The Russian crisis and the Eurozone: some economic context

Pretty dramatic things are happening with the Russian rouble. Its dollar value is as of yesterday just about half of what it was on average in 2013.

What does this mean for the eurozone? Over the course of the first decade of this century, oil revenues and the real appreciation of the rouble made the Russian economy much larger in euro terms than it had been, and it correspondingly became a more important export market for eurozone countries. The share of Russia in the eurozone's exports tripled between 1999 and 2008; while it has declined slightly since, 4.7% of eurozone exports went to Russia in 2013. Given that even the eurozone's anaemic growth since the financial crisis is entirely attributable to export growth, this is not insignificant.

Source: Eurostat, OECD, EIA, own calculations. Brent prices and export/import figures nominal

In the chart, I've tried to give some indications of possible impacts of the rouble's fall by recalculating 2013 figures on Russian and eurozone GDP at yesterday's exchange rate, and giving a rough extrapolative estimate of how much exports to Russia might fall as a result of the declining purchasing power of Russian consumers in euro terms.

This estimate suggests a fall in sales to Russia of 0.5% of eurozone GDP, which would be highly significant, especially to an economy growing as slowly as the eurozone's is.  However, there are potential compensating factors (and potential further dangers):

Potential compensating factors

• Russia's demand for imports may prove inelastic (consumers may not scale back purchases proportionately to the rouble's fall).
• The eurozone will be spending less on importing oil, improving its trade balance. If consumers and businesses spend and invest the money no longer going to oil, this will promote growth. 

Potential further dangers

• In liquidity trap conditions, consumers and businesses may not spend and invest the savings from cheaper energy prices. Then falling energy prices would simply contribute to the severe risk of deflation in the eurozone.
• There could potentially be serious consequences to the international financial system of Russian companies being unable to pay back dollar-denominated debt (see here for a relatively sanguine discussion of their payment prospects). Financial fragility means that relatively small events can have a big impact. 

Why Mario Draghi's ECB colleagues just kneecapped his credibility: the politics of market tripwires

Something is afoot at the European Central Bank.  People at the very top of the institution--leaders of the central banks of the member nations, and members of the small Governing Council responsible for key decisions--have apparently co-ordinated to anonymously tell Reuters just how very much they dislike Draghi's leadership style.  He even looks at his mobile phones--all three of them--when they're trying to say important things to him! 

I think it likely that these public complaints had a very specific goal--and it wasn't to get Mario to put his screens away.  Instead, they are intended to weaken Draghi's influence over ECB policy and strengthen the influence of other members of the ECB Governing Council. To do this, it was necessary to weaken the credence markets give to Draghi's statements, and that the ECB insiders shaped their remarks accordingly--or so I argue in this post.

The politics of market tripwires

To understand the conflict between Draghi and his colleagues, one needs to bear in mind that it is playing out on the backdrop of the intense attention financial markets pay to the pronouncements of central bankers.  

Financial markets, as is well-known (read Keynes on this) are characterised by self-fulfilling prophecies. If market participants believe an asset will fall in value, they will convert prediction into fact by selling it and driving down the price. Market participants thus have an understandable terror of being the last to sense a shift in the collective prophecy (more prosaically known as "market expectations"), unable to sell before the price has fallen or buy before it has risen. 

Thus, investors are especially sensitive to what I'll call "market tripwires" -- events expected to cause a general shift in market expectations. When one of these tripwires is triggered, investors rush to react as quickly as possible, in some circumstances creating a panic. An example of a market tripwire familiar from the financial pages is the earnings forecasts of stock market firms--whether these are met, exceeded, or undershot can set off large shifts in prices. 

Sometimes, political actors create market tripwires in order to impose costs or constraints as a tool of influence. For example, the IMF's Michael Mussa accused Argentina's Finance Minister Domingo Cavallo of doing just this to pressure the IMF into extending more help as Argentina fought to stave off devaluation of the peso in the summer of 2001 (I assume the story is true, but don't know for certain; for present purposes it's enough that it could be true):

