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ECB rate rise : the beginning of a new phase?

by eurogreen Fri Apr 8th, 2011 at 05:28:15 AM EST

This is more of an inquiry than a diary.

With today's rise of the repo rate from 1% to 1.25%, we seem to be exiting "emergency mode" and, according to the ECB's logic, returning to "business as usual". Inflation greater than 2% is anticipated, therefore, automatically, interest rates must rise. It now seems likely that they will continue to rise, tending to 2% before year's end.

Problem : most of Europe is enduring cost inflation, while wages do not follow; only Germany meets the standard criteria for increased interest rates.

Worse : the distressed nations (Greece, Portugal, Ireland) will be further stressed by rate increases. To say nothing of distressed mortgage holders...

The new phase would seem to spell disaster for debtors (individual or governments), for whom inflation would seem their best hope of long-term solvency.

This seems prima facie evidence that the ECB is the Bundesbank by any other name... and smells as sweet.

But perhaps There Was No Alternative?

Discuss.

front-paged by afew


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In today's Eurointelligence Daily Briefing Wolfgang Münchau writes:
ECB is expected to decide on a pre-announced 25bp rise in repo rates to 1.25% today; Deposit rates are likely to be left at 0.25%, effectively neutralising the rise in repo.
Not to make a fine point of it, but an one-month (21-business-day) exponential moving average of EONIA was until today within 35bp (bp = "basis point" or 0.01%) below the repo rate or, equivalently, over 40bp above de deposit facility. It has been as low as 10bp above depo.

In addition, Euribor 1M is now within a few bp of the 1% former repo rate. In the time since June 2009 it has been as low as 15bp above depo and 60bp below repo for about a year.

See the charts labelled "EONIA and ECB Policy rates" in my diary the EONIA heartbeat. They're over a month out of date but the raising trend in EONIA and eonia volatility has persisted so they're good charts for illustrative purposes.

While I can't find fault with the ECB raising the repo rate while maintaining full-tender liquidity auctions, I don't think one can be quite so sanguine about the consequences of a rate rise, except in so far as the rise has already been priced in in the interest rates.

The reason is that insolvent banks need to be gradually pushed over the edge since governments won't recapitalize them of their own accord despite the sternly worded warning from Commissioner Almunia at the start of December 2010. It appears that the only politically palatable way to do this is to raise the repo rate.

However, Münchau was wrong in that the ECB did not just raise the repo rate while keeping depo at 25bp. They also raised de depo rate to 50bp. This, I think, is true insanity. But it is consistent with the ECB's view of things.

I say this because the depo rate is what the ECB pays for excess reserves held at the ECB. Raising this rate means that solvent banks having excess liquidity have a bigger incentive to park that excess liquidity at the ECB. If what you want to do is withdraw liquidity from the system, raising the depo rate makes sense. The ECB believes there is excess liquidity.

I believe there is no excess liquidity and the liquidity that there is needs to circulate. To that end, keeping the depo rate low keeps the incentives to circulate the liquidity. But if you believe in the quantity theory of money and believe there is excess liquidity and believe there are inflationary pressures, you won't want liquidity to circulate.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Apr 7th, 2011 at 09:31:27 AM EST
Belief in the quantity theory of money is prima facie evidence of incompetence in a central banker (or anybody else who is tasked with forecasting, regulating or studying the political economy).

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Apr 7th, 2011 at 10:26:26 AM EST
[ Parent ]
You sound like a crackpot. What are your qualifications?

Besides, it's not the quantity theory, it's their internal Dynamic Stochastic General Equilibrium model.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Apr 7th, 2011 at 10:28:38 AM EST
[ Parent ]
You sound like a crackpot. What are your qualifications?

I'm an economist from a Very Serious University.

Besides, it's not the quantity theory, it's their internal Dynamic Stochastic General Equilibrium model.

A rose by any other name...

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Apr 7th, 2011 at 06:58:45 PM EST
[ Parent ]
ECB: Smets-Wouters (2003) Model
The main difference between empirical DSGE models and the more traditional macroeconometric models (such as the AWM) is that both the parameters and the shocks to the structural equations are related to deeper structural parameters describing household preferences and technological and institutional constraints.

