Possible Futures for the European Banking Union

In September 2012, the European Commission proposed a single supervisory mechanism (SSM) for banks as a preliminary step towards a European banking union. Plans for the union continue this week, as European Union leaders meet in Brussels to set new rules regarding how future bank bailouts will be paid for.

 Earlier this year, I attended the Future of the Euro Conference at UC Berkeley. One of the conference panels was about banking unions. The panelists all draw upon economic history to discuss the possible future of a European banking union. Here are videos of their talks:   

Long Before the NSA...

The following clipping is from the April 15, 1813 edition of the Daily National Intelligencer. I came across it by accident, but thought it was worth sharing. In the United States Gazette, the government is accused  of having a "general office for breaking open private letters at Washington."

The Daily National Intelligencer counters that it is "entirely false that any letter of any description has been opened by the government, except letters passing to and from the enemy." The Daily National Intelligencer, if you were wondering, was edited by Joseph Gales, Jr. and William Seaton, supporters of the Madison and Monroe administration. They later became printers of Congress, and Gales became Mayor of Washington, D.C.

The Sword of Greenspan

According to an ancient Greek parable, Dionysius, the tyrant of Syracuse, had a courtier named Damocles who complemented Dionysius on his wealth and power. Dionysius asked Damocles if he would like to experience the kingly lifestyle. Damocles accepted the offer, and was enjoying the great luxury, until he noticed, hanging above him by a single horsehair, a gleaming sword. He then begged Dionysius to be allowed to leave the throne and return to his position as a courtier.

Common usage of the phrase "sword of Damocles" often misses the point of the story. According to classics scholar Daniel Mendelsohn, the sword of Damocles has come to refer to impending doom, even though:

"The real point of the story is very clearly a moral parable. It's not just, oh, something terrible is going to happen, but it's about realizing that what looks like an enviable life, a life of wealth, a life of power, a life of luxury is, in fact, fraught with anxiety, terror and possibly death.
And so that's the moral lesson of the original story, which has completely, I would say, gotten lost in the common usage. We all use that expression, oh, it's a sword of Damocles. But the point was all this stuff is meaningless, power, luxury and wealth, and if you know what's good for you, you'll be happy to be a much lesser kind of person."

The sword of Damocles frequently is used and misused in economic references. An Irish news article in 2011 titled "Inflation is sword of Damocles over Irish economy" uses the expression just to reference (alleged) impending doom. In "The Sword of Damocles hangs over Cyprus," the expression is slightly more correctly, as an analogy is made between Cyprus' decision to join the EU and Damocles' decision to try out the life of a king: "Like Damocles, some older Cypriots are now longing for their old farming lives, where living off the land was part and parcel of living here." And of course, the sword is used in the context of the Federal Reserve. Andy Kessler, for example, writes "The Fed’s inevitable Sword of Damocles could be brutal for bonds and stocks. Some of us recall the massacre of 1994."

Now, the original sword of Damocles was not used for massacre or brutality, so I think Kessler misuses the reference, missing the moral lesson of the story. He actually makes two sloppy allusions-- first to the sword, and second to 1994. Gavyn Davies writes that "The 1994 example, when the Fed failed to guide the markets about the likely pace of tightening, is of course part of the folklore of the bond market." Just as with the ancient parable of the sword of Damocles, the real lessons of the "parable" of 1994 are getting lost--dangerously--in the common usage.

Lately, the Fed's tightening actions in 1994 are coming into the spotlight as people wonder, and worry, about when the Fed will taper its bond buying program. The problem is that the more nuanced points of the 1994 episode have been lost to a simpler, cruder interpretation: that a move by the Fed (to slow the pace of purchases, for example) will be shortly followed by a succession of rate hikes. The lesson of 1994 is not that once the Fed starts tightening, it will just keep going, but unfortunately that is the lesson the markets choose to remember.

Let's look back at the Federal Reserve transcripts from 1994, when Alan Greenspan himself alluded to the sword of Damocles on multiple occasions. At the first meeting of the year, on February 3-4, the federal funds rate was at 3%, after having been lowered repeatedly since 1989. Discussions centered around how much to raise the rate. Mostly it was a question of raising by 25 or 50 basis points.

