I am confident that increasing the supply of money will eventually lead to an increase in nominal demand.

TO BE NOTED: From The FT:

"Credibility is key to policy success

By Martin Wolf

Published: April 2 2009 19:29 | Last updated: April 2 2009 19:29

The UK has followed the US and Japan into “unconventional monetary policy”. Meanwhile, Mervyn King, governor of the Bank of England warns the UK government of the dangers of further discretionary fiscal stimulus. Yet what are the implications of the policies followed by central banks? Are these not the big threat to monetary stability?

According to forecasts from the International Monetary Fund, the UK’s general government deficit will be 9.5 per cent of gross domestic product this year and 11 per cent in 2010, the largest in the Group of 20. As I argued earlier this week (“Why G20 leaders will fail to deal with the big challenge”), the rise in the deficit, from 2.7 per cent of GDP in 2007, is the counterpart of the swing in the private balance, forecast at 8.9 per cent of GDP between 2007 and 2009.

As my colleague, Samuel Brittan, asked last week, why should such a temporary increase in the fiscal deficit be terrifying? UK net public debt – forecast at 61 per cent of GDP this year – remains well below the average of advanced country members of the G20. At the end of the Napoleonic and second world wars, UK public debt was close to 2.7 times GDP. Yet even this triggered none of the hyperinflationary consequences now widely feared. As the IMF also notes, even a 100 percentage point increase in the debt ratio should require an offsetting shift in the primary fiscal balance (with interest payments removed from spending) of no more than 1 per cent of GDP, provided fiscal credibility is maintained.

The condition for this is evident: in his Budget, the chancellor of the exchequer should lay out fiscal measures to go into effect, automatically, once the economy recovers. In short, what is needed is a far more credible fiscal regime.

Yet it is very peculiar to be agitated about the inflationary impact of fiscal deficits, yet relaxed about monetary expansion by central banks. Is the latter not the true danger? Or are these not just two sides of one coin, the ultimate inflationary risk being the central bank financing of deficits?

Yet, even before reaching that point, reliance on aggressive expansion of the balance sheet of the central bank has dangers, including for the fiscal position, as my colleague Willem Buiter has noted in his Maverecon column. Unconventional monetary policies work by expanding the money supply (“quantitative easing”), by easing credit constraints (“credit easing”) and by altering relative yields on assets, particularly through direct purchases of longer-term assets. The Bank of Japan focused on the first; the Federal Reserve has concentrated on the second; and the Bank of England has now initiated the last, with direct purchases of gilts.

Carried out with sufficient single-mindedness, such programmes will “work”. At the limit, a modern central bank can drown an economy in infinite quantities of fiat (or man-made) money. The question is the obverse: it is whether the longer-term inflationary impact of monetary expansion can be reversed in time. To this, again, two answers exist: one concerns feasibility; and the other concerns credibility.

On the former, the broad answer is that a central bank’s unconventional monetary operations are reversible: if it buys bonds, it can resell them; if it buys short-dated paper, it can allow it to expire; if it directly finances government deficits, it can sell the public debt to the public; and even if it sends cheques directly to every citizen, which would be closest to a purely fiscal operation, the government can always sterilise the monetary effects by issuing new bonds. So, if and when economies and, as important, financial systems, recover, aggressive action by the authorities would unwind the inflationary impact of even these unconventional policies.

So, as over fiscal policy, the fundamental question – as Spencer Dale, the Bank’s new chief economist, notes in an important recent speech – is the credibility of the commitment to stability.* If, for example, the central bank takes very large credit risk and the public doubts the willingness of the fiscal authorities to reimburse resulting losses, it will expect these losses to be monetised.

Similarly, the public may well doubt whether the huge expansion in central bank balance sheets – as is evident in the US – would be reversed in time. Inflationary expectations may then gain a firm hold, driving inflation-risk premia up and the exchange rates down. This would greatly increase the costs of restoring credibility on the inflationary upside, thereby further undermining the central banks’ ability to do so when the time comes.

The conclusion is straightforward: the ability to navigate through the crisis, using either fiscal or monetary measures effectively and at modest overall cost, depends in both of these cases on the credibility of the authorities’ commitment to long-term monetary stability. Neither huge fiscal deficits nor massive monetary expansions are themselves an unmanageable threat, provided the regime itself remains credible. This is crucial even for a country as indispensable to the global economy as the US. For the UK, it is close to a matter of economic life and death.

* Tough times, unconventional measures, www.bankofengland.co.uk"

