financial Times Gets it Right on Greece

Check this link out (if you can)

http://www.ft.com/intl/cms/s/0/86d3d470-5bb8-11e1-a447-00144feabdc0.html#axzz1n5UR8lcr

Basically, Gregorz Kolodko, a former Finance Minister of Poland, argues that the ECB has the capacity and the policy obligation to buy Greek debt and stave off the crisis. His argument makes sense given the parameters of the Greek tax base and the inevitability of default otherwise, as he lays out.

Plus any expansionary action on the part of the ECB would be good action at this juncture.

ECB Halts Expansionary Policy

This is deeply, deeply, troubling. Click the headling below to see what I'm talking about.

http://www.cnbc.com/id/46453949

Now I have covered two different models, IS-LM and market monetarism, both of which strongly suggest the need for monetary expansion in a depressed economy with high unemployment and low inflation. Europe, as everyone nows, still strongly resembles such an economy.

Thats why Jean Claude Trichet's rate hike last year was so wrong headed, and why I attribute much of the blame for the continued crisis in the Eurozone to his tight money policy. But when Trichet was replaced by Mario Draghi in Novemeber of last year, I thought maybe a change in the winds was on the horizon; and for a while, it seemed to be true. Draghi announced that the ECB would begin a program of bond-buying aimed at purchasing at-risk government debt, namely securities issued by Spain, Italy, Ireland, and Greece.

This program served to both increase the nominal money supply (non-inflationary in such an environment, but highy expansionary) and to take some of the pressure off bond markets to load up on all the risky debt, breaking the cycle of self-fullfilling panic. And for a while it seemed to be working.

But today, the program, and implicitly the expansionary policy mindset I'd hoped would be Europe's salvation, has abruptly ended. More on this story as it developes.

Another Way of Looking at Things part 2

So using our equation M/P * V(i) = Y we can constrcut a different way of looking at business cycles other than IS-LM-FE, as we have done so far.

With our "monetarist" model, we aren't looking to find the appropriate real interest rate that clears the market for real money balances and loanable funds are full employment. We are instead looking at the real money supply M/P and the "velocity" of that money supply, or how many times each dollar "changes hands" i.e. is used in a transaction in a year.

It stands to reason then, from the above equation, that a decline in Y must either be attributable to a fall in M/P, V, or both. So we need to look at what might CAUSE these variables to decline in value.

Lets start with M/P. A decline in the nominal money supply M would reduce M/P at least in the short run. Theoretically, a decline in the money supply SHOULD lead to a decline in the price-level. But here we come to the fork in the road that divides modern macroeconomists: how QUICKLY do prices adjust? Monetarists and Keynesians say prices are "sticky," as we've seen before. New Classical economists say prices adjust very rapidly, if not instantaneously. For this model, however, we assume prices are sticky. If thats the case, a fall in M will cause a fall in M/P not quickly corrected by a fall in P.

This is, by the way, the basic model Milton Friedman used to describe the Great Depression. He catalogued the fall in the nominal supply of money from 1929-1933 which, in his thesis, combined with "sticky" prices to give us the fall in Y that was the Great Depression. Keep M stable, the story goes, and you stabilize the business cycle.

But lets look at the V(i) term as well. Friedman and most monetarists of his day thought the velocity of money was more or less constant, so that observing M/P was where the action was at. But a decline in the velocity of money is just as able to cause a fall in income Y as a fall in M.

More on this later.

Another Way of Looking at Things part 1

I normally like to think about the business cycle in term of the IS-LM-FE model described so laboriously below. But lately I've been investigating another apporach taken by Scott Sumner (for one): market monetarism. As well as I can piece together, market monetarism is an udated version of the old monetarism of Milton Friedman: changes in the quantity of money, or the rate of change of the quantity of money, drive the business cycle, i.e. flucations in real output. Let examine how that works.


The workhorse of the market monetarist approach, as near as I can tell, is, surprise! Irving Fisher's Equation of Exchange, which is:


                                                             M x V = P x Q

Where M is the nominal money supply, V is the velocity of money, P is the price level, and Q is real output or real GDP. The equation can be rewritten as:


                                                            M/P x V(i) = Q


Where P is now used to deflate the nominal money supply so as to give the real money supply, and velociy is given as a function of the nominal interest rate which is


                                                          i = r + π e 


Where i is the nominal interest rate equaling the real interest rate plus expected inflation. 


The rewritten form is a bit easier to work with because you can think about the real money supply being multiplied by its velocity to get real income. Less convulted. 


So what about the business cycle? 

By the Way, I did not originate this plan...

But guess who did?

"The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt."

-Ben S. Bernanke, circa 2002

Ben Bernanke should target the dollar/euro nominal exchange rate

Ben Bernanke should announce an explicit target for the dollar-euro nominal exchange rate. One that is substantially below the present parity of about $1.30 to a euro. He would do this by purchasing Italian, Spanish, Irish, and (possibly) Greek debt with open market operations, i.e. by expanding the Fed's balance sheet. This would do several things:

1. More M for the M/P part of M/P* V(i) = Y. Market monetarists will be pleased.

2. We've done all we can do on interest rates; why not target exchange rates? Boost NX instead of I in C+I+G+NX. Keynesians will be pleased.

3. The periphery will recieve a repreive from their looming debt crisis and see a fall in interest costs. Crisis averted.

4. Northern Europe (especially a certain German Chancellor)  will flip out about the "competitive devaluation" and (hopefully) pressure the ECB to return fire, i.e. expand.

It sounds foolish, but it just might be a way for central banks on both sides of the Atlantic to do the kind of expansion the both economies still desperately need.