Why the ECB Should Buy US Treasuries
[Formerly titled What’s Out and What’s In with International Money?]
Jeffrey Frankel, Harpel Professor of Capital Formation and Growth
Harvard Kennedy School
Keynote Speech
Tower Center / Owens Memorial Foundation Conference:
The Political Economy of International Money
Common Currencies, Currency Wars and Exorbitant Privilege
Federal Reserve Bank of Dallas and Southern Methodist University
Dallas, Texas
April 4, 2014
Five years ago I gave a speech titled “What’s In and What’s Out in Global
Money.”1 I argued that the Corners Hypothesis was out, for example, and intermediate
exchange rate regimes were back in.2 The G7 was out, and the G20 was in. And so
forth. When Kathy Cooper first asked me to give this keynote, I thought I might do an
update. Indeed, I will argue that some ideas, such as Currency Wars, may have outlived
their usefulness. I am going to suggest that, like actors exiting the stage in sequence, the
time has come for many of them to go.
But I find it easier to offer my own idiosyncratic prescriptions for what the policy
response should be, than to make good predictions as to what will actually happen next.
The most important of my conclusions is going to be a recommendation that
Mario Draghi buy US bonds. This strikes some as a radical notion. It is probably true
that the ECB has never considered such a thing in its history, let alone done it, and has
not intervened in the foreign exchange markets in either direction in 14 years. But I hope
to convince you that the proposal not only is not radical, but is quite natural.
Three years ago, if anybody had suggested such a thing, I would have thought it
was a poor idea. As recently as one year ago, such a proposal would have provoked
vigorous and understandable objections. But the wheel has turned.
Monetary Economics has been dominated in recent years by talk of QE, forward
guidance, and currency wars. In euroland it has been OMTs and “we will do what it
takes.” In Emerging Markets it has been carry trade and “reach for yield.” Each of these
ideas arose for good reason. I am not questioning their usefulness. But each of the
broader concepts had more specific incarnations that were wedded to historical
circumstances. These circumstances are now changing.
[I propose to review recent history, to go through in turn these concepts that have
been so dominant in the last few years. In each case, we will go from the general concept
to the specific incarnation, identify the recent developments that in my view are now
rendering them obsolete, and conclude with my own thoughts on a desirable direction to
go now.]
The fundamental problem that gave rise to these phenomena was the need for
monetary easing in response to the global financial crisis of 2008 – which I have been
persuaded by Rakesh Mohan (IMF ED from India) to call the North Atlantic Financial
Crisis. After the policy rate was pushed to zero in the US and the UK, the question
became what to do about the Zero Lower Bound.3 The twin responses were QE and
forward guidance. Both were ways of trying to get a bit more stimulus by keeping long
term interest rates a bit lower than they would otherwise be. I want to be very clear that
I supported both of these policies. I think the Fed did a great job after the onset of the
global financial crisis. And it is not yet time to tighten monetary policy. Nevertheless,
QE and forward guidance have each recently run into new limitations.
The reasons for tapering QE are pretty clear: the Fed does not want on a regular
basis to be in the business of buying treasury bonds and MBSs. But in the taper tantrum
of May/June 2013, longer-term interest rates began to rise, which I think is not what the
Fed wanted. In the period ahead, the Fed presumably wants to begin working down its
bond holdings without yet putting upward pressure on long-term interest rates. It might
be ideal if someone else could buy these bonds instead. But who would want to do such
a thing at this time? Let’s put that question aside and come back to it later.
Let’s first consider the other tool, forward guidance. Its goal was to convince
markets that the Fed would be keeping the short-term policy interest rate low for quite
awhile. To strengthen this effort the Fed in December 2012 switched to a form of
forward guidance that was phrased in terms of a specific threshold for one specific
economic variable: the unemployment rate. Interest rates would be kept low at least until
the unemployment rate fell below 6 ½ % [and as long as inflation remained low]. In
mid-2013the Bank of England adopted a similar strategy in, with a threshold of 7%.