These micro foundations have three advantages:

  1. They provide a theoretical discipline on the structure of the model that is being estimated, which may be particularly helpful in those cases where the data themselves are not very informative, for example regarding the long-run behaviour of the economy or because there has been a regime change.
  2. Being able to relate the reduced-form parameters to deeper structural parameters makes the use of the model for policy analysis more appropriate, i.e. less subject to the Lucas critique, as those structural parameters are less likely to change in response to changes in policy regime.
  3. Micro-founded models may provide a more suitable framework for analysing the optimality of various policy strategies as the utility of the agents in the economy can be taken as a measure of welfare.

For these reasons, staff at the ECB and the Eurosystem have started to develop empirical DSGE models for monetary policy analysis. The Smets-Wouters (2003) Model is an example of such a medium-sized DSGE model, which has been estimated on the basis of quarterly euro area macro data. The model features three types of economic agents: households, firms and the central bank. Households decide how much to consume, how much to invest and how much to work and at what wage. Firms employ workers and capital and decide how much to produce and at what price to sell their products.


Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Fri Apr 8th, 2011 at 02:14:20 AM EST
[ Parent ]
It would seem, from the ECB's own description, especially point 1, that the primary virtue they see in their DSGE model is that it allows them to proclaim any policy they wish based on any conditions that arise. This is probably as close to an admission of that reality as we are likely to get.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Apr 8th, 2011 at 09:36:53 AM EST
[ Parent ]
Empirical models? That's not very Serious.

but I suppose they model all the entities as rational actors with perfect knowledge... That would be the Serious thing to do.

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Fri Apr 8th, 2011 at 11:31:08 AM EST
[ Parent ]
You can make Serious models with imperfect information, as long as you don't try to do it as an undergrad. You need to be properly indoctrinated what model behaviour to aim for, or you might end up modelling imperfect information in a manner that is too close to how it actually operates in the real world.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Fri Apr 8th, 2011 at 11:38:39 AM EST
[ Parent ]
That would lack elegance and so be Wrong.
by afew (afew(a in a circle)eurotrib_dot_com) on Fri Apr 8th, 2011 at 11:48:51 AM EST
[ Parent ]
After one year of macro studies on by own.. I can finally udnerstand you... we should make a guide to explain macro in four or five easy point for anyone interested.

Given that there is not a lot we know for sure about macro is a very good exercise. I would do it. as soon as I have time.

A pleasure

I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude

by kcurie on Fri Apr 8th, 2011 at 05:00:07 AM EST
[ Parent ]
We need:

  1. a guide to macro for dummies
  2. a guide to macro for dummies in positions of authority

Kindly proceed.
by afew (afew(a in a circle)eurotrib_dot_com) on Fri Apr 8th, 2011 at 05:30:42 AM EST
[ Parent ]
  1. The little guy gets screwed.
  2. See 1.
by ThatBritGuy (thatbritguy (at) googlemail.com) on Fri Apr 8th, 2011 at 06:35:27 AM EST
[ Parent ]
 The short piece by Keynes THE GREAT SLUMP OF 1930, that I included in Towards an Economic Tutorial, is about as good a two page introduction to macro as one could hope to get, especially if the reader does the simple exercises in arithmetic that Keynes recommends.  Some of the links, especially Irving Fisher's The Debt-Deflation Theory of Great Depressions, the two Minsky links, and the Tobin article would make a good "Related Reading" list.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Apr 8th, 2011 at 10:00:14 AM EST
[ Parent ]
Correct link to The Great Slump of 1930, by John Maynard Keynes.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Fri Apr 8th, 2011 at 10:09:53 AM EST
[ Parent ]
The Great Slump of 1930, by John Maynard Keynes

3. How can it be that prices have fallen more than costs? For costs are what a business man pays out for the production of his commodity, and prices determine what he gets back when he sells it. It is easy to understand how for an individual business or an individual commodity these can be unequal. But surely for the community as a whole the business men get back the same amount as they pay out, since what the business men pay out in the course of production constitutes the incomes of the public which they pay back to the business men in exchange for the products of the latter? For this is what we understand by the normal circle of production, exchange, and consumption.

