An actual money shortage

Running a central bank with fiat currencies gives you a unique opportunity to make a profit. The cost of printing notes is obviously much lower than the cost of the bank notes themselves. The difference between the cost of producing bank notes and coins and the face value of them is a profit that accrues to the Central Bank, and is usually passed on to the government. This profit is known as seignorage. If the cost of creating a note or coin is higher than the face value, it makes no sense to continue producing them. That's why the penny still exists; the US government is making a profit on producing them, so any decision to get rid of it would be a political one, and not driven by economics.

Pumping up the money supply by printing more and more notes thus actually generates revenue for the government. In countries with hyperinflation, the effects can be enormous. At the height of Ukraine's hyperinflation in 1993 (with inflation rates of 10,000% annualized), the seignorage profits amounted to 13% of GDP. While it may be tempting for a government to keep on printing as much money as it can, the resulting hyperinflation will still wipe out the gains. Real economic growth in the Ukraine was negative during hyperinflation, and other experiences with the phenomenon have been negative as well. The Weimar Republic is one example, but hyperinflation also ravaged oher European countries in the 1930s, and the people of Latin America still think back with dread on their brushes with worthless money.

But how bad must the situation be that the central bank can't afford to print any money at all? The answer is Zimbabwe bad. Chirac's new bestest friend on the African continent has managed to run the economy into the ground to the extent that the central bank can't even afford to print money any more. This must be a first in the history of central banking. Amazing.

There is something to be said that part of the cash shortage is due to hoarding of notes. In modern times the actual amount of currency in circulation (i.e. notes and coins) is just a fraction of the total money supply. In the United States, the actual amount of currency in circulation is just $600 billion, whereas broad money supply (M3) is $8.6 trillion. There'd be a real problem if everyone wanted to cash in all paper deposits at the same time. A structural collaspe of the financial system would bring something like that about, and this is what's happening now in Zimbabwe. It's tragic to see a country that used to be (relatively) rich, and could have been even richer to fall so low. No country is ever rich enough that a communist-inspired dictatorship can't destroy it.

Monetary union and economic flexibility

The question whether the euro will in the long term benefit Europe or harm it cannot be answered at this point with any certainty. I have been skeptical about monetary union in Europe as it is constituted now, as there are serious divergences undermining EMU. There is no agreement between economists (is there ever?) on whether even in theory it is better to have fixed exchanged rates or floating ones. And the split goes right down the middle of the free market camp too, with both views represented by the Big Names of Economics.

So I was very interested to find a discussion between Milton Friedman and Robert Mundell on this very issue. (I came across it via Arnold Kling, whom I found through this post at Asymmetrical Information). The discussion goes around in circles to a certain extent, but in the end it boils down to the issue of economic flexibility. As exchange rates are prices, they convey information on supply and demand of currencies, which again is based on numerous other factors in the real economy. By shutting down a mode of expression for the information by fixing currency prices, you can't make the information go away. It will have to express itself by other means, and that's where economic flexibility comes into play.

Mundell argues that having a sound monetary policy is of vital importance, and that economic benefits will follow if only there's stable money. In fact, he takes the argument to its logical conclusion and advocates having a world currency. The larger an area a currency covers, the greater the stability will be. Mundell does say he does not advocate a single world currency, but just a world currency; the difference though seems to be semantic rather than substantive. He says:

My ideal and equilibrium solution would be a world currency (but not single world currency) in which each country would produce its own unit that exchanges at par with the world unit. We could call it the international dollar or, to avoid the parochial national connotation, the intor, contraction of “international” and the French word for gold. Everything would be priced in terms of intors, and a committee—in my view, say, open market committee designated by the Board of Governors of the International Monetary Fund—would determine how many intors produced each year would be consistent with price stability. Every country would its currency to the intor following currency-board system principles.

This is different from having a single world currency only in that it retains the option of re-floating national currencies, which would be harder if they were abolished altogether. And the practical difficulties are enormous too, as its ultimate viability would depend on the proposed "G3 Open Market Committee" being able to determine the right amount of intors to issue. In effect, this creates a single fiat currency for the whole world. I get nervous with three fiat currencies being dominant. The art of central banking has not evolved to the point where one would wish to bet the world's economic future on central bankers getting it right.

Friedman argues for flexible exchange rates, arguing that they provide an important escape valve for the adjustment of prices within an economy. Mundell counters that the same adjustment can take place by changing domestic price levels, and that it can be done more effectively that way. In theory, Mundell is right, but in practice it does not work that way, and this is what Friedman argues too. The case of Argentina is instructive in this regard, as it had a fairly orthodox currency board which ultimately failed. The discussion between Friedman and Mundell took place before the Argentinian currency board collapsed in late 2001, so there are no port-mortems of this event, nor do they spend much time discussion the Argentinian situation.

By tying the peso at parity to the US dollar, Argentina did get the immediate benefit of vastly improved monetary policy in 1991, just as Mundell argues. It also introduced thitherto unheard-of macroeconomic stability, and the Argentinian economy prospered. But Argentina was pricing itself slowly out of the market by maintaining convertibility with the dollar. It simply wasn't producing enough economic added value to justify charging the prices in a convertible peso, nor did it have the productivity gains that would allow the economy to remain competitive internationally. The 2001 collapse in Argentina came after Brazil had unpegged the real from the dollar in 1999, which added to the competitive pressures on Argentina. At this point, Argentina had the choice of adjusting its domestic price level downward, or achieve a similar result by devaluing the peso and thus breaking the currency board. In a very messy process that exacerbated the outcome manifold, it ultimately defaulted on its debt and devalued the peso. It sank from parity with the dollar to 4, essentially wiping out 75% of Argentina's wealth if measured in dollars.

The key again is economic flexibility here. Had Argentina possessed an economy flexible enough to adapt quickly to competitive pressures by improving productivity and reducing the domestic price level, it would have been able to keep the peso convertible to the dollar at parity. Looking at a single dimension of productivity, it might have had to reduce aggregate labor costs by, say, 25% in the mid-1990s. Firing 25% of all workers is one way of doing that, or by all workers taking a 25% pay cut. Neither is very appealing.

One of the architects of the Argentinian currency board, Steve Hanke, defended the currency board against the critics (such as Paul Krugman):

And how did the Argentine economy fare during the Menem decade? As Table 1 shows, Argentina responded with a growth spurt that left its neighbours in the dust. All this is not an anomaly. Since 1950, countries with currency boards have realized average GDP growth per capita that is 54% higher than comparable countries that had central banks with discretionary monetary powers.

This is not to say that a sound currency is everything. Indeed, Argentina desperately needs a good dose of supply-side economics. Unemployment is high because labour market regulations are burdensome and taxes are too high and complex. Bring on deregulation and a flat tax. Clone Hong Kong, please. And that's not all. The government apparatus needs a complete overhaul. The only way to attack the endemic corruption spawned by the state is to shrink it. Those reforms, on top of its sound money, would put Argentina back on a high-growth track.

The table at the bottom of his article shows that Argentina's economy grew by 230% in the years 1989-1999 in US dollar terms. The devaluation of the peso (now trading at about 3 to the US dollar) means that all that growth and then some has been wiped out if measured in dollars. In fact, in dollar terms the Argentinian economy contracted about 25% in the period of 1989-2002. Hanke actually sees the seeds of demise for the currency board when he argues for structural reforms. (As an aside, the picture for the Asian economies he mentions would now be different, as some floating-rate countries like South Korea have done pretty well since the crisis of 1997.)

Using the currency board as both the carrot and the stick in Argentina failed to get the necessary structural reforms get implemented. The members of the European Monetary Union are no Argentinas, but there are a number similarities. Structural problems are contributing greatly to the current economic weakness in the entire Eurozone. The problems are the same as in Argentina, although probably not as severe: rigid labor markets and high non-wage costs are preventing European companies from adjusting to the weak global economic environment (and the strong euro too). Mundell's argument is that the single currency will be a driver of reforms, making it more likely that these structural problems will finally get tackled. Are reforms a necessary precursor for monetary union, or is monetary union a catalyst to bring these changes about?

There has been some progress in Europe on structural reforms, but overall far too little has been achieved. While there is a reasonable single market now in goods, the services sector is still highly fragmented. And even the European directives establishing the single market for goods are poorly implemented, with France being one of the biggest offenders. Not very surprising, that. It does show that there is a difference between the Single Market on paper and the reality on the ground. But the intentions here of the EU are good for a change, and Brussels will be trying to create a true single market for services. It's not going to be easy:

A commission report published last year listed 92 barriers encountered by businesses wishing to offer their services in more than one EU country.

The report found problems began with the founding of businesses, which can be hindered by local and national requests for several authorisations.

The distribution of services was also made difficult by laws forcing the provider to have a physical base in the country.

The advertising industry was hampered by a maze of different national regulations.

Belgian electricians have to pay three times the Belgian rate to register with the authorities in neighbouring Luxembourg for a one-day job. And Austrian bakers need eight different licences if they want to set up in Italy.

If the euro is to become successful, it is vital that the internal market be as free as possible. This still does not address the issue of structural reforms within member countries, though. Eurosclerosis is a problem that won't go away easily. Having a true single internal market will make cross-border competition more intense in many more areas than is possible now. This could be one of the great strengths of the European Union, by allowing countries to experiment with their domestic economic policies by competing against one another. Competition is an essential tool in the economic discovery mechanism of what works and what doesn't. But competition is scary to those who like the status quo, and especially those who like the power they wield in their own countries. So plans are afoot to stifle competition between countries, because it's so unfair:

Plans to scrap the national veto on tax to eliminate "unfair" tax competition in Europe will this month be proposed by Valéry Giscard d'Estaing, the man drawing up a new EU treaty.

His plan, designed to stop some EU members poaching inward investment and savings by setting very low tax rates, has the backing of most member states, including France and Germany.

According to aides, Mr Giscard d'Estaing is determined to press the issue, even though Britain and Ireland are opposed to deciding any EU tax issues on the basis of majority voting.

The former French president believes that without reform, the EU's single market will be distorted as countries embark on a damaging race to undercut one another's company tax rates.

It's the same old argument against capitalism and competition, but transported into a different context. It shows that the European elites still don't understand why an economy works and prospers. It's not a new insight, but it's the statists of d'Estaing's ilk who are drawing up the new EU constitution. That does not bode well for the future, but that's not news either.

There is some evidence that the euro has indeed spurred greater economic integration and flexibility in Europe. But this enforced discipline has not extended very far, nor is it making much of a difference in the discussions about structural reforms. My view remains that European Monetary Union is currently doing more harm than good.

Meanwhile, in Latin America, the idea of monetary union seems to be catching on. Brazil and Argentina have floated the idea of moving to a joint currency. Coordinating economic policy is one thing, but moving to a joint currency at this stage seems foolhardy in the extreme. Moreover, one report quotes deputy foreign minister Martin Redrado as saying:

"The currencies are worth almost exactly the same, this is the time,"

Yes, the exchange rate between the real and the peso happens to be close to one at the moment, but that is utterly meaningless. You could multiply either currency's nominal value by a constant and it would not change underlying economic reality one bit. If they're going to base a single Latin American currency on this kind of reasoning, it's doomed before they even start.

Careful what you wish for

The euro is a political construct. While the idea may have its roots in economics, the introduction of the single European currency was always a political project, meant to solidify European integration and to give Europe a bigger say in the world. The French definitely did see it right from the start in political terms too, as they wanted the euro to provide a counterweight to the almighty US dollar. It's the old French obsession with their own irrelevance, and the euro was a way of reasserting French relevance in the world, channeled through the dank sewers of the European Union.

Given what's riding on the euro for Europe's ruling elite, the first years of its existence were a bitter disappointment. Virtually since the introduction on January 1st, 1999 the euro fell like a brick against the dollar. This in turn led to much gnashing of teeth of the European elites, because it wasn't supposed to be like this. The value of the currency was seen as a sign of Eurocratic virility, and all it was producing was a high falsetto squeak. It's dangerous to look at the value of the currency in these terms, because it leads to even more contorted economic policy than usual. But there you had it: a massive outpouring of anguish from the ruling elite about the euro's weakness and constant reassurances that the euro was a strong, viable currency.

