Neue Ideen für die EZB

Neue Ideen für die EZB

Neue Ideen für die EZB

Written by Christian Odendahl, 06 October 2014
From Neue Zürcher Zeitung

Why devaluing the euro is not mercantilism

Why devaluing the euro is not mercantilism

Why devaluing the euro is not mercantilism

Written by Christian Odendahl, 02 October 2014

The value of the euro is a topic of constant debate in European policy circles. The debate follows a regular pattern: French or Italian policy-makers bemoan the strength of the euro because it hurts their exports; German policy-makers rebuff such claims; the European Central Bank (ECB) claims it is not aiming for a particular value of the euro as its mandate is focused on price stability only; and international commentators point out that the eurozone is simply too large to pursue a purely export-oriented strategy anyway. All sides have a point. But more expansionary monetary policy is necessary to kick-start a broader eurozone recovery, in part via a boost to exports from a lower exchange rate. This is not a mercantilist strategy as imports are likely to grow, too, when incomes recover. The recent fall from $1.37 in early July to $1.27 at the time of writing is a good start but the ECB needs to be innovative and drastic to lower it further and start a proper recovery.

A major benefit of having a national currency is that it devalues in times of economic weakness, thereby boosting exports. Such devaluations are usually not the main aim of monetary policy-makers but a side-effect of more accommodative monetary policy (or the expectation thereof): the central bank lowers interest rates, which leads investors to search for higher yielding assets abroad, and this weakens the currency. Besides its effect on exports, a weaker currency usually leads to higher inflation too, as imports – such as energy – become more expensive. The combination of stronger economic growth via exports and higher inflation via imports is what the central bank was after. The currency is thus one of many ways in which monetary policy actions affect the economy.

Currently, the euro is too strong for the eurozone. While there are various ways to estimate the ‘fair value’ of a currency, the easiest way is to look at current inflation rates and growth prospects. Both are, for various reasons, at exceptionally weak levels in the eurozone. Given that weakness, monetary policy is too tight, and the euro would be weaker with a more appropriately aggressive monetary stance. If the euro is too strong for the eurozone as a whole, it is certainly too strong for its weaker economies such as Italy. When France and Italy bemoan the strength of the euro, they are in effect calling for a more expansionary monetary policy. The currency is just a catchy way of phrasing that.

For Germany, the euro could in fact be higher than it is now; most estimates consider a value of around $1.40 as appropriate – despite disappointing German growth and inflation. The reason is that the demand for German goods from outside the eurozone, for which the exchange rate matters, is hardly to blame for low growth and inflation. The causes are rather the weakness of demand from within the eurozone, one of Germany’s main export markets, and of domestic German demand, which is growing on the back of moderate wage growth and record employment but not fast enough. A higher euro by itself would do little to weaken the German economy.

A stronger euro would give consumers a boost in real income, though. After all, a stronger euro buys more iPads and holiday trips than a weaker one. This is the first reason why Germany rebuffs demands to devalue. The second is that it involves further easing of monetary policy, which at this point, after interest rates are already at zero, means buying risky private assets and, more importantly, sovereign bonds – which Germany strongly resists. However, given that Germany would clearly benefit from a stronger eurozone economy, more monetary easing and a weaker euro is ultimately in Germany’s self-interest.

The ECB claims that it is not aiming for a particular value of the euro, and that its sole objective is to deliver an inflation rate of “below, but close to, two per cent”. While this is true, the euro’s value has an impact on the inflation rate and growth: if the currency’s value falls, it lowers the prices of export and raises those of imports. A rule of thumb is that a 10 per cent fall in the trade-weighted exchange rate of the euro leads to higher inflation of 1 percentage point. The ECB’s own estimates, for example, show that a euro value of $1.24 at the end of 2016 (down from the $1.34 at the time of this estimation, and corresponding to a 3.9 per cent decline in the trade-weighted exchange rate) increases inflation by 0.2-0.3 percentage points.

Since most other transmission channels of monetary easing do not seem to be working as expected or hoped, the currency remains an important way to stimulate the economy, and ECB president Mario Draghi has made similar points recently. But will it work to boost European exports, or even: should it? After all, the eurozone is a large part of the world economy, and an export-led growth strategy would have to be absorbed by the rest of the world via imports, which might be impossible or at least unsustainable.

It might seem counter-intuitive, but an export-led recovery, driven by a depreciation of the currency, does not necessarily lead to an increase in net exports (that is, exports minus imports). The reason is that more export revenues might be used to import goods from abroad. This is especially true in a depressed economy where imports have already massively contracted: incomes are low, and hence consumption, investment, and imports are depressed such that a gain in income boosts all three, leading to a virtuous circle of growing domestic incomes and more imports. The effect on the trade balance is ambiguous. The exchange rate depreciation can thus be a kick-starter for a broader monetary policy-led recovery, without driving the export surplus to unsustainable levels. In fact, it can reduce it.