Vice Chairman McDonough: ... It seems to me that the question is not so much whether we should tighten but by how much...I think there are two downside aspects to a 50 basis point firming. First of all, it could be interpreted--and in my own view would be interpreted by a fair number of market participants--as a one-time fix, a one-time adjustment which would be followed by a "Fed-on-hold" period. Secondly, I think it could be deemed, especially in light of some of the discussion in this town and others, a macho response, and I've always thought macho responses confused brains and bravado. A 25 basis point move, on the other hand, I believe would send the right signal in the sense that the Federal Reserve, the central bank, is being watchful, as it should be...I think it would be interpreted as the first of a series of moves and thus would be deemed, in my view, to be a stronger signal than a 50 basis point increase--if the 50 basis point increase were seen, as I believe it would be, as a one-time adjustment to be followed by the "Fed on hold."

President Jordan: ... I would come down on the side of 50 basis points even though Bill McDonough's argument about that being viewed as a one-time adjustment followed by the "Fed on hold" is interesting. The other side of that would be that 25 basis points would be viewed clearly as the first of a series of moves. And if the market quickly built in pricing and expectations of the next 25 basis point move, then the equilibrium rate would move
at least as much as our move, implying de facto that we eased conditions relative to where the market is if it's ahead of us. I don't know what the timing might be as to market expectations, but if it's a fairly short horizon--maybe no further out than the next FOMC meeting--we may find that 25 was not enough to restrain reserve growth...

Chairman Greenspan: I thought about 50 basis points, or I thought about it in the sense of trying to move the rate to where we want to put it and then sticking with it. But I think it may be very helpful to have anticipations in the market now that we are going to move rates higher because it will subdue speculation in the stock market; at this particular stage having expectations hanging in the market that we may move again, and move reasonably soon, could have a very useful effect. If it is in any way contemplated that we have moved and are going to stop, that could create the type of erosion in the economy that I've watched over the past decades, which is precisely what we don't want. If we have the capability of having a Sword of Damocles over the market we can prevent it from running away... If we're going to move, I would not mind moving again at the next meeting or the meeting after that, for example. That depends on the evolution of events, frankly.

Greenspan got his way, after imploring the committee to "act unanimously." The February 14, 1994 New York Times reported that "in the two weeks since the rate action, it appears that rather than reassuring traders and investors, the Federal Reserve has managed to leave them with a worse case of the jitters. The financial markets seem to have increased their focus on inflation amid a general consensus that the Federal Reserve will have to raise short-term interest rates again soon. Both factors have led to a sharp selloff in the bond market and a jump in both long- and short-term interest rates." Later the article adds,

The interest rate hike validated the market's inflation fears," said Matthew F. Alexy, a government securities specialist at CS First Boston. "The market must have asked itself: Why would the Fed move to raise interest rates unless there was, in fact, a problem with inflation?"  

The added sensitivity was demonstrated Thursday when traders and investors chose to overlook the positive report on consumer prices in January, which were unchanged, and instead focused on a Federal Reserve Bank of Philadelphia report that suggested that prices had been on the rise in early February. 

The markets saw inflation where there was none. By the March 1994 meeting, Greenspan raised the case of the missing inflation. "...we are pretty far along in this business cycle. So why is inflation not showing its head a little more? Now, the next set of numbers may come out and I'll be sorry I said this, but the earlier experience raises the question: Is it automatically the case that when the economy is tightening up that inflation takes hold?" He recognized that inflation was nowhere to be seen, but halfway expected it to rear its head at any minute. And then he brought it up again: the Sword of Damocles!

Greenspan:  One of the elements that I think we have all been observing with respect to the markets--and one of the reasons why there has been such a level of instability in the markets--is that when we were perceived as moving on the basis of economic data, the markets had a certain sense of what it was we were doing...Now they are worried that they don't know when we are going to move, so we have this Sword of Damocles hanging over the market. They don't know whether we are going to move in 2 days, 5 days, or 12 days; they have no basis to judge and they are understandably nervous. So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position--having done that and in a sense succeeded perhaps more than we had intended--to try to restore some degree of confidence in the System. And that means we have to find a way, if at all possible, to move toward a policy stance from which we will not be perceived as about to move again in any short period of time.

