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An Obituary for the European Union

Extract from An introduction to European History Published 2050.

With hindsight, it appears obvious that the structure of the Greece bailout of 2010 was an error of catastrophic proportions. By partially socialising the losses of a banking system in crisis due to an impending sovereign default, European leaders transformed a banking and financial crisis into a contest between nations, unleashing titanic political forces which the Euro-zone’s unfinished political institutions could not hope to contain. Like the League of Nations before it, the Eurozone institutions depended on the large nations of Europe both to behave with restraint, and to enforce Commission directives on the smaller nations, since they were institutionally incapable of enforcing decisions when large countries violated commission directives.

The first warning signs cam in the pre-crises era, when France and Germany became serial violators of the Stability and Growth Pact. While punitive procedures were started against Portugal in 2002, and Greece in 2005, no such proceedings were initiated against either Germany or France, despite being serial violators. This inability to offer fair and equal treatment to all Euro-zone Members proved to be a serious contributory factor to the unfolding crisis.

Finally, perhaps the decisive factor, was the insularity and hubris of Europe’s Governing elite, who allowed their views to become divorced both from the public opinion in the countries they governed, and from economic reality. Indeed, in the crucial days of 2015, which now seem to be the chance to avert disintegration, Anglo-American economic commentators looked on in disbelief at creditor behaviour which would not have looked out of place among the debtor prisons of Victorian England.

The financial crisis of 2008-09 had myriad causes, but in the Eurozone two features stand out. Firstly, that European regulation gave to all European sovereign debt a risk weight of zero, which allowed banks to effectively up-risk their portfolios while staying within their capital limits, and indeed, this was an extremely profitable trade from 1999-2006, massively enriching bank shareholders as periphery interest rates declined towards the levels seen in core European Countries, and secondly, that there were large intra-country financial flows driven by different economic policies which encouraged some nations to run surpluses. Although the currency would adjust to counteract large surpluses at the level of the Euro-zone, there was no such balancing of intra-country flows inside the currency area, allowing Germany to build current account surpluses as periphery nations built large balancing deficits. Indeed, in some sense these flows of capital were a success of the European project, allowing capital to flow to those countries who most needed it. As it turned out, the financial infrastructure of periphery nations was simply not well enough developed to ensure that this money was channelled into efficient investment. Instead much went to finance consumption. In fact, given the scale of the inflows, it is extremely unlikely that any country could absorb capital flows of this magnitude relative to GDP. A historical parallel will be discussed below.

It is striking to note how little scope periphery nations had to prevent this build up of debt. Spain and Greek engaged in opposite policies. Spain ran a large government surplus, of which the end result was only to drive the cheap loans from the core into private sector debt via a boom in housing construction and financing. Greece ran persistent public sector deficits to absorb this capital flow, which resulted in having private sector debts which were among the smallest in the Eurozone. According to Eurostat private sector greek debt rose from 41% in 1998 to 93% in 2006. Spain, by comparison, grew its private sector debt from 89% to 193%. Germany and Austria, by way of comparison, saw private debt remain stable at around 120% of GDP.

This, then, was the Hobson’s choice presented to periphery countries by Euro membership: run a large government deficit or allow a dangerous level of growth in private debt, with the implicit associations of malinvestment and bubbles. This was a predicament that the German’s might have had sympathy with. Indeed, history is replete with parallels where dramatic capital inflows lead to enormous bubbles in financial assets. Perhaps the most notable was that in Germany following its victory of the Franco-Prussian war of 1871. Germany received an “indemnity” of around 20% of German GDP (5 billion gold frans) over three years. By driving the German current account into massive deficit, and a deficit being by definition an excess of investment over savings, the end result was a speculative mania culminating in a massive stock market boom in 1873 and a crash which it took years to recover from. Micheal Pettis’s article is an absolutely vital primer for anyone wishing to understand how these balance of payment issues drove the European debt crisis. The French economy, on the other hand, went from strength to strength, to the extent that by 1873 Germany was considering returning part or all of the indemnity!