"Page 1 of 12
Speech by
SPENCER DALE
EXECUTIVE DIRECTOR AND CHIEF ECONOMIST
BANK OF ENGLAND
Tough times, unconventional measures
Remarks at the Association of British Insurers Economics and Research Conference, London
Friday 27th March 2009
I would like to thank Rohan Churm, Alan Mankikar and Tim Taylor for their considerable help in
preparing these remarks. The views expressed are my own and do not necessarily reflect those of
other members of the Monetary Policy Committee.
Page 2 of 12
The UK economy is in a deep recession. Output in the United Kingdom fell at its fastest rate in
nearly thirty years in the final quarter of last year, and a similar fall in output in the first quarter of
this year appears likely. We are in the throes of a synchronised global downturn, which has spread
far and wide.
But the darkest hour is just before the dawn. Although immediate prospects appear bleak, the
substantial economic stimulus that is underway means that there are grounds for thinking that
economic conditions may start to improve later this year. An important part of that stimulus stems
from the extraordinary measures taken by the Monetary Policy Committee over the past six
months, including our decision to start using unconventional policy measures.
Today, I will describe my view of the economic outlook and outline the factors that I believe will
spur a gradual turnaround in our economy. And I will explain why, earlier this month, the
Committee voted to use unconventional policy measures: how they will work and how we will
monitor their effectiveness.
I am delighted to have the opportunity to discuss these issues at the Association of British Insurers.
The insurance industry is a key part of the UK economy and of the financial sector in particular.
Indeed, it accounts for a third of all the jobs in the UK financial sector. Your industry, like
virtually every other sector of the UK economy, is being affected by the recession. And given
your members’ significant holdings of gilts and corporate bonds, it will have a key role to play in
the transmission of the unconventional policy measures recently begun by the Committee.
1. THE ECONOMIC OUTLOOK
The causes of the current recession can be traced back to at least the summer of 2007. The fallout
from the sub-prime mortgage crisis and the resulting pressure on banks’ balance sheets led to a
Page 3 of 12
sharp tightening in the price and availability of credit. And the first stages of what became a
renewed and prolonged surge in oil and other commodity prices began to erode households’
spending power and eat into companies’ profit margins.
As a result, the UK economy gradually slowed through the end of 2007 and into the first half of
2008. But the economic outlook took a dramatic turn for the worse in the autumn of last year.
That deterioration followed the failure of Lehman Brothers, which triggered the most severe
banking crisis for almost a century. Confidence in the very essence of banking – as well as in
individual financial institutions – was shaken to its core and measures of financial market risk and
uncertainty ballooned. The resulting contraction in the supply of credit has had a significant
impact on the ability of households and companies to borrow and spend.
But the nature of the downturn over the past six months cannot be explained solely in terms of the
direct effects of the collapse of Lehman Brothers on the supply of credit. The impact of changes in
credit conditions on investment and consumption decisions tends to be gradual, as existing loans
mature and new contracts are negotiated. This contrasts with the dramatic pace at which economic
activity and sentiment turned during the final quarter of last year. Output, orders and investment
all fell precipitously in a matter of months. Moreover, the downturn in economic activity was
seemingly indiscriminate. Output in virtually every corner of the world fell sharply, irrespective
of a country’s exposure to sub-prime loans, the state of its banking system, or its level of
indebtedness. The effects of the shock were also felt far beyond its epicentre in the financial
sector. Manufacturing output has been particularly hard hit, with UK manufacturing output
estimated to have fallen by 4.9% in the fourth quarter of last year; the largest quarterly fall for over
thirty years. Many other countries have suffered even larger falls: Japanese manufacturing output
is estimated to have contracted by over 12% in Q4 and German manufacturing output by over 7%.
World trade is estimated to have fallen by over 6% in January alone.
Page 4 of 12
The pace, breadth and spread of the global downturn suggest that tighter credit conditions were not
the only force at work. It seems clear that a pronounced and widespread collapse in confidence
also played a major role. With the failure of Lehman Brothers it became all too apparent that the
problems in the financial sector were more acute than had previously been thought. This was
compounded by the realisation that even the largest financial institutions were not ‘too big to fail’.
More fundamentally, the demise of Lehman Brothers may have led to a questioning of
policymakers’ ability to deal effectively with such unprecedented financial turmoil. The view that
the impact of the financial crisis would be largely restricted to the exclusive confines of the Square
Mile and Wall Street was dispelled once and for all. Households and businesses cut back on their
spending as it became increasingly apparent that the effects of the financial crisis on the real
economy were likely to be deeper and more widespread than previously envisaged.
The impact of the tightening in the supply of bank credit and of the widespread collapse of
confidence was compounded by developments in the supply of trade credit. In previous
recessions, many large businesses in the UK were able to support smaller companies by reducing
payment times to companies further up the supply chain and by extending credit to those further
down. But pressures on corporate cash flows and the reduced availability of bank credit may have
limited the scope for larger companies to behave in this way in this downturn. The Monetary
Policy Committee, via its network of regional Agents, is monitoring closely developments in the
demand for and availability of trade credit.
The reduction in the availability of trade credit has been accompanied by a tightening in the supply
of credit insurance. This is at a time when the demand for such insurance is at its highest.
Similarly, heightened uncertainty about the global environment has increased the demand for
letters of credit from UK exporters.
Page 5 of 12
These developments are understandable and predictable: the economic environment has
deteriorated markedly and as insurers you need to protect yourselves against future losses. There
is a limit to how much insurance premiums can be raised before they exceed the profit margin
associated with a particular transaction. Higher prices can have the same effect as the complete
withdrawal of supply.
I know that members of the ABI are working hard with Government and with business to agree
how best to meet these challenges. It is vital for the long-term success of both your industry and
our economy as a whole that a workable solution is found.
Where next for the UK economy?
The Monetary Policy Committee set out its latest economic outlook in the February Inflation
Report. That Report went to great pains to stress the considerable uncertainty surrounding the
prospects for the economy. Nobody can predict with any certainty how the UK economy, or
indeed the world economy, is likely to fare over the next year or so. So beware of anyone that
suggests otherwise.
With that warning in mind, let me outline my central economic outlook, which is broadly similar
to that described in the February Report. Near-term prospects are bleak. Output is likely to
contract further in the first half of this year, as a weakening labour market and concerns about job
prospects weigh on consumption, companies run down their stocks and scale back investment
spending, and the synchronised slowing in world demand restrains export growth. But as we go
through 2009, I believe it is most likely that the pace at which output is contracting will ease and
that we will see some signs of recovery by around the turn of this year.
This view is based on the substantial stimulus that is already starting to flow through the pipelines
of our economy. There has been a marked easing in global monetary and fiscal policies; authorities
Page 6 of 12
around the world have also enacted substantial initiatives to revitalise the global banking system;
the sharp falls in commodity prices will boost households’ purchasing power; and the marked
depreciation in sterling should support demand, both at home and abroad, for domestically
produced output. The scale of this stimulus is significantly greater than that seen at comparable
stages of the recessions in the 1970s, 80s or 90s.
But to repeat, there is huge uncertainty about the precise form and timing of the recovery and so
this central path should be treated with a healthy degree of scepticism. In particular, I think the
risks around this central path are weighted to the downside, reflecting the possibility that the
actions taken by the authorities around the world to improve the availability of credit and to restore
business and consumer confidence are slow to take effect. So there may still be more to do.
Learning from past recessions
When considering the likely scale and duration of this recession, it is natural to examine the
experience from past recessions. And simple comparisons with recent recessions are not
encouraging. For example, taking account of developments in Q1, output appears likely to have
fallen by more in the first few quarters of this recession than in any of the preceding ones. But
when making these comparisons, it is important to recognise that the parallels are far from perfect.
The causes of this downturn are very different from those of most recent recessions and, as I have
just described, the policy response on this occasion has been much quicker and more decisive.
There is also a third factor that needs to be borne in mind when drawing lessons from history.
This is the first recession in the UK for nearly 20 years. The structure of our economy has
changed significantly since the early 1990s, and even more so since the early 1980s and 1970s.
The UK economy has undergone extensive reforms and deregulation, and businesses have been
transformed by the implementation of new technology and the effects of globalisation. It is hard
Page 7 of 12
to quantify precisely the various ways in which the structure of the economy has changed. The
appropriate data are not always available and it may be a long time until the effects are discernible
in aggregate economic statistics. Importantly, the significance of some of these structural reforms
may not be fully apparent until the economy is subjected to a substantial shock.
For example, one consequence of globalisation is that supply chains around the world are far more
integrated. This is likely to have played an important role in the speed and synchronisation of the
world downturn, as the effects of falling demand in a few countries were translated into lower
orders and production in many in a matter of weeks. That increased integration is also likely to
affect the speed and nature of the recovery.
Similarly, the technology used to control and manage inventories has changed substantially over
the past twenty or thirty years. This may have enabled companies to run down their stocks earlier
in this recession than in previous downturns. And indeed there is evidence that firms have already
cut back aggressively on their stock levels. A corollary of this sharp correction is that the stock
cycle may be shorter lived than in previous recessions.
The behaviour of the labour market may also have changed. I have been struck by the number of
business people who tell me about the array of measures they have already taken since their orders
starting falling sharply last autumn. Wages have been frozen or even cut, hours have been
reduced, working practices have been adjusted. To the extent that wages and hours are now more
flexible, the adjustment in employment may be less. But if it is easier for companies to vary their
labour force than in the past, much of this adjustment may come through more quickly than in
previous downturns.
It is hard to know at this stage how significant these structural changes will be in determining the
depth of the recession and the speed of the recovery. But the possibility that there has been a
Page 8 of 12
material structural change in our economy highlights a further danger of viewing the current
recession through the prism of previous ones. The latest economic data on world trade, output and
unemployment are unmistakeably grim, but we must continually challenge ourselves about how to
interpret these and the economic data to come. They could be telling us something about the
causes and size of the downturn, the impact of the policy measures taken so far, or how changes in
economic structure are affecting the response of output and employment.
Let me now say a little about the role the Monetary Policy Committee is playing in addressing the
challenges posed by the global economic downturn.
2. UNCONVENTIONAL POLICY MEASURES
The MPC responded to the marked deterioration in the economic outlook with an aggressive
easing in monetary policy. We reduced Bank Rate from 5% to an historic low of just 0.5% in a
matter of months. Moreover, at our policy meeting earlier this month, the Committee agreed to
finance £75 billion of asset purchases by the issuance of central bank reserves, in order to boost
the supply of money and improve the functioning of corporate credit markets.
The purchase (and sale) of assets by central banks is nothing new; central banks have always
implemented monetary policy by changing the size and composition of their balance sheets. Nor,
importantly, has the objective of monetary policy changed, which is to hit the Government’s 2%
target for CPI inflation. What is different, however, is the range of assets being purchased by the
Bank and the scale of those purchases. Given those changes, I want to explain the rationale for
large scale asset purchases in the current economic climate. In doing so, I will address two key
questions. First, how will asset purchases help us meet the inflation target? And second, how will
we monitor the progress of the policy and assess its effectiveness?
Page 9 of 12
How will asset purchases help us to meet the inflation target?
The objective of the asset purchase programme is to boost nominal spending in order to hit the
inflation target. The tightening in the availability of credit and the collapse in confidence has led
to a sharp slowing in the growth of nominal demand. The four-quarter growth rate of nominal
GDP sank to a record low in the final quarter of last year. The weakness in nominal spending has
been accompanied by a sharp slowdown in the growth of bank lending to firms and households
and in the growth of money holdings of the non-financial sector. At our policy meeting earlier this
month, the Committee judged that without the additional stimulus provided by the asset purchase
programme, the growth of nominal spending would be insufficient to meet the inflation objective.
The MPC instructed the Bank to use the additional reserves to purchase two types of assets: gilts
and high-quality corporate debt. This twin-track approach allows for asset purchases to stimulate
nominal spending in a variety of different ways. Such a pragmatic strategy seems entirely sensible
given that this in the first time these unconventional tools have been used in the UK.
I find it helpful to summarise the different mechanisms through which asset purchases may boost
nominal spending into three broad channels.
First, the purchases of gilts will act to increase their prices and reduce their yields. This change in
the relative attractiveness of holding gilts is likely to cause investors to reallocate their portfolios
into other assets, such as corporate bonds, which in turn will tend to reduce the yields on those
assets. In so doing, the borrowing costs faced by firms and households should fall. As of today,
the Bank has purchased £13bn of gilts from investors.
Page 10 of 12
Second, purchasing assets with central bank reserves will significantly increase the amount of
liquidity in the system. This expansion in the supply of money may in itself encourage greater
levels of lending and borrowing. Bank deposits are likely to increase, providing banks with a
ready source of funding to finance additional lending. Similarly, as the additional liquidity
permeates through the economy, companies may feel less constrained by the need to hoard
liquidity and more able to undertake investment projects.
Third, purchases of high-quality corporate debt should help to improve the functioning of
corporate credit markets. Strains on financial institutions’ balance sheets, combined with
heightened levels of uncertainty and risk aversion, have impaired the liquidity of key corporate
credit markets. Firms’ access to some of these markets has been restricted and the cost of credit
inflated. By purchasing assets in a targeted way, the Bank can aid liquidity in these markets and
so improve the availability of corporate credit. The Bank has been purchasing commercial paper
for over a month now. It made its first purchases of corporate bonds this week. And we are
reviewing the case for intervention in other corporate credit markets.
Importantly, the objective of the Bank’s operations within corporate credit markets is not to
purchase a specific quantity of assets; rather it is to improve the functioning of those markets. The
scale of purchases required to improve market liquidity may in fact be relatively small: the very
knowledge that the Bank stands ready to purchase assets may be as beneficial as the actual asset
purchases themselves. Moreover, the required scale of purchases is likely to diminish over time as
liquidity improves and private investors return to the market. It is important not to judge the
potential significance of this channel by the scale of asset purchases.
How can we monitor the effectiveness of the purchases?
Page 11 of 12
It is much too soon to come to a firm judgement about whether this programme of asset purchases
is having its desired effect. In particular, the impact on the growth of broad money and credit will
not begin to be discernible for several months yet. There are, however, some encouraging signs.
Since the MPC’s announcement, yields on gilts have fallen by 40-60bp at the horizons at which
the Bank is making purchases. This has been accompanied by falls in yields on non-financial
corporate bonds of up to around 30bp. And since the Bank started to operate in the commercial
paper market, spreads have tightened and issuance has increased. These developments have been
mirrored in the positive feedback the Bank has received from issuers of commercial paper.
Over the coming weeks and months, the MPC will be monitoring a wide range of indicators as we
form an initial assessment of the likely effectiveness of the asset purchase programme in
stimulating nominal spending. A critical issue will be the extent to which movements in asset
prices and market spreads are translated into lower borrowing rates faced by businesses and
households. Equally important will be the extent to which the additional liquidity and lower
borrowing rates act to spur the growth of broad money and credit.
I am confident that increasing the supply of money will eventually lead to an increase in nominal
demand. But there is considerable uncertainty about the relative importance of the different
channels through which it may work. As such, I welcome the eclectic, twin-track approach
adopted by the Committee. There is also considerable uncertainty about the overall size and
timing of the impact of the monetary expansion on nominal spending and on the prospects for
inflation. That is why in the minutes of its March meeting, the MPC indicated that, just as with its
decisions on Bank Rate, we would review the appropriate scale of the asset purchase programme
each and every month.
3. CONCLUSION
Page 12 of 12
The extraordinary developments in the global economy since the autumn have been matched by
the magnitude of the policy response. Monetary policy continues to play its part, with Bank Rate
set at a historically low level and the launch of a large-scale asset purchase programme.
Throughout these dramatic developments, the objective guiding the Committee’s decisions has
remained the same: the need to keep inflation on track to meet the Government’s 2% inflation
target. It was that objective that underpinned the decisions to reduce Bank Rate to unprecedented
levels. And it was that objective that drove the MPC to adopt unconventional policy measures.
The inflation target will also dictate the rate at which the stance of monetary policy is returned to
normal as economic prospects recover. The outlook for inflation relative to the inflation target
provides the natural guide to exiting from this period of exceptional monetary stimulus.
Importantly, this exit strategy is clear, transparent and open to public scrutiny. Openness and
transparency have been the cornerstones of UK monetary policy since the Monetary Policy
Committee was established in 1997. That has never been more important than now.
The inflation target is symmetric. That requires the MPC to set policy in a symmetric way. The
Committee adjusted monetary policy boldly and decisively on the way down in order to meet the
inflation target. And, let me assure you that, when the time comes, we will be prepared to respond
with equal vigour on the way back up."

