The beef the Danes are having with the ECB at the moment is that the negative interest rates set in Frankfurt, with the Danish Central Bank having to follow the interest rate movements made by the ECB, are fuelling dangerous asset price bubbles, especially in real estate. This, of course, is sheer idiocy. I will not deny that low interest rates have an effect on asset prices, both directly by increasing its fundamental value as well as indirectly as cheaper credit can increase the demand for housing. However, housing prices in Copenhagen and elsewhere are still determined by economic conditions and regional fundamentals. It is beyond preposterous to assert that the ECB is responsible for the Danish housing price bubble. So here some cheap advice for the Danes if they are so unhappy. If you don't want to abandon the pegged exchange rate regime, how about deregulating the housing market and increasing the supply of housing in the regions where prices and demand are high (especially the metropolitan area of Copenhagen). Furthermore, adopting tighter credit restrictions in the mortgage market might also curb demand and thus cushion the "housing bubble". So take matters into your own hands and stop making the ECB responsible for your own policy failures.
Via Bloomberg I found out that a minister of the Danish government is now criticizing the ECB for its expansionary policies. Well, first of all, the ECB is and should be totally independent from political forces. I have mentioned in this blog before how it was completely inappropriate for members of the German government to criticize the ECB, trying to exert influence over monetary policy. The ECB is responsible for the Eurozone as a whole and must set its benchmark interest rate accordingly. So why the criticizm from Copenhagen now? The Danish don't even have the Euro. However, the Danish crown is pegged to the Euro, which means that monetary policy for Denmark is effectively made in Frankfurt instead of Copenhagen. The Danish Central Bank basically has to follow the ECB in all its interest rate decisions. This, however, is a choice. If the Danes are so unhappy with the current monetary policy framework, they are free to abandon the peg and adopt a flexible exchange rate like the neighboring country Sweden, which would also give them back the monetary autonomy they apparently seem to crave.
The beef the Danes are having with the ECB at the moment is that the negative interest rates set in Frankfurt, with the Danish Central Bank having to follow the interest rate movements made by the ECB, are fuelling dangerous asset price bubbles, especially in real estate. This, of course, is sheer idiocy. I will not deny that low interest rates have an effect on asset prices, both directly by increasing its fundamental value as well as indirectly as cheaper credit can increase the demand for housing. However, housing prices in Copenhagen and elsewhere are still determined by economic conditions and regional fundamentals. It is beyond preposterous to assert that the ECB is responsible for the Danish housing price bubble. So here some cheap advice for the Danes if they are so unhappy. If you don't want to abandon the pegged exchange rate regime, how about deregulating the housing market and increasing the supply of housing in the regions where prices and demand are high (especially the metropolitan area of Copenhagen). Furthermore, adopting tighter credit restrictions in the mortgage market might also curb demand and thus cushion the "housing bubble". So take matters into your own hands and stop making the ECB responsible for your own policy failures.
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Rudiger Dornbusch once famously said: "Expansions don't die of old age. Every single one of them was murdered by the Fed", which is in my opinion one of the most under-appreciated statements by a well-known macroeconomist. Modern macroeconomic theory clearly took a wrong turn in the early 1980s when some members of the profession decided that Real Business Cycle theory was the real deal, a theory that basically says that economic fluctuations are driven by productivity shocks and that unemployment is simply the optimal response of utility maximizing agents, which face an optimization problem on how to allocate their time between work and leisure. Meanwhile in the real world, people like Rudiger Dornbusch observed that most economic fluctuations were simply driven by aggregate demand shocks. Furthermore, money and credit seems to play a crucial role, a factor that is often forgotten and omitted, at least in the more simplistic DSGE models that are nowadays used by modern macroeconomists. But I digress. More often than not, the Federal Reserve tends to kill the Business Cycle by engaging in a premature and/or excessive tightening cycle, thus hiking interest rates by more than what is warranted by underlying economic conditions. One of the very few leading indicators of a coming recession is the structure of the yield curve, i.e. the relationship between short-term and long-term interest rates with respect to each other. Economic theory suggests that long-term interest rates are simply the sum of all future expected short-term interest rates. Consequently, the two-year yield of a bond is simply the yield of a one-year bond plus the the yield of a one-year bond purchased one year from now. However, investors also must be compensated for maturity risk. Since the risk of holding a long-term bond is higher than holding a short-term bond, interest rates on longer-dating securities are usually higher. Consequently, the yield curve is mostly upward-sloping. A flat yield curve or even an inverted yield curve where long-term interest rates are lower than short-term interest rates, on the other hand, usually spells trouble ahead. The picture below shows the difference between the two-year Treasury Securities and 10-year Treasury Securities. One can see an inversion of the yield curve just before all three recessions. We can explain this by short-term interest rates being too high given economic conditions. Long-term interest rates, on the other hand, are already lower because they price in the future declines in interest rates that the Fed will need to undertake with the upcoming recession. We now have reached a point again where the difference in yields between longer-term securities and shorter term securities has narrowed a lot over the last year (see the picture below for how the yield curve has evolved from December 2016). The reason for that is, of course, that the Fed started to engage on a tightening cycle, thus raising interest rates on the short-end of the yield curve. On the other hand, the world still seems to face an enormous safe asset shortage, most likely related to secular stagnation. Consequently, there are still more than 10 trillion bonds out there with negative interest rates as the ECB, the Bank of Japan, and the Swedish Riksbank are still engaging in Quantitative Easing and imposing negative interest rates on short-term bank deposits. These global forces, combined with low inflation and low productivity growth worldwide, aka secular stagnation, also put downward pressure on the long-end of the yield curve in the U.S.