Argentina and Japan are cases in point. In 2002, when Argentina devalued its currency, exports were a main driver of the recovery for the first six months, growing by an annualised rate of 6.7 per cent. Thereafter, however, imports grew by a whopping 50 per cent (annualised) during the two years between mid-2002 and mid-2004, making net exports a drag on growth and reducing the trade surplus considerably. Japan has recently embarked on a large devaluation experiment, as part of ‘Abenomics’. While the verdict is still out on whether it has been successful in boosting growth and inflation, it has certainly not, despite a massive devaluation of the yen, led to a surge in Japan’s trade balance (see chart one).

Chart one: Japan’s trade balance and exchange rate


Source: Haver

Of course, each case is special. The eurozone periphery has high levels of foreign debt and thus needs to pay down its debts (see chart two). This requires a positive trade balance for a while. Most eurozone countries are rapidly aging societies and therefore have fewer investment opportunities than the rest of the world. This means they should aim to invest abroad, again requiring a trade surplus. In addition, Germany’s current account surplus seems to be stuck at an extraordinarily high level, adding to the current account surplus of the eurozone which has now reached more than 2 per cent of GDP (up from roughly zero pre-crisis).

However, the current account surplus is unlikely to rise if and when more aggressive monetary stimulus depreciates the euro. As argued above, the depressed economies of southern Europe suggest that a boost to demand in the eurozone will reduce the trade surplus. The effect on the German current account surplus is ambiguous but a weaker euro might help to reduce it, too, if the boost to Germany’s exporters and the rest of the eurozone strengthens the German economy, leads to higher wages, and thus to higher incomes and more imports.

Chart two: Net foreign asset positions in million euros

Source: Haver

Overall, there is a strong case for more currency depreciation and hence, more aggressive monetary policy. Now that the euro has weakened, it seems that past ECB actions are finally working their magic via the currency channel. This downward trend is unlikely to continue for much longer, however. Currencies have a tendency to overshoot: investors first get out of low interest rate areas, causing the currency to fall, before it slowly appreciates. Japan has seen its currency constantly appreciate in the face of low growth, very low inflation and even lower interest rates.

The eurozone must avoid this Japanese trap. The ECB’s newest measures are unlikely to be enough to lower the euro further than the current $1.27, or to sufficiently stimulate the economy otherwise. First, its latest attempt to encourage banks to lend to firms (so-called TLTROs) has been underused by banks so far (the next round is in December), in part because demand for new lending from firms is low and the prospects of the eurozone economy do not suggest demand will increase by itself soon. Second, the ECB’s plan to buy private assets, while a good start, will not be effective if it remains a stand-alone measure, without the ECB pushing up inflation and income expectations of firms and households.

In order to provide the necessary stimulus to weaken the euro, the ECB needs to take two actions. First, it should make clear that it intends to make up for excessively low current inflation (just 0.3 per cent in September) with somewhat higher inflation in the future, such that two per cent inflation over the next five years is reached on average. This will increase future inflation, lower real interest rates and push down the euro. This approach is called price-level targeting. Second, in order to make its commitment to this price-level target credible, the ECB should announce unlimited purchases of assets of its own choosing – preferably domestic private and foreign public assets – until the target has been reached.  As the ECB has learnt when its famous OMT programme arrested panic in bond markets, threats of unlimited intervention by a central bank are much more effective than limited fiddling in financial markets. The Swiss were successful with a similar strategy of a credible promise and unlimited purchases in containing the appreciation of the franc.

With these two measures – the first innovative, the second drastic – the ECB will succeed in providing the monetary stimulus needed to put the eurozone on a path toward a proper recovery, including a weaker euro and potentially a lower trade surplus. Without more ECB action, however, the euro might well increase in value again, weakening exporters, lowering already too-low inflation and destabilising the eurozone economy further. The political backlash against the euro and the EU could become impossible to contain. It’s time for the ECB to really do whatever it takes, yet again.

Christian Odendahl is chief economist at the Centre for European Reform.


Hollande warns France of tough spending cuts

Hollande warns France of tough spending cuts

Hollande warns France of tough spending cuts

By Charles Grant, 30 September 2014
From Financial Times

Even the ECB thinks Germany needs to start spending more

Even the ECB thinks Germany needs to start spending more

Even the ECB thinks Germany needs to start spending more

By Christian Odendahl, 22 September 2014
From The Washington Post

Link to press quote:
http://www.washingtonpost.com/blogs/wonkblog/wp/2014/09/22/even-the-ecb-thinks-germany-needs-to-start-spending-more/

How Brussels' medicine is killing the 'French patient'

How Brussels' medicine is killing the ‘French patient’

How Brussels' medicine is killing the 'French patient'

Written by Simon Tilford, 24 September 2014

The French government’s announcement in early September that France would fail to bring its deficit below 3 per cent of GDP until 2017 was met with the usual mixture of frustration and resignation. Many eurozone policy-makers see France’s refusal to play by the fiscal rules and its inability to reform its economy as the biggest threat to the eurozone’s stability. The list of allegations is pretty comprehensive: a bloated state, a lack of competitiveness, intractable structural problems and a mulish refusal to reform or to acknowledge that globalisation has left France living on borrowed time.