that the rise in government spending and debt is a ticking time bomb. What contributes to the debt explosion is the rise in entitlement programs.

From Disciplined Approach To Investing, one view of the US Debt/Deficit :

"U.S. Government Debt/Deficit A Disaster In The Making?

For the U.S. government's fiscal year ending September 30, 2008 the total federal debt level reached $10 trillion. Michael Pakko, an economist with the Federal Reserve Bank of St. Louis, notes in a recent article that the rise in government spending and debt is a ticking time bomb. What contributes to the debt explosion is the rise in entitlement programs.

All told, the shortfall for government social insurance programs (Social Security, unfunded obligations of Medicare Part A & B and Medicare Part D-prescription drug coverage) comes to a present value of $40.9 trillion. This is the government’s official estimate—some private sector economists suggest that the total burden is even greater. Economist Lawrence Kotlikoff has recently estimated the total unfunded liabilities of current federal programs at $70 trillion.

Recent bailout actions are also contributing to the rise in obligations that will need to be repaid by U.S. taxpayers. Forecasts from the Government Accountability Office show the growth of the debt obligations if entitlement reforms are note undertaken. The below graph depicts the growth in expenses compared to total revenue as a percent of GDP out to 2080.

(click to enlarge)

and the resulting growth in the government's debt:

(click to enlarge)

The ballooning deficits and debt levels are issues that will need to be addressed sooner versus later in order to ensure healthy economic growth in the long run. Michael Pakko concludes:

Current measures of the federal deficit and the national debt, as dismal as they might appear, fail to reflect full consequences of current-law fiscal policy. The unfunded future liabilities of government entitlement programs imply rising deficits and a ballooning public debt far larger than today’s shortfalls. And debates about the immediate economic impact of government deficits on private savings and interest rates, while of academic interest, fail to address the full importance of these long-run consequences. Fundamental reform of entitlement programs is critical for putting U.S. fiscal policy on a long-run sustainable path.

Take the Fed's Flash Poll:

• What would you do to trim the debt and deficit?

Source:

Deficits, Debt and Looming Disaster: Reform of Entitlement Programs May Be the Only Hope
The Regional Economist
By: Michael Pakko
January 2009
http://www.stlouisfed.org/publications/re/2009/a/pages/debts.html
Sphere: Related Content

Posted by David Templeton, CFA at 9:30 PM

"if they start to view the pound as Europe’s equivalent of an Agency bond …"

Brad Setser on the wild ride of the dollar recently:

"Only a few days ago, so it seems, it took about $1.25 to buy a euro. Now it takes closer to $1.45 (it was more earlier today, but the dollar subsequently rallied). And — as Macro Man notes — the dollar’s move pales relative to the recent slide in the pound. Not so long ago a pound bought 1.5 euros. Now it buys a euro and change. The Anglo-Saxon currencies haven’t had a good two week run.

Both the US and the UK ( 1 ) had housing and finance centric economies. Both have ( 2 ) significant external deficits. And both are ( 3 ) inclined to use monetary and fiscal policy aggressively to combat a downturn.

But with global trade collapsing, the euro’s rise can not be all that comfortable for members of the eurozone. It isn’t clear that any one wants a stronger currency right now ( THIS MEANS THAT THEIR EXPORTS WILL BE MORE EXPENSIVE IN OTHER COUNTRIES, AND THEY DON'T WANT TO LOSE EXPORT BUSINESS DURING AN ECONOMIC DOWNTURN ). Currencies though are relative prices — and can go up or down amid a global contraction. In theory, everyone could ease monetary policy equally without changing the relative value of any currencies ( THIS WOULD KEEP THE DOLLAR HIGHER ). In practice things rarely work out as neatly ( EXACTLY ).

Dr. Krugman, I would assume, hopes that the euro’s rise puts more pressure on Germany to join a coordinated European fiscal stimulus — with good reason. Germany’s export machine relies on global and European demand. That demand is falling (watch Russian imports for example). And if the euro’s rally is sustained, Germany will soon face an additional headwind. So too will the less competitive members of the eurozone. They are in an even more difficult position if Germany doesn’t lead a coordinated European reflation. ( GERMAN EXPORTS WILL BE TOO EXPENSIVE )

Four other thoughts:

1) Until fairly recently, all the European currencies tended to move in tandem against the dollar. That meant their cross-rates were stable. And it meant that the euro wasn’t as strong as it seemed. The euro was strong against the dollar and the yen, but not against the pound, the Swedish krona, the Norwegian krona and similar currencies. Right now the euro is rising against all the smaller European currencies — not just against the dollar.

2) Japan is starting too worry about yen strength, not surprising. Renewed intervention seems like a possibility if the yen continues to rise. That shouldn’t be a surprise. Japan tends to intervene heavily when the interest different between the yen and dollar goes away, reducing private market demand for dollars.