The distinction between Greenspan's two uses of the sword is astounding and tragicomic. In February, the Sword is his tool; he controls it to serve his purpose. "If we have the capability of having a Sword of Damocles over the market we can prevent it from running away." By March, the Sword still hangs over the markets, but it is not Greenspan's tool; it works against him instead of for him. Greenspan is king of the markets, and the sword hangs above the throne. In February he speaks of the Sword as useful, and by March he wants it removed. He proposes this plan to remove it:

I think there is a certain advantage in [raising the rate by] 25 basis points because the markets, having seen two moves in a row of 25 basis points at a meeting, will tend almost surely to expect that the next move will be at the next meeting--or at least I think the probability of that occurring is probably higher than 50/50. If that is the case and the markets perceive that--and they perceive we are going to 4 percent by midyear, moving only at meetings--then we have effectively removed the Damocles Sword because our action becomes predictable with respect to timing as well as with respect to dimension. 

The plan is what in today's lingo we'd call "calendar objectives" as opposed to data objectives. Greenspan thought interest rates ultimately needed to get up to 4 or 4.5%, and wanted to set up a timeline to get there in movements of 25 basis points at each scheduled meeting. He thought that by moving by 25 bps at two meetings in a row, the markets would catch on and expect 25 bps at subsequent meetings (regardless of inflation, or lack thereof.) This timeline was not to be. At a conference call on April 18, before the next scheduled meeting, the rate was raised another 25 bps, then 50 in May, 50 in August, and 75 in November. Overall, 1994 was a bad year for bond investors and speculators (including Orange County, CA, which went  bankrupt after the rise in interest rates), but decent for the real economy. The Fed's actions that year were not ideal, but they also were not disastrous, except for certain categories of investors.

The real economy today faces a shakier recovery which could more easily be thrown off course. Inflation has not "shown its head" no matter how hard the markets and the Fed have looked for it. Since the data give no impetus toward reducing accomodation, the Committee, eager to exit, has switched to a calendar-based policy. President Bullard's press release describing his dissent to the FOMC decision announced on June 19, 2013, includes the following:

President Bullard also felt that the Committee’s decision to authorize the Chairman to lay out a more elaborate plan for reducing the pace of asset purchases was inappropriately timed. The Committee was, through the Summary of Economic Projections process, marking down its assessment of both real GDP growth and inflation for 2013, and yet simultaneously announcing that less accommodative policy may be in store...President Bullard felt that the Committee’s decision to authorize the Chairman to make an announcement of an approximate timeline for reducing the pace of asset purchases to zero was a step away from state-contingent monetary policy.

Tim Duy summarizes,

Bullard clearly felt the mood in the room was something to the effect of "We know the data is soft, but we want out of this program by the middle of next year, so we are going to lay out a program to do just that."...After weeks of being soothed by analysts saying that the data was key, that low inflation would stay the Fed's hand, Bernanke laid out clear as day a plan for ending quantitative easing by the middle of next year. Market participants then concluded exactly what Bullard concluded: It's the date, not the data.

Perhaps Chairman Bernanke looked up and glimpsed Greenspan's sword suspended above his head. I hope he can react to it with composure and not panic. The Committee in 1994 tried to manipulate market expectations through actions and through cryptic communications. While the expectations instrument was powerful, it was not precise. Although the Fed has improved its communications strategy since 1994, its messages still can have unintended consequences; 10-year yields rose sharply following the latest FOMC statement. Very clearly state-contingent monetary policy would be less confusing, and would project more confidence in the economy's eventual recovery, than semi-state-contingent, semi-calendar-driven policy. And if bond market participants look back to 1994 and expect a rapid succession of interest-rate hikes in the near future, the Fed should clearly communicate that this time will be different.

The OMT Goes to Court

Imagine a scheme that would transfer money from Spain, Greece, and Italy to Germany. According to Paul De Grauwe and Yuemei Ji, this is precisely what the European Central Bank's Outright Monetary Transactions (OMT) program has the potential to do. Yet 35,000 Germans have filed complaint against the scheme.

The Federal Constitutional Court of Germany is undergoing deliberations on the legality of the European Central Bank's OMT program. The program was announced last August, when the ECB announced that it would be willing, in certain scenarios, to buy government bonds without limit. Even though the ECB has not yet purchased government bonds under this scheme, the announcement alone reduced problematically-high bond yields in Italy and Spain, leading Mario Draghi to declare the program a big success.

