Cyclical sovereignty

Only two of the world’s major economic blocks appear to have cyclical autonomy – China and the United States. For many decades now, Japan’s ability to stimulate domestic demand has been trivial relative to cyclical swings in external demand. With large industrial shares of GDP in Germany and Italy, persistent export orientation, and secular declines in domestic demand growth driven by demography, the Eurozone has been steadily tending to this model.

The global industrial sector is either in recession on or the brink, so Europe is faltering. Germany may already be in recession. Why? On the face of it, Europe has loose monetary policy and has eased fiscal policy. But none of it seems to matter. Large export shares of GDP, with more volatile growth than domestic demand, imply that Chinese policy makers now determine the European economic cycle. When China launches a stimulus, Europe recovers, when China tightens, Europe teeters on the brink. The flip-slide of relentless German mercantilism is a loss of cyclical sovereignty. The Japanification of Europe, in this sense, now appears complete.

Is there an alternative, or is this the Eurozone’s destiny? We know that fiscal policy can never be a seriously forceful counter-cyclical tool in Europe. This is an inevitable consequence of Germany’s loss of monetary sovereignty. There is simply no way Germany will permit a central European authority issue liabilities on its behalf. The existential turmoil of witnessing the Bundesbank being overruled on every single important monetary policy development is difficult enough. Words to the contrary amount to wishful thinking.

So what about the ECB? Mario Draghi has already saved the Eurozone from its suicidal attempt at sovereign default during the Eurocrisis. He has also devised by far the most significant monetary policy innovation since the GFC – dual interest rates. By ‘dual interest rates’ I specifically mean using two policy rates, a lending rate and a deposit rate, to generate monetary stimulus.

The ECB now sets two interest rates which matter. The lending rate on TLTROs, and the deposit rate on bank reserves. The first, and significant break with historic central bank practice, involved providing loans under TLTRO II at a rate equal to the deposit rate of -0.4%. Under these programmes, the European Central Bank is in effect paying banks to make new loans to the private sector.

Despite breaking with tradition, these TLTROs have been modest, with muted effects. But it is clear that the power of this monetary tool is limitless, in contrast to QE, negative interest rates or forward guidance, all of which suffer from diminishing marginal impact [1]. If you are in doubt, consider the following. The ECB announces a TLTRO equivalent to 20% of Eurozone GDP at a negative interest rate of 2%, fixed for ten years, and leaves the deposit rate unchanged. The quantity of the TLTRO is fixed, there will be a upward limit to how much an individual bank can bid for, and the lending rate of -2% must be passed on to borrowers and is only available to new loans financing new investment by the private sector sector. Even in the Eurozone there is a surfeit of investment projects with positive expected returns. There will be overwhelming demand for 10-year loans fixed at -2%.

There are a number of objections to this proposal, some of which surfaced in the Financial Times. Firstly, the fear of ‘round-tripping’, where banks borrow TLTROs at -2% and simply hold reserves at -0.4% and make a profit. Under the proposed design, this is not a problem. The -2% interest rate is only available for new loans financing investment, it has to be passed on to borrowers (various rules could be devised for this), and individual banks cannot target their reserve holdings so simply.

The second fear is that the ECB will make a loss due to negative net interest income on the TLTROs relative to the deposit rate. A lot has already been written on this, and it is patently spurious. Central bank ‘losses’ don’t matter, and QE exposes central banks to much large potential losses than negative interest rate TLTROs. For economists obsessed with this topic, there is a very simple short-cut to the correct answer. Given that the ECB can create euros at will there is only a problem with its balance sheet if for some reason it cannot shrink the stock of reserves. The existence of tiered reserves and negative rates proves that this can never be the case. If the central bank wants to shrink reserves and raise rates it can simply increase required reserves and charge a negative interest rate on required reserves.

What then is holding the ECB back? It’s not clear. Having devised the dual interest rate TLTRO, an instrument of limitless monetary power, the ECB should step up and use it. It’s failure to do so may reflect widespread negligence on behalf of the macro-policy community to draw obvious conclusions. The abject failure of the media to raise any serious points about ECB monetary policy at post-meeting press conferences is also a serious dereliction of duty.

Cyclical autonomy is within the Eurozone’s grasp. It will require intellectual leadership, and bravery. The macroeconomics profession is on the verge of letting us all down – again.

[1] For chapter and verse on the effects of the various ECB tools, this speech by Chief Economist Philip Lane is a tour de force.