The United States has long had a "strong dollar" policy going back to the Reagan years. A strong dollar meant a strong America. Intertwining a political message with the external value of the currency was politically opportune, and perhaps even useful as a short-term expedient. The dollar had been on a continuous slide before then, and the external value of the currency does matter. If your currency goes down in value relative to others, then your entire currency area is impoverished by a corresponding percentage. In the long run, currency prices are best left to the interaction of supply and demand on the international markets rather than used as totems in policy making. An agnostic approach from politicians is best.

However, that's not how real life works. The danger of making a wish is that it might come true, and the Euro-elites are now discovering the hard way that the consequences of their wishes are in reality different from their imagined outcomes. The strong euro is a perfect example of this. Over the last year, the euro has gained almost 20% in value against the dollar, granting the Euro-elites their wish. But they're not exactly reveling in the experience, because exchange rate movements have effects in the real economy and do not exist merely to accumulate international bragging rights. Why is the dollar falling though? There are a number of reasons for that: the external financing requirement of the United States is huge. The current account deficit stood at about $500 billion in 2002, meaning that the US had to attract almost $2 billion every working day of the year to finance the deficit. At 5% of GDP it is clearly in a fairly extended position, and coupled with a federal budget deficit, the financing requirements of the US are pretty hefty. This is part of the reason why the dollar has been declining. Other reasons are the low yields on US cash and US Treasury bonds; US cash yields only 1.25% at best, while the euro short-term interest rate stands at 2.5%. Keeping cash in US dollars at the moment does not even get you compensation for inflation.

The flip side is that these low interest rates are stimulating the economy, or at least they should be. There's now an impressive array of positives for the US economy: negative real interest rates, falling oil prices, tax cuts and the weak dollar. In the past, this combination has led to a resurgence of economic growth and risks the reemergence of inflationary pressures. If all of these factors don't produce an economic rebound, then the old metaphors of pushing on strings become eerily appropriate. The next months will tell.

The weak dollar is a positive for economic growth because it makes American industry more competitive internationally, at the expensive of lowering the aggregative relative wealth of all dollar-denominated assets. The effects of the weaker dollar could already be seen in the first quarter earnings season, where both the top and the bottom lines were lifted by the currency effect. The weak dollar is helping America export more.

If the weak dollar is helping US exporters, then European exporters must be suffering, and they are. Interest rates in Europe are higher than in the US, especially at the short end of the yield curve, there is at best a neutral fiscal impact on economic growth and the strong euro is eating into sales and profits. Only the falling price of oil is helping here, but not as much as it is in the US, because of the strength of the euro and because energy is so heavily taxed in euro that swings in the underlying commodity have a smaller percentual impact on the final price than they do in the US.

So now that the Euro-elites have their stronger euro, its effects are not quite what they had in mind. Instead of basking in the warm glow of a rising currency, their exporters are hurting. During the period of dollar strength it was US exporters who suffered, but even during that time European economies underperformed the US. The growth differential between the US and Europe is not likely to close anytime soon. The secret is the more flexible US economy, where it is easier for companies to adjust to changing circumstances by cutting costs and firing people. This is painful in the short term, but has the long-term benefit of building more resilient companies and increasing aggregative wealth in the long run. Europe's labor markets are ossified, locking employers into costly arrangements, that make employing people unattractive and that erode the long-term profitability and even viability of companies.

The strong euro is therefore a problem because the domestic economic price structure is not flexible enough to respond. The cost of labor is high, and not amenable to downward adjustment. After all, people don't like taking a wage cut. The ultimate wage cut is to be laid off, and with unemployment creeping upward in all of Europe, that is what's happening.

There's also a different problem that is new to the Eurozone, and that is the existence of the Eurozone itself. Or rather, it's the single currency that has now put companies into the (for them novel) position where they are faced with strong currency and no escape valve. Countries like Italy used to devalue to their way out of trouble whenever Italian industry had lost competitiveness against, say, Germany. That sort of works, in that it keeps the country in business, but it does impoverish the entire nation and it imports inflation. But now that escape valve of devaluation is no longer there, so the adjustment will have to take place through other means, and that's going to be very hard in an environment of rigid labor markets and no structural flex.

Devaluations are not the way to go, but regional (i.e. national) responses were still possible in the sense that national monetary policy could account for the impact of a strong currency. The strong euro is an asymmetric shock that affects the Eurozone. Some economies (like the Netherlands and Ireland) are much more trade-oriented than others (Italy or Spain). So a strong euro has a much greater impact in the countries with open economies than in those with a less international focus. This brings us back to square pegs, round holes and the European Central Bank. It has to find a single interest rate to deal with the inflationary pressures and the impact of a strong currency on very different underlying economies.

Some time ago, I looked at a simple Taylor-rule approach to EMU, which is a way of trying to find the "right" interest rate by looking at inflation and the output gap. Another approach is to use a Monetary Conditions Index (MCI), which attempts to gauge the effect of real interest rates and exchange rates on the economy. Central banks in Canada, Norway and Sweden use MCIs as a policy instrument. Essentially what the MCI does is to try to find a trade-off between interest rate movements and exchange rate movements. For instance, for an open economy, a 3% change in the value of the currency has the same impact on growth as a 1% change in real interest rates. For closed economies, the multiplier will be bigger.

Looking at a simple MCI for the US, it's clear that monetary conditions in the US have been easing for a long time now. It's actually somewhat worrying that this has not translated into stronger growth yet, but the terrorist attacks and the wars in Afghanistan and Iraq are plausible explanations for the muted recovery thus far. The graph shows the year-on-year change in MCI for the US, but in absolute terms monetary conditions as defined by the MCI are now at their most expansionary in a very long time. Overall monetary conditions in the Eurozone are stimulative too, but as the MCI graph for EMU shows, the effect of the strong euro has meant that monetary conditions have been contracting a little for the last year. This is obviously not helping economic growth in the Eurozone. (MCI constructed with data from the ECB.)

A strong currency is not necessarily a good thing, nor a necessarily bad thing. You don't want a currency that's perennially weak, because that sets you on a course for long-term national indigence. What's more important is how you deal with changes in the exchange rate, and that depends on the flexibility of the economic structure. In that regard, the US is better off than Europe. If and when the US economy starts to pick up more decisively again, the dollar's slide will likely come to an end. The positive scenario for Europe would be that the strong euro forces the politicians into action and compels them to fix the structural problems that afflict Europe. It's a low-probability scenario though.

Chile's Unidad de Fomento

Traveling to different countries can be eye-opening. One of the things that struck me in all three Latin American countries I visited was the deeply ingrained fear of a return to hyperinflation. The ravages of annual inflation rates of 1000% or more were keenly felt by the population, and the poor were hard hit. While this has not turned them into raving monetarists or Chicago-style free marketeers, they are willing to through some short-term hardship as long as it prevents a return to hyperinflation.

In Santiago I was talking to some people about Chilean government bonds and how they're inflation-protected. That is, the yield you get on a Chilean bond is a real yield, corrected for inflation, rather than a nominal yield like most bonds. Chile isn't the only country in the world issuing inflation-protected bonds, but it was one of the first ones to do so. By now, many governments issue inflation-protected bonds. There are the index-linked gilts in the UK, TIPS in the US, OATi's in France and various other flavors in Sweden and (I think) Australia. Issuance is fairly limited as demand has been surprisingly low for them. You'd think that a risk-free return over inflation would snapped up by institutional and retail investors alike, but in practice the uptake has been limited. Apparently the Treasury in the US is looking at increasing issuance of TIPS. (TIPS stands for Treasury Inflation Protected Securities; the story on the grapevine was that Robert Rubin, then Treasury Secretary, had a fit when he heard people were calling them that. "The US Treasury does not give TIPS!" he is said to have exclaimed.)

Chilean inflation-protected bonds however are not denominated in peso, but in a unit of account called the Unidad de Fomento, or UF. The UF's exchange rate to the peso is calculated on a daily basis relative to the peso, which is the currency in Chile. This exchange rate is based on inflation in the last two months, so that the real purchasing power of one UF remains the same, but it fluctuates in value relative to the peso.

What's remarkable is how widespread the use of the UF is. The UF is used not just for government bonds, but also for rents, house prices, long-term contracts, wages, services and big-ticket items. Its use is deeply engrained in the Chilean economy. Its value is calculated on a daily basis and is widely disseminated. All banks and newspapers carry the conversion rate of the UF to the peso. The value of the UF expressed in pesos depends on the inflation rate of the preceding two inflation data points, so you can project forward the value of the UF until the next inflation data point becomes available. That's why the conversion rate can be calculated for some days into the future.

A large part of Chilean contracts and some goods are denominated in UF rather than pesos. This has the effect of indexing that part of the economy to inflation, moving it out of nominal (inflationary) peso space into real (inflation-protected) UF space. But for all this, the UF is just a conversion factor to pesos. All payments are still made in pesos as there are no UF notes or coins. Whenever a payment is due that was agreed upon in UF, the current conversion rate is applied and the payment is transacted in peso. This means that the functions of money are split into a currency (peso) and a unit of account (UF).

The Chilean Central Bank has published a series of papers on indexation and its effects. The two key documents to read are the introduction and Robert Shiller's look at the UF. They key argument against the widespread use of indexation is that it creates persistence of inflation because it is of necessity tied to lagged inflation information rather real-time inflation data. While an indexed unit of account will create inflation protection in high-inflation environments and can be useful in the transition to a low-inflation regime, it is actually harmful in trying to get inflation into the low single digits. Many of the papers refer to exactly this problem and try to quantify the impact. On the other hand, Robert Shiller is a long-time fan of indexation and argues that the problems of inflation inertia can be overcome.

Shiller argues that all countries should create a unit similar to the UF, and accompany that with another unit indexed to wages. I refer you to his paper linked above for the details. In fact, Shiller goes so far as to argue that a complete monetization of the indexed units of account would be feasible, de facto creating inflation-protected currencies. But what good would it do if all prices were denominated in an inflation-protected unit? Would it not simply reintroduce inflation by another means? Shiller argues that since the monetized units of account would at their base still be convertible to the nominal currency, any inflationary effects would correct themselves in an inflation-protected currency. The least sticky prices would rise in UF and therefore in peso too, be picked up by the inflation rate, which leads to an adjustment of the UF/peso rate which then in turn leads to a downward readjustment of the UF price, pushing the inflation back into the peso and peso only. I'm not sure this would actually work, because if all the UF to peso conversions happen transparently, people will stop thinking in terms of nominal pesos. This in turn will allow inflationary expectations to creep into UF prices.

As a behavioral finance guru, Shiller writes a lot about the illusion of money (again I refer to his article for more detail). The illusion of money is that people feel better off if they have more in nominal terms even if there is no improvement in real terms. The canonical example is that people feel better off if their wages increase only at the rate of inflation. The real purchasing power remains the same, but the nominal amount is higher. This also introduces an aymmetry into the flexibility of any real wage adjustments, as people are extremely unwilling to see their nominal wages reduced. There's a floor at zero, while the upside is unbounded.

We're all accustomed to living in a nominal world although we really should be thinking in real terms. This applies even to people who you might expect to know better such as CEOs and CFOs, who you might assume ought to have some training in these matters. But company balance sheets live in nominal space, their P&L's are nominal, their share prices are nominal and their dividends are nominal. We've seen part of the repercussion of this nominal thinking in recent times as nominal GDP growth in the US had fallen to its lowest level since 1962. As a rough approximation, you might expect a company's top line to grow roughly in line with GDP; as the economy expands, so does the potential for revenue. But companies had gotten used to high nominal growth rates in the economy, and the recession of 2001 coupled low GDP growth with low inflation, resulting in low nominal GDP growth of just 1% or so. This crimped the expectations that companies had for their top line as they saw nominal sales growth decline to unprecedented levels (not many of them were CEOs and CFOs in 1962). An even worse situation exists in Japan, were nominal GDP growth has been negative for the better part of five years now.