Through leaks to the local press, the Argentine government circulated the story that the Fund … would augment [a planned] disbursement with an addition of about $8 billion. Financial market reacted positively to this news, and the bank runs slowed. ...The suggested augmentation of Fund support was announced without consultations with the rest of the Argentine government. ... There were no prior consultations with the Fund, nor any prior indication of support from the Fund for a substantial augmentation of its lending. Indeed, Cavallo's tactic was to force the Fund to augment its lending by creating a fait accompli. Financial markets and Argentine citizens reacted favorably to the announcement of augmented Fund support. If they were disappointed that this support was not forthcoming, the Fund (and the international community more broadly) would be responsible for the consequences. [Mussa, Michael. 2002. Argentina and the Fund: From Triumph to Tragedy. Washington, DC: Institute for International Economics, p. 41-42]

In our terms, Cavallo tried to create a market tripwire.  He hoped to turn the IMF's failure to provide additional support into a signal for market panic, betting that the prospect of the panic would cause the IMF to agree to his demands.  

Draghi's tripwires

More than once, Draghi has used his status as the ECB's main spokesperson to do something very similar--make public announcements about policy, shifting market expectations, and implicitly (or explicitly, for all I know) inviting his ECB colleagues to contemplate the consequences of failing to carry out the policy.

A highly consequential example was Draghi's famous "whatever it takes" statement in July 2012, inserted into a prepared speech at the last minute.

Just as shocked were the ECB boss's aides and his colleagues on the bank's policymaking Governing Council, none of whom knew Draghi would make such a sweeping promise. "Nobody knew this was going to happen. Nobody," one senior ECB official said of the speech.

The tactic worked. Draghi's statement had a huge immediate impact in alleviating panic on sovereign bond markets, creating a market tripwire: failure to agree on an official lender-of-last-resort programme would reignite the panic, almost certainly in worse form.  The well-reported narratives of the ensuing hard bargaining that concluded with the announcement of OMT demonstrate that Draghi's statement was made well before he could be sure that he could get support for the sort of programme he wanted. 

This week's anonymous attacks were motivated by an effort to prevent Draghi from doing it again. This time, the issue on the table is not bond market panic, but the threat of deflation, brought on by weak growth prospects and the contraction of ECB lending as banks pay back earlier ECB loans without taking on new ones. To deal with this contraction would necessarily involve the buying Eurozone sovereign bonds (imprecisely known as Quantitative Easing, or QE), which German members of the ECB leadership oppose.

In recent months, Draghi has clearly been trying to encourage the market to believe that this sovereign bond buying will happen, creating a market tripwire that he can use as leverage to make the program happen. Examples are:

• Draghi's warning in his Jackson Hole speech--like "whatever it takes," inserted at the last minute beyond the control of the rest of the ECB leadership--that deflationary expectations were spreading and a promise that the ECB would "use all the available instruments" to try to fight them.
• A statement in early September that the ECB would try to expand its balance sheet to the levels of early 2012 (ie, reverse the contraction of its lending) 

Members of the ECB Council are perfectly aware of what this manipulation of market expectations is intended to accomplish.  According to one of Reuters' interviewees, the balance sheet statement,

"...created exactly the expectations we wanted to avoid," an ECB insider said. "Now everything we do is measured against the aim of increasing the balance sheet by a trillion (euros)... He created a rod for our own backs." 

You say that like it's a bad thing. Draghi wanted precisely that rod as a tool of policy influence. 

No, don't believe him

Of course, market tripwires only work as a tool of policy influence if markets believe the statements intended to set them. Cavallo would have gained no leverage over the IMF if the announcement of an impending expansion of support had not slowed bank runs. "Whatever it takes" would not have helped the passage of OMT without its calming effects on the markets.

So to disable the tripwire tactic, the German members of the ECB leadership Reuters' anonymous insiders set out to tell markets that Draghi is not to believed.  

"We specifically agreed at the meeting... not to put any numbers on the table," [said] one central banker. "Draghi's reference to the balance sheet of 2012 irritated a lot of colleagues. So he has had to backtrack a bit ... to compensate."

In other words, just because Draghi promises something, it's not necessarily going to happen. It is precisely Draghi's ECB opponents need to make this point, I believe, that explains why these complaints were made in public rather than in private. In July 2012, Draghi said:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

What his ECB colleagues are saying is: no, don't believe him. Wait to hear from us.