3) China has to be pleased by the euro’s rally. Dollar strength translated into RMB strength — and a rising RMB when Chinese exports were slowing (and likely now falling) made Chinese policy makers uncomfortable. There was even talk of moving to a real basket peg — which would have meant that RMB would depreciate against the dollar when the dollar was strong. But I rather doubt that China now wants to appreciate against the dollar to offset the dollar’s renewed weakness against the euro. Right now China is happy to see the dollar and thus the RMB weaken( THAT WAY THEIR EXPORTS DON'T GET MORE EXPENSIVE FOR US ) …

4) Central banks have been big buyers of the pound over the past few years. Reserves were growing, and the pound’s share was rising. Central banks liked its yield( PAID HIGHER INTEREST ) — and the fact that it an easy alternative to both the dollar and the euro. By my count, central bank inflows often were large enough to cover the UK’s current account deficit. Central banks reserves are shooting up, but if they “rebalance” their portfolios they should be big buyers of pounds now — as they need to hold more pounds to keep the pound’s share of their portfolio up as the pound’s value slides.

I’ll be interested to see if they do so — or if they start to view the pound as Europe’s equivalent of an Agency bond …( AND NOT BUY IT AS TOO RISKY )

Notice the Chinese Contradiction:

1) They don't want the dollar to weaken so that they can export to us

2) That's happening because we're printing money

3) Yet, they tell us not to borrow too much from them, and they don't want to spend too much

Problem: On 3, it has to be one or the other

Either we borrow more and they save more

or

we save more and they spend more

"“You still have a massive paranoia in the marketplace and you’ve got that safety-at-any-cost mentality,”

You can see the following behavior as sensible or over the top. From Bloomberg:

"By Matthew Benjamin and Liz Capo McCormick

Dec. 15 (Bloomberg) -- Bill Clinton was forced to abandon spending initiatives to boost the economy at the start of his presidency when advisers warned him that the borrowing needed to fund the programs would push interest rates higher. President- elect Barack Obama may not have the same problem.

While the total amount of U.S. government debt outstanding rose to $10.7 trillion in November from $9.15 trillion a year earlier, the amount of interest paid in the last two months fell by $10 billion, according to the Treasury Department.

Instead of shunning the U.S., where losses on subprime mortgages in 2007 triggered a global seizure in credit markets that led to the downfall of securities firms Bear Stearns Cos. and Lehman Brothers Holdings Inc., investors can’t get enough Treasuries. Even as estimates of Obama’s stimulus package and the budget deficit rise to a record $1 trillion, demand continues to increase as investors flee risky assets around the world and put their cash into U.S. bonds paying, in some cases, nothing in yield just to ensure the return of their principal.

“You still have a massive paranoia in the marketplace and you’ve got that safety-at-any-cost mentality,” said Jay Mueller, who manages about $3 billion of bonds at Wells Fargo Capital Management in Milwaukee. “People are not buying Treasury bills because they think the yields are attractive. They are buying them because they are afraid to put money anywhere else.”

This Fear and Aversion To Risk and the accompanying Flight To Safety are not driven but fundamentals and clear analysis. Could these investments prove sensible? Of course they could, but the Flight To Safety appears overdone.

Why to the US?

"Foreign central banks and other institutions are accumulating Treasuries at the fastest pace since 1988, boosting their holdings 12 percent since September, compared with a 7.7 percent increase last quarter, according to the Federal Reserve.

Purchases accelerated even as the yield on the benchmark two-year Treasury note tumbled to 0.76 percent last week from this year’s peak of 3.11 percent on June 13. Rates on three- month bills turned negative on Dec. 9 for the first time. The same day, the U.S. sold $30 billion of four-week bills at a zero percent rate. Yields on two-, 10- and 30-year Treasuries last week all fell to lowest since the U.S. began regular sales of those securities.

The two-year note yielded 0.73 percent as of 2:32 p.m. in New York, according to BGCantor Market Data, after falling as low as 0.66 percent on Dec. 12.

The drop in yields drove bond prices higher, pushing returns to 12.4 percent on average this year, the best performance since they gained 13.4 percent in 2000, according to New York-based Merrill Lynch & Co.’s U.S. Treasury Master Index. The returns compare with a drop of 41 percent in the Standard & Poor’s 500 Index and average losses of 15 percent in Merrill Lynch’s broadest corporate bond index."

If you had purchased bonds with higher yields, then you would be doing quite well now, which is why William Gross wishes that he had done so.

“This is not about return and yield and value; investors are functioning out of raw fear,” said Barr Segal, a managing director at Los Angeles-based TCW Group Inc., which oversees $90 billion in fixed-income assets. At the same time, “this is fabulous for the Treasury because they are borrowing at virtually nothing,” he said.

Japan’s bond market suggests that low yields may remain for a sustained period. In an effort to revive sagging growth in the 1990s, the world’s second largest economy ran its national debt to 1.5 times of gross domestic product. Yields on Japanese bonds are near the lowest in three years, with the country’s benchmark 10-year bond paying 1.40 percent, compared with 2.59 percent in the U.S. The national debt in the U.S. is 72 percent of GDP.

“It’s good news,” said James Horney, director of federal fiscal policy at the Center on Budget and Policy Priorities in Washington. “Even though we’re borrowing larger amounts of money, the total amount we’re going to pay in interest is going to be somewhat lower.”

Why aren't the people who claim that buying Toxic Assets during this crisis and Spending Money On Infrastructure now because wages and other costs are lower, recommending that we borrow freely now for no interest?

"Interest was $92.5 billion from August through November 2007 on the $9.15 trillion in total debt outstanding, resulting in interest expense of 1.01 percent. In the same period a year later, interest was $87.5 billion on $10.66 trillion in total debt, dropping the expense to 0.8 percent.

While the median estimate of 49 economists and strategists is for 10-year Treasury yields to end 2009 at 3.65 percent, that’s still below the average of 6.91 percent paid on the securities since 1962. The security helps determine corporate and consumer borrowing rates.

Obama plans an economic stimulus package that may approach $1 trillion, in addition to a middle-class tax cut and universal health care, which may add $4 trillion or more to the national debt over 10 years, according to the Tax Policy Center in Washington and health-care economists."

So we will borrow for less?

"The U.S. already posted a record $401.6 billion budget shortfall for the first two months of fiscal 2009, which began Oct. 1, according to a Treasury report last week. The largest postwar budget deficit by the U.S. was $412.7 billion in 2004.

“The role of the deepening economic slump in this deterioration coupled with the escalating size of the likely fiscal stimulus puts the deficit on course to exceed $1 trillion,” Edward McKelvey, a senior economist in New York at Goldman Sachs Group Inc., wrote in a Dec. 8 report to clients. “This implies upside risk to our $2 trillion figure for Treasury supply.”

Clinton’s proposals to spur the economy early in his administration in 1993 were stymied by concern how bond investors would react, according to James Carville, a Clinton consultant during the 1992 presidential campaign.

“Early in the Clinton days, the hallmark of policy was if you did this, how would it affect the bond market,” Carville said in an interview last year. “Every time I would talk to someone they would say ‘you can’t do that, it will freak the bond market out.’ I said ‘goddamn, whoever the bond market is, these bastards are powerful.’”

The potential for massive deficits has done nothing to damp demand for government debt as the U.S. prepares to spend $8.5 trillion to bailout financial institutions, homeowners and the economy. The biggest deficit as a percentage of the economy was 6 percent in 1983. A trillion-dollar 2009 gap would top that.

To prevent yields from rising, Fed policy makers indicated that the central bank may buy Treasuries. Fed Chairman Ben S. Bernanke suggested in a Dec. 1 speech that he would consider such a measure, saying one option is to buy “longer-term Treasury or agency securities on the open market in substantial quantities.”

“If there is a whiff of anything getting worse, the Fed can just go downstairs and start that printing press,” said Kevin Gaynor, head of economics and interest-rate strategy at Royal Bank of Scotland Group Plc in London. “They can easily stop targeting the federal funds rate and start targeting a two- or five-year Treasury yield.”

Policy makers may also cut interest rates again, which may keep bond yields low. The Federal Open Market Committee will reduce its target rate for overnight loans between banks by a half-percentage point, to a record 0.50 percent, when it meets Dec. 15-16, according to the majority of economists surveyed by Bloomberg News.

The U.S. economy has been in a recession for a year, the National Bureau of Economic Research declared on Dec 1. The economy will continue to contract through June, with unemployment rising above 8 percent the end of 2009, from 6.7 percent last month and this year’s low of 4.8 percent in February, according to Bloomberg surveys of economists. That would make the current slump the longest since the Great Depression.

“In some ways it’s ironic,” said Meg Browne, senior currency strategist at Brown Brothers Harriman & Co. in New York. “The U.S. turned down first and the crisis appeared first in the U.S., yet people continue to flock to the U.S. government debt market because it’s the biggest and deepest market in the world and still has a low risk.”

