Weekly e-mail from Tim Congdon of International Monetary Research Ltd. – 26th November, 2010
What of the ECB’s “second pillar” (i.e., money)?
Eurozone money trends in the Great Financial Crisis
Part of the ECB’s propaganda at its foundation was that it would pursue the same ‘stability-oriented’ framework as the German Bundesbank. Heavy emphasis was placed on the need for policy to be guided by a two-pillar approach. The first pillar consisted of a price level or inflation target where the forward views on price trends were based on “real forces”, such as analysis of the labour market and trends in aggregate demand. The second pillar, by contrast, focussed on money. According to Issing in his 2008 book on The Birth of the Euro,
At the press conference of 13 October 1998, when the President, Wim Duisenberg, presented the monetary policy strategy, a journalist asked about the ‘dual pillars’ for the strategy, namely the ‘monetary element’ and ‘the inflation forecast or real economy element’. Duisenberg pointed out that money would play a prominent role in the strategy of the ECB. Taking up the reference to ‘two pillars’, he emphasised that he could not say which of the two was the ‘stronger’ or ‘thicker’ one.
The initial statement of ECB strategy mentioned a ‘reference value’ for M3 broad money, although it did not include a specific target. Implicit in the ECB strategy were two understandings, that inflation was ultimately ‘a monetary phenomenon’ and that large fluctuations in money growth would engender macroeconomic instability.
For much of its life the ECB did indeed preside over fairly stable growth of Eurozone M3, and its reward was an even-keeled Eurozone economy and an impressive degree of price stability (or, at any rate, low-inflation stability). Otmar Issing, the ECB’s first chief economist, certainly paid attention to trends in money growth. However, since Issing retired in 2006, the ECB’s economics research has not had the same intellectual consistency. The closure of the wholesale money markets in summer 2007 caused some parts of the Eurozone banking system to have severe difficulties in funding their assets. Since the escalation of the Great Financial Crisis in October 2008, Eurozone M3 growth has suffered a dramatic plunge. Indeed, the yo-yoing of M3 changes since 2006 – in effect, since Issing’s retirement – makes a mockery of the ECB’s supposed commitment to a stability-oriented framework in which steady growth of money is a key desideratum.
At any rate, in mid-2007 – before the Great Financial Crisis hit seriously – the ECB’s Governing Council encouraged an intensification of the monetary research effort. An article on ‘Enhancing monetary analysis’ in the November 2010 issue of the ECB’s Monthly Bulletin is one product of this extra work. The article reiterates the ECB’s concern about trends in money as such, noting ‘compelling empirical evidence showing that, at lower frequencies, i.e., over medium to longer-term horizons, inflation shows a robust positive association with monetary growth’. The ECB’s authors seem to be particularly pleased with recent work on the household sector’s money demand function, in which they say that the desire to hold money balances is heavily influenced by wealth, including housing wealth. They also bless such constructs as ‘dynamic general equilibrium models’ – or even ‘dynamic stochastic general equilibrium models’ – of the economy. In the articles’ words, ‘Structural general equilibrium models that incorporate an active role for money and credit offer a formal and disciplined approach to explaining the money-holding decisions of households and firms.’ Such models are described as being superior to partial equilibrium exercises, since they lend themselves to testing counterfactual propositions.
But is this all so much ‘blah-blah’? Economists were assembling highly mathematical DSGE models a decade or so ago, and these were useless in anticipating or diagnosing the Great Financial Crisis, and in offering policy prescriptions for it. The article is eclectic and woolly about a number of key issues. Like similar exercises from other central banks, the article
1. cannot make up its mind about whether ‘money’ or ‘credit’ is the variable that matters to the determination of macroeconomic outcomes,
2. denies that a ‘single model can be expected to provide a fully satisfactory explanation of monetary developments at all times’, and
3. invokes a ‘suite’ of models to explain different aspects of a complex reality.
In truth, the ECB’s article gives its economists a range of excuses to find numerous, often inconsistent or even contradictory answers to the many questions that are likely to be thrown at them. They can duck the single, hard and definite answer that comes from genuine understanding.
The above chart shows the dramatic crash in money growth that occurred in late 2008 and early 2009, undoubtedly a major causal influence on the collapse in demand in 2009. But the ECB article on ‘Enhancing monetary analysis’ nowhere presents a clear and exact account of the forces responsible for the money crash. In my view the omission has to be described as appalling. The article does have a review of so-called ‘shocks’ to M3 growth, but it mixes up demand factors (i.e., those that affect the demand to hold money balances) with supply factors (i.e., those which affect the rate at which banks expand their balance sheets), and – to this analyst at least – the result is cryptic, muddled and almost incomprehensible. (See the text in the box below, with its references to ‘money capital formation’.)
What caused the crash in Eurozone money growth?
