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May 10, 2020

On court rulings and folk economics

Many commentators have expressed their shock and horror at the German court's anachronistic interpretation of the scope of monetary policy. On this, we would like to make two points. First, the German court's ruling seems consistent with the character of the public debate on monetary policy in Germany. And second, it is probably true that the ECB did not concern itself much with the side effects of its policy. To a certain extent all this is water under the bridge. In the short to medium term, the story is less likely to revolve around economic arguments than around issues of overlapping competences and the legal strategies of the various German and European institutions involved.

Court proceedings are orderly dispute resolution mechanisms and are to an extent political, the more so the closer one gets to constitutional law. When the law isn't clear, judges decide on the basis of principles and conventions. Judges are not experts on everything. When they decide on a matter with a technical component, they summon experts.

What all this comes down to is that it is probably to be expected that a court ruling on monetary policy will involve what one might call the folk theory of money. In this connection we find a paper by Benjamin Braun rather illuminating. This only recently became open-access, and so it is more widely shared and discussed. The global financial crisis starting in 2007 brought about a transition of inflationary to deflationary conditions, and a massive expansion of central bank balance sheets resulted. Braun's thesis is that this caused a disconnect between the way central banks communicate to the markets and to the general public.

Central banks communicate with the markets to manage expectations, and with the public to keep trust. When central banks had to fight inflationary pressures, they were able to communicate to both markets and the public in terms of a folk theory of money that Braun summarises in three principles: that all money is created equal; that banks are intermediaries only; and that the quantity of money is determined outside the system. In that world, central banks pretended to be in control of the money supply.  

The reality is different of course: there is a hierarchy of payment forms; banks create deposits when they lend; and a central bank that targets an interest rate must let its balance sheet grow or shrink in response to money market conditions. And, under deflationary conditions, central banks needed to convey a different message to the markets than to the public. In the last decade we have seen central banks, including the Bundesbank, communicate that the folk theory of money was wrong. 

The proportionality arguments of the German court are also based on folk notions that have become commonplace in the German political debate, such as that bond purchases finance enable fiscal indiscipline and improve the credit rating of banks, or that low interest rates damage savers and allow zombie firms to continue to operate. 

Part of the outrage by ECB watchers comes from the fact that the ECB has repeatedly addressed these fears and argued that they are misplaced. Notably, Isabel Schnabel addressed all these points in a speech in Karlsruhe in February. She argued that negative rates were a structural development beyond the control of the ECB, and that this required central banks to expand their balance sheets. She also dismissed the supposed side effects of policy: saver expropriation, zombie firms, and asset bubbles. However, Schnabel was not herself an expert witness to the German constitutional court. Most of the witnesses were conservative economists that disagreed with her. Her intervention also came rather late to the German public debate, where fears about ECB policy had already solidified. Schnabel also suggested implicitly that the ECB would have to address this issue of proportionality in its policy review.

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May 10, 2020

EU regions - some far better on Covid-19 but not on downturn

Some regions are less hit than others by Covid-19, yet they are not spared from the economic fallout. Demand and supply chains throughout Europe are too interdependent, and the poorer regions in the EU are too fragile are to withstand the economic consequences from the national lockdowns.

Greece and Portugal may have been spared the fate of Spain and Italy when it comes to spread and death toll of the virus, yet their economy is as much dependent on tourism from other EU countries. It is not clear yet whether tourists from northern Europe will return for the summer season. Sweden may have no lockdown, yet its industries had to pause production due to the lack of parts from European suppliers. Their economic forecasts also predicts a contraction of 6-10% this year, which is not that far from other economies.

As EU countries exit from lockdown with different speed and emphasis, the interdependence will become even more apparent. Greece is already lobbying hard to get the summer season started as of early July, but will there be enough tourists? Regional disparities are bound to widen in hard hit countries like Italy and Spain, writes the FT. The poorer regions in the south have been less hard hit by the pandemic, yet the economic fallout will hit them harder than the wealthier north. In both countries the north is expected to bounce back quickly thanks to its industrial and agricultural base, while the south with its dependence on tourism will continue to suffer.

Ideally the EU gets a union wide agreement for a form of virus safe tourism. Alternatively, destination countries will have to offer themselves a safety protocol with tests and quarantine procedures. This will have to be applied at the level the regions. Expect some strong divergence and beggar-thy-neighbour policies. We saw how in Germany some Lander already hasted ahead with their exit strategy much to the annoyance of the other states. In Italy's south some governors broke away from the official guidelines from Rome to restart their local economies, facing criticism from the medical community. There will be no easy choices, but time matters especially for those regions where the trade-off between virus spread and economic fallout is tilted towards the latter.

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