In particular, as becomes clear in the final paragraphs of the Reuters piece, don't believe Draghi if he hints that QE is coming. You can believe in QE if and when it is announced as an official policy. The insiders claim that without a consensus for QE in the ECB--and it's currently opposed by "at least seven and possibly as many as 10 of the 24 council members"--it can't happen because it's too politically divisive. (On this matter, one can only hope that the ECB majority will listen to Paul de Grauwe. A long as the ECB has unaccountable power, it should be used for good and not only for evil.) 

Kneecapping Draghi's credibility will make it harder for him to use his public announcements as a tool of unilateral policy-making, but it has costs, too. If the anonymous insiders succeed in turning Draghi into "the boy who cried QE," he will be unable to reassure the markets at moments when they need it most. For them that may be a feature rather than a bug of their strategy, but the rest of us should fear the dismantling of whatever capacity there is to contain the dangerous fickleness intrinsic to financial markets, and the destruction of whatever limited hope there is that deflation can be avoided without reversing austerity.

Governing by panic

Readers of this blog may be interested in my new paper, "Governing by Panic: The Politics of the Eurozone Crisis."  Here is the abstract:

The Eurozone’s reaction to the economic crisis beginning in late 2008 involved both efforts to mitigate the arbitrarily destructive effects of markets and vigorous pursuit of policies aimed at austerity and deflation. To explain this paradoxical outcome, this paper builds on Karl Polanyi’s account of how politics reached a similar deadlock in the 1930s. Polanyi argued that democratic impulses pushed for the protective response to malfunctioning markets. However, under the gold standard the prospect of currency panic afforded great political influence to bankers, who used it to push for austerity, deflationary policies, and the political marginalization of labor. Only with the achievement of this last would bankers and their political allies countenance surrendering the gold standard. The paper reconstructs Polanyi’s theory of “governing by panic” and uses it to explain the course of the Eurozone policy over three key episodes in the course of 2010-2012. The prospect of panic on sovereign debt markets served as a political weapon capable of limiting a protective response, wielded in this case by the European Central Bank (ECB). Committed to the neoliberal “Brussels-Frankfurt consensus,” the ECB used the threat of staying idle during panic episodes to push policies and institutional changes promoting austerity and deflation. Germany’s Ordoliberalism, and its weight in European affairs, contributed to the credibility of this threat. While in September 2012 the ECB did accept a lender-of-last-resort role for sovereign debt, it did so only after successfully promoting institutional changes that severely complicated any deviation from its preferred policies. 

When is a social democrat not a social democrat?

When he's Sigmar Gabriel, head of Germany's SPD and Minister for the Economy.  Here's Mr Gabriel in an interview with the Bild newspaper, defending the so-called "black null," the plan for a balanced budget:

Bild: There's a discussion in the SPD about whether or not new [government] debts ought to be incurred.  Is budget discipline social-democratic?   

Gabriel: Yes. Workers [Arbeitnehmer] want their taxes to be spent on social security, schools, or policy and not on interest payments to big banks for government debt. Only big banks earn money from high government debts. Government borrowing is antisocial.

There's a major problem with this argument: as Ambrose Evans-Pritchard noted, last week German government bond interest rates were "touching levels never seen before in any major European country in recorded history." In fact, correcting for inflation, Germany can literally borrow money interest-free:  August's inflation rate was 0.8% per year, and its ten-year bonds as of today yield 0.85%.  

Anyone who cannot find a way for the state productively to invest interest-free loans cannot be characterised as a social democrat (there's certainly plenty of low-hanging fruit).  For that matter, anyone who deliberately misleads workers about the costs of borrowing doesn't deserve the title either.  

Kalecki and the ECB

In 1943, Michael Kalecki gave what has recently become a very influential analysis of why it was that capitalists might object to Keynesian demand stimulus policies designed to ensure full employment. Such objections might seem puzzling, insofar as demand stimulus puts money in the hands of customers, selling to whom is how capitalists make their money. Kalecki argued that capitalists would indeed support stimulus to get out of recession for precisely this reason. However, they would object to using this policy to reach full employment (sacrificing profit as necessary), because

• Full employment raises worker bargaining power and undermines shop-floor discipline.
• Deficit spending involves allocating money to people who haven't "earned" that money (for backup for the scare quotes see here), challenging "the fundamentals of capitalist ethics [which] require that 'You shall earn your bread in sweat'--unless you happen to have private means." 
• For reasons explained here, without deficit spending, investment is crucial to maintaining full employment. Governments who shake business confidence therefore provoke unemployment.   "This gives to the capitalists a powerful indirect control over Government policy," which, Kalecki argues, they very much wish to preserve. Thus, "The social function of the doctrine of 'sound finance' [balanced budgets] is to make the level of employment dependent on the 'state of confidence'." 