The main point to understand then, is that the periphery had very little control over the build up of debt in their countries, two solutions were available (1) policies that increased Germanic consumption, and reduced their terms of trade advantage by raising wages. (2) A vast and well organised infrastructure spending campaign on behalf of the periphery, which was sufficiently productivity enhancing so as to support their worsening terms of trade.

The second option is a pipe dream, any country with a bureaucratic infrastructure which could design and implement such a program would already be a rich country which already had the financial infrastructure to handle large capital flows. Even some very successful countries lack the kind of institutional capital needed to organise such a program: The US and the UK stand out for having very poor infrastructure given their overall levels of development. The first option was of the table for political reasons, as in the Germanic view, being an exporter with a large current account surplus was a sign of success to be emulated. Never mind that such emulation was impossible, as the sum of intra-country surplus and deficits must be the deficit between the EZ and the world, and the Euro would adjust to keep that relatively close to zero. Thus, for Germany to run  a persistent surplus inside the EZ, it was necessary for other countries to run persistent deficits.

This sets the stage for the crisis which was to prove the EZ’s undoing, however, it should be noted that the rate of convergence between the periphery and the core was truly startling, and given another twenty years of relative stability in the global economy, these imbalances may have worked themselves out. However, fate intervened, and the Global Financial Crisis of 2008 threw the solvency of almost every major European Bank into doubt. At this point. Capital flows reversed and even went into reverse as investors rushed to the safety of Core bonds. With investment spending collapsing, unemployment and budget deficits exploded around the periphery just as spreads widened and the reality that a EZ sovereign might default dawned on financial markets, further damaging confidence in the banks.

Greece in particular found financing its deficits difficult, and in 2010 asked for and received a bailout. The standard template for sovereign default has long since been settled on by the IMF. You first restructure the debt, while offering bridging finance to allow the affected party to meet their obligations until they regain market access. In return you get a program of reforms designed to enhance competitiveness. The Greek bailout did not follow this template. The exact reasons are unclear (as the Eurogroup does not publish minutes we shall probably never know), but the basic premise can be surmised: Greek debt was mainly held by European banks, which were already feared to be insolvent. Restructuring Greek debt might lead to panic in the financial markets.

This was a justifiable concern, however, the template for rescuing banks is even more settled than that of rescuing sovereigns. You simply inject capital directly into the affected financial institutions using the balance sheet of your central bank. You receive in return an equity stake. If even more capital is needed you wipe out the bondholders at the same time. Indeed, had the Eurozone followed this template, much, if not all, of the subsequent politics might have been obviated. We can only speculate about the true motives of those involved, but there was certainly an element of hubris. Jean-Claude Trichet, then president of the ECB, demanded that there should be no haircut, perhaps worried about financial contagion.

At this point the IMF was in deep conflict with its Eurogroup partners, as the IMF’s own rules demanded restructuring, and there was little or no way that Greece’s debts could be deemed sustainable without restructuring. These conflicting demands where “made consistent” by the assumption of wildly optimistic growth forecasts. Thus the first bailout agreed to swap existing Greek debt at par for official loans with gentler profiles, amounting to a small reduction in face value. It should be seen then that from the outset this was at least partially, and possibly mostly, a bailout of European Financial Institutions, rather than the Greek people, with some estimates suggesting that more than 2/3 of the headline figure of the bailout was an implicit gift to the financial intuitions which held Greek debt.

However, this narrative was never publicly expressed, it was rather dressed up as a the generosity of the core towards the feckless Greeks who, despite an inability to manage their own affairs, where still fellow Europeans. This narrative allowed a poisonous dynamic to take place in public discourse, as the program failed to deliver its promised growth projections, and a second and third bailout was needed, it appeared that Greeks were just chronically unable to manage their finances, and that Greek was a black hole for the European Tax payer. Indeed, now that most Greek liabilities were held by the public it was much harder to manage debt re-profiling as that would be a direct loss to the European taxpayer, and a possible violation of the Lisbon treaty’s prohibition on financing Eurozone Governments. By this stage the economics were firmly in the back seat to the political considerations. In 2015 Greece elected a new government with a mandate to renegotiate the bailout. Greece’s primary concern was to get debt relief and restructuring in return for further reforms. In other words, that the Eurogroup should admit that they made a mistake in their original bailout, and should eat their losses by reducing the face value of greek debt. Politically, this was impossible for the Eurozone, however much economic sense it made. It was at this stage that it first became clear to the author the enormous difference between the Anglo-American view of debt and what we might term the “Teutonic view”.