While I applaud what they were trying to do, the choice of variable was perhaps not the
best.
The development that has now rendered the strategy obsolete in both the US and
the UK is clear: we look to be reaching the announced unemployment thresholds well
before the authorities judge the economy ready for monetary tightening. Both central
banks have had to acknowledge this and have thus been criticized for confusing the
public. In the case of the US, the problem wasn’t that the Fed was too pessimistic about
the pace of economic recovery. It chose a reasonable number, given the information that
was available at the time and given the decision to express the threshold in terms of
unemployment. The problem is that unemployment came down more rapidly than the
economy grew, largely because the labor force participation rate continued to fall with
unexpected speed. But we always knew that such shocks were likely, whether positive or
2
negative. The unemployment rate is an unnecessarily imperfect indicator of what is
wanted.
If the Fed or the Bank of England two years ago had announced thresholds
phrased in terms of nominal GDP, they wouldn’t have had to abandon them. There are
different versions of NGDP targeting, just as there are different versions of IT. But what
they have in common is that they are more robust with respect to shocks (supply shocks,
velocity shocks, labor force shocks) than the alternatives (IT, money targeting, and
unemployment thresholds).
I admit that such variables as the inflation rate and the unemployment rate have
the virtue of being more readily understood by the man in the street. But one need not
give up those advantages. One could announce a threshold or target for nominal GDP at
the one- or two-year horizon, and also announce estimates as to likely corresponding
paths for inflation or unemployment. The advantage: if there were unexpected shocks
arose during the intervening period, one could remind the public of the nominal GDP
target, rather than being left standing naked as the Fed and Bank of England are now.
The financial markets would appreciate the element of consistency.
By the way, although NGDP targeting has many proponents in the case of the
largest industrialized countries, going back as far as James Meade 35 years ago, my own
view is that the best candidates for this idea are middle-sized, middle-income countries.
Many of them supposedly adopted Inflation Targeting after the 1990s and are still paying
lip service to it. But they tend to experience more supply shocks and terms of trade
shocks than do large industrialized countries. Thus they are better candidates for nominal
GDP targeting, which is robust with respect to such shocks. (This is especially true of
those countries that export oil or other commodities and those that are vulnerable to
natural disasters.) Nominal GDP targeting for middle-income countries is my first
(idiosyncratic) policy prescription.
But the minds of Emerging Market central bankers are elsewhere today. They
feel that policy-makers in Washington are not adequately taking their interests into
account, as articulated in January by Raghuram Rajan, head of the Reserve Bank of India.
The big EM countries have a valid claim, that they do not receive a weight in global
governance commensurate with their economic size, to say nothing of their populations.
But several years ago, the specific complaint from the G-20 was that monetary
policy in the US and Japan was too loose. The resultant flood of capital into their
countries – call it a carry trade or a “reach for yield” or a “risk on” environment -- was
making life difficult for them. This idea was articulated by Brazilian Minister Guido
Mantega as “Currency Wars.” That term had more zing than the unfashionable old term
from the 1930s, “competitive devaluation.”
Perhaps the phrase “Currency wars,” should now be retired, at least with that
specific meaning it has had. Why? Ever since the taper tantrum of last May-June, the
emerging markets have been worried about tightening of global monetary policy, not
loosening. Rajan’s specific complaint was the increase in US interest rates over the year
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and the impact on the Fragile Five and others. The concern has been a reversal of the
carry trade, a “risk off” environment, a pull-out by investors. Mantega is “out” and Rajan
is “in.”
Several years ago, when monetary loosening suited the position of the advanced
economies but not the Emerging Markets, floating upward was the natural response.