Andreas Vosskuhle, president of Germany's Federal Constitutional Court, however, said Tuesday that the court will not take the success of the OMT into account when deliberating its legality or constitutionality. Andreas Wiedemann has written an excellent summary of the hearings on June 11 and 12. The court is expected to make a ruling some time after the German elections on September 22.  Mark Thoma links to a note by Helmut Siekmann and Volcker Wieland on the legal issues of the case. They begin by explaining several types of criticism of the OMT.

The first criticism is that "the ECB has ventured too far into the terrain of fiscal policy by announcing such potentially unlimited government bond purchases. The announcement itself is likely to cause delays in the implementation of necessary fiscal and structural adjustments by national governments, because it has reduced market pressures via government financing conditions." Moreover, the "strict and effective conditionality" prerequisites for OMT measures "can also be interpreted to indicate that the envisaged measures fall outside the area of monetary policy as these conditions serve to achieve other economic and fiscal objectives." An additional point of contention is that "critics fear that the independence of the ECSB and of the members of their decisionmaking bodies is jeopardized by the large-scale transfer of credit risks from the private and public sector to the ECSB."

In "Fiscal implications of the ECB’s bond-buying programme," De Grauwe and Ji argue that the fears that German taxpayers may have to cover losses made by the ECB are misplaced--based on a misunderstanding of solvency issues facing central banks. They say, in fact, that German taxpayers are the main beneficiaries of such a bond-buying program. They begin by explaining that a private company is said to be solvent when its losses do not exceed the value of its equity, which is the expected present value of future profits, but the same is not true for a central bank.

"A central bank can issue any amount of money that will allow it to 'repay its creditors', i.e. the money holders... Contrary to private companies, the liabilities of the central bank do not constitute a claim on the assets of the central bank. The latter was the case during gold standard when the central bank promised to convert its liabilities into gold at a fixed price. Similarly in a fixed exchange-rate system, the central banks promise to convert their liabilities into foreign exchange at a fixed price. 

The ECB and other modern central banks that are on a floating exchange-rate system make no such promise. As a result, the value of the central bank’s assets has no bearing for its solvency. The only promise made by the central bank in a floating exchange-rate regime is that the money will be convertible into a basket of goods and services at a (more or less) fixed price. In other words the central bank makes a promise of price stability. That’s all. 

Thus it makes no sense to state that the limit to the losses a central bank can make at any point in time is given by the present value of future profits (seigniorage). There is no such limit. The central bank can make any loss provided the loss does not endanger its promise to maintain price stability."

De Grauwe and Ji discuss the situation of a central bank with one sovereign, then discuss a central bank in a monetary union with many sovereigns. Consider the central bank of a stand-alone country buying government bonds in the secondary market:

"Government debt that carries an interest rate and a default risk becomes debt that is a monetary liability of the central bank (money base) that is default-free but subject to inflation-risk. To understand the fiscal implications of this transformation, it is important to consolidate the central bank and the government (after all they are separate branches of the public sector).
After the transformation the government debt held by the central bank cancels out. It is an asset of one branch (the central bank) and a liability of another branch (the government). As a result, it disappears. The central bank may still keep it on its books, but it has no economic value anymore. In fact the central bank may do away with this fiction and eliminate it from its balance sheet and the government could then eliminate it from its debt figures. It has become worthless because it was replaced by a new type of debt, namely money, which carries an inflation risk instead of a default risk. 

This is why it makes no sense to say central banks lose when the market price of the government bonds drops. If there were a loss for the central bank it would be matched by an equal gain of the government (whose market value of the debt has dropped in the same proportion). There is no loss for the public sector... 

When the central bank has acquired government bonds, a decline in the market value of these bonds has no fiscal implications."

What about in a monetary union (that is not a fiscal union) like the Eurozone? De Grauwe and Ji ask us to imagine the ECB buys €1 billion of Spanish bonds with a 4% coupon. Then the ECB would receive €40 million interest annually from the Spanish Treasury and return this €40 million every year to the national national banks according to national equity shares in the ECB. So 11.9% of the €40 million would go back to the Banco de España. The rest would go to the other member central banks, with 27.1% (or €10.84 million) going to the German Bundesbank. In short, the authors say, "An ECB bond-buying programme leads to a yearly transfer from the country whose bonds are bought to the countries whose bond are not bought."