In the Anglo-American view when one buys a bond one purchases, among other things, the default risk. This risk was the primary differentiator of European government bonds, which faced identical inflation and duration risks as members of a single currency area. When purchasing such a bond one trusts that the issuer will make a good faith effort to repay you, but you also accept, that in the event of unforeseen circumstances, the issuer has the unilateral right to restructure your bonds so as to maximise utility. There will be a cost for this in terms of future market interest rates, or in the case of default on institutions like the IMF in terms of future aid. But the issuer has the unilateral right to decide to default either partially or totally if they think the costs are less than the benefits. To my mind, the Eurogroup, in their first and second bailouts had effectively bought the default risk of Greece, which would materialise if, and only if, their economic projections turned out to be optimistic. This indeed is a sensible economic perspective, which aligns the incentives for debtor and creditor in a similar way to Chapter 11 Bankruptcy in the US. If the creditor wants to be made whole, he must support actions which maximise the value of his claims, which could only be fulfilled if the Greek economy was growing. This was a view shared by many commentators. The “Teutonic View”, held most obviously by Wolfgang Schauble, was that Greece had a moral duty to repay its creditors in full whatever the cost. The fact that the creditors toxic mix of austerity had all but destroyed Greek’s economy, or that the original bailout’s success was predicated on forecasts which turned out to be wildly optimistic, was of no consequence. Greece was to make good its creditors and its only recourse was to abandon the Euro and accept the immense pain that would inevitably follow.

No where was this made more clear than in the Eurogroup summit of 2015:

Firstly, the Eurogroup rejected all responsibility for the failure of its program of austerity, instead claiming:

There are serious concerns regarding the sustainability of Greek debt. This is due to the easing of policies during the last twelve months, which resulted in the recent deterioration in the domestic macroeconomic and financial environment. The Eurogroup recalls that the euro area Member States have, throughout the last few years, adopted a remarkable set of measures supporting Greece’s debt sustainability, which have smoothened Greece’s debt servicing path and reduced costs significantly.

This runs so completely contrary to established economic wisdom that it is difficult to see any virtue in this statement other than a desire to further strengthen the political narrative that the creditors are blameless, have only acted selflessly to aid Greece, and have been stymied by the failure of the Greek establishment to fully implement their totally reasonable “solutions”.

The Eurogroup stresses that [nominal] haircuts on the debt cannot be undertaken.

The Greek authorities reiterate their unequivocal commitment to honour their financial obligations to all their creditors fully and timely.

I.e. complete acceptance of the “Teutonic view” that the creditors bear no responsibility for the failure of the program that they designed, and no acceptance that the original bailout program had any other aims than the salvation of the Greek people from their “carefree” and “populist” government.

Moreover, it is obvious in retrospect that the creditor governments were setting Greece up for an impossible situations. With Greece’s economy imploding there was zero chance that supply sire reforms would have any impact, and may actually make things worse in the short term. One must also ask, with historical detachment why, if the implementation of the OECD toolkits was so vital to Greece “regaining competitiveness” its implementation was not asked for in earlier bailouts? If the measures were not sufficient in 2010, is the ever more rigorous commitment to reform not a comment on the earlier failed programs? At any rate, it is well established that reforms of the supply side will have little or no affect while the demand side of the economy is depressed. Increasing potential growth will have little effect on an economy already far from potential and rapidly deterioration. The economic reality is that Greece needs stimulus. Fiscal multipliers were certainly large in Greece, given its inordinately large unemployment, in such cases stimulus lowers debt burdens and austerity increases them.

Thus, in 2015 the Eurogroup committed Greece to another failed bailout and another trip round the merry-go-round of ever increasing debt burdens and falling national income which rapidly made the new forecasts as obsolete as the old ones.

