Meanwhile, in Europe (12). Deconstructing Trichet

from Merijn Knibbe

Introduction. Recently, mr. Trichet, head of the European Central Bank (ECB), raised the Euro-interest rate to an historical still low 1,25%. But considering the state of the economy, this 1,25% rate might still be quite high:

• Looking at it from the Keynesian point of view there still is quite an output gap. Unemployment (U-3) is 9,9%, construction is at 75% of pre-crisis levels and still declining and industrial production is still not back at 2007 levels. Also, restrictions on intra-EU labor mobility are rapidly waning (no, Keynesian thinking is not anathema to supply side thinking, increased labor mobility in fact increases the output gap).
• Looking at it from the monetarist point of view we see that money growth (M1 and M3), though slightly higher than last year, is, with about 2 to 3%, still way below targeted nominal GDP growth (and therewith deflationary)
• Looking at it from the post-Keynesian/accounting point of view, we see that balance sheets of households, companies and governments still show massive private debts – a risk to the economy, surely when inflation goes down and interest rates go up (and yes: a post-Keynesian economist is a Keynesian economist who knows accounting)
• Looking at it from the economic history point of view we have to investigate the possibility of a ‘Danube-miracle’, high economic growth which will raise very low eastern European hourly wage rates (3,60 in Estonia against 20,07 in Ireland) – as price levels in these countries will adapt to German levels this genuine growth will however show up as an increase in the price level
• Looking at it from the radical/libertarian point of view, the ECB may well be an instrument to guarantee the (banking) interests of the mightier states, instead of an impartial body which wisely agrees on the best rate possible

This means that there are sound reasons to investigate if Trichet was right to raise the interest level. Below, I’ll analyze the “introductory statement to the press conference” which accompanied the interest hike to investigate the ideas of Trichet and his economists. First, however, a prelude.

Prelude: central bankers can be wrong . On July 3, 2008, with the Great financial Crisis already visible to anyone except main stream economists, Business Week filed the next news:

“ The ECB Pulls the Rate-Hike Trigger. In a widely expected move, the European Central Bank raises its benchmark interest rate 25 basis points, citing medium-term inflation risks . By BusinessWeek, Standard & Poor’s, and Action Economics staff

Unlike the Federal Reserve, the European Central Bank has one policy mandate: maintaining price stability. And the ECB put its money where its mouth is on July 3, raising its benchmark interest rate 25 basis points to 4.25%. The Swedish Riksbank also raised its benchmark rate 25 basis points, to 4.5%, earlier in the day. The ECB’s move was widely expected by financial markets. Recent hawkish comments and the reaction to rising overall interest rates in the euro zone, along with stronger economic data, at least from Germany, had changed expectations to a rate hike in recent months. “We expect another rate hike, perhaps in October, but not an extended string of them,” wrote Standard & Poor’s chief economist David Wyss in a July 3 note” http://www.businessweek.com/investor/content/jul2008/pi2008073_684695.htm

Deconstructing Trichet: the “introductory statement to the press conference” (http://www.ecb.int/press/pressconf/2011/html/is110407.en.html)In the “introducty statement” to the April 7 press conference the ECB explains its policy, i.c. raising the interest rate. What does this document tell us about the mindset of Trichet and his economists? Quite a lot!

 A. Trichet and his economists look at the wrong metric. In 1982 mr. Volcker started to slash inflation in the USA. At that thime, Consumer Price Index (CPI) inflation was with 14%. The more broadly based GDP deflator however rose with ‘only’ 10%. This was still quite and increase but it was considerable less then Consumer Price Inflation: metrics matter. Differences between these two metrics are often smaller – but the example shows that they can also be quite large. As the GDP deflator is the more broadly based metric, it is the better one to guide economic policy. In the seventies and eighties, Jelle Zijlstra, the then president of the Dutch Central Bank, was keenly aware of this (according to the ‘Jaarverslagen’ of the Bank. In the eighties and nineties, Duisenberg, the then president of the Dutch Central Bank who would move on to become the first president of the ECB, was much more vague about this. Trichet and his economists doe not seem to be aware of the difference, as they explicitely target the CPI as the target for monetary policy. According to the “introductory statement” the goal of monetary policy is to keep CPI inflation “below, but close to 2%”. This is either ignorant or a clumsy way to keep wage demands in check. Let’s quote the “statement”:

“With regard to price developments, euro area annual HICP (Harmonized Index of Consumer Prices, M.K.) inflation was 2.6% in March 2011, according to Eurostat’s flash estimate (turned out to be 2.7% on April 14, M.K.), after 2.4 % in February. The increase in inflation rates in early 2011 largely reflects higher commodity prices. Pressure stemming from the sharp increases in energy and food prices is also discernible in the earlier stages of the production process. It is of paramount importance that the rise in HICP inflation does not lead to second-round effects in price and wage-setting behaviour and thereby give rise to broad-based inflationary pressures over the medium term. Inflation expectations must remain firmly anchored in line with the Governing Council’s aim of maintaining inflation rates below, but close to, 2% over the medium term”.

The CPI is a very important index – but is was never designed to be the target for monetary policy. It was designed to estimate purchasing power of households (more on that below). I do not know any metric specifically designed to guide monetary policy but the GDP deflator is admittedly a better one than the CPI. But even then there is more to prices than just GDP. By now, it should be be clear to Trichet and his economists that asset price inflation (houses, stocks) is important too. House prices are declining – except for Germany, but German house prices have seen quite some declines during the last decades. No inflationary tendencies overthere. Stock prices are up, surely some inflationary tendencies overthere. And there are more variables which show inflation or deflation. Profits are up, which is of course an inflationary pressure: profit inflation exists. The exchange rate is important too. The Euro recently appreciated – which (if mr. P. Krugman is to be believed) will cause deflationary pressures in Europe (read: a larger output gap and more unemployment) and inflationaty pressures (read: a smaller output gap and lower unemployment) in the USA and the UK. Another very important price: wages. Wages still increase, but less than headline inflation – and increases are ever lower. Even the increase of energy prices will dampend demand and inflationary tendencies in other markets, as this is in fact a terms of trade problem.

Inflation is a complex phenomenon. Trichet and his economist do, according to the “introductory statement” not seem to graps this. Better metrics are available.

B. Trichet and his economists have problems with simple arithmetic. As mentioned above, money growth is way below targeted or actual growth of nominal GDP. But this gap has become slightly smaller, which does not mean that is has become inflationary – but that is has become less deflationary. Can anybody explain to me why Trichet and his economists are afraid of Money growth which is below the targeted increase of nominal GDP (especially when commodity prices are up)?

 C. Trichet and his economists do not seem to grasp the idea of an output gap . Ecomists used to talk about output gaps. Modern economists have defined these gaps away: the so called Dyamic Stochastic General Equilibrium models can not predict cyclical unemployment – as it’s not defined in the model. It’s an impossibility. It just does not exist. We don’t want it, as it’s upsetting – so we don’t model it. Trichet and his economists seem to be victims of this line of thinking. The “introductory statement” states:

“Following the 0.3% quarter-on-quarter increase in euro area real GDP in the fourth quarter of 2010, recent statistical releases and survey-based indicators point towards a continued positive underlying momentum of economic activity in the euro area in early 2011”

A 0.3% quarter-on-quarter GDP increase? In case of a severe output gap (the present situation) this is below-trend growth, which won’t increase inflationary pressures. It’s a sign that the crisis is not yet over. Yes, unemployment may be down, and utilization rates may be up – but not because of increases in production, but because people opt out of the labor force and because productive capacity becomes obsolete.

D. There is no doubt in Trichet’s mind that, if need be, it’s necessary to slaughter the Spanish economy to maintain price stability in Germany.

At the end of the “introductory statement” Trichet answers questions. Again and again, he just does not want to talk about the problems of Spain (20% unemployment), Ireland, Estonia, Portugal,  and Greece (looming default) and the like. Read his answers! They do show a Leviathan which which tries to engineer a low wage/pleasant climate pension resort along the boards of the mediterrenean which, despite it’s low wages, still pays back debts to northern European banks which, at the time, were not professional enough to send a shrewd observer to these countries to investigate risks. I mean – that should have been the core business of banking… But I don’t mind! As I’m living in the Netherlands, I’m really starting to look forward at a nice, cheap villa in Tuscany and low wage gardeners and cleaning ladies…. (let’s hope that higher interest rates don’t bust the already deflating Dutch mortgage bubble, however).

P.S. – my own idea is that there is no perfect Euro interest rate, as differences between countries are too large

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