Changing the mindset from nominal to real is hard to do and seems to come unnaturally. But in Chile at least part of the economy has been indexed, and people can and do deal effectively with an inflation-protected unit of account, even if it is not fully monetized. Ironically, the Chilean authorities are trying to reduce the reliance on indexation because it hampers efforts to reduce inflation even further. A partial nominalization is underway, as the Chilean Central bank explains on page 29. The UF is not being abolished, but the setting of monetary policy is now based on nominal peso interest rates rather than real UF interest rates. The central bank has also started to issue short-dated debt in peso rather than UF. As long as there is an agreed-upon calculation of the UF the people can continue to use it. So at the moment there is no real danger that the UF will be abolished altogether.

The US Treasury already calculates a daily CPI series based on interpolated data, much like the Chilean UF. In principle it could be used to create an American version of the UF to base transactions on. A more interesting variant would be for a private provider to issue an inflation-protected currency that would maintain its purchasing power relative to the CPI basket of goods. Modern methods of payment (credit and debit cards) make the use of such alternatives technically feasible. But this still would not solve a more fundamental problem with the current monetary system: if the central bank gets policy wrong, the economy will suffer. The central bank has the potential to screw things up in a massive way, and an indexed unit of account like the UF won't help either. There is no price discovery mechanism for money and we have to hope central bankers get it right.

But even if we were to move to a world of real prices by monetizing an inflation-indexed unit of account like the UF in Chile, then that still would not mean an end to price fluctuations. The laws of supply and demand still apply, and if there's a dramatic increase in the demand for milk, then milk prices will rise, UF or no. Only those who buy the exact basket of goods used in the CPI calculation will be fully protected against inflation. And even that protection is imperfect as the inflation data is lagged.

An inflation-indexed unit of account like the UF can be useful as the Chilean experience shows. The current efforts to nominalize the economy are limited in scope and the UF will continue to be used for the foreseeable future. There's also the fundamental question whether it matters if the central bank can get inflation down to 3% from 5% if a large part of the economy is inflation-indexed anyway. The Chilean Central Bank does seem to think it matters.

Chile has become an interesting economic laboratory over the last 20 years, with fully funded pensions and innovations like the UF. Its economy has done reasonably well with far better macroeconomic stability than the rest of Latin America. Thus far the experiments seem to be working. But more importantly, they provide crucial empirical data for economists to ponder.

Now if only I could get a Pisco Sour here...

The farce at the ECB continues

Central banks wield enormous influence over the world economy, and we're in a year in which we are seeing big personnel turnover at two of the biggest. The new governor of the Bank of Japan has just been appointed, while Wim Duisenberg (Gretta's husband)is due to retire later this year. Well, he was due to retire in July, but that now appears to have been postponed. This is no way to run a central bank. The ECB has enough problems as it's trying to deal with diverging economies under its care without having to worry about the farcical nature of the succession.

When the ECB was founded, the French wanted the top job as a consolation prize for allowing the ECB to be based in Frankfurt. Of course, the French only act in the best interests of the European Union as a whole, that great organization that is making the nation state and national allegiances obsolete. In the French view of the world, the best interests of the EU coincide with surprising frequency with the narrow national interests of France. Funny, that.

In any case, the French wanted their man at the top of the ECB, but in the horse-trading that followed a compromise was struck. The smaller countries got their man in (in this case, Wim Duisenberg, who became quickly known as Dim Wim), but he agreed informally to step down halfway through his tenure. So he duly announced last year that he would be stepping down in July of 2003. There is a hitch though: the successor-designate, the Frenchman Jean-Claude Trichet, is in a bit of a pickle. In fact, he's being investigated and tried on charges of corruption stemming from his tenure as finance minister in the early 1990's. A corrupt French government minister? I'm shocked, shocked!

While the trial continues he can't really be appointed as the head of the ECB, so now Dim Wim has been asked to stay on a bit longer, so the French can clear their man of the charges and put in charge of the ECB later this year. As I said before, this is no way to run a central bank. In an era of fiat money, a central bank's credibility is its greatest asset. The ECB has struggled since its inception to gain credibility as an inflation-fighting central bank in the mould of the old Bundesbank, but by doing so it actually undermined that same credibility. It's been fighting the last war, while the Federal Reserve was trying to stave off deflation in the wake of the internet equity bubble. The Bank of Japan has dug in in the poppy fields of financial Flanders, sending wave after wave of monetary cannon fodder into the mud.

But the ECB's job is not easy to say the least. The structural economic problems that afflict Europe are severe, and much of the blame for Europe's poor economic performance can thus justly be laid at the feet of Europe's politicians. However the entire project of monetary union was always politically driven, without paying too much regard to economic fundamentals. The 12 economies of the European Monetary Union are diverging, and in need of different monetary policies. That's not a problem the ECB can solve, no matter who's in charge.

Chile and Argentina

There seems to be a war on, but it's largely passed me by. I simply haven't had time to read blogs, watch much news or even read newspapers, so I only have the most cursory knowledge of what is going on with the war, other than that it's not over yet. The reason for all of this is a lot of travel, with my days being crammed with meetings from breakfast till dinner, and even on the weekends my time has been seriously limited. Hence the limited blogging. I should be back in Amsterdam in a week's time, after which normal blogging is likely to resume.

Meanwhile, a canceled meeting has left me with some time to catch up on my work email (866 unread messages), and now I even have a bit of time to write this, sitting in the lobby of my hotel in Buenos Aires. I'll be flying to Sao Paulo later today, so that's where I'll be posting this from if all goes well. My two experiences with Latin America thus far have been fascinating in their contrast. The sheer difference between the drive into town from the airport into Santiago de Chile and Buenos Aires is remarkable. In Santiago, there's a crowded road that passes scrapheaps (sometimes with people living in them) and shiny new office buildings, leading onto jammed winding highway that goes over hills into Santiago. Coming out of Buenos Aires Ezeiza airport the contrast couldn't be bigger: a gleaming six-lane highway, that could have been lifted straight out of Germany. It spills out onto the wide and spacious avenues of Buenos Aires, including the 9. de Julio, the widest avenue in the world (or so the Argentinians claim). Santiago is a town that started small and has been growing into a big town, with all the concomitant problems. They're currently building a highway under the river that flows through town in an effort to fix the traffic problems at least partially. Buenos Aires has the feel of an imperial city, planned to be big, and planned to impress. The rich 19th century architecture fits in perfectly with the idea of wide avenues and luscious parks.

Looks deceive in this case. Santiago is the more dynamic city in the country with an economy that actually works, whereas Buenos Aires is suffused with a wistful yearning for past glory and still hurting from the wounds of the devaluation that was forced on the Argentine economy. After a very promising start in the 1990s with macroeconomic reforms, the government never quite got its act together on the fiscal side as especially the provinces continued to be profligate in their spending. The peg which had kept the peso at 1:1 convertibility with the US dollar had to be let go, and it's amazing that it survived for as long as it had. The peso was horrendously overvalued at $1, and the economy was simply not producing enough economic added value to justify that exchange rate. Meanwhile, the inflexible labor markets and somnolent corporate management never made the adjustments necessary to maintain competitiveness in the face of the strong peso. Put simply, the price level in Argentina was too high, and deflation was the alternative to devaluation. But cutting wages was politically impossible, so in the end it was the devaluation which achieved essentially the same effect, reducing Argentina's labor costs dramatically. It also resulted in a massive impoverishment of the country as suddenly the value of all peso assets was reduced to a quarter of what it had been previously. Then again, the underlying value of assets in Argentina should not have been as high as it had been in dollar terms anyway. The ridiculous price levels still have their repercussions today, although at 3 pesos to the dollar it's becoming affordable for foreigners with hard currency. But restaurant and hotel prices were pre-devaluation on a par with London or Tokyo, and that was completely unreasonable.

It shows the danger of relying on a pegged currency to conjure up macroeconomic stability. It can work, but it requires a flexible and open economy to survive. The exchange rate is the external price of the currency, and as a price it is subject to supply and demand pressures. Changing prices convey economic information, and if you take away the flexibility to convey economic information through the exchange rate, it will find other avenues to assert itself. The underlying economic information is still there and fixing the exchange rate does not make it go away. A currency peg can work if the economy is flexible enough to respond to economic information in other ways, for instance by lowering the domestic price level. But that is painful to the people, who don't like seeing their wages cut and their house prices drop. A weaker currency does the same thing, but it feels very different. Hong Kong, which has its currency pegged to the US dollar too, is experiencing deflation and as a result the price level in Hong Kong is declining. But Hong Kong is able to respond more flexible than Argentina ever could.

It is sad to see how a once-great country and economy has fallen so far. At the beginning of the 20th century, Argentina was one of the ten richest nations in the world, and the lavish architecture from those days still reminds the current generation of the former glory. As one Argentinian told me, "all the nice things you see were built by our grandfathers, and we have been destroying them ever since." A sense of despairing, fatalistic hopelessness lurks in the background here, but there is also a worrying sense of entitlement, the sense that Argentina deserves better. It would certainly deserve better, but it won't get there without doing something to get it. Magic solutions are not going to fall out of the sky. Coming to terms with former glory is a hard thing to do, and current-day Argentina still hasn't entirely vanquished the ghosts of its own past.

Chile is doing much better. It's not as flamboyant as Argentina, the people are more conservative and scared as hell about the instability in Argentina and Brazil. The Chilean economy has been plodding along without major mishaps for a long time now, and is slowly moving away from its dependence on copper. It's attracting investment from Australia and Asia as a manufacturing base for shipping exports into the Americas. It has reasonably well-developed capital markets and a fully funded pension system (which will be the topic of a future blog entry). There's also an inflation-protected accounting unit, called the UF. Chilean bonds are quoted in UF, and other prices, such as rents, are also expressed in UF, making it almost a parallel currency (more on this later). One question that many Chileans had as the war was starting was about the relationship with the US. The Chilean president had spoken out against the allied military action in Iraq, and Chileans wondered how that would impact US relations. The people I spoke to were unhappy with their government's stance, but then again, these people were not a representative cross-section of the population. Being there on business, I generally avoided commenting too much on the war other than in generic terms, but some of my interlocutors did express their distaste for France, which I found interesting.

Argentina is the flamboyant and overconfident member of the Latin American family. Its little brother Chile is far less conspicuous, but has plodded along calmly without pretension to build a surprisingly solid economy. The price level in Chile is far more appropriate to an economy that's still not quite fully developed, certainly compared to prices in Argentina. The wines in both Chile and Argentina are pretty good, although I still have to give the edge to the Chileans. A big discovery was also the national drink in Chile, Pisco Sour. It's somewhat like alcoholic lemonade, although that description does not do it justice. I wish they would export it, as I never had the time to buy Pisco Sour while in Chile. As it was, I almost missed my flight to Buenos Aires.

It is time to leave for my final meeting in Argentina; more blogging perhaps over the course of the weekend, which I'll spending in Rio (without too many meetings I hope).

Fukui enters the stage

The world's central banks wield enormous influence over the economies they are setting interest rates for. The mistakes they make can render an entire impecunious, so the question of who runs the central banks and what the policies are is of more than just ephemeral academic interest. The worst performer of the G-7 economies has been Japan for a long time, so the question there is especially acute. Earlier this week, Japanese prime minister Koizumi announced the successor to current Bank of Japan governor Hayami. The new man is Fukui, whose profile had been steadily rising in preparation for this moment. Fukui is very much an orthodox choice, and the speculation that Koizumi might nominate someone from outside the cozy sphere of Bank of Japan or Ministry of Finance officials has thus been proved wrong. Fukui used to work at the Bank of Japan until he was forced to resign as the result of a scandal in 1998. Despite the interlude since then, which he spent as the director of the Fujitsu Research Institute, he is still very much a BoJ man. More importantly, his views aren't significantly different from those of outgoing governor Hayami. Both are opposed to any form of inflation targeting, although Fukui might be more amenable to further non-conventional monetary easing than Hayami has been. With interest rates at zero, monetary easing has to take the form of liquidity injections. The BoJ has been buying Japanese Government Bonds (JGBs) in the secondary market for some time now, but further measures that have been floated include buying more bonds, buying corporate bonds, buying foreign bonds and buying equities. Since the BoJ can create the money necessary to buy these assets at zero cost to itself, it could amass a huge amount of assets. Of course, the idea is that as the supply of yen increases, the value of the yen will fall and that the economy will reflate. This is a perilous course to take. For if the BoJ buys more JGBs, perhaps even in the primary market (thus in effect underwriting any government borrowing by monetizing it), it would eventually have the effect of squashing the yield curve as flat as a dime at zero.

