A global experiment in the fiscal/monetary mix

February 19, 2012 2:25 pm by Gavyn Davies

A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings.

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Posted in Eurozone, Global economy, Macroeconomics, Monetary policy, US | Permalink

Eurozone’s reluctant take-over bid for Greece

February 17, 2012 1:43 pm by Gavyn Davies

Talks in the eurozone about the intended €130bn bail-out package by the EU and IMF have become more convoluted than ever this week. The latest deadline for a final decision by the eurozone is now said to be Monday, and there is no certainty that the deal will be ratified even then.

However, assuming that the Germans, Dutch and Finns are willing to sanction the deal, which on balance seems likely, the package will produce a further large increase in the exposure of eurozone taxpayers to Greece, without reducing the overall burden of Greek indebtedness very much at all.

The deal would therefore involve a further big step towards the “socialisation” of Greek debt to other eurozone sovereigns, while reducing the exposure of the private sector to any further Greek default. From now on, the burden of Greek debt will either by borne by Greek taxpayers, or by eurozone/IMF taxpayers, depending on whether additional defaults occur in future. It will be a simple head-to-head between sovereign governments, which is why the debate is becoming so heated.

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Tags: Greece, IMF
Posted in Eurozone, Macroeconomics | Permalink

Greek lessons for the eurozone

February 12, 2012 5:01 pm by Gavyn Davies

The Greek Parliament votes tonight on the latest austerity package, which Prime Minister Papademos says is essential if the nation is to avoid default, departure from the eurozone and economic chaos. If the motion fails, then markets will need to contemplate whether the euro can survive the contagion which would be caused by disorderly default on Greek debt.

In the more likely event that the motion is passed, and other political conditions are met, then the eurozone group of finance ministers is likely to approve the package on Wednesday. The second official bail-out of €130 billion would then go ahead, subject only to final agreement on private sector involvement (PSI) for debt write-downs of €100 billion.

Since agreement on PSI is also likely, the bail-out funds should flow before Greece needs to redeem €14 billion of government bonds which fall due on 20 March. Where does this leave Greece, and what are the lessons of the Greek deal for the rest of the eurozone?

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Posted in Macroeconomics | Permalink

Is QE still working?

February 8, 2012 3:24 pm by Gavyn Davies

The Bank of England meets on Thursday with expectations running high that the MPC will announce a further large dose of quantitative easing. Even if they pass this month, which seems possible, this is likely to be only a temporary postponement. Whenever it comes, the next move will be another bout of “plain vanilla” QE, involving the purchase of £50-75bn of government bonds, and taking the overall Bank of England holdings to over one third of the total stock of gilts in issue.

Meanwhile, the Fed is still debating whether to increase its holdings of long dated securities, and if so whether to focus once again on government debt, or to re-open its purchases of mortgages. Any further QE would be contentious on the FOMC, but there is probably still a majority in favour.

Central bankers, unlike many others, have not lost faith in the efficacy of QE. The vast majority of them not only believe that additional asset purchases can further reduce long term bond yields at a time of zero short term interest rates, but also that this can increase real GDP growth, compared with what otherwise would have occurred. Are they right?

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Tags: Bank of England, bond yields, central banks, Federal Reserve, liquidity trap, QE
Posted in Macroeconomics, Monetary policy, UK, US | Permalink

Assessing the risk of a fiscal crisis

February 5, 2012 4:35 pm by Gavyn Davies

The debate on the correct setting for fiscal policy at a time of recession is probably the oldest debate in macro-economics. One key element in the debate is the trade off between supporting output growth in the short term, versus the need to control the growth of public debt in the long term.

There are some economists who do not recognise that this trade off exists at all, because they claim that an increase in the fiscal deficit cannot impact aggregate demand, even in the short run. But this is not a view which I believe to be supported either by empirical research or by economic theory (except on some very restrictive assumptions about Ricardian Equivalence or Says Law).

I recognise that this last statement is very contentious, but it is not my subject today. Instead, I would like to take as given the assumption that a temporary easing in fiscal policy (of the type advocated last week by Martin Wolf for the UK) will increase aggregate demand in the near term. Accepting this, I would then like to ask whether the benefits of an immediate boost to aggregate demand outweigh the costs of higher public debt, and the consequent risks of a fiscal crisis. That is the nub of the issue which is, or should be, exercising policy-makers in the real world today.