Some of these criticisms have merit, but as a whole they form little more than a caricature. France has some supply-side problems: very high non-wage labour costs deter employment; and parts of the service sector urgently need an injection of competition. But these are secondary to those of its problems that stem from self-defeating austerity and chronically weak domestic demand elsewhere in the eurozone. Without change to the latter France could yet come to justify the ‘sick man of Europe’ tag so beloved of journalists.

How does the performance of the French economy stack up against its European contemporaries? France has certainly struggled since the financial crisis, along with the rest of the eurozone (with the partial exception of Germany). However, its growth performance has been nowhere near as bad as either Spain’s or Italy’s and, until recently, it has been better than the UK’s (see chart 1). And France’s record since 1999 has been rather good compared with many of its European peers. So much for past performance. Are critics of France (led by the European Commission and the German government) justified? Are they right to be so pessimistic about the country’s future and correct in the medicine they prescribe for it?

Chart 1: Economic growth (1999 – 2014)

Source: Haver

France certainly has a big state. Public spending stood at almost 57 per cent of GDP in 2012, higher even than in Sweden (see chart 2). There is little doubt that this is excessive, but France’s productivity levels (which are better than Germany’s and not far short of US levels) would not be so high if its large state sector was unproductive. Nor does the country’s big state appear to squeeze out private sector investment, which is about the same level as in Germany, Spain and Italy and much higher than in the UK (see chart 3). Moreover, putting together comparable data for the size of state sectors is far from straightforward. For example, spending by France’s state-owned rail operator (SNCF) counts as state spending, whereas spending by Britain’s (or Germany’s) nominally privatised railways does not. France could follow suit and sell off its railways, but it is far from clear that this would improve the quality of rail services or reduce the public’s liabilities.

Chart 2: General government spending, per cent GDP

Source: Haver 

Chart 3: Private sector investment

Source: Haver 

France’s general government budget deficit is sizeable (see chart 4), though much lower than Spain’s or the UK’s. Moreover, a sizeable chunk of the French deficit is down to much higher public investment than in the other big EU economies, and more generous childcare. For example, were French public investment as low as Germany’s, France would have no problem getting its fiscal deficit under 3 per cent of GDP. And generous childcare provision may help explain why France has the highest birth rate in the EU after Ireland. This could look like money well spent in a few years when populations start to age rapidly in many other EU countries, notably Germany and Italy.

Chart 4: Budget balances

Source: Haver

Is France really as uncompetitive as all that? The country’s share of world export markets has certainly fallen steadily over the last 15 years, but no faster than in other G7 economies, with the notable exception of Germany (see chart 5). France’s exports (like those of other G7 countries) have risen considerably but their share of the total has fallen as China and other big emerging economies have entered the global trading system. Germany has bucked this trend, but this is hardly a strategy all can emulate: if more countries become fully participating members of the trade system, Western countries’ overall share must inevitably fall.

Chart 5: Shares of global export markets

Source: OECD

France has run small current account deficits for much of the last decade (see chart 6). The principal reason is that domestic demand rose almost twice as fast in France in the 1999-2013 period as it did in the eurozone, with Germany accounting for much of the weakness of eurozone domestic demand. Persistent weakness in Germany – France’s biggest single export market – has been a continuing problem for French exporters. And while German domestic demand has strengthened gradually since 2010, this has been eclipsed by a much bigger combined fall in Italian and Spanish domestic demand, two of France’s other major export destinations.

Chart 6: Current account balances

Source: Haver

Which brings us onto the second reason for the deterioration in France’s trade performance: French exporters’ loss of competitiveness vis-à-vis their German counterparts. This has not come about because French costs have risen too rapidly (see chart 7), but as a result of prolonged wage restraint in Germany, where wages have lagged behind productivity growth. This was initially the product of a depressed German economy and then of structural changes in the German labour markets brought about by the so-called Hartz IV reforms introduced in January 2005.  German wage settlements have picked up a bit over the last year, but not by enough to make a dent in the gap that has opened up since the introduction of the euro.