It's really rather remarkable the extent to which these three motivations have found echoes in the Eurocrat and German establishments' reaction to the Eurozone crisis. 

• Calls for structural reform and especially competitiveness are directed primarily at reducing worker bargaining power.
• Moralised discourse about "earning" is deeply entwined with the export-led model that justifies the competitiveness emphasis.
• Some officials have voiced the idea that the "state of confidence" should determine policy quite directly (obviating Kalecki's functionalism.)

One might think that recent events--the end of growth, the fall of inflation to just .4%, the increasingly manifest limitations of ECB string-pushing--might be enough to change some minds. Perhaps--but not at the ECB.  Here's an updated picture of the European demand situation (for background see here).

Source: Eurostat, chain-linked prices with 2005 reference year; these figures show a small amount of growth in Q2 2014 , so they're more optimistic than the headline real figure of zero growth. Investment is "gross capital formation."

One could look at this and note that the economy has replaced only 2/3s of its lost growth, government consumption has dramatically failed to keep pace with even this anaemic growth, that household consumption is lower than it was five years ago, and conclude that it's no surprise that investment has fallen. What market would investment seek to tap? Even remarkable growth in the trade surplus can't compensate for missing domestic demand--stimulating the latter would seem the obvious policy.

But Mario Draghi has a different take. As Kalecki would have expected of a capitalist, but perhaps not a public servant, it's the state of business confidence that's key.  Here's Draghi speaking to a committee of the European Parliament yesterday.

the success of our measures critically depends on a number of factors outside of the realm of monetary policy. Courageous structural reforms and improvements in the competitiveness of the corporate sector are key to improving business environment. This would foster the urgently needed investment and create greater demand for credit. Structural reforms thus crucially complement the ECB’s accommodative monetary policy stance and further empower the effective transmission of monetary policy. As I have indicated now at several occasions, no monetary – and also no fiscal – stimulus can ever have a meaningful effect without such structural reforms. The crisis will only be over when full confidence returns in the real economy and in particular in the capacity and willingness of firms to take risks, to invest, and to create jobs. This depends on a variety of factors, including our monetary policy but also, and even most importantly, the implementation of structural reforms, upholding the credibility of the fiscal framework, and the strengthening of euro area governance.

Draghi clearly does not believe in Keynesian arguments. Consider the italicised words in the passage above. The idea that monetary stimulus won't work without structural reform is at least coherent--the idea is that there will be no demand for cheap loans without confidence in the business environment. But a fiscal stimulus does not depend on confidence in the same way--the government just spends the money.

As if further evidence were needed, when pressed about whether countries with a better fiscal balance should spend more expansively, all Draghi would say is that the country-specific policy recommendations agreed by the European Council in July ought to be followed. For Germany, the relevant recommendations actually endorse rapid movement toward a budget surplus.  

In sum, the evidence that the supposed change of tone of Draghi's Jackson Hole speech was not serious mounts.

Export orientation, supply-side thinking, and the theodicy of markets

This blog has argued (hardly uniquely) that the focus of the German and Eurocrat policymaking establishment on exports and competitiveness is destructive for the Eurozone's economy. Today, I want to argue that there's an intellectual feedback loop between highlighting export-led growth and the belief that individual, company, or country merit determines economic success. This is very much work in progress, and I'd particularly welcome feedback.

Kurt #Lauk eröffnet den #Wirtschaftstag: Wirtschaftlicher Erfolg ist kein Geschenk, sondern muss jeden Tag hart erarbeitet werden.#wt2014
— Wirtschaftsrat (@wirtschaftsrat) July 3, 2014

Early in July, Angela Merkel's party, the CDU, held its "Economy Day." The head of the party's economic council began with an excerpt from the Treasury of Teutonic Stereotypes a pronouncement. "Economic success is no gift;" he said, "rather, it must be earned every day through hard work."
I have a name for this kind of thinking: the "theodicy of markets."  In the study of religion, theodicy refers to the problem of reconciling the existence of evil with the presence of a god both omnipotent and benevolent (here's a moving example).  But Max Weber used the term more generally, to refer to a doctrine that explains and justifies good and bad fortune. He wrote:

The fortunate is seldom satisfied with the fact of being fortunate. Beyond this, he needs to know that he has a right to his good fortune. He wants to be convinced that he ‘deserves’ it, and above all, that he deserves it in comparison with others.