The U.S. will eventually have to commit to balanced budgets, said Alice Rivlin, former Fed vice chairman and founding director of the Congressional Budget office.

“We can’t press our luck,” said Rivlin, now a scholar at the Brookings Institution in Washington. “Eventually, we’ve got to show the world that we are fiscally responsible.”

This post went far and wide, then wider, but the points about printing money and showing that eventually we're going to handle this debt and deficit are correct points to be made.

She is sceptical of strategies aimed primarily at boosting consumption, given Germany’s high savings rate and low unemployment."

Let's start the German Problem with Willem Buiter in the FT:

"Confessions of a crass Keynesian
December 13, 2008

The German federal minister of finance, Peer Steinbrueck, does not like anything that increases government deficits. He does not like them, Sam-I-Am. I believe he is wrong - very wrong and dangerously wrong. In the interest of Anglo-German harmony and ever-closer cooperation, I have written this post.

It explains that there are bad deficits and good deficits. Or, in the words of Ecclesiastes: “To every thing there is a season, and a time to every purpose under the heaven:” a time to cut taxes and a time to raise taxes, a time to borrow and a time to refrain from borrowing.

Today is a time, even Ecclesiastes would agree, made for increased government borrowing, provided a few key conditions are satisfied.

Mum, the government are running a deficit again!

Government deficits have to be financed by selling assets, by borrowing from the domestic private sector, from the rest of the world or from the central bank. Asset sales by the government can be ignored as a financing option for the governments of the USA, the UK and the nations that constitute the Euro Area. Quite the opposite has been happening lately, with governments acquiring large stake in domestic banks and other financial institutions.

Borrowing from the central bank

Borrowing from the central bank (selling Treasury debt to the central bank) requires the central bank either to increase its monetary liabilities (currency or bank reserves held with the central bank), or to increase its non-monetary liabilities, or to run down its stock of official foreign exchange reserves or other central bank assets. The USA, the Euro Area and the UK all have floating exchange rates, and foreign exchange market intervention has not been a significant pastime for the monetary authorities of these countries. Under current economic circumstances, financing the acquisition of additional Treasury debt by running down central bank holdings of private securities would not make sense. True non-monetary liabilities of the central bank (Central Bank Bills or Central Bank Bonds) are common in developing countries and emerging markets but have not been a common sight on the balance sheets of the Fed, the ECB and the Bank of England - until recently.

The Federal Reserve System today holds a large amount (more than $400 bn) of Treasury deposits on its balance sheet , the result of the Treasury selling Treasury securities to the public and depositing the money with the Fed. The Fed has used these funds to acquire additional private securities. Instead of borrowing from the Treasury (through the Treasury’s deposits with the Federal Reserve System), the Fed is currently considering the possibility of issuing non-monetary, interest-bearing securities directly to the market. Assuming Treasury and Fed securities of the same maturity are perfect substitutes for private investors, this would give the Fed another, economically equivalent mechanism for expanding its balance sheet without increasing the monetary base. Why the Fed would want to increase the size of its balance sheet by issuing non-monetary liabilities rather than monetary liabilities is unclear to me. Liquidity preference remains unbounded from above. Further quantitative easing is not inflationary for as long as current economic conditions last.

Once the official policy rate is at its zero floor, quantitative and qualitative easing are the main instruments of monetary policy, which becomes inextricably intertwined with liquidity management. By acquiring longer-dated government securities and financing these purchases by expanding the base money stock, central banks can bring down the risk-free nominal rate of interest at longer maturities than overnight. Such purchases of longer-maturity government securities reinforce the expectations mechanism - long-term risk-free nominal yields are tied to current expectations of future overnight rates, give or take a term premium. By acquiring private securities, including illiquid private securities, whether through outright purchase or as collateral in repos or at the discount window, the central bank can influence a range of term spreads and liquidity spreads on these private securities.

For simplicity and to put the issue as sharply as possible, let’s assume that when the government (the Treasury) borrows from the central bank, the central bank monetises its acquisition of the Treasury securities, that is, it increases the sum of currency and banks’ deposits (reserves) with the central bank. In practice, the increase in base money is likely to take the form mainly of larger bank reserves with the central bank.

As long as the economy is in the doldrums, with a large (or even large and growing) amount of spare capacity and extreme risk-averse behaviour of banks, other financial institutions and individual investors, the increased quantity of central bank money will be absorbed willingly at the current price level and at the current (near zero) level of the short-run nominal interest rate. Fear and loathing in the financial markets have created a near unbounded liquidity preference - a willingness to hold a humongous quantity of real base money. Such injections of base money are therefore not inflationary.

When the economy recovers, as it will, and private investors recover their bottle, the demand for real base money normalises and the private sector finds itself with excessive real base money balances at the current official policy rate and price level. The private sector will try to reduce its holdings of real money base money balances partly by switching their portfolio allocation towards non-monetary assets and partly by spending them. In the aggregate, of course, the private sector cannot reduce the nominal stock of base money, unless the central bank plays ball and de-monetises the public debt it had monetised earlier. If it does not do so, monetary equilibrium will have to restored through a higher general price level.

This de-monetisation of the public debt (the reversal of the earlier monetisation) will be automatic if, when the economy recovers, the official policy rate rises again above its zero lower bound and quantitative easing comes to an end. When the official policy rate is set (pegged) above its lower bound, the demand for real base money balances becomes finite again. With the general price level pre-determined (given/sticky in the short run because the world is crass-Keynesian in the short run, that is, in real time), the nominal base money stock becomes endogenous. Given the central bank’s balance sheet, the counterpart of the endogenous (and lower) stock of base money is the endogenous (and lower) stock of Treasury securities held by the central bank.

When the economy normalises, the public debt issued by the Treasury to finance any deficits incurred during the slump leaves the central bank and comes back home to mama. Mama will have to convince the markets (the domestic private sector and/or the rest of the world) that it wants to hold this public debt. If the interest rates at which the markets are willing to hold that debt are high, or if there is no interest rate level, however high, at which the markets wish to hold the additional public debt spewed out of the central bank’s balance sheet, we have a problem. Either the government forces the central bank to hang on to the Treasury debt or the economy will have to live with very high interest rates or, in the most extreme case, with default on the public debt.

The first scenario - permanent monetisation of public debt issuance - means that, when the economy recovers, the central bank is forced to engage in whatever amount of monetary issuance may be required to finance the government deficit. The result will be inflation, when the economy recovers - quite possibly inflation in excess of the explicit or implicit inflation target of the central bank

While it is therefore true that the government can always, if it has the power to tell the central bank what to do, monetise the outstanding stock of government debt and any amount of new issuance of government debt, no matter how large, as long as the debt is denominated in domestic currency, there is a limit, for most base money demand functions, to the amount of real resources the government can extract though the inflation tax. This implies that there is a limit to the real value of the government deficit that can be financed through the inflation tax and also to the amount of index-linked government debt and foreign-currency-denominated government debt that can be monetized and inflated away.

The nastiest alternative is that the real value of the government deficit is larger than the real value of the additional issuance of money balances that the private sector is willing to absorb at any constant rate of inflation: the maximum long-run inflation tax at a constant rate of inflation is less than the real value of the government deficit. In that case hyperinflation will result.

It is a long way from the current threat of deflation (negative inflation) to hyperinflation, but it is never to soon to start worrying about the next crisis.

Borrowing from the market

Now consider the case where the government deficit is financed by borrowing from the markets rather than from the central bank. Like every other economic agent, the government is subject to an intertemporal budget constraint. A government is solvent if the value of its net stock of outstanding debt does not exceed the present discounted value of its current and future primary surpluses. The government’s primary surplus is its conventional financial surplus plus net interest paid on its outstanding stock of debt. Since the government here excludes the central bank, among the government revenues that are included in the government’s primary surplus are the taxes paid by the central bank to the Treasury. These contributions of the central bank to the government budget are not usually referred to as ‘taxes’.

Central bank operating profits (net interest income and other income minus the cost of running the show) are usually split between a contribution paid into the government budget and an addition to the central bank’s reserves. The contribution of the central bank to the government budget (called taxes on the central bank in the previous paragraph) increase one-for-one with any increase in interest paid by the government to the central bank on the central bank’s holdings of government securities. At the margin, therefore, borrowing from the central bank is free to the government.

As regards the solvency of the central bank, it makes no difference whether base money is non-interest-bearing (the case of currency) or interest bearing (often the case with banks’ reserves with the central bank). Ultimately, the central bank can settle any domestic-currency denominated claim on itself by paying in currency, which is both non-interest-bearing and irredeemable.