4. No! Unfortunately this is not so; and here is the root of the trouble. It is not true that what the business men pay out as costs of production necessarily comes back to them as the sale-proceeds of what they produce. It is the characteristic of a boom that their sale-proceeds exceed their costs; and it is the characteristic of a slump that their costs exceed their sale-proceeds. Moreover, it is a delusion to suppose that they can necessarily restore equilibrium by reducing their total costs, whether it be by restricting their output or cutting rates of remuneration; for the reduction of their outgoings may, by reducing the purchasing power of the earners who are also their customers, diminish their sale-proceeds by a nearly equal amount.

5. How, then, can it be that the total costs of production for the world's business as a whole can be unequal to the total sale-proceeds? Upon what does the inequality depend? I think that I know the answer. But it is too complicated and unfamiliar for me to expound it here satisfactorily. (Elsewhere I have tried to expound it accurately.) So I must be somewhat perfunctory.

The mechanism by which this happens is credit, which is intertemporal.

In a boom, goods and services (including capital goods and services) are bought on credit, in a cycle in which the expectation that prices will grow justifies lending for purchase since what is purchased will rise in value enough to repay the loan. So, in a boom sales proceeds exceed costs because the sales are being paid not only with the money that exists today, but with money loan money which will be paid back in the future.

In a slump, debt is being repaid and no new credit is extended because decreasing prices make debt unlikely to be paid back. So, prices exceed costs.

Effectively the economic cycle consists of paying for the profits of the boom with money coming from the subsequent bust, through the intertemporal nature of cretit.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Fri Apr 8th, 2011 at 10:16:48 AM EST
[ Parent ]
I thought I had checked all three links! Thanks, Mig.

Immediately following what you quoted from Keynes' article is this:

Let us take, first of all, the consumption-goods which come on to the market for sale. Upon what do the profits (or losses) of the producers of such goods depend? The total costs of production, which are the same thing as the community's total earnings looked at from another point of view, are divided in a certain proportion between the cost of consumption-goods and the cost of capital-goods. The incomes of the public, which are again the same thing as the community's total earnings, are also divided in a certain proportion between expenditure on the purchase of consumption-goods and savings. Now if the first proportion is larger than the second, producers of consumption-goods will lose money; for their sale proceeds, which are equal to the expenditure of the public on consumption-goods, will be less (as a little thought will show) than what these goods have cost them to produce. If, on the other hand, the second proportion is larger than the first, then the producers of consumption-goods will make exceptional gains. It follows that the profits of the producers of consumption goods can only be restored, either by the public spending a larger proportion of their incomes on such goods (which means saving less), or by a larger proportion of production taking the form of capital-goods (since this means a smaller proportionate output of consumption-goods).

But capital-goods will not be produced on a larger scale unless the producers of such goods are making a profit. So we come to our second question--upon what do the profits of the producers of capital-goods depend? They depend on whether the public prefer to keep their savings liquid in the shape of money or its equivalent or to use them to buy capital-goods or the equivalent. If the public are reluctant to buy the latter, then the producers of capital-goods will make a loss; consequently less capital-goods will be produced; with the result that, for the reasons given above, producers of consumption-goods will also make a loss. In other words, all classes of producers will tend to make a loss; and general unemployment will ensue. By this time a vicious circle will be set up, and, as the result of a series of actions and reactions, matters will get worse and worse until something happens to turn the tide.

....

Why is there an insufficient output of new capital-goods in the world as a whole? It is due, in my opinion, to a conjunction of several causes. In the first instance, it was due to the attitude of lenders--for new capital-goods are produced to a large extent with borrowed money. Now it is due to the attitude of borrowers, just as much as to that of lenders.....A wide gulf, therefore, is set between the ideas of lenders and the ideas of borrowers for the purpose of genuine new capital investment; with the result that the savings of the lenders are being used up in financing business losses and distress borrowers, instead of financing new capital works.

....