Assume that the traditional concern, of the Bundesbank and the original ECB, about M3 growth is correct. Assume, in other words, that the crash in M3 growth in late 2008 and early 2009 was a basic causal influence on the Great Recession in Europe. Two questions then arise, ‘what force (or forces) was (or were) responsible for the money growth crash?’ and ‘what can and should the ECB now do to restore a sensible middle-of-the-road rate of money growth similar to that which applied from 1999 to 2006?’.
The central cause of the money growth crash in the Eurozone – as elsewhere – was that banks stopped expanding their claims on the private sector. This is obvious from the chart, which shows bank lending to the private sector increasing by a mere 200b. euros in the year to September 2009 compared to about 1200b. euros in the year to September 2008. The sudden collapse in bank credit to the private sector had two main causes. First, in the middle of 2007 the international wholesale money market closed, so that banks heavily reliant on inter-bank funding (such as those in Greece, Ireland, etc.) could no longer readily expand their assets and somewhere else in the international banking system that meant slower growth of deposit liabilities (i.e., money). Secondly, in a grotesque misunderstanding of what was required for the purpose of macroeconomic stability, regulators decided in autumn 2008 to force banks quickly to raise capital/asset ratios. Subsequent efforts to boost capital/asset ratios had the effect of intensifying the money slowdown. Not surprisingly, the shedding of risk assets increased, not decreased. Meanwhile the raising of capital reduced the private sector’s deposit claims on the banks. (When I use my bank deposit to buy newly-issued bank shares, my bank deposit – and hence the quantity of money – falls.)
Banks’ capital-raising in 2009 was therefore a second force behind the money crash. ECB data show that banks’ longer-term liabilities (i.e., their equity and bond liabilities, mostly, or – in other words – their ‘monetary capital’) climbed by about 450b. euros in the year to December 2009, or by almost 7 ½% at a time when money and credit growth were virtually nothing. But in fact banks had been growing their longer-term liabilities by more than 5% a year for most of the previous decade.
Contrary to the (extraordinarily hard and frankly weird) paragraph in the ECB’s ‘Enhancing monetary analysis’ article, the change in ‘monetary capital formation’ was not a particularly salient causal influence on the 2009 money crash. What differentiated 2009 from earlier years was the collapse in bank lending to the private sector. That was the cause of the slump in Eurozone money growth. The ECB participated in the wider scramble among central bankers and regulators to raise bank capital/asset ratios, and to that extent its activities contributed to the money crash and caused the Great Recession.
And what must now be done to raise Eurozone money growth?
The accusation in the last paragraph – that the ECB contributed to the Great Recession because of its endorsement of the move to higher bank capital/asset ratios – may seem harsh. After all, all the leading central banks endorsed the move to higher capital/asset ratios in the commercial banking industry. (And more fool them.) But there is an important difference between the ECB and the other central banks.
Commercial banks have two main kinds of assets and two main kinds of liability. The two main kinds of asset are claims on the private sector and claims on the state (i.e., claims on the government and/or the central bank, with claims on the central bank usually taking the form of cash); the two main kinds of liability are deposits, which are money, and non-deposit liabilities, such as equities and bonds, which are not money. Suppose that the task is to raise money growth (and so to defeat a recession), even though an overriding external factor (the idiocy of regulators, central banks, politicians, etc.) is preventing the expansion of banks’ claims on the private sector. It is then obvious that the only variable on which policy can work – taking official idiocy on banks’ capital as a given – is the banking system’s claims on the state.
Terrible mistakes have been made in monetary and banking policy in the last few years. Nevertheless, the key central banks in the English-speaking world – the Federal Reserve and the Bank of England – have now come to understand that, in collaboration with the government, they can alter the size of the banking system’s claims on the state. As I have explained on numerous occasions (but see, particularly in the recent past, my paper on ‘Monetary policy at the zero bound’ in the first 2010 issue of World Economics), two main approaches are available,
i. direct borrowing by the government from the commercial banks, or
ii. central bank purchases of assets from non-banks financed by the central bank issuing new cash reserves.
My general preference is for the first of these, because it is simple, and consequently avoids overblown and needlessly controversial central bank balance sheets. However, at present the enthusiasm for central bank independence has resulted in these decisions being regarded as the province of monetary policy-making and hence of central banks. In March 2009 the Bank of England embarked on large-scale purchases of government bonds and prevented a contraction in bank deposits, in a set of operations known as ‘quantitative easing’. The Federal Reserve had at that stage been involved in massive purchases of commercial paper from non-banks, later to be replace by massive purchases of mortgage-back paper. The effects of these operations on the level of bank deposits was the same as the Bank’s gilt purchases, but the chairman of the Federal Reserve – Ben Bernanke – favoured the term “credit easing”. At any rate, earlier this month the Fed announced operations very similar in character to the Bank’s March 2009 exercise, with $600b. of purchases of longs intended to increase the quantity of money.