I'm not sure if it is fair to call the example above a transfer away from Spain. Sure, Spain would make an interest payment to the ECB and receive only 11.9% of it back. But without the program, Spain would make an even larger interest payment to other lenders and receive none of it back. The ECB purchase would be a net gain for Spain. And I agree that it would benefit Germany, but not because of the €10.84 million, small change in the scheme of things. The real benefit is compared to the counterfactual of a member state sovereign insolvency and contagious financial instability. Remember that no bonds have been purchased under the OMT so far, so no interest payments have been made, and the hope is that "a credible commitment alone is sufficient to eliminate the speculative equilibrium." Also remember that according to De Grauwe and Ji's earlier logic, if the ECB wanted to give Germany €10.84 million, they don't need the corresponding asset backing of a Spanish interest payment to do so.

So, while I agree with De Grauwe and Ji that German taxpayers benefit from the OMT, and hope for the program to continue, I don't think interest payment transfers are the main point to emphasize. Rather, as Holger Schmieding of Berenberg Bank writes,

"Critics claim that the OMT redistributes risks within the euro zone and that the ECB has no mandate to do so. That is disingenuous. First, the major effect of the OMT is to reduce the level of risk for everybody in the euro zone. An economic depression with a chaotic collapse of the euro would have been much more expensive even for the German taxpayers than any risk that may come with the OMT. Second, due to the OMT announcement, the ECB balance sheet has contracted and improved in asset quality, reducing risks for German taxpayers. Third, it is the very nature of monetary policy to change relative prices and hence risks in financial markets. That is how monetary policy sets incentives for households and companies to adjust their behaviour. Outlawing this feature would mean outlawing monetary policy itself."

In a week from today, I will start working as a graduate student instructor for an undergraduate macroeconomics course at Berkeley. It will be fun to bring up this court case when they are learning about the standard textbook distinction between fiscal and monetary policy and see what they think.

Depressing Slow Recovery Graphs

Earlier this year, Fed Vice Chair Janet Yellen described the economic recovery as "painfully slow," and said that an "important tailwind in most economic recoveries is one that tends to be taken for granted--the faith most of us have, based on history and personal experience, that recessions are temporary and that the economy will soon get back to normal." This tailwind, she implied, was particularly weak. Here I've made two graphs that give an indication of the painfully slow recovery.

The Michigan Survey of Consumers asks respondents, "Compared with 5 years ago, do you think the chances that you (and your husband/wife) will have a comfortable retirement have gone up, gone down, or remained about the same?"

Before 2008, on average 45% of people would say that their chances of a comfortable retirement had stayed the same. About 28% would say their chances got worse, and 26% would say their chances got better. Figure 1, below, shows the percent of respondents who chose better or worse each month. By October 2008, only 11% of respondents thought their chances of a comfortable retirement were better than 5 years ago; 45% thought they were worse. 

As of October 2012, the numbers are barely improved: 15% of people think their chances of a comfortable retirement are better than they were in 2007, and 41% think they are worse.

Figure 2 shows the percent of respondents in the highest and lowest income terciles who think their chances of a comfortable retirement are worse than 5 years ago. For the top income tercile, hit harder by falling asset prices, this number peaked at 62% in February 2009, and averaged 41% over 2012. For the bottom income tercile, hit harder by the deteriorating labor market, this number peaked later, at 56% in May 2011,  and averaged 45% over 2012.

Figure 1: Constructed with data from Michigan Survey of Consumers

Figure 2: Constructed with data from Michigan Survey of Consumers

Macroeconomic Consequences of the Allocation of Talent

This afternoon I'm attending a seminar on "The Allocation of Talent and U.S. Economic Growth" by Chang-Tai Hsieh, Erik Hurst, Charles Jones, and Peter Klenow. Here's the abstract of the paper:

In 1960, 94 percent of doctors and lawyers were white men. By 2008, the fraction was just 62 percent. Similar changes in other highly-skilled occupations have occurred throughout the U.S. economy during the last fifty years. Given that innate talent for these professions is unlikely to differ across groups, the occupational distribution in 1960 suggests that a substantial pool of innately talented black men, black women, and white women were not pursuing their comparative advantage. This paper measures the macroeconomic consequences of the remarkable convergence in the occupational distribution between 1960 and 2008 through the prism of a Roy model. We find that 15 to 20 percent of growth in aggregate output per worker over this period may be explained by the improved allocation of talent.