At this point a mention should be made of the ECB. It was at this stage that the true political divisions of the ECB were revealed. A true central bank, faced with a locally imploding economy, would act swiftly and promptly to intervene to support the banking system. Instead it acted to deliberately cap Emergency lending, so that Greece was forced to issue capital controls to prevent the complete collapse of its system. This move further destabilised the Greek economy, which was, if not recovering, at least flirting with an exit to recession. This revealed that the ECB was not an independent central bank intent on fulfilling its mandate, but a political entity controlled by the northern Europeans. The rate rise in 2011 and failure to do QE was subsequently recast as more than an error of judgement, but instead a deliberate attempt to favour Germany and the core. After all, a robust recovery would have rebalanced German wages through moderate inflation and wage increases, leading to lower balance of payments problems. It was now clear that an unelected and unaccountable body was not independent and was instead the enforcer for a group of unaccountable finance ministers who kept no minutes of their meetings and operated with a total lack of transparency.

The outrage among the twittering classes was instant and enormous. For a dry euro-group statement to engender such open hostility from all sides was a shock, as the #ThisIsACoup gained traction in almost all European countries it quickly became clear that any who thought making an example out of Greece would quell support for populist parties had miscalculated badly. What they failed to see was the subsequent realignment of European Domestic Politics. European integration was The Issue. It was no longer left vs right, or socialist vs free market, or even ordoliberal vs statist. It was now pro-integration or pro-repatriation. The previously stable centre ground of a quiet drift towards more power for European Institutions came to an abrupt halt. Trust in the benevolence of Franco-German leadership evaporated as quickly as Hollande rounded on Merkel for putting Grexit on the table. The IMF and former US treasury secretary Tim Geithner’s accounts of Eurogroup discourse became must reads for all those who styled themselves as “intelligentsia”, and they made for damning reading. Geithner described the Eurogroup as early as 2010 as “wanting to take a bat to Greece”. Sarkozy and Merkel asked president Obama to help them force out Berlusconi, a democratically elected leader of a major European economy.

We can get a sense of the outrage across Europe by looking at some of the commentary:

Wolfgang Munchau, an influential FT commentator, said:

few things that many of us took for granted, and that some of us believed in, ended in a single weekend. By forcing Alexis Tsipras into a humiliating defeat, Greece’s creditors have done a lot more than bring about regime change in Greece or endanger its relations with the eurozone. They have destroyed the eurozone as we know it and demolished the idea of a monetary union as a step towards a democratic political union.

Paul Krugman, Nobel Prize winner and NY Times columnist:

Even if all of that is true, this Eurogroup list of demands is madness. The trending hashtag ThisIsACoup is exactly right. This goes beyond harsh into pure vindictiveness, complete destruction of national sovereignty, and no hope of relief. It is, presumably, meant to be an offer Greece can’t accept; but even so, it’s a grotesque betrayal of everything the European project was supposed to stand for.

European democracies might have been pre-occupied by the immediate after affects of the crisis, but by the time the Third Greek Bailout had dissolved into acrimony as the Greek economy imploded there was no more room for inaction. Greece didn’t come asking for a fourth bailout. They just closed their banks in December 2015 and announced they were re-denominating. Having retained control of their assets they wiped out all their creditors with a total default. And the worst part for the Germans was, the private creditors didn’t mind at all. Greece got market access almost at once and its recovery, following six months of pain, was dramatic. Redenomination risk was back for all European Sovereigns. Spain and Ireland were by this stage recovering rapidly, but the election of governments extremely sceptical of the European project meant that the UK was no longer a lone voice calling for the repatriation of powers. From the point of view of the European Institutions, this only made it all the more vital that none be surrendered. Within the wider economic union the division grew wider. With Poland and Ireland wishing to exempt themselves from the legalisation of Euthanasia across Europe in late 2016, they traded the promise of a British veto for support for the renegotiation of British membership. In the event the British, along with most of the non-euro states agree to exit the European Union but to stay part of the common market, and to have a say in shaping common market policy. With the British exit from the European Union, the dream of a unified Europe died.