Chart 7: ECB’s harmonised competitiveness indices (minus indicates increased competitiveness)

Source: ECB

Critics of France are on firmer ground when it comes to the supply-side of the French economy. Although France’s productivity levels are impressive, there are some significant structural problems. The first is that French unemployment is higher than it should be given the country’s growth performance and moderate wage growth (see chart 8). One reason is that the costs of financing social benefits are loaded too heavily onto employers, pushing up the cost of hiring people. Another is the inflexibility of labour contracts, which can deter employment. Successive French governments have introduced reforms to address these issues, such as reducing the cost of social insurance paid by employers, but more will need to be done, in particular to reduce the costs of employing low-skilled people.

Chart 8: Unemployment

Source: Haver

France also requires reform of various service industries. IMF data for total factor productivity – a measure of the efficiency of all inputs into the production process – suggest that the biggest problems lie in sectors such as accounting, legal services, insurance and logistics. The lack of competition and barriers to entry in these sectors mean that costs are higher than they should be, hitting overall business competitiveness.

To recap, the French economy is in trouble. It has barely grown for the last two years and unemployment is stuck at near record levels. But France has performed pretty well in a eurozone context. It stacks up favourably not only compared with the currency union’s periphery but also with the likes of the Netherlands and Finland. France’s supply-side problems are no doubt significant, but do not justify its status as some kind of hopeless case. They are certainly not as serious as those faced by Italy, and arguably no worse overall than those of Germany and the UK, although they are in different areas. Nor will France’s economic prospects be improved by adhering to the European Commission’s calls for austerity, wage restraint and labour market reforms which, if heeded, would exacerbate unemployment.

Since 2012 France has tightened fiscal policy considerably in a largely unsuccessful attempt to bring down its deficit. This failure was foreseen: the IMF has demonstrated that the so-called fiscal multipliers (the impact of changes in government spending on economic activity) are very large in today’s depressed European economic environment. Although spending has been cut, the resulting weakening of economic activity (and hence inflation) has meant that the deficit has fallen little. A long-term objective for the French government should be to reduce the ratio of government spending to GDP, but this can only happen once the economy is growing again. Further cuts to public spending now would further damage the economy by causing even competitive firms to go under and eroding physical and social infrastructure, for example by pushing more people into long-term unemployment.

Wage growth has fallen sharply in France as high unemployment has undercut private employees’ bargaining power and public sector wage freezes have come into force. However, such wage restraint has had little impact on the price competitiveness of French exports, because French wage restraint has been exceeded by the likes of Spain and Italy and matched by Germany. Even if France could depress wages relative to other eurozone economies, it would take a long time for that to bring about a big boost to France’s economy because exports account for less than 30 per cent of French GDP (as opposed to 40 per cent in Germany in the early 2000s, or over 100 per cent in Ireland today). In addition, further wage restraint would depress household consumption and prove a zero-sum game in terms of export competitiveness since Italy and Spain are attempting the same thing. It would also exacerbate deflationary pressures in the French economy and across the eurozone (see chart 9). Rather than cuts in its own wages, what France desperately needs is a sustained recovery in German wages (and with it, German domestic demand).

Chart 9: Core consumer price inflation

Source: ECB

The French government should certainly push ahead with structural reforms of its economy, but not necessarily those prescribed by the European Commission. When demand is very weak and firms do not need to hire workers, reducing social protection and wages increases unemployment rather than reducing it, and depresses consumption. However, France should reduce the burden of taxation from labour and transfer more of it to wealth, property and carbon consumption. And it should open up the country’s non-tradable services sector to greater competition. But even structural reforms of this kind will do little to increase economic growth without a change to fiscal policy, aggressive measures by the ECB to reflate the eurozone economy as a whole and concerted action by the German government to rebalance Germany’s economy.

France is not the ‘sick man of Europe’, but it is certainly ailing thanks to the medicine prescribed by Brussels and Berlin. The French government needs to step up its resistance. Indeed, perhaps the most serious charge that can be laid at France’s door is that it has meekly gone along with a eurozone policy doctrine that has done so much damage to the French economy rather than corralling opposition to it and forcing through a change in direction.

Simon Tilford is deputy director of the Centre for European Reform.

Comments

Added on 30 Sep 2014 at 09:48 by Adair Turner

Message for Simon Tilford

Dear Simon,

Really excellent article on Brussels medicine and the French patient.Spot on.

Best wishes,

Adair

How to pull the eurozone out of the mire

How to pull the eurozone out of the mire

How to pull the eurozone out of the mire

Written by Christian Odendahl, John Springford, 26 September 2014

Germany considers giving states more autonomy on taxes

Germany considers giving states more autonomy on taxes

Germany considers giving states more autonomy on taxes

By Christian Odendahl, 12 September 2014
From Reuters

Link to press quote:
http://www.reuters.com/article/2014/09/12/germany-tax-idUSL5N0RD2RN20140912

Syndicate content