The paper notes that "A large literature attempts to explain why white men differ in their occupational distribution relative to women and blacks and why those differences have been changing over time. Yet no formal study has assessed the effect of these changes on aggregate productivity. Given that innate talent for many professions is unlikely to differ across groups, the occupational distribution in 1960 suggests that a substantial pool of innately talented blacks and women were not pursuing their comparative advantage. The resulting misallocation of talent could potentially have important effects on aggregate productivity."

The authors build a model in which people are born with a range of talents across all possible occupations and choose the occupation with the highest return, subject to some frictions representing labor market discrimination and discrimination in the acquisition of human capital. The frictions essentially act as "taxes" that differ across time, demographic group, and occupation, distorting the optimal allocation of talent across occupations. They use Census data to quantify these frictions decade by decade. They find large reductions in the barriers to occupational choice facing women and blacks from 1960 to 2008. Using a general equilibrium setup of their model, they calculate that falling barriers may explain 15 to 20 percent of aggregate wage growth and 75 percent of the rise in women’s labor force participation over that time period.

As part of their empirical work, the authors construct an occupational similarity index that measures how closely the occupational distribution of white females, black males, and black females compares to the occupational distribution of white males. The index runs from zero (no overlap with the occupational distribution for white men) and one (identical occupational distribution to white men). Table 1 of the paper shows how the index has evolved over time:

Hsieh et al (2013), Table 1

They also estimate the occupational frictions for different occupations. Figure 3 below shows their barrier measure for white women in select occupations. A barrier of 1 means that there is no friction relative to white men. They interpret the graph to indicate that "white women in 1960 did not have an absolute advantage over white men in the home sector. In essence, we find that white women were choosing the home sector because they were facing disadvantages in other occupations. Figure 3 shows that τˆig is close to 1 for white women in the home sector in all years of our analysis. This suggests women did not move out of the home sector because they lost any absolute advantage in the home sector. Instead, our results suggest that women moved into market occupations due to declining barriers in the market."

Hsieh et al (2013), Figure 3

In the conclusion, the authors note that "We have focused on the gains from reducing barriers facing women and blacks over the last fifty years. But we suspect that barriers facing children from less affluent families and regions have worsened in the last few decades. If so, this could explain both the adverse trends in aggregate productivity and the fortunes of less-skilled Americans in recent decades." I think this is a very important point.

I would also add that the benefits of reducing occupational barriers to different groups reach far beyond aggregate productivity and wage gains. In the model, people get utility from consumption and from leisure time. But I think people can also get a lot of utility from doing work that they enjoy, if they actually have the opportunity to pursue the kind of career they want. There is considerable utility to feeling like you have wide opportunities, and to choosing a job you like, regardless of wage. For example, I don't really know how my comparative advantage in economics--a profession that very few women could choose in the 1960s-- compares to my comparative advantage in a lot of other occupations. In terms of maximizing my wages and leisure, it was certainly not my optimal choice. But I much prefer a world in which I have that choice than a world in which I don't.

In the occupational choice model, each person is endowed with a certain amount of talent in each occupation  and, fully aware of their talents, can make their decisions about human capital accumulation and occupation. In reality, there is a considerable discovery process to becoming aware of our own talents. A young girl doesn't wake up and think, "Hey, I have a lot of talent for computer programming. I think I'll go to college and get a degree in computer science and then work for a tech company." She especially doesn't think this if she barely has access to a computer and has no role models who work in that area or teachers who help her discover her talents. So there is another friction, a "talent discovery" friction, that might be in play. And this friction also varies across groups and occupations. A lot of boys whose fathers are engineers discover that they have engineering talent (I noticed this at Georgia Tech.) But for a lot of other kids, it never occurs to them to even consider whether they might make a good engineer. So I think there are externalities to having more underrepresented groups in highly-skilled occupations, by making these occupations more visible to young people who might face high "talent discovery frictions."