Without that dream, the Germans became increasingly unsettled about paying for a Europe which offered them little, and which included an increasingly embittered relationship with the French. In the end the Euro dissolved. Germany, Austria Belgium, the Netherlands, Finland and Luxembourg remained within the rump of the euro, along with most of the minor states. Spain and Portugal and France started a new currency. Italy and Cyprus went their own way.

The European Union became little more than than a common market, of little practical importance as a political entity, although still a useful forum for European Powers to negotiate trade agreements and economic agreements.

Something I don’t understand: Endogenous Money, Forward Guidance, and QE Exit

Endogenous money has been used to represent several slightly different things. In this post I am referring to the way in which a central bank moves the short term interest rate by controlling the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government bonds. 

This means that for any non zero short term interest rate, given a set of real factors in the economy, there is only one possible size of the monetary base. If you control interest rates the base is endogenous. Once the short term interest rate hits zero, this relationship breaks down, and once can expand the monetary base without lowering the short term nominal interest rate. That is the situation in which we find ourselves.

Now, my question is, when we raise interest rates off the zero lower bound, surely we will reenter the regime of endogenous money, in which case surely it is impossible to raise rates without at least partially unwinding QE? 

It might seem obvious that the Fed can put upwards pressure on the interest rates while holding the monetary base constant by selling long treasuries and buying short ones, but that is not the case. Provided there are a large amount of excess reserves, any attempt to raise the short term interest rate above the interest rate paid on excess reserves (IOER), will result in money moving out of reserves into the short term treasuries, they being essentially perfect substitutes as a risk free interest bearing form of money.

This brings me onto forwards guidance. Many people have said that forward guidance is largely pointless. I wish to point out here, that as the economy strengthens, and spending increases, the quantity of base money consisted with a given non zero interest rate increases. Thus, the date of the first rise in interest rate wholly determines how much of the QE base expansion is permanent and how much is temporary. It is widely known that temporary expansions in the base are not inflationary, this also tails nicely with the apparent decreasing effectiveness of QE. If forward guidance means you think you know the MB at the date of the first interest rate rise, QE over and above that will do little. The only question is, are we there yet? The reaction of the stock markets to the taper talk in may strongly suggests that they believe that the US economy is not yet strong enough to withstand a tightening of policy. 

In conclusion….I don’t know if I really believe the argument set out above. It seems to me, when I look at the comparative GDP paths of US, UK and EZ, or 1990’s Japan vs 2013 Japan, that those countries which have done more QE have better GDP growth. Economies are to complicated to be able to guarantee that we always have a concrete transmission mechanism and 100% understanding of the consequences of policies. For all that, it does not seem obviously wrong, and it does trouble me, and suggest that th eexit from QE may be harder than some in central banking assume.

The Astounding Hypocrisy of Jens Weidmann

The Eurozone crisis has been replete with politicians and ECB board members declaring victory after miscalculations of tragic proportions. We have seen plenty of congratulatory back-slapping on the Cyprus bailout, which is only predicted to destroy a quarter of their economy. We have seen pious talk of the need for “reallocation” in periphery economies, and that  only “confidence boosting austerity” will allow their economies to recover, despite virtually every reputable study showing the exact opposite. We have had Olli Rehn, EU commissioner for finance, berating the economics profession for publishing studies showing the failure of austerity, because they are destroying confidence and making the problem worse. But this weeks pronouncement really takes the biscuit. Jens Weidmann, inflation hawk extraordinaire, has topped all that.

This week he was quoted as saying:

 that eurozone interest rates could be cut, if warranted by further weakness in the region’s economic data.

Now what weakness was he referring to that day? Was it the fact that Eurozone unemployment has risen for the sixteenth consecutive month? Was it that fifteen months in a row wasn’t enough for a rate cut? But sixteen, that really shows weakness. But no, instead he was referring to a sharp fall in orders for German cars. Twelve percent unemployment is nothing to get worked up about, but if they stop buying German cars, that’s a disaster.

Surely Weidmann just believes that Germans are in need of some belt tightening to improve confidence. Austerity is for the periphery, if the German economy is slowing, obviously monetary stimulus is the answer.