Similarly, floating downward is the natural response now, during the phase when US
interest rates are beginning to rise. To be sure, in both phases foreign exchange
intervention to dampen the swing is often appropriate.4
Regarding the lack of adequate representation of EM countries in global
governance more generally, the right policy response is obvious. The White House has
already over the last few years helped broker a negotiated reallocation of IMF quotas
toward large EM members, mostly at the expense of European shares which are
anachronistically high. All that remains is for Congress to approve the reform. Bu it has
refused. It would cost the American taxpayer nothing and would allow the US to
exercise some global leadership at a time when it is sorely lacking. We all should be
screaming about this.
My last topic concerns the big common currency, the euro. I hope I manage here
to bring together the various strands of my remarks.
It is widely recognized that the ECB should further ease monetary policy. Inflation at
0.7% across the euro zone is below the target of “close to 2%.” Unemployment in most
countries is still high and GDP low. (According to this week’s euro statistics, the most
recent inflation rate is 0.5% and unemployment 11.9%.) Under current conditions it is
hard for the periphery countries to bring their costs the rest of the way back down to
internationally competitive levels as they need to do. If inflation is below 1% euro-wide,
then the periphery countries have to suffer painful deflation.
The question is how the ECB can ease, since short-term interest rates are already
low. Most of the talk in Europe is around proposals for the ECB to undertake QE,
following the path of the Fed and the Bank of Japan, expanding the money supply by
buying the government bonds of member countries. This would be a realization of Mario
Draghi’s idea of Outright Monetary Transactions, which was announced in August 2012
but never had to be used.
QE would present a problem for the ECB that the Fed and other central banks do
not face. The euro zone has no centrally issued and traded Eurobond that the central
bank could buy. [And the time to create such a bond has not yet come.] That means
that the ECB would have to buy bonds of member countries, which in turn means taking
implicit positions on the creditworthiness of their individual finances. Germans tend to
feel that ECB purchases of bonds issued by Greece and other periphery countries
constitute monetary financing of profligate governments and violate the laws under
which the ECB was established. The German Constitutional Court believes that OMTs
would exceed the ECBs mandate [though it temporarily handed the hot potato to the
European Court of Justice in February]. The legal obstacle is not merely an
inconvenience but also represents a valid economic concern with the moral hazard that
ECB bailouts present for members’ fiscal policies in the long term. That moral hazard
was among the origins of the Greek crisis in the first place.
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Fortunately, interest rates on the debt of Greece and other periphery countries
have come down a lot over the last two years. Since he took the helm at the ECB,
Mario Draghi has brilliantly walked the fine line required for “doing what it takes” to
keep the eurozone together. (After all, there would be little point in preserving pristine
principles in the eurozone if the result were that it broke up. And fiscal austerity was
never going to put the periphery countries back on sustainable debt paths.) Global
investors seem to be “rotating into” euro periphery bonds, in retreat from EM bonds.
Spain’s government this week has been able to borrow as cheaply as ours! At the
moment, there is no need for the ECB to support periphery bonds, especially if it would
flirt with unconstitutionality.
What, then, should the ECB buy, if is to expand the monetary base? It should not
buy Euro securities, but rather US treasury securities. In other words, it should go back
to intervening in the foreign exchange market. This is my last (idiosyncratic) policy
prescription.
Here are several reasons why the European monetary authority should buy
dollars.
First, it solves the problem of what to buy without raising legal obstacles.
Operations in the foreign exchange market are well within the remit of the ECB.
Second, they also do not pose moral hazard issues (unless one thinks of the long-term
moral hazard that the “exorbitant privilege” of printing the world’s international currency
creates for US fiscal policy).
Third, ECB purchases of dollars would help push the foreign exchange value of
the euro down against the dollar. Such foreign exchange operations among G-7 central
banks have fallen into disuse in recent years, in part because of the theory that they don’t
affect exchange rates except when they change money supplies. There is some evidence
that even sterilized intervention can be effective, including for the euro. But in any case
we are talking about an ECB purchase of dollars that would change the euro money
supply. The increased supply of euros would lower their foreign exchange value.
