...against fictions and other tall tales

Sunday, 18 December 2011

ECB staff: Interest rate hikes decrease output, increase unemployment and widen public deficits

From a new working paper by the European Central Bank:
The impact of an interest rate tightening in our model is consistent with existing evidence for the euro area and with widely accepted theoretical prior: (i) output and prices decrease (the latter more persistently); (ii) consistent with a liquidity effect, money falls below the baseline; (iii) unemployment grows and labour productivity falls, resulting in a pro-cyclical response of the latter.
...The public deficit widens significantly after the restrictive monetary policy shock, in line with the expected budget worsening due to lower tax receipts following the slowdown in economic activity induced by the interest rate hike and with the outlays related to the automatic stabilizers at work. (Bonci, 2011:5-6) (emphasis added)
It wouldn't surprise me if Mario Draghi was given an advanced copy of this paper to read on his first day as head of the ECB. If so, it might explain why he was so decisive in lowering interest rates upon his appointment. In many respects, the findings in the paper appear to support the view that the decisions of Mr. Draghi's predecessor to raise interest rates earlier this year were ill-advised.

Indeed, while it does not explicitly aim to do so, the study provides evidence as to why Jean-Claude Trichet's final actions as ECB President may have had the effect of worsening the economic situation in Europe by increasing both unemployment and reliance on automatic stabilizers, and thus enlarging public sector deficits in a pro-cyclical manner. As far as I know, this is the first study examining the impact of interest rate policy on the different sectors of the economy within the euro area as a whole.

Bonci, Riccardo, "Monetary Policy and the Flow of Funds in the Euro Area", ECB Working Papers Series, No. 1402, December 2011


  1. Manfredo Incantalupo18 December 2011 at 12:06

    Nice touch circuit. The results have been floating around Frankfurt for a while. The real clincher is that Mr. Trichet made the same mistaken decision (raising rates) that some economic analysts consider threw the US into the great depression. An old friend's favorite quote, when he was irritated with bad policy, was: "Those who cannot remember the past are condemned to repeat it" (Santayana)

    In that context and as a tribute to the friend's wisdom, consider the following Santayana appropriate:"...Before you contradict an old man, my fair friend, you should endeavor to understand him."

    No older man than history, is there? I guess not for Trichet. I think you are correct about Mr. Draghi

  2. Thanks for the reference. Quite e gem. Really enjoy your work.

  3. MI, there's only one place where this paper truly needs to be read and studied--and that's Frankfurt! Hopefully the copies of the paper are well-worn and plenty scribbled over at the ECB and Buba.

    Welcome OG. Very much obliged!

  4. I'm glad Draghi eased, but I don't think this paper was the catalyst. I think it was more that Trichet was a complete moron, and that the governing council don't seem to be a lot better. I mean, tightening into the teeth of two recessions? Please. The content of this paper seems really quite conventional, as opposed to the irrational fear of inflation embodied within the eurozon's policy makers and economic "thinkers". ... apj

  5. @ apj: Yeah, Trichet's decision to hike rates the very next day after a member's state (Portugal) applied for a bailout will probably go down as one of history's most inappropriate actions by a policymaker.

    @MI: It's as though history and Trichet were meant to meet. I always thought that Santayana's ideas were appropriate in policy discussions. I may have said this before in an earlier post, but I have always found that the mark of a good policymaker (or analyst) is knowing when to adequately apply the insight of history to decision-making. Not an easy task. But with good data, an open mind and a sensible inventory of experiential knowledge, I think it can be attained. Not enough of them see the similitude with the 30s, unfortunately.

  6. mcm, pt, jt (squallwatch )19 December 2011 at 12:55

    Completement d'accord avec vous: MI, apj, circuit !: Trichet a manque le quai. Pourtant tous les phares etaient allumes, tous les phares signalaient les parages dangereux. Je viens de prendre connaissance de la rubrique de Laliberte sur defricher l'economie-il mentionne les anomalies de l'irlande. Certains (squallwatch) commencent a penser que le vrai probleme cache ou supprime c'est plutot l'economie française, plus que les PIIGS. La finance publique francaise est si lourde que le navire ne peut meme plus se virer.

  7. Riccardo Bonci's results were known by many, and the conclusion is not new. Interesting to consider is the timing of the disclosure, and to the cynic-why disclose it at all.

    As to the latter, it may suggest to the market a preclusion of ECB options; it may also signal the ECB's frustration with limited tactical resources when inflation is no longer a credible target. Finally, it may also be the very simple need to break with the past in a manner more radical than usual, trusting that the membership recognize the underlying anachronism of the institution,and that the political institution of the Union is actually undermining ECB prescriptions.

    In Bocca al lupo, Mario.

  8. GC, I agree with the last part of your comment. Mario will need plenty of luck in the years to come. And good policy-oriented research wouldn't hurt either. As for the timing of the paper's release, I hope your third rationale is the truest.

    mcm, pt, jt: "La finance publique francaise est si lourde que le navire ne peut meme plus se virer."

