This morning has brought an intriguing opinion piece in the Alphaville section of the Financial Times. It concerns the European Central Bank and comes from what you might call a classic insider as the header suggests.
Lorenzo Bini Smaghi, Société Générale chairman, Project Associate at the Harvard Kennedy School’s Belfer Center for Science and International Affairs, and Senior Fellow at LUISS School of European Political Economy in Rome.
This covers a lot of ground as after all shouldn’t being chairman of Societe Generale be a full-time job? This dichotomy where lower jobs are full-time but more senior ones are not seems to be ever more common. With a share price less than a quarter of what it was at its peak and furthermore it being down 25% over the past year you might think directors would be fully employed trying to make things better. Of course we are invariably told that such people can have so many roles because they are so capable and intelligent which of course then begs the question of how we are where we are?
For some reason the Financial Times header was a little forgetful of the fact that Mr Bini Smaghi was an Executive Board member of the ECB for six years from 2005. This matters as it is likely that he is being used like a weather vane, so let us take a look.
The Inflation Target
Here is the opening salvo, with which regular readers will be familiar.
The ECB’s primary objective is price stability, defined as “a rate of inflation below but close to 2 per cent”. The average inflation rate over the 20 years of the euro has been 1.7 per cent, which may suggest success.
Now even your average Martian will be aware that the last decade has not been a success but look what Lorenzo picks out.
However, the result has been less satisfactory (a dalliance with deflation) in more recent periods.
This focusing on deflation is misleading for several reasons. Firstly he is deliberately equating falling prices or disinflation with shrinking aggregate demand or deflation. This matters because Lorenzo’s “deflation” was essentially the result of a lower oil price as I pointed out at the time. Also rather than a problem, at a time of restricted wage growth lower and indeed negative inflation provides an economic boost via its positive impact on real wages. I pointed this out back on the 29th of January 2015.
However if we look at the retail-sectors in the UK,Spain and Ireland we see that price falls are so far being accompanied by volume gains and as it happens by strong volume gains. This could not contradict conventional economic theory much more clearly.
Thus Lorenzo is flying something of a false flag here and is an example of what I predicted back then.
If the history of the credit crunch is any guide many will try to ignore reality and instead cling to their prized and pet theories but I prefer reality ever time.
You will not be surprised to find that the suggestion is a loosening of the target as seen below.
Furthermore, research shows that the ECB’s policy decisions over the years anyway reflect a symmetric interpretation of the target around 2 per cent. So why not move to such a target? It would at least be more transparent.
This matters even more if we note that in spite of the negative interest-rates and the QE inspired balance sheet expansion the ECB has in its own terms not yet achieved its target. This is because whilst inflation is above 2% at 2.1% of that some 0.8% is energy costs which are mostly outside its control. Putting it another way it is remarkable how little consumer inflation has been created by so much monetary easing. In fact with it so low we have to question whether it also has disinflationary influences not predicted by economics 101.
Thus even what seems a minor reshuffling of the target would if we remain in a similar situation to now lead to the possibility of a large policy change. We could get QE to its current maximum in terms of Euro area sovereign bonds where they are bought up to the limit imposed by the German bond market. In a way it all comes from this misrepresentation or lie.
reconsider the definition of price stability.
Price stability would be 0% not 2% per annum. In response my suggestion would be to lower the Euro area inflation target to either 1.5% or 1%.
The next bit is even odder.
The two pillars are analysis of economic and monetary data, but the latter — money and credit aggregates — have proved over time to be unreliable predictors of inflationary pressures……….. In July 2008, for instance, the resilient fast pace of credit growth justified the rate hike which was made, even as the real economy had started to show signs of a slowdown
Actually if we look at annual M1 growth which is the leading indicator for monetary data the annual rate of growth had fallen from 11.7% in December 2005 to 0.1% in July 2008. So the truth is that the ECB simply looked at (backwards-looking) credit growth rather than the clear signal from M1. Actually, looking at like that the series without seasonal adjustment could hardly be much clearer.
As you can imagine our bank chairman is not keen on the way countries can be excluded from this. After all who will think of the banks holding their debt? Here is his proposed solution.
Consideration should be given to return to a system based on progressive haircuts.
Share risk, as well as supervision
This would have the Starship Enterprise on yellow if not red alert. This is the current state of play.
Banks that are solvent, but do not have adequate collateral, may require the central bank to act as a so-called “lender of last resort”. That function for banks is still decentralized, with the national central banks bearing the risks.
So if an Italian bank were to fail it is the responsibility of the Bank of Italy to step in. Whereas Lorenzo wants this.
In particular, if the decision on whether a bank is solvent and is eligible to emergency lending is centralized, the risk for such lending should be shared.
So in this new universe the ECB would be responsible and not the Bank of Italy as the federal web gets more steel and perhaps titanium. The issue of being “solvent” is usually a red herring as central banks seem to find the most disastrous business models as being viable.
Exit Troika, stage left
Nobody seems to have told Lorenzo about the nomenclature change to “The Institutions”, but of course bankers often struggle with current events. Anyway it is hard to disagree with the thrust here, frankly who would want to be a member of it?
Remaining a member of the Troika is now less justified, and the unpopularity of adjustment programmes tends to erode the ECB’s reputation and independence.
Let somebody else take the blame!
The good news is the implied view that the ECB needs reform. Sadly the predictable part is that it heads in a direction which has so far caused more trouble than it has solved. For those who believe that the Euro establishment want crises so that they can present what they wanted to achieve anyway as part of the crisis resolution there is another tick in that box. My suggestion would be for a much more root and branch reform of central banking. For example inflation control has morphed into inflation creation or in consumer inflation terms attempted inflation control. Plus of course a boost for those who own assets.
However it is also true that the ECB has been left exposed and in the cold by the Euro establishment. The lack of any political response in terms of economic policy to the credit crunch left it and monetary policy with far too much to do. It has overplayed its hand in response, and must now fear heading into the next downturn with its foot still pressing down on the accelerator. At least it managed to shuffle its holdings of Greek debt largely to another Euro area body but that process and its insistence on full repayment added to the crisis at its height.
Heading forwards I would have two main suggestions.
- Lower the inflation target
- Much more questioning of what QE actually achieves.