Its an outrage.

The depressing state of the Eurozone

The ECB continues to destroy the Eurozone. Jens Weidmann continues to make a fool of himself pretty much every time that he opens his mouth. Austerity continues not only to fail but to destroy the economies of the Eurozone at the same time. Jens Weidmann warns France about the dangers of not sticking to austerity. The Fed has made history. Its growth and employment forecasts have now been more optimistic than the fact for forty consecutive quarters. A truly staggering observation.

They say that a picture says a thousand words. Well here is my picture.

The price of Failure

Unemployment in the Eurozone

Eurozone employment is now approaching 11%. The lessons of the depression tell us that unemployment will continue to increase every month that NGDP growth stays below trend. Marco Nunes offers us some graphical insight:

Credit to Nunes

The first graph shows the heart of the political problem in the Eurozone. If the Eurozone economy is to re-balance  Wages in Germany must rise, because German workers are more productive. Germany currently has 1.4 million workers earning less than 5 euros an hour. The real secret of German success is a vast underclass that works for a pittance combined with inflation so low that it prevents any meaningful re-balancing of wages. Rowntree will be weeping in his grave.

Germany workers must accept wage increases if the Eurozone economy is to re-balance  You would think persuading workers to accept pay increases would not be so hard, but as we all know, increasing wages is inflation. And there is nothing more certain than that the German political elite cannot accept inflation. Thus German workers accept less than their fair share, which crushes the periphery economies as they cannot compete on price given their relatively overpriced labour and lower capital investment. The Eurozone cannot recover without NGDP growth. Whatever NGDP growth you generate in the Eurozone will not be evenly spread until productivity has balanced out, so Germany `suffers’ from above trend NGDP growth even while the Eurozone falls apart due to insufficient demand.

Eventually, the price of labour will reach an equilibrium. Either through the relatively painless route of higher NGDP growth and some inflation in Germany, or through mass  unemployment and wage cuts, coupled with sovereign defaults, or through mass immigration from the worse performing regions into the better performing ones. Germany is ruling out the first one, happily imposing the second upon the Eurozone periphery. Even France has become a target of the Bundesbank due to its higher than agreed deficits. I fear that the near limitless capacity of Eurozone electorates to accept the pain imposed by the witless ECB is reaching its end.  The ECB has to act.

My pessimism about the ECB and its policies knows no limit. So I have put my money where my mouth is and have cashed out a substantial portion of my long positions in the equity markets last week.

Understanding the UK recovery – The Most Important Chart

So this post is about the Consumer Price Index, and its relevance to monetary policy. First we shall have a little background about what the CPI actually measures, why central banks believe a little inflation is healthy, and the general relevance of inflation to monetary policy.


Inflation, in principle, is the change in prices caused by the changes in the purchasing power of the Medium of Account. Famously, this began when Hume imagined what would happen if the amount of gold in the world suddenly doubled. The answer is that prices and wages would have doubled, but nothing else has changed. (Except gold jewellery would have become cheaper!).

In today’s world UK inflation is controlled by the BoE, since it can print money to increase prices, or destroy it to lower prices. It also affects inflation through changes to the interest rate. This is preferred since it is assumed to be less distortionary. What this means is that if the central bank prints money, it has to buy stuff, and the increased demand for this “stuff” tends to price up the price level asymmetrically  as the prices of the “stuff” increases must faster than the other items the BoE is not buying. In the long run, this leads to an economy that produces more of that “stuff”, since the BoE is making it more profitable to do so. In contrast, changes to the interest rate result in marginally more lending to many different customers, all with different preferences, and so they buy stuff in aggregate in roughly the quantities that you want the economy to produce, so there is no distortion, and prices tend to move roughly together.