There's not much chance that will happen. Fukui, like Hayami, believes that the deflation that is gripping Japan is primarily a structural phenomenon, and that it therefore cannot be cured by purely monetary means. He is likely to keep up the pressure on (or pass the buck to, depending on one's point of view) the Koizumi administration.

Two deputy governors were also nominated, Toshiro Muto and Kazumasa Iwata. The former is a Ministry of Finance official, whose current job is in the government as Cabinet Office Director General for Economic and Fiscal Management. As such he is close to both prime minister Koizumi and finance minister Takenaka. He could provide the bridge between the BoJ and the government in order to coordinate policy better. But as someone with a Ministry of Finance background Muto also tends to be hawkish on the budget, favoring fiscal consolidation rather than further deficit spending. Iwata on the other hand is an academic, who is the farthest from the Hayami orthodoxy. He has advocated on several occasions the introduction of an explicit inflation target in order to battle the deflationary spiral. So the three nominations of Fukui, Muto and Iwata represent three main reservoirs from which Koizumi could have picked his candidates: the Bank of Japan, the Ministry of Finance and academia. The much-rumored private sector candidate has not materialized.

None of these nominations are going to change the outlook for monetary policy much in the short term. Fukui's voice will be dominant and he will be able to sway the six sitting members of the BoJ Policy Board. With inflation targeting off the radar, the policy options for Japan to deal with its deflationary spiral are bank reform (and the cleanup of non-performing loans), deregulation and structural reform, yen depreciation and fiscal stimulus. Bank reform and deregulation have been making scant progress, so hoping for salvation from that front is futile. Yen depreciation is politically problematic and would not necessarily solve Japan's problems; inflation generated solely by currency effects could steer the economy into stagflation rather than new growth. Fiscal stimulus has been tried many times in the last decade and has never produced a strong enough response to pull the economy out of its slump. What we are likely to see is further policy stalemate between the BoJ and the government, with each blaming the other for the current situation.

The Koizumi administration has been in power for almost two years now, and the initial promise of reform has never been realized. There has been some progress, but no major milestones have been reached. For instance, the commission that was supposed to cut down on unnecessary road building seldom meets, which of course means that more unnecessary roads are getting built in order to fatten the pockets of the LDP's traditional construction cabal. Koizumi's popularity was grounded in the percepetion that he was different, that he was a new kind of prime minister who really would tackle Japan's problems. Now that he is proving just as impotent as his predecessors in slaying the dragon of deflation and pushing through reform, he popularity is waning. A recent Yomiuri poll put his approval rating at 49%, while Asahi put him at 44%. These numbers are down very considerably from earlier in his tenure as prime minister. Since Koizumi is an outsider within the LDP, he has no real power base with the party. The only reason why he has not been ousted yet was because he was seen as the LDP's only electoral hope. With his popularity sliding and a leadership election looming in the fall, Koizumi's position is coming under pressure. There is still a large reservoir of yearning for reform (perhaps more in the abstract than in the painfully concrete), and none of the political parties are doing a good job of addressing this. The same Yomiuri poll that showed Koizumi's sliding popularity also gave the LDP 30% of the vote. What is more striking though is that more than half of those questioned did not have a preference for any party. This shows the disconnect between the desire for reform amongst the electorate and the political leadership.

In short, it looks like the Japanese economy is not going to recovery anytime soon. The export sector is doing OK, and that is also the home of Japan's best corporate governance, with CEOs actually paying some attention to concepts such as return on capital employed, rather just blindly pursuing market share at all costs. But the prolonged slump in the Japanese economy has had repercussions far and wide. With the Japanese out of the picture, only the US and Europe remained to keep the world economy afloat after the Asian crisis of 1997. And Europe's not doing too well either. A return to health of the Japanese economy would be a boon to the entire world. Structural reforms are badly needed, as is a cleanup of the non-performing loan problem. But until the politicians in Japan can dispose of their ossified mindset, it's hard to see how such an economic revival might take place.

And that brings different dangers with it. A country that's long been suffering from poor economic performance and a general feeling of hopelessness is a fertile breeding ground for all sorts of nasty, illiberal tendencies. Creating a feeling of wounded pride and resentment is but the first step. The most extreme case of this has been Nazi Germany, which went from defeated empire to world-threatening menace in less than a decade. The situation in Japan is not as bad as it was in post WW I Germany, so such an extreme outcome is unlikely. On the other hand, Japan never faced up to its war crimes of WW II, and to this day is grossly unsensitive to the victims of its imperialist past. So what is Koizumi doing in visiting the Yasukuni shrine, where all war dead, including the worst war criminals, are honored? Is it because he's too dim to realize the effect this has abroad? Is he forced into it by the dark side of the LDP? Is it a cunning plan to inure the public, both at home and abroad, to a more militaristic Japan?

I don't know. Koizumi is hard to read. His track record as a reformer is very disappointing. He could be a ruthless opportunist who uses whatever issues he needs to stay in power. Or it's a long-term strategy planned by the darker forces in the LDP to lay the groundwork for a new, more assertive Japan in the international sphere. Having Japan play a larger role in international affairs need not be a bad thing, but a Japan that will separate itself from the West would be (insofar as we can still speak of a monolithic West these days). An arms race between Japan and China would raise tension in a part of the world that is capable of generating a large amount of economic growth and prosperity. The world is complicated enough without having another wildcard thrown into the mix; I'd much rather the Japanese continued to rely on US troops as a guarantee of their safety than have a new inimical Imperial Navy ply the seas of the orient. The missile tests by North Korea won't have helped though.

The most likely scenario is that nothing much will change in the short term. There'll be piecemeal reform efforts, more economic stagnation and not much action. As always, Japan will keep muddling on. For how much longer? That depends on the pain threshold of the Japanese electorate.

Three single points of failure

2003 looks like it's going to become an interesting year for the world's major central banks. First up is the change at the helm of the Bank of Japan, where governor Hayami will be replaced in March. The process by which his successor is being chosen is appropriately arcane and Japanese. There are informal rules that the governorship alternates between appointees from the Bank of Japan internally and bureaucrats from the Ministry of Finance. It's now the MoF's turn to appoint a governor, but the final decision will have to be made by prime minister Koizumi. Hayami is often blamed for the delfation that has gripped Japan for the last ten years and he's often described as an inflation hawk. His refusal to print money to lift Japan out of deflation has meant that Japan is now in deep trouble, the critics argue. On the other hand, Hayami has argued that the problems lie elsewhere, in the rigid economic structures and the unwillingness of the politicians to push through economic reforms. The betting now is that the new governor of the Bank of Japan will be someone who's more in tune with the government's policies and will be more likely to the politicians' bidding. Whoever the new governor is, he's not going to be able wave a magic wand and restore the Japanese economy to health. The politicians aren't helping much either, as proposals have been floated recently to double the sales tax. This will hardly help Japan emerge from its slump.

The next big change will be at the European Central Bank, where Dim Wim Duisenberg will be riding off into the sunset. His term as governor is not yet up, but he premature departure is a result of an informal deal at the time of the ECB's creation. The French desperately wanted the governorship after the Germans had succeeded in moving the ECB's headquarters to Frankfurt. In the horse-trading that followed, Duisenberg emerged as the preferred candidate as he was seen to reconcile German central banking prowess with a concern for the smaller countries of the Eurozone. The French only accepted the deal because Dim Wim promised to step down halfway through his term, and that's going to happen this summer. His successor is very likely to be French, although the front-runner, Jean-Claude Trichet, has been caught up in a corruption scandal which could endanger his chances.

The entire process of selecting the ECB governor has thus been a perfect example of what's wrong with the structures of the EU. The gap between the level of institutional unification and the real level of convergence on the ground is huge. Putting your own countries' people in charge of EU institutions is seen as a goal in itself with the purpose being of imprinting whatever desired characteristics on the other countries. Despite the many affirmations of the European Ideal, the member countries still primarily look out for themselves. The French are obviously the best example of this. But this is only to be expected. It would not be so bad if the EU's structures were built to reflect this reality. Instead, the structures are built on the assumptions of currently unattainable unity of purpose.

It's hard to guess what changes there will be to the ECB's policy once Dim Wim is gone. It can hardly get worse, one would assume, yet the ECB's hands are tied to some extent. Its primary goal is to achieve price stability in the Eurozone, and that means a targeted inflation rate of 2% for the Eurozone as a whole. With the economies of the Eurozone diverging it faces the unenviable task of trying to contort the square peg of reality to fit the round hole of the European Ideal. The reins of monetary policy will likely be loosened a bit. Given the relatively sad state of the world economy, that's not likely to become a problem for the Eurozone. The stronger euro is keeping import prices down. With Germany stagnant, there is no great danger that the inflation rate of the entire Eurozone will spin out of control anytime soon.

The most intriguing possibility is the possiblity that Alan Greenspan will retire. He's now 77 years old and may feel he's done his bit for the keeping the US and world economies afloat. Having been first appointed by Ronald Reagan in 1987 just a few months before the equity market crash, he's now serving under his fourth President. His reign at the Federal Reserve has been marked by low macroeconomic volatility and deft intervention in times of crisis. His first big test was the crash of 1987, and he responded by expanding the money supply to avert any systemic risk from developing. This has been his tried and true method over the years, which was repeated during the Asian crisis, the Russian default, the failure of LTCM and the aftermath of September 11th. His critics argue he's just been postponing the inevitable final reckoning by inflating the economy, which led to the internet bubble and is now feeding a housing bubble. I don't think the US housing market has reached bubble proportions yet (in contrast to the UK housing market).

However, Alan Greenspan has become an iconic figure in international finance. Filling his shoes is not going to be easy with the kind of reputation he built up. And his job is the most important of the big three. So why would he resign this year? His age is certainly a factor, and at 77 he may just want to relax for the remaining years of his life. But there's also the political aspect. His successor will be nominated by the President, and then confirmed by the Senate. As an original Reagan appointee, he'd rather have a Republican President and a Republic Senate decide on who succeeds him. 2004 is too late, because that would come in the middle of a presidential election cycle (although it already seems to have begun with the Democratic candidates), and 2005 brings the uncertainty of who'll be in charge of the White House and Senate. Besides, in 2005 he'll be 79.

So it's going to be an exciting year in the world of central banking. But the reason is this is an important issue is also troubling. The central banks have a huge impact on the course of the world economy. They're the single point of failure that can sink an otherwise healthy economy. If they make mistakes, and they certainly do, the impacts are felt far and wide. Central banking is the last big bastion of centralized decision making in the world economy. It brings with it the inherent dangers of having a single centrally-directed policy. Get it wrong and the consequences are severe. In this age of fiat money it's hard to imagine a world without central banks. But the Federal Reserve system is less than 100 years old. This means this US economy managed to do just fine without a central bank at its helm for a long time. Of course, the economy has grown infinitely more complex since the Federal Reserve System was established.

But that would argue even more for decentralizing the decision making process of monetary policy. The greatest economic tragedy of the 20th century, the Great Depression was largely caused by wrong-headed monetary policy at the Federal Reserve. The ratcheting up of inflation during the 1970's was also a massive failure of central bank policy in an era of fiat money. It wasn't until the monetarist crackdown on inflation in the early 1980's that central banks found a semblance of competence. But it is a very fragile state of affairs. The central bank has to guess the appropriate amount of liquidity needed without the benefit of a decentralized, distributed price discovery mechanism. Even Alan Greenspan has repeatedly said that despite the successes of central banking in recent years (his critics would demur) one should not assume that we've now cracked the art of central banking. I think it's mostly a matter of time until some more serious mistakes are made in new and unforeseen circumstances.