While many other banks apparently expect long-term interest rates to rise in the near future as global growth and also U.S. growth has picked up some steam over the last year, JP Morgan apparently expects the yield curve to flatten even further, potentially becoming flat or even reverting by the end of next year. This, in my opinion, really is not such an outrageous prediction to make. The Fed really seems to be hell-bent on its tightening cycle despite falling short of its inflation mandate of 2%. Tomorrow, they will increase short-term interest rates by another 25 basis points, which will lead to further flattening of the yield curve. While we are not quite there yet, the yield curve is very likely to become flat or even revert if they will hike by another 3 to 4 times, which they currently project, a forecast that is overly optimistic in my opinion. Note that over the last 3 years the tightening cycle has turned out to progress much more slowly every single year than projected by their forecasts. That is because economic conditions simply do not warrant much higher interest rates at this time. With Yellen being replaced by Powell as new chairman, we do not exactly know how the Fed will behave in the coming years. At the moment, the U.S. economy is approaching full employment and GDP growth is slightly above potential. So right now there is little to worry about. However, we know that an excessive tightening cycle can surely engineer a recession. So it is time to worry if the Fed will continue to hike next year with long-term yields barely budging because that would imply an inversion of the yield curve and thus bad news. This time is now different despite some claims to the contrary. https://www.bloomberg.com/news/articles/2017-12-07/inverted-yield-curve-in-2018-is-taking-over-wall-street-outlooks I recently saw on Twitter a power point presentation by David Beckworth at the Mercatus Center on the Zimbabwe hyperinflation. As a result, I had a look at some old German bank notes that I got from my Dad a few years ago. Apparently, he obtained the bank notes in some kind of antiquity store. The notes are from the time of the German hyperinflation in the early 1920s during the Weimar Republic right after World War I (see the pictures of the banknotes in the presentation below). The Weimar hyperinflation is certainly one of the most dramatic periods in German economic history. The peace treaty of Versaille in 1919 imposed enormous reparation payments on Germany, which found itself on the losing side of World War I. In fact, John Maynard Keynes predicted at the time that the reparation figures are excessive and counterproductive. His thoughts are summarized in his book "The economic consequences of the peace", which he wrote in the same year. Germany's economy still suffered from the economic consequences of World War I in the early 1920s. The country thus found itself unable to pay the reparation payments that were asked for by the Allies. To make matters worse, French and Belgium troops occupied the Ruhr in 1921, an industrialized region in Western Germany, to extract resources and raw materials instead as Germany was unable to meet its debt obligations. Consequently, the German state started to print massive amounts of money to buy foreign currency, which then was used to pay back its debt to the Allies. The result was, of course, a quickly depreciating currency as well as rapidly rising inflation. As the German Mark depreciated, Germany had to print more and more money to buy a given amount of foreign currency. Here we see Milton Friedman's principle in action: (Hyper-)inflation is always a monetary phenomenon. Peak inflation was reached in 1923 when prices increased by a factor of about one billion over the course of the entire year. This basically meant that prices were doubling every second day by the end of the year. Money literally became worthless. In the end, people even used banknotes to heat their apartments. As the paper started to have more value than its monetary equivalent, the economic system broke down and people had to resort to barter. This time period is certainly one of the most dramatic episodes in German economic history. It is often argued that memories of the hyperinflation are somehow engrained into German culture. The German Bundesbank was well known for its relatively hawkish attitude in the post-Word War II period and Germany's inflation rate was lower than that of most other countries during the inflationary period of the 1970s, commonly known as the "oil price shocks" (even though it was rather easy money instead of increasing oil prices that caused the general rise in the price level). During the early 1990s, many European countries started to peg their currencies against the Deutsche Mark in order to reign in inflation levels and to achieve some credibility in financial markets. Moreover, it is sometimes argued that the ECB is modelled after and continues to pursue policies that are in accordance with Bundesbank preferences. Especially during the Euro Crisis, the degree of ECB hawkishness has imposed severe economic costs on many Eurozone countries, especially Southern Europe, as inflation rates were not allowed to exceed 2%. Deflation and economic stagnation in Southern Europe has led to enormous losses in output and large increases in unemployment. These are economic scars that will affect some of the member countries in question for years to come. One of the key lessons, unfortunately very often overlooked in Germany, is that deflationary episodes are often even more scary that rapid inflation. Yes, the hyperinflation almost led to a total breakdown of the economic system. However, it is the deflationary episode during the gold standard and the banking crises in the early 1930s, which led to mass unemployment and facilitated the rise of the NSDAP, culminating in the election of Hitler in 1933. |
AuthorMy name is Julius Probst. Archives
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