The reason why a little inflation is healthy has to do with contracts. In today’s world, for whatever reason, people mostly sign contracts in nominal terms. Very few contracts are inflation linked in any way. In fact, it is usually cheaper and more uncertain to sign a nominal contract and buy interest rate swaps to hedge against inflation, if it is a concern. This is particular true for mortgages. I do not sign a mortgage for a particular sum of consumption, I sign one for a particular number of pounds. This means that if the purchasing power of the pound declines, that is a win for me, as I have, in effect, traded less future consumption for my house than I had planned. However, this has serious knock on effects for the economy. In particular, I have signed a nominal contract based largely on expectations of my nominal income. This means that it is very hard to survive a loss of nominal spending power, it is much easier to survive a loss of actual spending power if my nominal wage is maintained.

This is important, so I will restate it: in theory receiving a ten percent wage cut, and experiencing a wage freeze while there is 10% inflation for one year aught to be the same. In practice, they are not, as the second of these things also decreases the burden of my debts. This plays out into a simple empirical fact: no worker will accept a nominal wage cut. This means that if I am working in an industry with no productivity gains, the fastest I can lower prices is by imposing a wage freeze and waiting for inflation to lower the real cost of labour. In a deflationary period, I cannot lower prices. I end up, effectively, being forced to liquidate my labour force and start again from scratch with new contracts. Not a pretty picture. This is how “zombie companies” are created. They are unable to lower wages in real terms, and so their products remain forever uncompetitive. This is the “Japan Scenario”.

Alternatively, if I have strong productivity growth, I can lower the price of my product without needing to cut wages in real or nominal terms. However, productivity growth in sectors tends to be periodical. There will be a period of strong productivity growth, and then a period of stagnation. You can see the last decades annual productivity growth in the US here. Funeral homes became less productive, in terms of productivity per hour. Software development productivity grew 13% a year. 

This leads us to a nice intuition. We must generate sufficient inflation for most of the sectors of the economy to be able to lower their wage burden when they need do. This tells us, for example, that if there were an oil embargo, which sent the price of oil to infinity (as is happening now in Iran due to trade sanctions), it would be wrong for the central bank to attempt to hit a 2% inflation target by driving every other sector of the economy into deflationary conditions. If that happens, all industries without strong productivity growth would be doomed to becoming uncompetitive “zombie” companies for the foreseeable future.


The consumer price index should be thought of as an average of price increases weighted by the relevance of each sector to the `average’ consumer. This makes some sectors, like Food, energy, and transport, much more important than, say, insurance costs, as UK consumers spend more on the former than the latter. However, the weighting is not too important. Moreover, from the perspective of monetary policy the weighting obscures the truth. Prices change for real reasons, and also because of changes to the value of money, the value of money is clearly a common factor that should affect each price equally, and hence should be susceptible to regression analysis.

The CPI itself is build of out sub indices. Each sub-index takes many prices to cover a small part of the economy, e.g. alcoholic beverages. The CPI is then build out of each of the sub indices weighted by their `sector weights’ which are their relevance to the consumer. The RPI is identical except the sector weights are different, as retailers do not buy quite the same stuff as consumers.

We are going to track the distribution of the sub indices. In particular, if monetary policy is driving the current spike in CPI, we would expect it to be broad based, with many sectors contributing, if it is caused by a few outliers, then it is a `false signal’ about the looseness or tightness of monetary policy, similar to what might happen under an oil embargo.

To do this, we look at the monthly percentage changes, and in each month we will look for a point, \rho which minimises

\sum_{i} (x_{i}-\rho)^{2} \exp\left(\frac{(x_{i}-\rho)^{2}}{L^{2}}\right)

This has several useful features. As L\rightarrow \infty, it produces the sum of least squares, i.e. the usual mean. For smaller values of L it starts to ignore outliers, and will usually give a pretty good approximation of the median. One way of thinking about it intuitively, is to say that it finds the centre of the largest group that is distributed normally with a width (st dev) L. The downside of this is that it is not single valued (\rho \rightarrow \infty also minimises the distribution), and if L is chosen too small it may produce several groups which are each local minima. If we allow L to go to zero this results in it finding a local minima for every individual data point. Nevertheless, for appropriate choices of L it is a powerful way to minimise the distorionary effect of a few outliers on a regression line. To get a feel for what this does, look at this graph of the sum for different values of \rho with a histogram of the frequency of the sub indices in the background.