A theodicy, in Weber's sense, explains why people deserve what they get. A theodicy of markets argues that those who flourish in a market economy deserve to do so. The sentiment expressed above is an example: economic success is no gift--it's deserved, because it results from hard work.

Weber's argument--made in the context of religion--is that intellectuals work hard on their theodicies trying to make them logically coherent. The intellectual difficulties they confront drive the development of doctrine and thereby influence action.

In this light, it's worth investigating the intellectual challenges facing the theodicy of markets.
Mapping desert (or merit) onto market outcomes is at best a dicey business, because it implicitly involves endorsing the fairness of the multitude of bargaining situations determining relative prices. (Germany, for instance, is an exporter of luxury cars, demand for which probably has something to do with increased economic inequality in the countries beyond its borders.) To refer to "productivity" as justifying success is just to rename the problem, since productivity is measured with respect to output prices.

More generally, at a very high level of abstraction, success in any endeavour is a joint product of merit (skill and effort) and circumstances. To maintain a claim that success is deserved, prediction of and adaptation to circumstances can be defined as part of the relevant success-generating effort. However, this move requires a very particular conception of circumstances: they must be amenable to prediction and, hence, fairly resistant to change, including change through the vagaries of deliberate human action.  An actor's success under a given set of circumstances would otherwise have to be ascribed in part to some other actor's decision not to change those circumstances, downgrading the importance of desert.  

Now in talking about the concrete issue of economic success such a conception of circumstances is, of course, quite absurd. The circumstances under which economic success is pursued can and do change due to deliberate action. Even Mr Lauk, who told us economic success is no gift, concedes in another context that sanctions on Russia will damage the German economy. So prior economic success was, in part, a "gift" of good relations with Russia (not to mention the purchasing power gifted to Russian consumers by high oil prices).

So how does one maintain a theodicy of markets in the face of the manifest role of manipulable circumstances?  Consider this remarkable July 2014 statement from Andreas Dombret, a member of the board of the Bundesbank:

[The] strong influence of international trade [on Germany's recovery] worried some observers. Many felt that Germany's reliance on exports was risky, as it exposed Germany to the ups and downs of the global economy. ... 

I have doubts that turning away from global markets would strengthen the German economy. Facing global competition ensures that German companies keep up with technological progress and retain their high productivity. This might come at the price of higher volatility, but to me this seems like a price worth paying.

The first thing to note is how very, very weak this is as a piece of economic argumentation.  To claim that policy of supporting domestic demand is equivalent to a policy of insulating firms from international competition is absurd--indeed, one of the arguments sometimes made against demand stimulus is that its effectiveness is limited when consumers prefer foreign to domestic products. 

Given the flimsy argument, maybe Dombret's statement is better understood as motivated reasoning emerging from an emotional commitment to the theodicy of markets. In particular, it resolves the problem of reconciling merit with the role of circumstances by

1. Partitioning circumstances under which economic success is pursued into the mutable (domestic demand) and the immutable ("the ups and downs of the global economy").  
2. Asserting that altering the mutable circumstances would undermine the promotion of merit ("productivity") and should thus be avoided.

One implication of [1] is that there ought to be a strong "elective affinity" between a commitment to the theodicy of markets and support for an export-led demand model. Export performance is the true test of economic merit, precisely because exports are directed into a "global economy" imagined as impermeable to policy manipulation. 

Imagined is the right word here, because of course "the ups and downs of the global economy" are strongly affected by policy decisions in individual nation-states. Or course, this problem could be avoided if every nation-state would accept the self-denying ordinance to ensure the triumph of merit by avoiding demand stimulus. Here's Bundesbank head Jens Weidmann throwing cold water on the idea that external circumstances should be changed in an interview with Le Monde (German, French) last month:

In general I am sceptically inclined to the idea that one can demand a contribution from others to one's own sustainable growth... Growth must instead come through one's own efforts. It is the responsibility not of the governments of neighbouring countries nor of the European Central Bank, but rather of each government to create a domestic environment that supports business innovation and employment.

