Ancestors of the eurozone crisis, with Richard Koo — from the Nomura economist’s latest note (our emphasis):
In 2005, I told a senior ECB official that it was unfair to force other countries to rescue Germany by boosting their economies with loose monetary policy without requiring Germany to administer fiscal stimulus, when it was Germany that had become so deeply overextended in the bubble. The official responded that that is what a unified currency means: because Germany could not be granted an exception on fiscal stimulus, the only option was to lift the entire region with monetary policy.
In other words the ECB is at fault for blowing bubbles, helped by the framework of fiscal deficit (dis)allowance.
Picture yourself back in the bursting of the IT bubble, which hit Germany hard. The Nasdaq-like Neuer Markt plunged 96 per cent in value before shuttering in 2002.
According to Koo, a balance sheet recession struck the German economy. As Germans increased savings, aggregate demand decreased. With fiscal policy somewhat constrained by the Stability and Growth Pact (not really, but a little), the ECB had to step in (our emphasis):
Germany’s actual fiscal deficits modestly exceeded that threshold on several occasions, but the resulting fiscal stimulus was far from sufficient to prop up the economy. The ECB therefore took its policy rate down from 4.75% in 2001 to a postwar low of 2% in 2003 in a bid to rescue the eurozone’s largest economy.
But those ultra-low rates still had little impact on Germany, where balance sheet problems were forcing businesses and households to minimize debt. The money supply grew very slowly, and house prices continued to fall. Naturally there was only minimal inflation in wages or prices.
In Germany, inflation was low and money supply grew slower than the rest of the eurozone, because people were paying down debt. But it was another story in the periphery:
The countries of southern Europe, which had not participated in the IT bubble, enjoyed strong economies and robust private sector demand for funds at the time. The ECB’s 2% policy rate therefore led to sharp growth in the money supply, which in turn fueled economic expansions and housing bubbles.
In short, the ECB’s ultra-low policy rate had little impact in Germany, which was suffering from a balance sheet recession, but it was too low for other countries in the eurozone, resulting in widely divergent rates of inflation.
Which reminded us of just how skewed monetary policy has been inside the eurozone. Fernanda Nechio of the San Francisco Fed did a post a while ago, plotting the ECB’s monetary policy against a simple Taylor Rule for the core and the periphery:
Anyway, back to Koo (our emphasis):
In other words, there would have been no need for such dramatic easing by the ECB—and hence no reason for the competitiveness gap with the rest of the eurozone to widen to current levels—if Germany had used fiscal stimulus to address its balance sheet recession.
The creators of the Maastricht Treaty made no provision for balance sheet recessions when drawing up the document, and today’s “competitiveness problem” is solely attributable to the Treaty’s 3% cap on fiscal deficits, which placed unreasonable demands on ECB monetary policy during this type of recessions. The countries of southern Europe are not to blame.
And so it is today. Essentially, Germany and the periphery have traded places.
The competitiveness issue, which is being addressed albeit slowly, has the problem of overshooting in the core if only moved by monetary policy:
But the 1% policy rate and a 10-year Bund yield under 1.5% are clearly too low for a strong economy like Germany and have prompted house prices to rise sharply for the first time in 15 years.
So instead of letting fiscal policies help smooth out the imbalances — monetary policy is at the forefront. A tool not right for the job, says Koo.
Not that he’s a fan of fiscal integration…
Unfortunately there have been growing calls in the eurozone for fiscal union. But that would only make the problem worse by forcing the same fiscal policy on all countries, regardless of whether they were in a balance sheet recession.
European policymakers simply do not understand the concept of balance sheet recessions. Inasmuch as many continue to argue—whether out of ignorance or emotion—that the current gap in competitiveness is attributable to laziness in the southern European countries, I suspect a proper policy response is still far off.
Monetary Policy When One Size Does Not Fit All – Fernanda Nechio, the Federal Reserve Bank of San Francisco.
Money still matters – Macro and other market musings
Cheat sheet for Europe – FT Alphaville
Richard Koo’s prescription for Greece (and Germany) – FT Alphaville