When the government violates its ex-ante intertemporal budget constraint or solvency constraint (its outstanding debt is larger than the present discounted value of its planned/expected primary surpluses) there are but three options for closing this ‘solvency gap’. (1) it cuts current and/or future public spending; (2) it raises current and/or future tax revenues; or (3) it defaults on part or all of the sovereign debt.

When will the future spending cuts or tax increases have to be implemented? The solvency constraint and intertemporal budget constraint are silent on this matter. They only assert that the present discounted value of current and future spending cuts and tax increases has to be at least equal to the solvency gap. It does not tell you when this has to happen. So could we wait until the years 3125 before spending is cut or taxes are increased? Market realities imply the answer is no. Markets are doubting Thomases. To them seeing is believing. They want to put their fingers in the wounds. In practice, spending will have to be cut and/or taxes will have to be increased as soon as this is sensible from a conjectural or cyclical point of view. As soon as a tax increase or public spending cut would be counter-cyclical rather than pro-cyclical, it will have to be implemented. Failure to do so at the first opportunity would weaken the credibility of the government. Markets will entertain steadily stronger doubts about the sustainability of the fiscal-financial programme of the government. Default risk premia will be added to the interest rates at which the government borrows. As the perceived likelihood of a sovereign default increases, the default risk premia will rise and, ultimately, the government will be rationed out of the primary debt markets: it will become impossible to add to the government’s net indebtedness and even to roll over maturing debt.

So is Steinbrueck right in condemning proposals for deficit-financed fiscal stimuli in Europe and elsewhere to counteract the contraction of effective private demand? This question has two parts: (1) does a temporary tax cut or spending increase, followed by a future tax increase or spending cut that restores government solvency stimulated demand? Can governments credibly commit themselves to raise future taxes or cut future public spending by enough to maintain government solvency if they deliver an immediate tax cut or public spending increase?

Does a temporary tax cut boost consumer spending?

For the moment, let’s assume that the answer to the second question is ‘yes’ and let’s address the first. I will focus on a temporary tax cut. Will a temporary tax cut today resulting in a larger budget deficit and increased government borrowing stimulate demand, if future government taxes are raised again by the same amount, in present discounted value, as the current tax cut? Or, in other words, does postponing taxes, holding constant their present discounted value, boost demand?

I will focus on cuts in household taxes, like the personal income tax or VAT. The argument that deficit-financed tax cuts don’t boost consumption demand is known as Ricardian equivalence or debt neutrality. For it to be true, the aggregate consumption demand of consumers has to behave in the same way as would the consumption of a representative infinite-lived consumer with perfect foresight. This consumer knows, when his taxes are cut, that he will pay higher taxes in the future and that the present value of current and future taxes has not changed. His permanent income or wealth have not changed. He will not feel better off as the result of the tax cut. He will save all of the tax cut to pay the higher future taxes.

The demographics of the Ricardian equivalence model are not convincing. People are born, live for a while and die. While they are alive, they overlap with earlier generations (the old) and with generations born since their own generation arrived (the young). Postponing taxes will therefore shift the burden of paying the taxes from the older generations to the younger generations, and possibly even to the (as yet) unborn. The usual life-cycle arguments suggest that the old (who have fewer remaining years to live) will have a higher marginal propensity to consume out of a temporary tax cut than the young. The old certainly will have a higher marginal propensity to consume than the unborn. So cutting taxes today and raising them again in the future by the same amount in present discounted value raises aggregate consumption demand.

It is important that the current tax cut and the future tax increase don’t affect the same people equally in both periods. For the fiscal stimulus to work through a life-cycle mechanism, the current tax cut would primarily have to benefit today’s old and working generations. The future tax increase would be paid mainly by today’s young and working generations, or by those who today are still unborn (future generations). This will be the case if the tax is a tax on labour income or a capitation or head tax. It would not be true if the future tax increase were on the income from an asset that is already in existence and fully owned today (land or physical capital). In that case, both the current tax cut and the future tax increase will be reflected in the value of the assets, which will not change. Taxes on future labour income are not, however, capitalised in the value of any asset owned by anyone currently alive. This is because we have abolished hereditary slavery: the human capital of future generations is not owned by anyone currently alive today. Postponing labour income taxes therefore redistributes resources from the young and the unborn to the old. The life-cycle For life-cycle reasons, the old have a higher marginal propensity to consume than the old, and the unborn don’t consume at all.

If current generations care about their descendants, they may be planning to leave bequests for them. Should the government then try, by cutting taxes today and raising them in the future, to redistribute towards parents and grandparents and away from their children and their grand children, the parents and the grand parents would simply offset this involuntary intergenerational redistribution by the government with voluntary intergenerational redistribution towards their descendants. Lower taxes today would be saved and left as increased bequests. Since most people don’t leave bequests in the first place (most retirement wealth is annuitized), this ingenious argument in favour of Ricardian equivalence even in a world of overlapping generations with finite life spans, is a theoretical curiosum, not a useful empirical benchmark.

In addition to life-cycle reasons for current tax cuts boosting aggregate consumption, there are liquidity reasons. If some consumers are liquidity-constrained (unable to borrow more or sell assets) a cut in current taxes will relax a binding liquidity constraint on current spending, even if the consumer were to be fully aware that he would have to pay higher taxes in the future. Of course, not all households can be liquidity-constrained, otherwise there would be no-one to purchase the securities the government is issuing to finance the increased government deficit.

In the current liquidity crunch there is bound to be a significant increase in the number of liquidity-constrained households. If they could be targeted through the tax cuts, the consumption effects would be strengthened. Liquidity constraints are especially likely among those with large debts, no liquid assets and no collateralisable assets who suffer a temporary interruption in their labour income, due to unemployment, say. They are also likely to affect those with rising age-earnings profiles who have few liquid and collateralisable assets. This would include yuppies and other upwardly mobile groups.

It is hard to believe that, provided a government has the fiscal-financial credibility to be able to commit itself to future tax increases or public spending cuts when it implements immediate tax cuts or public spending increases, that this would fail to stimulate aggregate demand through the usual life-cycle effects and liquidity constraint effects.

The VAT cut rubbished so emphatically by the German minister of finance is in fact quite a clever tax cut, precisely because it is temporary. By cutting the price to the consumer today and raising it again tomorrow, there is an incentive to shift the timing of consumption of non-durables and services, and the timing of the purchases of consumer durables, toward the present, when consumer prices are temporarily low. The neo-classical substitution effect reinforces the Keynesian current disposable income effects.

Mr. Steinbrueck is not impressed and provides variations on the ‘who would cross the road for a 2.5 percent VAT cut when there are 20 percent to 50 percent discounted sales on everywhere’ argument. I think Mr. Steinbrueck underestimates the German and British shopper. But even if he were right and the substitution effect of the temporary VAT cut is negligible, there still is the income effect.

Would the income effect have been stronger if, instead of a VAT cut worth, say £14 bn, the same amount of money had been sent directly to British households in the form of a cheque with the same amount of money for each tax-paying or benefit-receiving adult? This is not at all obvious to me. Assume households spend the same amount following the VAT cut as they did before. If prices come down by the full 2.5 percent cut in the VAT rate, they will buy a larger amount of real commodities with the same amount of income. This stimulates the demand for real goods and services. If prices were to come down by less than the cut in VAT, after-tax profits would increase for the sellers, which could boost the consumption demand of their owners or the demand for investment or working capital inputs by the enterprises themselves.

If none of this sounds convincing to the German minister of finance, he could always implement a temporary investment credit or a similar temporary subsidy to or tax cut on investment on fixed assets. Precisely because it is temporary, it would shift the timing of investment spending toward the present.

So Mr. Steinbrueck’s outburst appears to be rooted in faulty logic and sloppy thinking.

Who can afford even a temporary tax cut or spending increase?

Until further notice, I will assume in what follows that the central banks in the countries or monetary union I am discussing stick to their price stability or dual price stability and full employment mandates. That means that they will monetise government debt and deficits only up to the point where they perceive such actions to undermine the effective pursuit of price stability.

Not all nations in the north Atlantic region are equally well positioned to implement a fiscal stimulus that would result in a significant increase in the government deficit. The decision of the EU to call on all EU member states to implement a 1.5 percent of GDP stimulus to GDP therefore appears to be ill-advised. The magnitude of the stimulus should be modulated (a) according to the needs of the country (how deep is the recession, how open is the economy) and (b) according to the fiscal-financial sustainability of the government and the credibility of the government, that is, the likelihood that it will act in a determined counter-cyclical manner during the next economic upswing, raising taxes and/or cutting public spending.

