Tuesday, August 26, 2014

Should the ECB Buy State Bonds and Encourage State Deficits?

In remarks at Jackson Hole, Wyoming, European Central Bank president Mario Draghi urged greater fiscal and monetary coordination to boost the E.U.’s economy. A ship cannot move along at full speed if all the sails are not coordinated so that each is poised at its optimal angle to the prevailing winds. So too, various policies in a political economy must all sail in the same direction for a full-sail recovery to really take off. Just as a sailing ship must avoid jagged pitfalls lurking in rocky waters, so too must policy makers; for it is all too easy in focusing on one point on the horizon to ignore or dismiss baleful downsides to the dominant policies.

At the foot of the Teton Mountains, there being no foothills, Draghi “called for explicit policy co-ordination between the [Eurozone’s] monetary guardian and [the states].”[1] Brandishing considerably less concern on inflation, he linked the ECB’s future purchases of state bonds (i.e., quantitative easing, or QE) to structural reforms, tax cuts, and more spending at the state level. 

At the time, E.U. law limited state budget deficits to 3% of gross domestic product. Pointing to the existing flexibility in that law, the central banker urged the state governors to “better address the weak recovery and to make room for the cost of needed structural reforms.”[2] I submit that the accent should be placed on the latter, as they would have more staying power. It is like the difference between consuming sugar (even in fruit) before running, and drinking a protein shake after lifting weights; both food elements are helpful, but only the protein becomes a part the body and can thus strengthen it for the future.

Quantitative easing can unfortunately impact an economy in both foreseen and unforeseen ways due to the intended artificially-low interest rates. The market-mechanism cannot but be distorted, with harsh byproducts free to silently ravage certain segments while others benefit without merit. The human brain is not so omniscient as to be able to fully anticipate and plug all the leaks that can arise from a systemic distortion in a macro-economy. That is to say, the system is so complex that a huge distortion using one macro policy tool can introduce significant systemic risk.

In the U.S., for example, low rates in the 1990s incentivized a housing bubble whose collapse in 2007 triggered the potentially catastrophic credit freeze and collapse of Lehman Brothers in September of 2008. The government bailout of GM, AIG, and Wall Street banks worsened the federal public debt. By 2014, that debt reached over $17 trillion. Meanwhile, the Federal Reserve printed money far exceeding the meager growth of GDP by buying bonds to artificially lower interest rates to prompt a recovery.

With interest rates low, money flooded into stocks. “The market is in effect rigged because of the [low] interest rate,” Charles Biderman said on CNBC as the summer of 2014 was coming to an end.[3] A grinding ethical fault-line ran between the stocks increasing at 25% a year and the wages and salaries increasing at a mere 3 percent. Moreover, the middle and lower economic classes would doubtless feel the brunt of a collapse of the stock market due to irrational fear should rates be raised to counter the inflation from too many dollars chasing too few goods.

With borrowing money being so cheap at the low rates, government officials did not feel the normal market pressure to hem in the deficits. Corporate managements could borrow money cheaply to acquire or merge with other companies without being perhaps as discerning of the degree of compatibility and synergy as would be the case under naturally determined interest rates. In 2014 through August, more than $2 trillion in mergers and acquisitions were announced—an increase of 70 percent over the same period the year before.[4] While managers, stockholders, and lawyers make out like bandits on the deals, subordinate employees are left out of the largess and may even lose their jobs as the price of synergy.

As dark as the underside of quantitative easing is in pushing rates abnormally low, the most potentially harmful byproduct of Draghi’s plan concerns his intent to encourage the E.U.’s state governments to make greater use of the “existing flexibility” already in the federal law limiting state budget deficits to 3% of annual economic output. Even large states such as France and Germany had had trouble keeping within the law; states such as Greece, Spain, and even Italy carried so much debt that the systemic risk of default became a problem not just for the E.U., but for the global financial system as well. To encourage flexibility might be like giving money to an alcoholic standing outside a liquor store. The last thing state legislators need to hear is additional flexibility to tax less and spend more can be found in the fine print.

As an alternative, Draghi could have emphasized that the ECB would focus on assisting states with structural reforms both by lending its expertise and finding the right monetary incentives that would not distort the financial market in potentially unforeseen ways. Sticking to old ways is not necessarily the best route to getting structural changes capable of ushering in new ways.

1. Claire Jones, Peter Spiegel, and Robin Harding, “Draghi Softens Tone on Austerity,” The Financial Times, August 22, 2014.
2. Ibid.
3. Charles Biderman, CNBC TV, August 28, 2104.
4. Trish Regan, “Has Fed Jumped the Shark?” USA Today, August 26, 2014.