Seldom in modern history has the gap between the two been so wide and so difficult to bridge. Unless we bend our wills and our intelligences, energized by a conviction that this diagnosis is right, to find a solution along these lines, then, if the diagnosis is right, the slump may pass over into a depression, accompanied by a sagging price-level, which might last for years, with untold damage to the material wealth and to the social stability of every country alike. Only if we seriously seek a solution, will the optimism of my opening sentences be confirmed--at least for the nearer future.


And, of course, the slump did pass over into a depression. Government spending on capital projects did help -- so long as it was continued -- but the real cure was the reversion to state planning needed to prepare for WWII. This brought about a return in confidence to the business class. That aspect is well described in Systemic Fear, Modern Finance, and the Future of Capitalism by Bichler and Nitzan  

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Apr 8th, 2011 at 11:55:32 AM EST
[ Parent ]
Nevertheless, according to NBBooks:
The "Arsenal Democracy" story is actually mostly myth: U.S. captains of industry had to be dragged, kicking and screaming, into industrial mobilization by some very determined and angry Army officers.


Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Fri Apr 8th, 2011 at 12:04:17 PM EST
[ Parent ]
U.S. captains of industry had to be dragged, kicking and screaming, into industrial mobilization...

Not the first or last time they had to be clubbed over the head to insure their own prosperity. Most probably didn't understand that the economics they had studied or read was intended as class based propaganda, not as a guide to practical economic success, let alone survival.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Apr 8th, 2011 at 01:39:16 PM EST
[ Parent ]
These kinds of things are best written by people as they are learning. Once you think you know what you're talking about you become unintelligible.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Fri Apr 8th, 2011 at 05:59:07 AM EST
[ Parent ]
Jake:
Belief in the quantity theory of money is prima facie evidence of incompetence in a central banker

That presupposes that economic theories are chosen and defended on the basis of their explanatory, analytic and predictive power. But they are instead chosen and defended on the basis of their usefulness to the economic elite in their efforts to part all but themselves from their money. The problem is that they have succeeded too well and cannot figure what to do now.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Apr 8th, 2011 at 12:54:28 AM EST
[ Parent ]
I'm wondering whether shifting the benchmark rate is a matter of bowing to the inevitable, given that effective interest rates have been creeping up. We are asked to believe that interest rates are decreed, rather than determined by objective economic phenomena. Or is the decreed interest rate a sufficient economic phenomenon, insofar as it is accompanied by a promise of unlimited liquidity...?

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Thu Apr 7th, 2011 at 10:46:02 AM EST
[ Parent ]
It now seems likely that they will continue to rise, tending to 2% before year's end.

Once the ECB starts raising or lowering rates it is quite capable of doing it a a quarter point per quarter. See this chart from my EONIA diary:



Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Apr 7th, 2011 at 04:39:40 PM EST
Worse : the distressed nations (Greece, Portugal, Ireland) will be further stressed by rate increases. To say nothing of distressed mortgage holders...

The interest rate rise stresses mostly the banks.

Interbank lending (Euribor) on which lending to states and individuals is based, and to which mortgages are pegged in some countries, has been rising for a number of months, so the current rise is unlikely to have noticeable effects on Euribor.

I should note that Euribor, like LIBOR, is based on a survey, not on actual interbank transactions, and when the market is very thin as is the case now the Euribor rate is basically fictitious. The banks set it at what they feel like. And that's the benchmark for lending to the real economy. Oh joy.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Apr 7th, 2011 at 04:46:35 PM EST
With today's rise of the repo rate from 1% to 1.25%, we seem to be exiting "emergency mode" and, according to the ECB's logic, returning to "business as usual". ...

...

The new phase would seem to spell disaster for debtors (individual or governments), for whom inflation would seem their best hope of long-term solvency.

The new phase is more related to the need/desire to see the banking sector finally restructured and recapitalised and off life support. Some of the healthier banks are already off life support and the others need a little nudge since governments and regulators aren't doing their job here.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Apr 7th, 2011 at 04:48:30 PM EST
Problem : most of Europe is enduring cost inflation, while wages do not follow; only Germany meets the standard criteria for increased interest rates.