Italy’s fiscal-financial sustainability and the credibility of its government were it to announce a pleasure today - pain tomorrow temporary fiscal stimulus are close to zero. The UK’s fiscal-financial sustainability is poor and the credibility of its government is severely impaired after years of pro-cyclical fiscal policy during the age of excess that preceded the current bust. The UK government, by de facto or de jure underwriting the liabilities of the UK banking system has assumed debts worth over 400 percent of GDP. Of course there are assets on the other side of the banks’ balance sheets, but the liabilities are firm and clear, while the assets are dodgy and of uncertain value. The same applies to the United States of America, where the Federal government is not only up to its neck in actual and contingent liabilities through its underwriting of the banking system, GSEs like Fannie Mae and Freddie Mac, insurance companies like AIG and non-specific partly financial enterprises like GE, but is about to have the water rise even higher as it bails out the three domestic automobile manufacturers.

Germany’s Maastricht gross general government debt as a percentage of annual GDP was about 20 percentage points higher than that of the UK at the end of 2007. However, the cyclically adjusted budget deficit in Germany is far smaller than that of the UK. In addition, the exposure of the German government to its banking sector, while non-trivial, is much smaller than that of the UK government to its over-developed banking sector. Most important, the German authorities have demonstrated both the willingness and the capacity to engage in countercyclical fiscal policy during the most recent boom period.

This means that reasons of national self-interest and as a constructive member of the global community, Germany can and should engage in a significantly larger fiscal stimulus (relative to the size of its economy) than the US and the UK. Spain and France also should deliver an above-average fiscal stimulus, while Italy cannot afford much of a stimulus at all.

Sovereign default versus inflation levies

For the first time since the German default of 1948, a number of countries in the north Atlantic region (North America and Western Europe) face a non-negligible risk of sovereign default. The main driver is their governments’ de facto or de jure underwriting of the balance sheets of their banking sectors and, in some cases, of a range of non-bank financial and non-financial institutions deemed too big to fail. Unfortunately, in a number of cases, the aggregate of the institutions deemed too large, too interconnected or too politically connected to fail may also be too large to save. The solvency gap of the private institutions the authorities wish to save exceeds the fiscal spare capacity of the sovereign.

The clearest example of the ‘too large to save’ problem is Iceland. Iceland’s government did not have the fiscal resources to bail out their largest three internationally active banks. The outcome was that all banks went into insolvency. The government then nationalised some key domestic parts of the three banks out of the insolvency regime, decided (under massive pressure from the British, Dutch and German governments) to honour Iceland’s deposit guarantees and left the rest of the unsecured debt to be resolved through the insolvency process.

Other countries face the problem of the inconsistent quartet ((1) a small open economy; (2) a large internationally exposed banking sector; (3) a national currency that is not a major international reserve currency; and (4) limited fiscal capacity). They include Switzerland, Sweden, Denmark and the UK. Ireland, the Netherlands, Belgium and Luxembourg have all but the third of these characteristics.

There can be little doubt that, faced with the choice between sovereign default and an unexpected burst of inflation to reduce the real value of the government’s domestic-currency-denominated debt, the US government would choose inflation. It would simply instruct the Fed to produce the required burst of inflation. The Fed is the least independent of the leading central banks. The Fed regained a measure of operational independence in the conduct of monetary policy in 1951 through the US Treasury Federal Reserve Accord. This accord does not have the force of law, and can be revoked at any time by the Treasury.

In the UK too, I believe that, given the choice between sovereign default and a burst of unanticipated inflation, the UK Treasury would choose inflation. The Treasury could repatriate the rate setting powers of the Monetary Policy Committee of the Bank of England under the Reserve Powers clause of the Bank of England Act 1998.

Things are different in the Euro Area. The independence of the ECB is embedded in the Treaties. A unanimous decision by all member states is required to change the Treaty. Given this operational independence ‘on steroids’ of the ECB, it is unlikely that any Euro Area national government or coalition of governments could bully the ECB into engaging in a burst of public-debt-busting unanticipated inflation. Perhaps Mr Peer Steinbrueck’s intemperate expostulations about the horrors of increased public debt are due to his recognition that he, unlike his fellow ministers of finance in the UK and the US, does not have the option of inflating away the public debt, unless Germany were to decide to leave the Euro Area.

If instead we accept as an axiom that every German finance minister worth his salt would emulate the stance taken by Ludwig Erhard in 1948 and would therefore never choose the inflation option, even if the only alternative would be government default, then Peer Steinbrueck’s eruption is hard to rationalise. Perhaps it cannot be rationalised because it was an emotional outburst rather than a thought-through argument. Surely not…."

Now Wolfgang Munchau in the FT:

"Over the past three years, I have closely followed the German finance minister with a growing sense of disbelief. Peer Steinbrück’s lack of diplomacy is remarkable only insofar as that it has now become known to a wider audience. He has been talking like this forever. His bashing of the “Anglo-Saxons” goes down very well in Germany for now. But at the time of the general elections in September 2009, Germany and the rest of the eurozone will be in the middle of an economic depression. Then people will be asking why their chancellor and their finance minister have been so extraordinarily complacent.

Given the extreme economic deterioration in the past few weeks, I actually expected they would have done something by now. But they are digging in. Angela Merkel, the chancellor, held a domestic summit in Berlin to discuss the economic situation. I suspect another stimulus package will come eventually, sometime next year. But I doubt it will come in time to help the economy in 2009. Whatever is eventually decided will have no economic effect until well after the elections. Germany is thus entering 2009 with a total stimulus of 0.5 per cent of gross domestic product, in other words, with essentially no fiscal support. Since monetary policy has little traction when credit markets are dysfunctional, there is hardly any support at all.

Two weeks ago, I forecast that the German economy would contract between 2 and 4 per cent in 2009. What looked to some like an eccentric forecast has now become mainstream. Last week, two of Germany’s large economic institutes forecast a decline in growth for 2009 of 2 and 2.2 per cent respectively. Norbert Walter, chief economist of Deutsche Bank, said a contraction of 4 per cent in 2009 was possible. The Ifo institute predicts that the contraction will continue in 2010.

Expect all those forecasts to get progressively worse throughout the winter, especially if global trade continues to contract at current rates. Germany ran a current account surplus of 7.6 per cent of gross domestic product in 2007. This means that a global trade crisis will hit Germany disproportionately hard. Last week’s most shocking economic news was the 2.2 per cent year-on-year fall in Chinese exports in November, which is a bellwether of global trade volumes. To make matters even worse, the real effective exchange rate of the euro is beginning to rise again.

What about Germany’s domestic consumption? The optimists say this is providing some support. This is true for now, since total unemployment is low. But consumption is sensitive to changes in unemployment. By next spring, exports, investment, employment and consumption will all be falling. And with Germany, the rest of the eurozone will also go down.

What about the €200bn European Union stimulus package that was agreed in a watered-down form by EU leaders on Friday? Unfortunately, it is a public relations exercise first and foremost, designed to dupe people into believing that the EU is finally doing something. The headline figure of 1.5 per cent includes some new money, but mostly expenditures that were already committed before the crisis, as well as guarantees.

Ms Merkel now claims that the German stimulus is not a meagre €12bn, but an impressive €32bn ($47.8bn, £28.6bn). Italy provides an even more comic example of fiscal stimulus accounting. Tito Boeri, professor of economics at Bocconi University in Milan, has noted* that the Italian stimulus programme has a negative cost. It includes more taxes than expenditures.

The recently announced €26bn French stimulus is a useful package of structural expenditures, which might even raise the country’s potential growth in the long run. But unfortunately, it is not a stimulus. European politicians simply cannot get it into their head that the sole purpose of stimulus should be to stop a dangerous, self-fulfilling economic slump. This is not about bridges and canals, or structural reforms.

Last week, at a debate in Brussels organised by the Financial Times and Friends of Europe, a think-tank, André Sapir, professor of economics at Université Libre de Bruxelles, made an astute observation. He said we should not try to avoid 1929. We have already failed. The best we can do now is to avoid 1930, 1931 and 1932. It will depend on the quality of our policy response whether we succeed.

At the present rate, I fear, the effort is not going well. The electoral timetable in the US has delayed an effective policy response and I fear that the new economics team of President-elect Barack Obama will be too much focused on domestic stimulus and not enough on global co-ordination. The Europeans and Asians, meanwhile, are unbelievably complacent. Even a US stimulus at 10 per cent of GDP will not miraculously pull the world economy out of recession. It will most likely focus on domestic infrastructure investment rather than private consumption. US households, meanwhile, will continue to adjust their balance sheets, which will take some time.

So our financial crisis is on the brink of turning into a policy crisis. People will blame not only bankers, but increasingly politicians as well. I would expect that Mr Steinbrück will be one of those politicians. He seems to be enjoying his crisis so far. But just wait a few months."

