The Slow Motion Train Wreck that is ECB Governance: Cyprus Edition
It is really, truly, colossally staggering quite how wrong the troika seems to be about this crises, its causes, and its solutions.
I banged on in my previous post about the importance of NGDP. NGDP is, essentially, demand. A large rise in NGDP will be split between RGDP and inflation depending on how responsive supply is to increases in demand. This split is not stable. It bears much resemblance to the arguments about money multipliers – if the multiplier is high it means a rise in NGDP will come in mostly RGDP, and little inflation. If they are zero you will get only inflation.
The same point is true in reverse. If you have a large fall in NGDP then it will be split between a fall in RGDP and deflation. One of the major problems in this crises has been that the the CPI the developed countries has not reflected this deflation. This is because wages are sticky, and so prices do not fall easily or quickly. Instead we get large unemployment and stagnant wages, possibly for years, until productivity increases make it possible to rehire workers at their original wage (since you seldom fire you’re entire workforce you can seldom rehire fired workers at lower wages than your current workers).
There is one place where this deflation does show up very clearly, and that is in governments and municipal budgets. Falling NGDP means falling tax revenues, and this puts pressure on wages. The result is that deficits have skyrocketed, resulting in a wave of municipal bankruptcies and even sovereign defaults. These are about the failure to meet nominal claims. If I am a government and agree a five year pay deal, I did that on the expectation of a certain level of inflation, if there is less inflation I am paying my employees more in real terms. In the US inflation is cumulatively about 7% below target since the crises. That means you would expect, all things being equal, a 7% budget deficit. Automatic stabilisers adjusting to large unemployment make things worse in practice.
A second place this shows up is in mortgage defaults. I have a nominal claim to pay $X a month for my mortgage. This is independent of the real value of that money. So among those who were lucky enough to keep their jobs, falling real wages causes an undermining of their ability to pay nominal contracts. This, if it goes on long enough, eventually undermines the stability of financial institutions. While certainly there was some risk taking in banks, by and large their ability to pay was based on the belief that central banks would keep NGDP growth more or less on track. It is no surprise at all that US banks, where the Fed has supported the recovery more or less appropriately, are back in a strong position. EU banks continue to wither, and Japanese banks have spent 20 years as zombies.
The key point is that NGDP falls inevitably cause financial crises if they are sustained. In the eurozone, where tight money continues to choke of NGDP growth, we are slowly working our way up from the bottom in causing financial, and then sovereign defaults. Here is a list of Eu countries by NGDP growth rates:
The lower NGDP growth is below trend, the quicker the crisis comes. So Greece first, then Ireland, next Spain, then Cyprus. Portugal is doubtless coming. I don’t know anything about slovenia. France is missing its deficit reduction strategies. This is not a symptom, this is the cause. NGDP is completely within the control of the ECB. It is simply allowing eurozone NGDP to stagnate, to the misery of all concerned.
We are witnessing an abject failure of ECB governance, aided and abetted by the complete and dismal failure of the EU policy elite to grasp the problem at all. George Osbourne was quoted today saying that Cyprus’s problems were caused by too much debt, when in fact they were one of the best looking countries by debt statistics pre crisis.
So, if, beyond my bad tempered rant, I have a point, its this: Cyprus, this wasn’t your fault, and there’s nothing you can do, so leave the euro before the abject policy failures of the ECB and the EU condemn you to decades of pointless misery. Also, Portugal: You’re next.