Monetary expansion that depreciates the currency is effective. It is more effective
than monetary expansion that does not, especially when, as at present, there is very little
scope for pushing short-term interest rates much lower.
Depreciation of the euro would be the best medicine for restoring international
price competitiveness to the periphery countries and bringing their export sectors back to
health. Of course they would devalue on their own, if they had not given up their
currencies for the euro ten years before the crisis (and if it were not for their eurodenominated debt). Depreciation of the euro as a whole is the answer.
The strength of the euro has held up remarkably during the four years of crisis. It
could afford to weaken substantially.
Central banks should and do choose their monetary policies primarily to serve the
interests of their own economies. The interests of those who live in other parts of the
world come second. But proposals to coordinate policies internationally for mutual
benefit are fair [discussed by Jeff Frieden in the dinner speech that opened this
conference].
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How would ECB purchases of dollar bonds fare by the lights of G20 cooperation?
Well, it seems to me. As I have noted, the rest of the world is worried about US interest
rates going up, not coming down. As the Fed tapers back on its purchases of US treasury
securities, it is a perfect time for the ECB to step in and buy some itself.
So to recap my conclusions, I have argued that (i) forward guidance may work
better if phrased in terms of nominal GDP; (ii) that nominal GDP targeting may be
especially relevant for middle-income countries which are vulnerable to supply and trade
shocks; (iii) that the US Congress should pass the IMF reform to give EM countries a fair
share in global governance, and (iv) that the ECB should pursue QE by buying US bonds,
not euro bonds.
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Addendum: A Version of the Proposal Without Euro Depreciation
What if the European authorities are told by the international community,
especially the US, that it doesn’t want them to push the euro down against the dollar, that
it fears a re-ignition of the currency wars? And what if the ECB concludes that it can’t
buy US treasuries without US agreement?
I have a Plan B to propose in that case, a version of the idea that would not put
downward pressure on the foreign exchange value of the euro. The ECB still pursues
QE by buying US bonds; but it buys them from the Fed rather than on the open market.
Recall that the goal is for the ECB to expand its monetary base, without flirting
with illegality. And that the Fed’s goal is to taper and then reduce its holdings of
Treasury bonds and Mortgage Backed Securities, without yet forcing up long-term
interest rates.
Everybody gets what he wants. The Eurozone gets to expand its monetary base.
The Fed gets to reduce the bonds on its balance sheet. By selling them to the ECB rather
than on the private market it avoids upward pressure on interest rates. (And what central
bank wouldn’t like to have more foreign exchange reserves, other things equal?) If the
ECB buys its dollars from the Fed instead of on the private market if avoids downward
pressure on the euro.
The counter-argument from the viewpoint of the ECB is that, even though this is a
way to expand its monetary base, it probably doesn’t achieve the objective of lowering
Euro interest rates, if the Fed holds the euros as deposits at the ECB. It would work if the
Fed used them to buy longer-term euro bonds, which lots of central banks do these
days. But that idea would not go over well with the American public. So maybe it has to
be Plan A.
ENDNOTES
1
"What’s 'In' and What’s 'Out' in Global Money," Finance & Development, 2009.
2
International Monetary Economics is subject to fads and fashions like any other field. The
conventional wisdom after the currency crashes of the 1990s was the corners hypothesis, the
proposition that countries were moving either to the extreme of exchange rates that were rigidly
fixed under institutions such as currency boards and monetary unions or, in the opposite corner to
the regime of a floating exchange rate. Today currency boards and monetary unions are not
looking as good, and fear of floating is common. A majority of countries, particularly most EM
and developing countries still following intermediate exchange rate regimes and one no longer
hears much of the Corners Hypothesis.
3
As in Japan at the turn of the century. The ZLB is of course an example of the old Liquidity
Trap; but that phrase had long since fallen out of fashion.
I am not sure why a regime of systematic “leaning against the wind” has never received very
much research attention, in comparison to target zones, for example.
4
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