The case for QE2 in the Eurozone
If the ECB’s economists seriously wanted to ‘enhance’ their ‘monetary analysis’, their focus today should be designing similar operations in the Eurozone. Yes, the Maastricht Treaty prevents governments from borrowing directly on overdraft terms from the European System of Central Banks. But
1. The ECB and its member central banks can purchase government bonds in the secondary market, with two possible strategies,
i. They can do so in such blatant fashion that governments are, in effect, receiving direct central bank finance. The ECB’s purchases of Greek, Irish and Portuguese government debt in 2010 show that this option is available. (I should emphasize that I strongly oppose this sort of thing in general terms, but it is there in the extreme.)
ii. They can agree large targeted amounts of German bund purchases, French government bond purchases, etc., with the explicit objective of boosting both broad money and banks’ cash reserves, with the proportions between the various governments’ debt stocks agreed between finance ministers. The resulting operations would amount to multi-national, pan-European QE.
2. Since the Maastricht Treaty does not prohibit commercial banks from holding government debt, the various governments of the Eurozone can arrange for their deficits to be financed mostly from the banks. They merely have to order their Debt Management Offices – if they have such institutions – to downplay their enthusiasm for the lowest cost form of finance and instead to ensure that, as far as possible, finance is from banks rather than non-banks. This instruction would of course not be permanent, but would be in force for as long as necessary to maintain a reasonable rate of growth of broad money. The size of the purchases would
i. need to be calibrated so that broad money growth was neither too fast nor too slow, and
ii. again, proportions between the various governments’ debt stocks would have to be agreed between finance ministers.
The challenge – in other words – is to design a set of “debt market operations” (using my vocabulary in the World Economics paper) to deliver positive and stable growth of M3. The challenge is particularly difficult in political and logistical term, because the Eurozone – unlike the USA or the UK – is not a traditional monetary jurisdiction, with one government, one central bank and one currency. Nevertheless, something could be organized. This the task to which the ECB’s economists and senior staff should now be addressing their attention.
The Club Med/PIGS group of countries are trapped in a downward deflationary spiral, where efforts to improve public finances aggravate monetary contraction, asset price declines, commercial bank insolvency and so on. The banking problems could be relieved only by a return to asset price inflation in the Eurozone as a whole, some of which would filter into the Club Med/PIGS countries. If the votaries of orthodoxy insist than any kind of asset price inflation is verboten, the answer is twofold. First, asset prices have been going up and down for centuries, and to insist that only downward movements are respectable is monetary sado-masochism. Secondly, moderate but positive money growth ought to be associated with mild asset price inflation. All being well, that would help Ireland, Greece, etc., without sparking rapid inflation in goods and labour markets.
Conclusion: the ECB has no active strategy to boost M3 growth
The article on ‘Enhancing monetary analysis’ was badly-written and confusing. It gave little confidence that the ECB’s senior staff is now focussed on vital practical topics arising from the Great Recession. Most worrying of all, the ECB’s attitude towards ‘the second pillar’ – the distinctive emphasis on broad money growth for which the Bundesbank was once so celebrated – is now uncertain. The analyst has to wonder whether the ECB now has any organized view on money growth at all. Readers of the ‘Enhancing monetary analysis’ article in the November 2010 Monthly Bulletin certainly cannot find any guidance on the relative desirability of, say, 1% and 6% growth of M3 over the next twelve months.
But Europe’s macro outlook turns on whether M3 growth in 2011 is 1% rather than 6%. It is possible that – with no further prodding from policy-makers – Eurozone M3 growth next year will revive to 6%. But this seems implausible in view of the still worsening situation in the PIGS group. Particularly alarming were statements in press reports on the Irish situation that the rescue package will ensure that the Irish banks sell off a high proportion of their assets. Do any of the relevant officials understand that – when a bank sells an asset to a non-bank (say, an insurance company or a pension fund) – the effect on the quantity of money is the same as the repayment of a bank loan? Sure, the Irish banks have lost shareholders’ money and do not have enough capital to justify the present scale of their loan portfolios. But – unless offsetting steps are actively taken (by, for example, QE-type operations) – banks’ sales of loans to non-banks destroy money balances and add to the deflationary spiral. Two leading investment managers at Jupiter Asset Management – Guy De Blonay and Philip Gibbs – have today called for a QE2 programme to be unleashed by the ECB. They claim – very understandably – that Eurozone banks in general are too risky for their funds while the macroeconomic context is so disheartening. The analysis in this note supports the De Blonay-Gibbs position, although it must be recognised that QE is more difficult to structure in the Eurozone than in a traditional monetary jurisdiction. The alarming message from its November 2011 Monthly Bulletin is that the ECB has not begun to think about an agenda to restore positive money growth to the Eurozone.
26th November, 2010