A return to the gold standard is pretty much out of the question. That's just not going to happen, and I am not sure it's desirable in the first place (but that's another long story). The best way to lessen the dependence of the economy on the skill of the central bank is to decentralize the provision of liquidity, and the idea of using private providers of currency has seen some academic interest in recent years. This is also a very far-fetched possiblity, especially with Europe now actively moving towards more centralization rather than less. Mistakes made by private currency providers would affect their market share and thus their profitability. The best-managed currencies would have the biggest market share. One could imagine a situation in which one issuer uses gold as a store of value, giving those skeptical of fiat money the option of using "real" money again. With the advances in technology, conducting transactions in a world with many parallel competing currencies is now technically possible. In theory it should all work quite well, and indeed better than the current central banking paradigm. Competition can be introduced gradually, and indeed the first providers already exist.

Far-fetched? Yes, and I don't really see that happening either anytime soon. However, the current situation in which we are so dependent on a few central bankers' good judgment makes me very uneasy. We need a better solution for the provision of liquidity, which means some form of market-based feedback will be necessary.

Policy response in a slow-growth environment

The world economy is still stuck in a slow-growth environment. Japan is in the doldrums, Europe is griding to a halt and only a few countries are showing any signs of growth. Australia, Canada and to a lesser extent Great Britain have been relatively well in the global economic growth league tables, but the world economy remains dangerously and depressingly dependent on the performance of the US economy. Growth in the US has been far stronger than in Europe, but there is a lingering sense of fragility to the current recovery. Unemployment may not be very high, but it hasn't started to come down yet. Consumer confidence is low, retail sales weren't as strong as expected, capacity utilization is very low, and capex is lagging the cycle. Despite all that, the economy is still growing at a pretty decent pace (and much more strongly that most European economies), but any of the aforementioned factors could become a more serious problem.

Faced with the slowdown in economic growth, the difference in policy response between the US and the Eurozone is striking. Whereas in the US both monetary and fiscal policy are aligned to boost growth, policy in Europe on both fronts is either paralyzed or even actively counterproductive. The Federal Reserve is fully on board in getting the economy moving again; Alan Greenspan is much more scared of deflation than of inflation. We know the cure for the latter; curing the former is much harder. President Bush's proposals for a $670 billion stimulus program over the next 10 years is bold and ambitious. The Democrats' program also aims to restore growth, although their proposals are far less likely to be effective. Be that as it may, there is broad consensus on the need for stimulating growth in the US even if there is disagreement on the means by which to achieve it. Double taxation of dividends is something that should never have happened in the first place, although the current proposals have problems of their own. Ironically it was President Carter who last tried to get rid of the double taxation of dividends in 1979, but it was corporations who lobbied against it, and I suspect many CEOs would prefer to keep the double taxation. Why? Because it encourages companies to retain earnings rather than pay them out as dividends, which means that CEOs have more money to play with. But the Bush plan also calls for $300 billion in other tax cuts as well, which will definitely help the economy. Given the timing of passing legislation and the structure of the tax cuts, the bigger boost is likely to come in 2004 rather than 2003, although the 2003 effect is also positive.

This will, of course, increase the budget deficit. The fiscal boost to the economy over the last two years has already been substantial mostly due to the Bush tax cuts and the increase in defense spending following September 11th. So how big a budget deficit is acceptable? Both total US government debt and the budget deficit will increase initially with the tax cuts. But, given the economic circumstances, if you're going to increase the budget deficit, this is the time to do it in order to generate support for the economy when it is weak. The growth it will generate will put the economy back into a positive cycle which will raise revenues from taxation again. The crucial mistake that Japan has been making for the last ten years is that they've been trying to spend their way out of trouble by pumping more and more yen into government programs. That has been shown not to work time and time again. The structural problems in Japan are also to blame. Tax cuts increase incentives in the economy and allow people to keep more of their own money which in a reasonably free and flexible economy will improve the long-term competitiveness and growth rate.

Contrast that with the situation in Europe where both monetary and fiscal policy are not helping very much. The European Central Bank is still obsessed with its 2% inflation target, while fiscal policy is actually counterproductive. At a time where growth is grinding to a halt politicians are planning massive tax increases in Germany in order to bring the budget deficit back down to under the 3% ceiling set in the Growth and Stability Pact. The deficit for 2002 is likely to reach 3.8% of GDP. And it's not just Germany that's in trouble with the Pact; France and Italy have also received a rebuke from the European Commission. The entirely situation is ludicrous but also sadly inevitable. The politics of the euro have created a situation which ties the Eurozone governments' hands behind their backs. They themselves are culpable too for not bringing their finances into order when times were good, but the problem is also that times weren't really that good in Europe in the 1990's. Nor in the 1980's. So the relentless momentum of the tragic euro-logic is tumbling ever onwards to a bigger crisis.

Things will come to a head one way or the other. The current situation was entirely predictable; at some point one of the Eurozone economies would end up with a deficit problem which then would need to be policed somehow. If it's a smaller country, then the big ones will twist its arm back into compliance. The European Commission can hand out hefty fines for countries which violate the rules of the Stability Pact. However with all of the big countries in the Eurozone now in violation (or being close to it) it's hard to see how any of this could be enforced or even imposed. The only reason countries would agree to pay any fines would be because of peer pressure. But with so many peers in similar problems, the peer pressure is going to be more of a gentle touch on the arm rather than the weight of a supertanker.

So a crisis will take place. Either the Commission refuses to impose fines on the violators, or the violators refuse to pay. Either way the very fabric of credibility which the EU has been trying weave for Monetary Union will be damaged. There is already substantial divergence in the EMU economies, and the odds are improving that we'll see a big crisis this year. I still don't think it's the most likely scenario, since the political capital that has been invested in Monetary Union is too big on all sides for it fall apart so soon. Some sort of economically nonsensical compromise will be reached.

Even as a crisis in EMU looms, the negative effects of the Stability Pact will still be felt in the Eurozone economies because politicians will trying to reduce their budget deficits. Even if they don't get the deficit fully into lines with the strictures of the Stability Pact, the effect on growth will still be negative at a time when Europe is desperate for growth. Of course, none of these short-term fiscal effects affect the longer-term structural problems of Europe, such as the rigid labor market, demographic troubles and lack of entrepreneurial spirit. Unless those problems start to get solved quickly, Europe's future is dismal.

The difference in response to slow growth on either side of the Atlantic is huge. The American authorities recognize the problem and are determined to avert them, even if this means storing up other problems for the future (inflation, for instance). It's the lesser of two evils, and a deflationary spiral in the US would be devastating for the world economy. In Europe the problem is compounded by the fact that EMU is a politically-driven creation that lacks fundamental economic legitimacy. With 12 governments each running substantially different fiscal policies (something the Stability Pact was trying to prevent) the ECB's already difficult task becomes even harder, especially considering the divergence that already exists in the economies. A fiscal blow-out in one of the bigger countries affects the entire Eurozone and there's not much anyone can do about that. The EMU could be seen as an another example of the Tragedy of the Commons. The euro is a common good that was supposed to bring lower interest rates and macroeconomic stability and credibility (for most countries anyway). This is a common good, but in order for it retain its beneficial qualities, the Eurozone countries need to exercise discipline. They're not doing so because why bother if you can get all the benefits without really having to maintain discipline? Unless the EU gets a united federal government (a prospect I dread), and one that can achieve real convergence in the economies without blowing itself up, then having a single monetary policy is going to remain highly problematic.

The Taylor Rule and EMU

Happy new year everyone! The Wiener Philharmoniker are going through their New Year's tradition while I'm typing this. I just can't believe it's Nikolaus Harnoncourt conducting Strauss (any of them); I still associate him primarily with earlier composers. There is a guest appearance by Johannes Brahms this year in the form of his Hungarian Dances, which makes the Harnoncourt association somewhat more plausible. But in any case, with the effects of the fireworks dissipated and a whole new year to trudge through, how can I resist writing about monetary policy in the Eurozone?

I have written before about the stresses in the European Monetary Union, focusing mostly on the divergent inflation rates within the member states. Looking at real interest rates deflated by the harmonized inflation indices there is a huge difference between large member states of EMU such as Germany and Italy of almost 200 basis points. Trying to refine this analysis a bit further, I've been playing with Taylor-Rule implied interest rates.

The Taylor Rule was first formulated by economist John Taylor in 1993 with European Monetary Union in mind. The rule is fairly simple: it says that the nominal interest rate is determined by four things: the real equilibrium interest rate, recent inflation, the central bank's inflation target and the output gap. Conecptually it's one of those things that make good sense, but in practice it's hard to get much out of it. The problem is that out of the four quantities you need to calculate the nominal interest rate, two are hard to quantify. The real equilibrium interest rate is usually approximated by taking a long-run average of real interest rates in the past, which of course have been influenced by monetary policy. Inept monetary policy in the past will lead to higher real interest rates as a "credibility premium" that the market demands. Even hard to estimate (especially contemporaneously) is the output gap. This is the difference between actual growth and potential growth in the economy. Actual growth is simple to measure, but how do you come up with potential growth? This is usually again calculated by taking a long-term trend growth rate for the economy. Neither of these two approximations is perfect (or even close to it), but the Taylor has gained widespread currency as a rule of thumb for assessing monetary policy. Many of the practical problems are explored in this paper by Robert Hetzel of the Federal Reserve Bank in Richmond.

In the case of European Monetary Union, the Taylor Rule does a remarkably good job (pdf) in explaining central bank policy. Graph 2 on page 7 of the linked document shows the Taylor Rule interest rate set against the actual interest rate prevailing at the time. In order to see what the Taylor Rule is telling us now about the proper level of interest rates for the member countries of the European Monetary Union, I used the latest OECD data, which includes estimated output gaps, nominal interest rates and inflation rates. From this I calculated the average real interest rate over the 1994-2001 period and used that as the equilibrium value in the Taylor Rule, except for the EMU countries where I used the 3.55% value calculated in the BIS study linked above. As an inflation target I used 2% for EMU (which is the ECB's "reference value"), and 2.5% for the UK and the US. The Federal Reserve does not have an official inflation target though. The results are very interesting. This graph shows the Taylor Rule implied nominal short rates for most of the OECD countries, while this graph shows just the EMU data.

There are two immediate observations: first, the Taylor Rule comes up with much higher interest rates than the current ones in most countries and second, there is a very substantial dispersion in Taylor Rule rates for the EMU countries. The first phenomenon can be explained by the fragile state of the world economy. The threat of deflation is bigger than the threat of inflation, so the Federal Reserve is erring very much on the side of loose monetary policy. Curing inflation is easier than curing deflation. The ECB has grudgingly followed the Fed's lead, although the widespread perception still is that the ECB is still fighting the last war rather than the current one. This explains the very low interest rates that we're currently seeing. The equilibrium real interest rates that went into the calculation are higher than the currently prevailing nominal interest rates for both EMU and the US. Obviously the judgment now is that such high levels of real interest rates are inappropriate. Reducing the equilibrium real interest rate is a translation: all levels of Taylor Rule rates shift down by the same amount. If one were to assume that real rates should be 3% lower than the equilibrium used in the calculation, one should subtract 3% from the values shown in the graphs.

But as for the second phenomenon, why is there such a huge divergence within EMU countries when the BIS study showed that the Taylor Rule did such a good job explaining monetary policy? The reason is that the BIS study used a weighted average of EMU countries' economic data. This means that within that average, each country was able to fine-tune its monetary policy to the prevailing domestic circumstances. Having a single interest rate for all 12 EMU countries means that this fine-tuning of monetary policy to local output gaps and inflation is no longer possible. Thus the single interest rate set by the ECB is wildly inappropriate for a number of countries. The only ones within a 25 basis point range of the Eurozone Taylor Rule rate are Italy and the Netherlands. As noted above, this dispersion is not affected by assuming a different equilibrium real interest rate for the Eurozone. The dispersion would be affected if one were to calculate an equilibrium real interest rate for each of the countries, resulting in a lower rate for Germany and higher for Italy (a gap of 110 basis points). In other words, the Taylor Rule dispersion would be even bigger in that case, from 151 basis points to 261 basis points. Either one is a huge difference in monetary policy.