Figure 1: The effect of the outliers is reduced, and it minimises only with respect to the core grouping. It gives a similar result to choosing the mode or the median.

The value of \rho that is chosen is that which gives the local minima of the red line.

A technical note: the most attractive part of this algorithm is that if the data is normally distributed, it will always yield the same result as the sum of least squares (provided L chosen appropriately), if it differs from the mean it tells you that the data is not normal. The graph below shows the results of this procedure on the CPI sub indices for various values of L. Note that these values mentioned in the legend are for month on month percentage changes, whereas those on the y-axis have been annualised. Figure 1 shows that the vast majority of the data is within \pm 1\% of the median, so even using L = 2 includes more than 90% of the data points. I have also used the twelve month moving average, as that reduces volatility and makes it much easier to read.

Figure 2:Note the huge diversion since the financial crises. This graph represents strong empirical evidence that UK monetary policy is too tight, and is producing close to deflationary conditions for the vast majority of sectors. Prior to the start of this graph the data was given quarterly, rather than monthly, so would not be directly comparable. This graph takes the twelve month moving average, to reduce volatility.

So there is a huge amount of useful information in this graph. In particular, notice the following points:

(1) Much is made of the sector weightings, but the weighted CPI (the black line) tracks the straight mean of the sector averages very closely.

(2) In normal times the different choices of L to not make a huge difference, this indicates that the data is normally distributed.  It suggests that policy was very slightly loose in 1997-2000, and extremely tight right now.

(3) The CPI is clearly dominated by some extreme outliers at the moment, as even a choice of L=10 is moving the average by a full percentage point.

(4) The UK has had some significant changes in VAT, since these are broad based, they probably move the whole graph. It went from 17.5 to 15 in Dec 08, it returned to 17.5 in Jan 2010, and went up to 20% in Jan 2011. Once you account for these changes it seems extremely likely that the median sector of the economy is in outright deflation.


Those who know me know what I think the remedy to this problem is: More NGDP! More Expansionary QE! Unsterilised Purchases!

In all seriousness, the starkness of these results was a surprise to me. As a devotee of Scot Sumner, I believed that the NGDP shock of 2008/9 should have been deflationary, and yet the CPI remained high, so I decided to dig a little deeper into the data. This is the evidence, and it is, as far as the author is concerned, indisputable evidence that the BoE should engage in expansionary monetary policy. Policy is too tight, and the high CPI is an aberration caused by a few sectors. We should be ignoring the CPI at the moment as a measure of the tightness or looseness of monetary policy.

Sticky Wages

It is often said, that since we are five years into a depression, real wages should have adjusted. In the long run money is  neutral. Well I am sure that the Chicago teachers were therefore willing to take a pay cut from Mr Rahm, when he logically explained that when their pay package was last discussed, inflation was expected to be at 2%, and since it has consistently undershot, the teachers are now getting 8% more purchasing power than was agreed upon, and therefore should be happy to take an 8% pay cut. If they want raises that match inflation when it is above average, they should take pay cuts when it is below average. Oh no wait. That didn’t happen. They went on strike when they didn’t get further pay rises.

This is the money illusion at work. Public employees in unionised industries can almost never take a pay cut, and as a result, the lower than expected NGDP growth/inflation, is causing funding crises in US cities. To see the scale of the problem lets look at a graph of hourly compensation (which I have shamelessly stole from Scott Sumner’s excellent blog:

Sticky wages in action

No remember, in a well functioning economy, all money spent = NGDP = all money paid out. So if wages per person do not fall in line with NGDP, there must be unemployment.


That tiny narrowing between the red and the blue line, that is wage adjustment. I also used to think that `the medium term’ when applied to wages meant about five years or so. I am revising that to twenty years or so.

Things that are cool: Astrophysics

The sun is really big. Its really hard to get across the sheer incomprehensible bigness of these things, but sometimes you come across numbers that really brings it home:

Here is one: The sun creates light by converting mass into energy through fusion. Since the creation of the earth some 4.7bn years ago, the sun has converted roughly the total mass of the earth into energy. (6*10^24 Kilograms). This is a negligible proportion of the suns mass of 2*10^30kg.