Now, Paul Krugman in the NY Times:

"European macro algebra (wonkish)

I’ve been on the warpath over Germany’s refusal to play a constructive role in European fiscal stimulus. But what does the math look like? Here’s a simple analysis — well, simple by economists’ standards — of the reason coordination is so important for the EU.

We start from the proposition that Europe is, or soon will be, in a position where interest rates are up against the zero lower bound. This means both that fiscal policy is the only game in town, and that we can use ordinary multiplier analysis.

Let m be the share of a marginal euro spent on imports — either for an individual county, or for the EU as a whole (I’ll explain in a minute). I’ll assume that m is the same for government spending and for domestic demand. Let c be the marginal propensity to consume. And let t be the share of an increase in GDP that accrues to the government in increased taxes or reduced transfers.

Consider the effects of an increase in government purchases dG. This will raise GDP directly, to the extent that it falls on domestic goods and services, and indirectly, as the rise in GDP induces a rise in consumer spending. We have:

dY = (1-m)dG + (1-m)(1-t)c dY

or dY/dG = (1-m)/[1 - (1-m)(1-t)c]

Since governments are worried about debt, it’s also important to ask how much the budget deficit is increased by an increase in government spending. It’s not one-for-one, because higher spending leads to higher GDP and hence higher tax revenue. We have

dD = dG - tdY

A crucial number is “bang for euro”: the ratio of the increase in GDP to the increase in the deficit. After a bit of grinding, it can be shown to be

dY/dD = (1-m)/[1 - (1-t)(1-m)c - t(1-m)]

OK, some numbers. The average EU country spends about 40 percent of GDP on imports, and collects about 40 percent of GDP in taxes. Let me cut corners and assume that the marginal rates are the same as the average, and also assume that the marginal propensity to consume is 0.5. That is, for an average EU country, m = 0.4, t= 0.4, c = 0.5.

We can represent a coordinated fiscal policy by looking at the numbers for the EU as a whole. The only difference is that m falls to 0.13, because two-thirds of the imports of EU members are from other EU members.

And we get the following results:

UNILATERAL FISCAL EXPANSION

Multiplier = 0.73
Bang per euro = 1.03

COORDINATED EXPANSION

Multiplier = 1.18
Bang per euro = 2.23

The bang per euro is what matters: the tradeoff between increased debt and effective stimulus is MUCH better for the EU as a whole than it is for any one country.

You can play with these numbers, but I don’t think that conclusion is very sensitive to the details as long as you keep the large intra-EU trade effects in there. The lesson of this algebra is that there are very large intra-EU externalities in fiscal policy, making coordination really important. And that’s why German obstructionism is such a problem."

I don't know what to make of this problem. Forcing Saver Nations to be Spender Nations seems like a hard task, although look at this in the FT:

"It has become a cliché in political Berlin that of all the ministers in chancellor Angela Merkel’s cabinet, the one she gets along with best is Peer Steinbrück, holder of the finance portfolio and, as a Social Democrat, a political rival to the chancellor.

Yet as they have joined forces to rebut mounting criticism of their economic policy abroad, a subtle division of labour has developed between the two, with Mr Steinbrück, it seems, all too happy to play bad cop to the more soft-spoken Ms Merkel.

This was obvious in Mr Steinbrück’s assertion, in an interview with Newsweek this week, that Gordon Brown, the British premier, was pursuing “crass” Keynesian policies and “tossing around billions” by cutting value-added tax in a move that would burden British taxpayers for generations.

This was tougher stuff than anything Ms Merkel has said. Though the chancellor expressed “serious concern” recently about attempts to tackle the crisis by injecting cheap money into the economy – a comment aimed mainly at US fiscal and monetary policies – officials say she sees the VAT cut as a valid decision for the UK, albeit one that would not work in Germany.

This is not the first time Mr Steinbrück has breached the rules of diplomacy. In a speech in the Bundestag held in the immediate aftermath of the Lehman Brothers collapse, he proclaimed “the end of the US as a finance superpower.”

In a more recent, deeply sarcastic interview, he accused other European leaders of acting like “lemmings” – a species of rodents with an undeserved reputation for committing mass suicide - by following the UK in raising their deficits to battle the crisis.

That the German finance minister does not take outside advice graciously is a gross understatement. Indeed, European counterparts have long grown wary of his lengthy lectures at European meetings about the alleged superiority of German economic management and its three-pillar banking system.

And although the tandem with Ms Merkel has worked well so far, even the chancellery has become slightly uncomfortable with the minister’s verbal outbursts.

One factor in Mr Steinbrück’s boldness, however, is the perception within Germany that he has indeed been largely successful in managing a financial crisis that originated in the US and has affected the UK in a more graphic way than it has the rest of Europe.

A passionate chess player – he spends idle moments confronting his Mephisto chess computer and once played, and lost, against world champion Vladimir Kramnik – Mr Steinbrück is not as impulsive and short-sighted as his public comments may suggest.

The first test of his strategic skills was the near-collapse of Sachsen-LB and West-LB, two state-owned regional banks, just after the outbreak of the subprime crisis last year, followed by the rescue of IKB a Düsseldorf-based lender, and its eventual sale.

He then engineered the state-sponsored €50bn bailout of Hypo Real Estate, a property and public sector lender, wrapped up over two weekends of intensive talks.

For all his love of chess, his behaviour throughout these talks was more akin to that of a poker player. By insisting that the government would not deploy a UK-modelled rescue package for the financial sector and would never resort to nationalisations, he persuaded the country’s assembled top bankers to foot a large part of the bill for the HRE rescue.

Only once this rescue was sealed, did the government launch a €500bn rescue fund for Germany’s banks and insurance companies, exposing Mr Steinbrück’s bluff.

Many of the reforms of the world financial system members of the G20 agreed to in Washington last month were championed by Mr Steinbrück as far back as 2007, when Germany, then holder of the G8 presidency, tried and failed to rein in the under-regulated sector.

Despite the high regard he enjoys at home, the minister has had little ground to rejoice lately. Politically, he looks likely to get few rewards from his performance in the crisis since opinion polls show at least a third of respondents do not know he is a Social Democrat – a legacy of his image as a moderate right-winger in a centre-left party.

And the economic crisis has robbed him of what would have been the crowning achievement of his career as minister, namely his goal to balance the federal budget by 2011."

And this in the FT:

"Germany will wait to launch its next fiscal stimulus until it has a clearer view of the economic plan of Barack Obama, who is to be sworn in as US president on January 20, say German officials.

Michael Glos, economy minister, said – after a meeting of government officials and business leaders on Sunday night – the government would decide late next month whether to adopt more measures to stimulate the economy, Reuters reported.

That would mean Berlin would not top up its €12bn ($16bn, £10.7bn) growth-boosting package at an extraordinary meeting of leaders of the governing coalition on January 5, as many economists and international leaders had hoped.

“We will probably know what Obama is going to sign before January 20 but I would be surprised if any decision were made on January 5,” said an official before the meeting.

European Union leaders agreed on co-ordinated fiscal action worth 1.5 per cent of the region’s gross domestic product on Friday and urged Mr Obama to join them in a “transatlantic economic recovery plan”.

The German chancellor and several ministers met on Sunday night with 32 economists and trade union, business and bank leaders summoned to the chancellery.

Germany has come under pressure from experts and other governments to beef up its steps to combat the threatening slump.

Angela Merkel, the chancellor, has long acknowledged that more muscular measures would be required but she insisted more time was needed to measure the scale of the downturn and draft an appropriate plan.

She is sceptical of strategies aimed primarily at boosting consumption, given Germany’s high savings rate and low unemployment.

“We will assume our responsibility and we will keep working on stabilising the situation,” said Ms Merkel in an interview in Bild am Sonntag on Sunday. “We will work hard on a co-ordinated approach over the next few weeks.”

Sunday night’s meeting was “less about policies than about trying to get some clarity about the economic picture”, the official said beforehand, pointing to the wide range of estimates for growth next year.

The German economy will shrink 0.8-2.2 per cent in 2009 while unemployment shoots up, according to economists, most of whom see the government’s prognosis of 0.2 per cent growth as hopelessly outdated.

Berlin may soon be forced to modify its €500bn bank rescue package, adopted in October, which has failed to revive the interbank lending market and prevent lending to companies drying up.

“We designed the fund so that its rules could be modified by decree,” the official said. “This means we can change them very quickly if we have to, though I am not saying we have to.”

Politicians led by Ms Merkel and Peer Steinbrück, finance minister, have lambasted the banks for parking their cash with the European Central Bank at very low interest rates instead of lending it to each other or to companies for higher fees".

I can't help feeling that Germany is committed to a larger stimulus but is bluffing its way towards some unstated goals. Maybe these bluffs are directed at the German People in order to prepare them for a stimulus. Just a hunch.