The Taylor Rule is not explaining current monetary policy very well, even if it has a decent track record in the Eurozone. Real interest rate are now much lower due to the balance of risks in the world economy. Whatever framework one uses, be it simple real interest rates or a Taylor Rule, the divergence within the EMU countries is still substantial and shows that having one interest rate for all the EMU countries is far from an optimal situation.

Japan's two faces

Some time ago, Samizdata linked to "Is Japan Faking It?", an essay by Eamonn Fingleton arguing that Japan's problems were nowhere near as bad as we here in the west seem to think. It's about as contrarian as you can get these days without completely losing sight of reality, but it was worthwhile reading nonetheless. Not because I agree with it, but because it's plausible enough to be true, which in turn forces you to think about what's really going on the Japanese economy. It is certainly true that the reflexive reaction to Japan now consists of chanting the from the Holy Basketcases Hymnbook, starting with "All Debts Great and Small." This is an abrogation of thought and analysis in favor of convenience. I too have often been guilty of this, so I took Fingleton's article as a starting point for re-examining Japan, focusing in on some of the out-of-consensus calls he makes.

In terms of fundamental data, I find the article wanting. To get an overview of macroeconomic data, I highly recommend the OECD's database. All data I will be using here is taking from the spreadsheets you can download from that page, unless otherwise noted. To start, there's this claim in Fingleton's article:

The latest "disaster" is Japan's allegedly out-of-control government spending. But Japan's budget problems are grossly exaggerated. OECD figures show that in the first eight years of the 1990s, Japan actually ran large budget surpluses. Since then the government's position has deteriorated somewhat but is still no worse than many other nations.

This is relatively easy to find in the OECD data, and it's simply not true. This graph shows the government balances as a percentage of nominal GDP for the US, Eurozone, UK and Japan. As you can see, Japan has been running a budget deficit since 1993. This also holds true if you look at the other OECD budgetary indicators, such as cyclically adjusted deficits and the primary budget balance. This latter is the deficit the government is running excluding debt servicing. The very low interest rates that the Japanese government is paying on its debt have kept debt servicing from becoming an additional problem. Even looking at gross or net financial liabilities his line of reasoning does not hold up. The footnotes the OECD provides in its spreadsheets note that these latter number are not necessarily comparable across countries due to differing methodology. Still, even if the level is not perfectly comparable, the first derivative is. Fingleton also claims that:

Living standards increased markedly in Japan in the so-called "lost decade" of the 1990s, so much so that the Japanese people are now among the world's richest consumers.

Japan's consumer have been amongst the world's richest, although perhaps not on a purchasing power parity basis. However, the OECD does provide data on this as well. Net household wealth as a percentage of disposable income has been shrinking in Japan over the last decade. What's missing here are the disposable income numbers, and unfortunately the OECD does not provide them. However, this data we can find in the Statistical Handbook of Japan 2002. Scroll down to figure 12.2, where you will see that real disposable personal income saw its last significant increase in 1991, and even that was less than 2%. In comparison, real DPI in the US has been growing at a 3-6% pace over the last ten years. So here too Japan has been losing ground, rather gaining it.

Another aspect of Fingleton's case rests on Japan's superior trade performance during the 1990's. He points out that the trade surplus has risen by a factor of 2.4 since 1990. Japan's current account is also showing a healthy surplus, while the Japanese savings rate is the envy of the industrialized world at 8.7% according to Fingleton, while the OECD data puts it even higher. There is a trap in talking about trade balances in terms of "surplus" and "deficit" as I have done just now (and as is usually done) because those terms have connotations of "good" and "bad." The trap is that a trade deficit is not necessarily a bad thing. It depends on the circumstances. Let's scale the example down to a household. As a result of the job you're doing, you add to your hoard of little green bits of paper. Now suppose you decide you need a new hammer. You could go to a mine, get your own iron ore, smelt it, bang it into shape and use wood you cut down to make a hammer out of it. Chances are you're going to go to yuor hardware store and choose from one of dozens of hammers someone else has produced for you. In order to obtain the hammer legally, you then hand over some piece of green paper to the store and go back home with your new hammer. You've just increased your personal trade deficit. Unless you sell more goods than you buy, you have a trade deficit. Cause for panic? Not really, as long as you continue to earn enough bits of green paper to finance your trade deficit. This applies in a wider sense to the US economy as well: as long as the sum total of value added in the US economy grows sufficiently to finance the purchases from abroad, there is not a problem. Americans give green pieces of paper to the Japanese and get shiny consumer goods in return. It's the aggregate wealth of the US economy that has made this possible. To keep this working, not only has the US economy to produce enough wealth, but it also requires a continued willingness of the part of the Japanese to trade shiny consumer goods for green pieces of paper. As long as they're happy to do that, there is no problem and both sides benefit.

A similar story also applies to the current account balance, where again the US is importing capital while Japan is exporting it. In essence, the low savings rate in the US is compensated in part by the Japanese sending their money to the US. This is one of the things Fingleton points out as a positive for Japan. The large capital outflows indeed enable the Japanese to buy stuff abroad. But they're not doing it because they want trophies on their mantlepieces (well some of them might), but because they want to earn money. And because they're sending their capital to the US, they're also giving an implicit vote of no confidence in the Japanese economy. Actions speak louder than words, and these actions mean that the Japanese think they can get a higher return on their capital if it is invested in the US than in Japan. So the current deficit could become a problem if for instance another region in the world gets its act together and becomes the preferred destination for international capital. This does not seem likely in the very short term, but you never know. Congress could suddenly raise taxes or pass regulatory bills that affect American companies' competitiveness, and money might go elsewhere. Right now, America is still the default place to invest your money though.

The high savings rate in Japan is extolled by Fingleton as a great positive. It could be, but it isn't. And the reason for that is the broken banking system. The people are saving money, but the banks aren't lending. One of the key tasks of a healthy banking system is to provide risk capital to entrepreneurs, and this is simply not happening in Japan. The banking system is seriously broken; the Bank of Japan has been printing money (metaphorically) at a tremendous rate. The monetary base has been expanding at a 30% year-on-year rate for some time now, but the broader monetary aggregates are not picking it up. M3 and M4 are growing at 1 to 2% year-on-year. So despite the creation of large amounts of additional yen, this is percolating into the broader economy. The money multiplier is dead in Japan for now. And that's because both the banks and industry are in a mess. As a final comment on the high savings rate, it should be pointed out that Japanese savers are getting virtually no nominal return on their savings, and haven't been getting return for many years now. The Zero Interest Rate Policy of the Bank of Japan has ensured that both lending and borrowing rates are very low. The real return on cash is slightly positive, but it's still puzzling that the Japanese would be so risk-averse as to put so much of their income into an essentially dead asset. As Fingleton points out, the net national savings position of Japan is considerably lower than the government's, if you count personal savings too. So he's right that there is no solvency issue at the moment, but that's looking at the country as a whole. If interest rates ever go up, the debt servicing burden on the government will become very onerous very quickly. Sure, Japan can afford it, but only by transferring money from private to public coffers. This means taking money away from the consumers and giving it to the government by taxation. This is not going be popular or short-term positive for the economy. What we're seeing is perhaps a case of Ricardian equivalance, which states that the timing of how government debt is financed has no impact on the real economy. So whether you tax now or issue debt now (to be paid later) makes no difference. A perpetuity of $50 at 5% interest has a present value of $1000. So whether you pay $1000 in tax now or $50 in perpetuity makes no difference. But the people who'll be paying off the debt will in the end be the children of the people who issued the debt and presumably benefited from it. So an intergenerationally altruistic household will put the $1000 in non-levied taxes to buy the bonds issued and then use the coupon income to pay the $50 perpetuity. Do real people really think like this? There is some evidence that in the aggregate the expectations of future taxes are influenced by current debt issuance and levels. So a high savings rate would not be a surprise in such a context.

If the monetary base is expanding so rapidly but broad money supply isn't, where is the money going then? It's certainly not going to Japanese consumers, nor does Japanese industry seem to be benefiting much from it either. It's not going into real estate or land, nor is the stock market benefiting. Instead, the money is going into funding the JGB bubble. JGBs (Japanese Government Bonds) have real yields that are surprisingly low for a country with a fiscal position as dire as Japan's. It's partially due to the structure of the Japanese savings system, which tends to invest disproportionately in JGBs, as well as the printing of money by the Bank of Japan. At some point, this bubble will have to burst, just like the Dot-Com Bubble in the US and Europe burst.

One last point of criticism of Fingleton's piece is his comparison of the deflation currently rampaging through Japan and the US experience in the latter half of the 19th century. There are some significant differences between the two situations. First and foremost is the structure of the economies. Even back then, the United States was attracting foreign direct investment (FDI) to finance the growth of the economy. In fact, the United States has pretty much throughout its history run trade deficits, with the exception of the depression years of the 1930's. (Sorry, couldn't find a link). While the US was importing capital, Japan is exporting it now. Furthermore, he quotes LaFeber as saying that the 25 years to 1897 were "economic hell" because of persistent deflation. The date chosen is no coincidence, as that is the year in which the US returned to the gold standard at the pre-civil war parity. During the war, the US had three currencies: the greenback, the Confederate dollar and the yellowback. The yellowback was the original US dollar backed by gold and continued to be used in the West. Both the greenback and the Confederate dollar were fiat currencies (i.e. not backed by gold or any other metal. Virtually all currencies now are fiat money). After the war, the greenback and the yellowback needed to converge again, and this process took till 1897. It took so long because to restore the price level more quickly would have caused a massive recession. This long period of deflation was engineered and deliberate, and the US economy grew during the period. Japan's economy has not grown much in the last ten years. (Data taken from this dataset compiled by NBER's MacroHistory project. More information on post-civil war currencies can be found here. Inflation data downloaded from Global Financial Data.)

I'm not impressed with Fingleton's case. Japan's economy does have serious problems, and I simply don't buy his analysis. However, this article is title Japan's Two Faces, and that's where I think he does have a point, although it is not as controversion or contrarian as his call on the economy. There are some really, really good Japanese companies, and they've been doing pretty damn well over the last ten years (and before too). Some of them are well-known names in the West, such as Toyota and Sony. Others are doing well again after having come to the brink of collapse; Nissan had to be rescued by the French, for instance. Japan's corporate landscape shows a mixed picture. In general, the companies doing best are those that have been exposed in full force to the rigors of the international marketplace. That forced them to become well-run, modern companies, exactly the kind that the rest of Japan is still lacking. As the Japanese market becomes more open (and not just to Chinese imports) and red tape is slowly abolished, market mechanisms will force more Japanese companies to become competitive again or face death. As long as bank are not willing to foreclose on non-performing loans though, this is not going to happen. So it's certainly not all gloom and doom in Japan. But it's exactly that part of the Japanese economy that has been most exposed to Western-style free markets that is doing best. Japan has a deep base of knowledge and excellence in products that need to be unleashed, quite literally. As long as the arcane, indeed pre-capitalist, structures and linkage continue to prevail, the spread of Good Companies in Japan will remain limited. The risk is rather that the bad, zombie companies will infect the good ones by undercutting them. If you're essentially dead and have no hope of paying off your debts, why not sell below cost? At least you'll get market share and you can pretend to be alive for a bit longer. Good companies are then forced to compete with the zombies, and can't last very long usually. Bankruptcies are sorely needed in Japan.

Not all of Fingleton's arguments are on the mark in the company area either. For instance, the supercomputing lead Japan has is not directly related to manufacturing expertise. Rather, the US and Japan took differing approaches to supercomputing about a decade ago. US researchers thought that by bundling together lots of cheap computers, you could create a cost-effective machine that is very fast. The Japanese continued the "old-style" supercomputing tradition, which has proven superior.