    À mon avis, la France a un léger avantage puisque celle-ci a un peu plus de marge de maneuovre (p-ex. augmenter la taxation) Les finances des ménages sont encore en relativement bon état. De plus, elle ne semble pas avoir été affectée par une bulle spéculative immobilière. Cependant, je serais d'accord à dire que les banques françaises nous cachent probablement une surprise.

    All I mean to say is that France's problem is not really a public finance issue. It's most likely a problem with their banking sector.

  9. GC, I've been thinking about your comment and can't for the life of me figure out which is the most probable scenario. Although I tend to be fairly cynical, I'm actually more inclined to think that the ECB (at staff level, at least) may be trying to pave the way into different areas. Thanks for shedding light on this angle.

  10. I think a very large portion of French growth is contingent on tourism. With austerity becoming an unfortunate global phenomenon, revenues from that source will decrease substantially and second round effects also.

    The recent hikes in unemployment, household debt and overall trade deficit for France does not fare well. Health and Social Security are entitlements that the French population consider untouchables. They represent substantial amounts of public expenditures. Perhaps increasing taxation revenue is an option. Unfortunately, as unemployment and corporate budgets deplete the tax base, overall revenue from this source is not optimal. I think, circuit, you are correct that at the moment, French Public Finance is better than many other countries in the EU. However, I hope that it can hold the course. At the moment, every policy option initiated by the Government of France appears to be prone to review and subsequent reversal. Is this an ominous sign? Maybe the squallwatch are pessimistic about the projections being circulated.

    I hope you are correct.

  11. Those are all valid points. And the turn toward greater austerity is only going to make things worse. As France in no way can increase exports (and hence attempt to narrow its current account deficit) during the current (and future) phase(s) of cutbacks, the private sector financial balance is bound to deteriorate. Also, France won't be able to count on businesses to spur activity, as these are in the process of deleveraging. So, in effect, this lends support to the view that the government's flexibility may not last. Hence, govt revenues may be hard to come by without negatively impacting the private sector. You may be interested in this recently released working paper by Semieniuk et al (2011). It contains a good analysis of what's to come in the Euro area under austerity: http://www.levyinstitute.org/pubs/wp_694.pdf

  12. Best Wishes to all of you.
    @circuit,gc...especially your position that inflation targeting (IT) is no longer 'credible', I assume you intend that it is no longer a credible monetary policy at the moment. I would agree with the latter qualifier.

    A couple of years ago, Andy Rose concluded that IT was a Bretton Woods Reversed, because it depended on voluntary sovereign implementation rather than internationally coordinated action under the auspice of an authority. As a policy, it certainly appeals to a large contingent of our economies' central banks. However, IT is policy constraining expectations more than policy adjusting current parameters, although its application, as anything else embeds reflexivity.

    The BoE's recent shelving of IT considerations, regardless of the fact that inflation in the UK is above the acceptable parameters, suggests that longer turn prospects for the Beast are not 'credible' and that perhaps it may not be the squall that is most imminent and insidious.

    Is this suspension of IT merely temporary or are we heading for a Japanese rerun-where IT is an historical endorsement only (Price Stability is explicitly politicized as their mission, along with more recent embellishments-growth et al ). Policymakers, at least the better ones at BoJ, and there are some pretty outstanding ones, have taken the bull by its horns and even challenged the IT premise for over twenty years. Of course, success is a relative optic. In my opinion, BoJ has done a superb job of keeping Japan's Titanic afloat, while Europe has shown poor effort in less than a year in breaking up the Euro-Area.

    Are we going to see this abandon of IT with other central banks, and acknowledge that monetary policy is a bit like JMK's policymaker's worldview-adapt to the facts, change if you must. Even Friedman back in '88 was promoting a version of QE. The essence of good policy is its ability to adapt in a timely and insightful manner, both critical facets of pragmatic policymaking.

  13. Thanks for the greetings, Swells. Best to you, as well.

    To follow-up on your comment, it's been amusing to see some CBs hold on to the IT mantra while trying to justify other objectives, such as financial and/or macroeconomic stability. The efforts of CBs in the last year to try and re-invent IT as a more 'flexible' regime makes me wonder why the label isn't just dropped altogether. For instance, in Canada, some economists closely associated with the BoC are saying the CB has 'restrained discretion' to meet various policy goals (other than inflation-targeting). Many will claim that this flexibility was always there, but that would appear somewhat disingenuous to me: CBs in the past often justified the lack of action on other fronts by claiming that they were limited to price stability.

    If anything, all this seems to vindicate the position of those who have been against the idea of IT since the get-go. In a way, we should applaud the US (and all those responsible, elected or not) for having resisted the urge to give the Fed an inflation-targeting mandate.

    All that said, I should probably say that I've never been convinced of the benefits of adopting an IT mandate. For instance, in terms of interest rate policy, I fail to see how the BoC has done better than the Fed. I would argue that IT unnecessarily dampens output. Thus, I would agree with others that inflation-targeting rules are anachronistic.

  14. I hope I'm not too late here. So what would you rather see?

  15. Something closer to a dual mandate that includes employment. I like that the Fed is answerable to congress and the public for employment. It supports and enhances the democratic governance of the institution. Also, I think there's a good argument to increase the inflation target to 3 or 4 percent, at least in the current context. Krugman, Baker, Blanchard all seem to support the idea.