And here he is in Spain in July:

At the time [of founding the Euro and agreeing the deficit-limiting Maastricht criteria], it was assumed that by constraining governments' ability to fiscally stimulate demand - and by shifting monetary policy to the European level - governments would have no choice but to implement structural reforms, improve their supply side, and strengthen their potential for sustainable growth.

Note the use of the word "sustainable" in both contexts, which seems to me to be another tactic of displacement, analogous to the rejection of demand stimulus, an implicit assertion that the market generates morally appropriate outcomes, at least in the long run (when, of course, we're all dead).

To sum up, then: to sustain the idea that "economic success is no gift" requires some substantial mental gymnastics with deeply destructive consequences for economic policy; in particular, it promotes an unrealistic reliance on export demand. I'd be very curious to hear from readers whether they found this convincing and/or of interest.

Draghi and fiscal demand stimulus: he's not serious

Mario Draghi's speech in Jackson Hole last month has been widely seen (one more auf Deutsch) as a bellwether, particularly for his discussion of the importance of increased demand to ward off deflation and create growth.

In plain language, Draghi seemed to many to be saying: austerity plus structural reform is not going to work; Germany needs to spend more and stop raising a fuss about budget deficits elsewhere in the Eurozone. 

I would have parsed the words of the speech differently, but in any event a better way of judging how serious Draghi is about promoting fiscal demand stimulus is to look at how he acts. And I think the evidence of the succeeding weeks strongly suggests that bringing fiscal stimulus to pass is low on his list of priorities. 

We have some information on how the ECB leadership has acted when it wants to promote particular fiscal or other policies on the part of Eurozone national governments.

• It makes maximum use of its bargaining leverage, conditioning its monetary actions on government policy.
• Rather than viewing the Eurozone's governing treaties as a given, it advocates changes--as Draghi did when pushing the fiscal compact or more recently in his call for more centralized control over structural reform. 

But we don't observe anything like a parallel assertiveness in pushing for fiscal stimulus at Draghi's recent press conference or anywhere else. A counterfactual Draghi pushing stimulus with similar forcefulness would have

• Tried to exert leverage over German policy, for instance by throwing his weight behind the application of external mandates and financial penalties to reduce the German trade surplus (which would require stimulus of German domestic demand). After all, this is part of the legal framework of the Eurozone, for other parts of which Draghi isn't in the least hesitant to advocate. He might even have hinted that monetary policy measures known to annoy Germany would be needed if these rules were not followed.
• Stated that should budgetary rules not give sufficient flexibility to stimulate demand, they ought to be changed.

Instead of this, what did we observe? (From last week's press conference.)

• Draghi declined the opportunity offered by a questioner to address the need for expansive policy in Germany and other countries with low budget deficits.
• He stated "the Stability and Growth Pact [setting out budget-balance rules] is our anchor of confidence ... [and its] rules should not be broken," and went on to say that "... discussions on flexibility should not be viewed or should not be such that they would undermine the essence of the Stability and Growth Pact." 

Draghi's example of how one might use the flexibility of the SGP is also indicative of how distant he is from serious demand-stimulus advocacy:

Within the Stability and Growth Pact, one could do things that are growth-friendly and also would contribute to budget consolidation, and I gave an example of a balanced budget tax cut. Reducing taxes that are especially distortionary, where the short-term multipliers could be higher, and cutting expenditure in the most unproductive parts, so mostly, actually not mostly, entirely, current government expenditure.

Since tax cuts put money in the hands of people already known not to be spending or investing enough, they're ineffective stimulus policy, even more so when offset by spending cuts. And how does Draghi support the idea that this sort of policy might be good for "business confidence and private investment ... [even] in the short-term," in the words of his Jackson Hole speech? Who's that hiding in footnote 15? Yes, it's Alberto Alesina (more).

Draghi did announce sweeping new monetary policies measures last week. But it don't mean a thing if you just push that string. People who think Draghi is on the side of the demand-stimulus promoting angels now (including Krugman) are misreading the situation badly. The ECB went to war for austerity and structural reform--it could do the same for stimulus, but it isn't.