To you that is a problem. The ECB's stated policy goal is to prevent at all costs that wages follow costs.

They call this "second round effects".

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Thu Apr 7th, 2011 at 04:51:09 PM EST
They call this "second round effects".

The results of which are similar to the effects the drunken "Ivan Muzhakh" produced on his foundering donkey by beating it in the memorable scene from Brothers Karamazov.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Apr 8th, 2011 at 01:05:51 AM EST
[ Parent ]
New phase in austerity. EU = The Robber Baron.

EUOBSERVER / GODOLLO, HUNGARY - European Union finance ministers meeting in Godollo, Hungary on Friday (8 April) have given the green light to launch talks not just with the caretaker government of Portugal but also the "main opposition parties" for a bail-out of around €80 billion.

In return for the financial assistance, the caretaker government and opposition must agree to an "ambitious" three-year programme of liberalisation, privatisation and spending cuts.

They are seriously robbing the public domain to pay private debts. Pure robber barons.

In couple of weeks in Finland are parliament elections and something really strange is happening here. Not only the populist party, but also SDP, left wing coalition and christian democrats (all opposition) are against franco-german bank bailout. Only ruling parties (right wing coalition, center party and greens) are for. Will be very interesting.

by kjr63 on Fri Apr 8th, 2011 at 05:59:28 PM EST
The EU is being destroyed by EPP rule. But the Social Democrats share responsibility by virtue of having adopted third-wayist policies and effectively establishing an economic policy consensus with the EPP. They're the good cop to the EPP's bad cop.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Sat Apr 9th, 2011 at 06:36:07 PM EST
[ Parent ]
They're the good cop to the EPP's bad cop.

That is an excellent metafora.

by kjr63 on Sun Apr 10th, 2011 at 06:22:52 PM EST
[ Parent ]
It's more that the Social Democrats adopt as pragmatism succumbing to the ideology of the EPP. That's what they've been doing for the last 20-30 years and for good reasons.

"Eurozone leaders have turned a 50bn Greek solvency problem into a 1,000bn existential crisis for the European Union." David Miliband
by Kostis Papadimitriou on Wed Apr 13th, 2011 at 05:49:02 PM EST
[ Parent ]
For understandable reasons.

Good ones? Not so much.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Apr 13th, 2011 at 06:45:38 PM EST
[ Parent ]
"Good", because whether I like it or not, that was what the society/electorate desired at the time. The alternative was to stick to your values and remain "unelectable". The alternative to New Labour was not Labour, it was Thatcher/Major. How this happened, it is another story that deserves renewed discussion in the light of the current events.

"Eurozone leaders have turned a 50bn Greek solvency problem into a 1,000bn existential crisis for the European Union." David Miliband
by Kostis Papadimitriou on Thu Apr 14th, 2011 at 02:18:27 AM EST
[ Parent ]
Electoral expediency does not justify purging the ranks of anybody who remembers how to do responsible policy.

Whether electoral expediency justified Tory Bliar and Gerhard Schröder is a debatable point. But electoral expediency never justified internalising the bullshit they were spewing for public consumption, to the extent that they no longer had any real social democrats in the second echelon to replace the third-way flim-flam artists when they became a liability. The fact that the PES parties that they failed to purge the third-wayers around 2006 (when it was obvious to everybody who was paying attention that we were headed for a serious crash) was a political decision for which they are politically responsible.

They were pandering to a public that had gone temporarily insane, and now they have institutionalised the insanity. They deserve everything that's coming to them, and we can only hope that they don't waste too much of their dying breath on disrupting the ascent of real social democrats like Die Linke.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Apr 14th, 2011 at 05:35:28 AM EST
[ Parent ]
It's more than that. See European Tribune - Comments - Stick the fork in Zapatero: he's done
Los asesores económicos del presidente Zapatero | nuevatribuna.es (22.5.2009)PM Zapatero's economic advisors - NuevaTribuna.es
Extended quotes translated in the ET comment.

Economics is politics by other means
by Migeru (migeru at eurotrib dot com) on Thu Apr 14th, 2011 at 05:40:53 AM EST
[ Parent ]


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