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Posted in Macroeconomics | Permalink

Fear and greed in the eurozone

January 29, 2012 5:08 pm by Gavyn Davies

According to reports from Davos, the consensus among global economic leaders is that the most dangerous phase of the eurozone crisis may now be over. Mario Draghi has emerged as the hero of the hour. By using the central bank balance sheet aggressively to stem the credit crunch, the ECB President has dampened bankruptcy fears in the financial system, and talk of “another Lehman” has died down. But while market fear is on the wane, greed has not yet taken over, and that leaves much work for the central bank to do.

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Posted in Macroeconomics | Permalink

Asset market returns in a liquidity trap

January 25, 2012 6:31 pm by Gavyn Davies

Mount Fuji, Japan. AFP/Getty Images

Until recently, Keynes’ notion of a liquidity trap was of great interest to macro-economists, but was viewed by investors as a rare aberration which, outside Japan, could be safely ignored. In the aftermath of the 2008 credit crunch, all that has changed. Many developed economies seem to be falling into a liquidity trap, and may stay there for several years. What does this imply about asset returns? (This blog is a slightly longer version of an article which first appeared in the FT’s Market Insight column on 24 January, 2012.)

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Tags: bond yields, credit crunch, liquidity trap
Posted in Global economy, japan, Macroeconomics, Monetary policy | Permalink

Fed to reveal almost all

January 22, 2012 4:50 pm by Gavyn Davies

Ben Bernanke has been very focused on the Fed’s “communications strategy” for several years now, and has patiently pushed the FOMC in his desired direction during a series of detailed discussions. Now it seems that he has reached his destination, and will reveal all (or almost all) in his press conference after the FOMC meeting which begins on Tuesday. Always a fan of explicit inflation targets, the chairman seems finally to have won agreement from colleagues on establishing a formal objective for core inflation of about 2 per cent, though the FOMC will also need to keep Congress happy by talking about its long term unemployment objectives as well. More unconventionally, each member of the FOMC will also publish for the first time their projections for the Fed funds rate extending to 2016.

What is the motivation behind these changes? Mr Bernanke has normally justified such steps in terms of stabilising expectations about the Fed’s genuine intentions, especially on inflation and the forward path for interest rates. At a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman is looking for alternative ways of easing monetary conditions without printing more money. Modern macro-economics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see.

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Tags: Ben Bernanke, Inflation, The Fed
Posted in Macroeconomics | Permalink

How the Fed defeated President Truman to win its independence

January 20, 2012 2:36 pm by Gavyn Davies

Getty Images

In 1951, an epic struggle between a US president who stood on the verge of a nuclear war, and a central bank that was seeking to establish its right to set an independent monetary policy, resulted in an improbable victory for the central bank. President Harry Truman, at war in Korea, failed in a brutal attempt to force the Federal Reserve to maintain a 2.5 per cent limit on treasury yields, thus implicitly financing the war effort through monetisation. This victory over fiscal dominance is often seen as the moment when the modern, independent Fed came into existence.

The idea that the central bank should place a cap on the level of bond yields is firmly back on the agenda, at least in the eurozone. This week, Italian prime minister Mario Monti said that he was increasingly optimistic that his country’s bond yields might soon be capped. Although he stopped short of saying that this would be done by the European Central Bank, there really are no other viable candidates to achieve this. Furthermore, many economists are arguing that this is the right policy, since Italy is now following a sustainable budgetary policy which deserves to be rewarded by ECB action in the bond market.

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Tags: ECB, Federal Reserve, Harry Truman, Italy, Mario Monti
Posted in Central Banks, Eurozone, Macroeconomics, Monetary policy | Permalink

Inflation and the central banks’ new paradigm

January 15, 2012 6:18 pm by Gavyn Davies

Last week, in the first of a series of blogs on the use of the central bank printing press, I argued that the deliberate decision to increase the monetary base several fold in the US, the eurozone and the UK is an almost unprecedented event in the history of economic policy. Only in Japan, in the early 2000s, has anything like this been seen before.

In this blog, the second in the series, I ask whether this remarkable injection in central bank liquidity is destined to result in rising global inflation in coming years.

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Tags: central banks
Posted in Macroeconomics | Permalink

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