Finally, where Fingleton goes off into fantasy land is when he posits that the Japanese have deliberately been talking of crisis to get the rest of the world off their backs. It's supposed to be part of a centuries-spanning plan that would put Asia back in the number one position in the world, having been supplanted by the West, and specifically the US. That's just nonsense. Japan is not welcoming China's exports "with open arms," but instead there's an enormous amount of bellyaching about Chinese exports. Japanese versions of Ross Perot with their Giant Sucking Sounds are popping up all over the place. Instead what's happening is that Japanese companies are trying to create better profit margins, and that means shifting commoditized manufacturing offshore to China, which is becoming Japan's reservoir of cheap labor. It's benefiting both countries, of course: Chinese become wealthier and Japanese companies become more efficient. But the adjustment process is painful. Rather than a sinister long-term plot, it's just another sign that Japan is slowly rejoining the world economy by opening up a bit. It's becoming more western, more free-market, even if only at the margin. There is a core of good companies upon which Japan can build to try to regain its economic strength. It's up to the Japanese government to take further action in liberalizing the Japanese economy and opening it up to market forces.

Fixing the euro

No, they're not talking about the fundamental problems of the euro. That would be too much to hope for. However, one of the complaints of consumers in the Eurozone has been that prices have gone up in the past year as a result of the introduction of the single currency. It has been one of the big discrepancies between what people think they're experiencing and what the official inflation statistics are telling them. Looking at the Harmonized Indices of Consumer Prices (HICP), most European countries have fairly low inflation; it varies between 1% for Germany and around 3% for Italy, plus some outliers on either side. Yet in both Germany and Italy, consumers are up in arms about huge price increases.

The difference is due to the composition of the inflation indices and a bit of psychology as well. The inflation indices try to measure the overall cost of living, which includes longer-term purchases, such as computers and printers, as well as everyday items such as groceries. The biggest increases have been in the lowest-priced items, which people buy all the time. But in the inflation index, these rises are offset by cheaper inkjet printers, for instance. This accounts for some of the difference. But psychology also plays a part, as people feel the impact of high-frequency purchases more keenly than the low-frequency ones.

But there's another psychological effect here, at least according to politicians from certain European countries: the euro coins. Apparently people put a higher notional value on banknotes than on coins, so they're much more likely to spend a one euro coin than a one euro bill. So the ECB is now considering the introduction of one euro notes. I don't know whether this would work though. Prices have already been set, and printing one-euro notes now would take quite a while and of marginal impact. As with many things connected to the euro, this is going to be a political decision in the end.

What is amusing though is how deep the European inferiority complex runs though. Witness this comment from Guy Quaden, the governor of the National Bank of Belgium:

He suggested the introduction of one euro notes could be a boost to the internationalisation of Europe's single currency. "The one dollar note is one reason for the popularity of the US dollar . . . everybody knows and uses this note."

The dollar's popularity has very little to do with the one dollar note. It's more a function of the trust that people all over the world place in the US government to maintain the purchasing power of the dollar, especially in countries where the people have repeatedly been robbed by their own government's actions. The German mark had a similar status in parts of the Balkans, where the euro has succeeded it. But worldwide acceptance of the euro as a serious substitute for the dollar will only come if the euro is seen to be as stable, reliable and trustworthy a source of value as the dollar. It's going to take a long time to build that kind of reputation. In any case, the ECB and European politicians would be better advised to stop obsessing about the dollar and start focusing on the economic problems that beset the European continent. Once they fix those problems, the euro's acceptance will increase too. One euro notes are not going to make the slightest bit of difference.

Euro coins: a failed user interface

For those allergic to these things, let me just say that this post is not going to become a Mac versus Windows item. Having said that, I have been a Macintosh user for a very long time. One of the things that has always attracted me to the Macintosh was the superior usability of the Mac platform. The foundations for this were laid in what are now the prehistoric times of computing. While Windows has caught up to some degree, it's still a skin-deep appropriation of the user interface design principles that made the classic Macintosh interface what it was. The difference between the Mac and Windows has become even smaller with Mac OS X, which in many cases is a step backwards in terms of usability. I can understand that Microsoft has had trouble acquiring a deep understanding of user interface design, but Apple should have known better. Designing good user interfaces is hard work, but there has been a lot of research done in the quarter century since mice and GUIs were invented at Xerox PARC.

User interface design is a surprisingly neglected field, even in places where one would expect a large premium to have been placed on getting things right. The canonical example of VCRs being hard to program is harmless. But even in aviation user interface design can go horribly wrong. The crash of a commuter plane in Switzerland about a year ago was due to a poorly designed display. One display panel for landing approaches had two modes: one to show the rate of descent, the other the angle of descent. So a display of 3.2 could mean either a descent of 320 ft/min or 3.2 degrees, depending on which mode the display was in, without any clear identification of which mode was being used. The pilots had not had many flying hours in the type of aircraft, and thought they had the display in the other mode than was showing.

The best user interaces are those that you don't even notice. A hammer has a simple user interface. But even something as seemingly simple as light switches can be infuriating. Many a time have I had to wrestle with light switches in hotel rooms before I got them to work. Money has a user interface too, although in this case it's just the design of the notes and coins that matters. As regular readers of this blog will know, I am not a big fan of European Monetary Union as it exists now, but I am also unhappy with the usability of the coins specifically.

Having used euro coins for almost a year now, I still spend way too much time trying to find the right coins. This is an inordinately long time to get used to the coins, because whenever I have to use other currencies, I seem to become acquainted with the coins within days. Is it just a spill-over from my dislike for the concept of the euro?

It's more of a design problem with the euro coins. The design of euro coins was an excellent opportunity to come up with new coins and designers had a field day. The winning design is a nice, logical ordered sequence. There are three sets of coins: the 1, 2 and 5 cent pieces are reddish in color, the 10, 20 and 50 cent pieces are golden/yellow and the 1 and 2 euro coins are two-colored. The coins all have distinguishing marks with differing edges and different thicknesses. So clearly the designers did have distinguishability in mind.

But why does it not work? There are two big problems. The first is that there are too many coins. There are 8 in total, compared to the 6 we used to have in the times of the guilder. US coins are especially parsimonious with only 4 coins in common use. Sacagawea dollars are too rare to be counted. But simply the number of different coins can't be the whole story, because German marks came in the same 1, 2, 5 series up to 5 marks. So there were even more of them than euros. The British pound coins have the same face values as the euro coins, yet it's still easier to find the right coin when I am in Britain than when I am in the eurozone.

This leads to the second big problem: the euro coins are too logically arranged. They're too ordered. For all the efforts to make them different, they're still too similar in shape, size, color and weight. The old Dutch dime and the US dime shared the trait of being very small. There's no logical reason to make the dime smaller than a penny, or why a 50 pence piece should be octogonal. The haphazard historical evolution of coins led to an almost random assortment of coins in shape, size and weight. This large disparity made recognizing coins easier, especially when fumbling around under poor lighting conditions in your wallet. I find it hard to tell the difference between a 10 and 20 euro cent piece, or between 20 and 50 cents in practice. Even the different colors of the 1, 2, 5 series and the 10, 20, 50 series become less apparent in poor light. The sizes are not sufficiently different to tell them apart quickly. Even the difference between a 1 and 2 euro coin can be tricky to tell from just seeing them half-obscured at an acute angle. Yet that's how they end up jumbled in my wallet.

Euro coins need to be redesigned to alleviate this problem. We need some whacky coins, like the old Dutch rijksdaalder (2.5 guilders) which was much larger than the 1 guilder piece. Or make a big coin like the 5 mark, 50 pence and a small one like the dime. One thing though: don't make them too heavy. I hate to carry around one pound coins, as they weigh so much. And get rid of the 1 cent piece. I always end up with large quantities of those (much like pennies in the US), and they're just a damn nuisance.

It's not going to happen of course. The design of the notes and coins was politically sensitive, so re-opening this issue is not going to happen for a very long time. I also suspect the political sensitivity of the initial design led to the situation we have now. The euro coins would never been allowed to look like any existing coins of the legacy currencies, so the safe escape route of making them logical and orderly was an obvious way out. Except I don't think it works in practice. Then again, this would not be the first time that political expediency triumphs over practical concerns. I would expect that there has been research into the usability of coins and that coins designers are aware of it. But as the aircraft example shows, neither the research nor the awareness of it can be taken for granted.

Dim Wim stands pat

After yesterday's 50 basis point rate cut by the Federal Reserve, the European Central Bank in its usual form refused to do anything, despite the fact the Eurozone economies are substantially weaker than the US economy. Unemployment is higher and economic growth is lower. The ECB insists on fighting the previous war against inflation by trying to get it under its own 2% "reference rate," which in practice has acted more as a ceiling rather than aas a symmetric inflation target. But the main problem for the ECB is the divergence of the Eurozone economies in their economic cycles and the corresponding macroeconomic indicators. The ECB has the task of fitting the one square peg of monetary policy into the 15 oddly-shaped holes of national economies. It just does not work. The Monetary Union project is headed for longer-term problems.

The German economy is now on the verge of a deflationary spiral and the current interest rate is way too high. Of course, the problem is compounded by the fact that the German government is doing exactly the wrong things by raising taxes in order to try to stick to the Stability Pact. But inflation in other parts of the Eurozone, such as in Italy and the Netherlands is much higher. Yet if Germany does indeed sink into the morass of deflation, then the whole of the Eurozone will be dragged down with it to some extent. This is the real danger the ECB should be focusing on.

This talk of what the central banks are doing also points to a scarier problem. Central bank policy has now become the choke point of modern economies. It's the single point of failure that can strangle an otherwise healthy economy, and having fewer central banks around the world just reduces variety and competition. If one of them screws up, it affects the domestic economy, but now we have the Fed, the Bank of England, the ECB and the Bank of Japan as the major players. Japan is already paddling up many creeks with miasma emanating from every pore, Europe is sickly and the Bank of England and the Fed have not screwed up in a big way recently. They still could.

Variety and competition are good things as they build resilience into the system, allowing it to function more robustly. Also, it makes the system handle failure modes more gracefully. A monetary monoculture can be wiped out by a single antagonist organism. But building more diversity into the global monetary system is going to be hard to do. Private currencies are the answer, but there are serious implementation issues with that. That's a topic for another day.

Divergence undermining European Monetary Union

When I looked at the possibility of European Monetary Union being undone, I pointed out that the strains and stresses the Eurozone is currently subjected to are already making the entire project fray at the edges. The current member nations of the Eurozone are too diverse to form an optimal currency area and labor mobility is much too low for it to function as a balancing force. The United States in its history has had periods of monetary strain too, when asymmetric shocks hit certain parts of the country much harder than others. For instance, a drought could depress the agricultural states, while the eastern seaboard still had strong economic growth. This led to conflict between the regions over the then-equivalent of money supply, namely gold. The stock of money could be expanded or decreased by adjusting the gold reserves and the areas that were in recession obviously sought relief. While these conflicts did take place, they concept of the Union was never questioned as a result. The United States was a solidly established country, with strong domestic support. The big glaring exception to this is the Civil War, but that was fought over the issue of slavery, not money supply.

The European Union lacks such strong domestic support. The "politics first" way in which the monetary union was conceived and implemented has led to irrational economic decisions within monetary union which have sewn the seeds of its eventual demise. Not all choices being made necessarily have to be economically rational; it would be nice, but reality is seldom that kind and the political reality especially can impose constraints on the freedom of action. As long as this is realized and the consequences of the irrational choices are not too grievous, it need not be fatal. Look at it as a tactical retreat to win the wider war. But the European Project as it has been in the last 20 years or so has increasingly become a plaything of the European political elites. They found themselves on autopilot towards "ever closer union" and they never stopped to question why. Post-war Europe certainly needed reconciliation between Germany and the countries it had invaded, but by the 1980?s the European Project had acquired completely new dimensions. The political elites went along with it partially out of inertia, and partially because it was a rich source of cozy jobs. It also provided a structure for them to solidify their hold on power, moving ever further from the pesky electorate that so often inconveniently ruined their domestic plans. And so the European Project steamed merrily into the turbulent waters of monetary union. The political decision for monetary union had long been made, but the consequences were certainly not understood by the politicians. Huddled in their Reality Distortion Fields they had no clue what they were letting themselves in for. More importantly, they were (and are) under the impression that political fixes can counteract the weight of economic reality; if it works in backroom deals in parliament, why should it not work in the economy?

However, a semblance of macroeconomic rigor had to be maintained. So in the Maastricht Treaty, in which monetary union was formalized, contains a number of convergence criteria that aspirant countries have to meet in order to be allowed in. The buzzword here is convergence. If the economies converge sufficiently, then they can be joined in monetary union. But they way these criteria were drafted they ended up as being coincidence criteria rather than convergence criteria. They converged much as a stopped clock converges with the time of day. Sure, it'll be briefly right, but it does not mean the clock can be relied on to show the time. It's the convergence of two elevators, one going up, the other going down. Real convergence can only happen over time, and it needs to be measured over time. The Maastricht criteria did no such thing, and even then they were subject to political fudging. The criteria were:

1. Price stability. Inflation rates had to be no more than 1.5% over the average of the three best performing countries over a period of one year. For a supposedly irrevocable monetary union, one year of roughly similar inflation is hardly convergence.

2. Government deficits and borrowing. The budget deficit should not exceed 3% of GDP and national debt should not exceed 60% of GDP. Since neither Belgium nor Italy would have had any chance of meeting the 60% criterion, this rule also gives a passing grade if the national debt is being reduced. And the 3% of GDP budget deficit rule has been fudged in many countries, by counting one-off privatization revenues as structural.

3. Exchange rate stability. Within the precursor to monetary union, the European Rate Mechanism the aspirant countries' currency had to maintain their pre-set bands. Britain almost wrecked its economy by trying to stay within the ERM in the early 90?s by trying to create artificial convergence. A very deep and painful recession was the result.

4. Convergence of interest rates. The yields on long-dated government bonds had to be within 2% of the average of the three best performing countries. This is virtually a consequence of point 1 above, although bond markets tend to be harsher than politicians. But once it was clear that political considerations would allow countries like Italy to join, the great convergence play in the bond markets was on.

None of these criteria actually measures real convergence, for that could only be observed over much longer periods of time with a number of business cycles to go through. These criteria were a political fig leaf, prone to and designed for easy and expedient manipulation.

The European Central Bank's key role is to keep inflation under control, targeting a rate of 2%. The Federal Reserve in the US has a less specific goal, as it has to keep prices stable while also taking economic growth into account. Looking at the US experience and contrasting it with the situation in Europe is instructive. How diverse is the US economy by region? It is very diverse, but it does rise and fall on the same business cycle. The Bureau of Labor Statistics has a wealth of information on regional inflation data and it's available online. It has data going back to 1915 for various conurbations, and a second set of series for larger regional areas since 1967. Using the numbers for the All Items CPI series, this graph shows that inflation did vary by region, but the moves were very highly synchronized. There's a striking divergence at the very end of the series though, as the brown line representing San Francisco, Oakland and San Jose spikes upward. This is the internet bubble and most of this rise is due to the housing component in the area. I also plotted the largest dispersion over time by taking the highest inflation rate and the lowest, and looking at the difference between the two. This graph shows two lines, one for all regions, the other excluding Silicon Valley. In post-war America the dispersion of inflation rates has been fairly low. It was only the high inflation period of the early 1980?s where the dispersion ticked up to around 4%. But with 13.5% national inflation, the difference between 15.8% inflation in Los Angeles and 11.4% in New York matters not so much. Both are way too high, and the monetary response is obvious (and Paul Volcker certainly applied it). Had the national average rate been 3% with individual regions fluctuating between 1% and 5%, then the situation changes. You don?t want to push the 1% regions into deflation, yet the 5% regions are in danger of spiraling out of control. But this situation has not arisen in the US aside from the internet bubble in Silicon Valley. Arguably the area would have benefited from higher interest rates when its inflation started to creep up as much as it did, and in that sense it's a small-scale failure of monetary policy there.

The situation in Europe is more difficult to assess, simply because data is harder to come by. I managed to scrounge together some data on Harmonized Inflation in Germany, France and Italy from various sources. Unfortunately, the amount of history is limited. Still, the graph shows that as recently as 1996 there was an almost 5% inflation differential between Germany and Italy. The last time there was a regional differential this big in the US was in 1917. It is completely unrealistic to assume that the Italian and German economies have become sufficiently similar to share the same interest rate simply because the Italians managed to get inflation down to something reasonable in the late 1990's. And the divergence is growing again as Italian inflation is almost 2% higher than German inflation. In other words, real interest rates are 2% lower in Italy than in Germany. This is exactly the opposite of what is required, as the German economy flirts with deflationary oblivion and the Italian is doing relatively OK by European standards.

Right now, the one-size-fits-all interest rate in the Eurozone is clearly and painfully inappropriate for many parts of the continent. There is no convergence, nor has there been any. These are the fault lines which lie under the exterior of European Monetary Union. The sad thing is that there were pre-programmed.

Tomorrow I will have a follow-up, focusing on the growth gap between Japan, Germany, Europe and the US.

Can European Monetary Union be undone?

The strains on the euro have been there right from the start, but tectonic plates of European politics and economics are close to producing an earthquake. It's not going to be the Big One yet. To throw in the towel so soon after the euro's creation is politically unthinkable, even if it were economically rational to do so.

This begs the question whether it was economically rational to create the monetary union in the first place. Actually, there are two aspects to this question: is a monetary union economically desirable in Europe, and what structure should it have? The advantages of having a single currency are fairly obvious to anyone who travels quite a bit throughout the continent. It has certainly made my life a lot easier, since the only foreign currencies I now usually carry are the British Pound and the US Dollar. The benefits are also obvious in business and finance throughout the continent. By removing exchange rate risk, the euro allows European consolidation of previously fragmented industries. But this is where the first signs of trouble begin to show: politics. Obviously. Although extremely pro-European in the abstract, once it comes to the sale of a Big Domestic Company to some foreign competitor, the politicians start to protest.

But in the most immediately visible impact, having a single currency is a good thing. It also gives Eurocrats a nice warm fuzzy feeling for having taken yet another step on the path of Ever Closer Union. But a currency is the lifeblood of the economy, and in an ideal world, the currency decision would be a purely economic one. So when should countries merge their currencies? When the benefits of having a single currency and monetary policy outweigh the disadvantages. These disadvantages result from having a single interest rate for the entire area. If the regional differences are too big, then different parts will end up either being overstimulated or being driven into the ground by the prevailing interest rates. Under multiple currencies, these differences would be adjusted by fluctuations in interest rates and exchange rates.

The exchange rate is the external value of the currency, reflecting supply and demand. The interest rate reflects domestic supply and demand for a currency, usually managed by a central bank. Both in a sense are prices, and prices carry information on supply and demand. The price signals of currency fluctuations reflect the relative demand for currencies, and thus convey information about the economies. This information is an amalgam of the labor market, producitivity, tax rates, business climate, government policies, literacy rates, education levels et cetera. By moving to a monetary union, the fundamental information will still exist, but it can no longer express itself in the exchange rate, so it is going to have to find other means. Unemployment could be one of those means, if the cost of labor is structurally higher in one part than another. Adjustment of wage levels is the flip side, but generally much harder to achieve. It's easier to fire people (even in places like Germany) than to cut their wages.

Europe is naturally not the first area to implement a monetary union. There is another large economy, with big regional differences, that has a single currency: the United States. In a highly interesting paper, Hugh Rockoff of the National Bureau of Economic Research examines the question of how long it took the US to become an optimal currency area. In other words, how long did it take until the benefits of having a single currency in the US outweighed the disadvantages? The question itself may seem strange, because nowadays we have a mental mapping of currencies to countries. A country has a currency. It does not occur to us that a single country would have more than one currency; at least officially, because in many poorly developed economies a second parallel currency operates on the black market. It's usually the US dollar.

The answer is actually surprising. Depending on how you measure it, the US may not have been an optimal currency area until the 1930's. It was only when regional differences became smaller due to automatic stabilizers in the form of transfer payments such as unemployment benefits, but also due to higher labor mobility and tighter overall intergration of the economy with the advent of the telephone, radio and faster travel. Even now, regional difference obviously persist, but they tend to be cyclically aligned. The flexibility of the economy is also important, as it needs to adjust to an interest rate that may not be optimal for a particular region.

In the case of European Monetary Union, the regional differences now are much larger than they were in the US of the 1930's. Labor mobility is negligible across national borders. An unemployed plumber in Paris is not likely to move to Munich which may have a shortage of plumbers. Moreover, the disparity in economic structures and levels of development is also substantial. Is the Greek economy really sufficiently similar to the Belgian to have the same currency and interest rate?

Some countries in the current European Monetary Union could certainly be called on optimal currency area. Germany with the Benelux countries are close enough in that regard, and adding France might also work. Beyond that, it becomes harder to see an economic rationale for other member countries. But the project of monetary union was only partly about economics; to a larger degree, it was about politics. And with any politically-driven process, rational economic decision making, as it might happen in a free market, goes out the window in order to advance the Grand Schemes of politicians. This is what happened in Europe. when the idea of monetary union was born, the drivers were Germany and France, and they were none too keen on having a large group of countries join them. So they came up with the Maastricht criteria and the Stability Pact, which they thought would be harsh enough to keep party-crashers like Italy out. But it soon became obvious that by fugding the numbers sufficiently and some real reform too, Italy was going to make it. The political pressure was too big, so Italy had to join. But if Italy were allowed to join, then Spain must join too. And Portugal. And then Greece.

Thus the Big EMU came into existence. I am fairly certain that the current EMU does not constitute an optimal currency area, and the pressures are showing. The title of this post refers to the question whether EMU can be undone if the pressures become large enough. Monetary unions have been dissolved before, most recent when Czechoslovakia split apart. The Czech and Slovak economies were tightly integrated, albeit in a highly inefficient communist-imposed system. Still, having had the same currency for almost half a century (or even going back to 1918, if you count the First Republic), the split did occur, and both countries have been the better for it. The divergences in the two countries' situations were too big to accomodate a single currency, so breaking up was the sensible thing to do. Ironically, both countries may yet end up with a single currency again by the end of the decade, if both do join EMU.

So monetary union is not immutably set in stone. It can fail. And given the economic malaise in the EU, the regional economic, fiscal and structural disparities in EMU, the chances are significant that a major break could occur in the next ten or fifteen years, with the emergence of a smaller core monetary union, and reappearance of some previously extinct currencies.

Stability Pact going wobbly

The Stability and Growth Pact was designed to enforce fiscal discipline amongst member states of European Monetary Union. Key provisions are limits to the budget deficit at 3% of GDP and medium-term balanced budgets. As currently stated, the member countries have committed themselves to achieve balanced budgets by 2004. The European Commission is now waking up to reality and acknowledging that several member countries are not going to make it. In fact, even the 3% of GDP deficit limit is likely to be breached in the coming year. The culprits? Portugal, Italy, France and Germany. With the three largest Euroland economies being in breach, the Stability Pact is looking very wobbly indeed.

By tinkering with the timetable the European Commission hopes to defuse the situation and save the Pact in some form. The Pact is important because each member state can set its own fiscal policy. Absent such a Pact there is a serious risk of a free-rider problem developing in that one country could have its budget deficit balloon while others suffer through fiscal discipline. This would be an unstable situation; bond yields would rise, affect all member states, and the incentive for maintaining fiscal stability would be weakened. After all, if bond yields are higher because of other countries' fiscal irresponsiblity, why not run a higher budget deficit yourself?

Now with the adverse economic conditions prevailing in Europe, the Pact will be broken. Government expenditure is up, revenue is down. To an extent having a counter-cyclical fiscal policy is a good thing, as long as it does not run up structural deficits. But this stabilization is unavailable to countries that go into a downturn with their budgets already in deficit under the current Pact. So something will have to give.

Depending on the amount of realism that prevails, the process could become very messy indeed. The European Central Bank is going to fight it tooth and nail, and there will be a trilateral showdown between governments, the ECB and the European Commission. Within the governments' camp, some will side with the ECB. Others will welcome a relaxation of the rules. The more rancorous and chaotic it gets, the higher bond yields will rise, and the further the euro will fall.

Europe is taking the next steps with the experiment of the single currency, spread among 11 countries with different economic and fiscal policies. This is one of the fault lines that had been apparent for some time. The euro is not popular with its users, and now we will see whether it can stand the strain.