Larry Summers’ interest rate conundrum. CEPS Hi-level Brief, 16 January 2014

Larry Summers has attracted much attention recently for invoking old theories of secular stagnation to explain the persistence of low interest rates in the recent past. The German economist Carl Christian von Weizsäcker has pointed to a retirement savings glut as the cause for low rates. In the view of Thomas Mayer, however, as expressed in this High-Level Brief, these theses lack both theoretical and empirical support and he offers as an alternative explanation the fall-out from the recent credit boom-bust cycle.

Did quantitative easing affect interest rates outside the US? New evidence based on interest rate differentials. CEPS Working Document No. 416/January 2016

This paper explores the effects of non-standard monetary policies on international yield relationships. Based on a descriptive analysis of international long-term yields, we find evidence that long-term rates followed a global downward trend prior to as well as during the financial crisis. Comparing interest rate developments in the US and the eurozone, it is difficult to detect a distinct impact of the first round of the Fed’s quantitative easing programme (QE1) on US interest rates for which the global environment – the global downward trend in interest rates – does not account. Motivated by these findings, we analyse the impact of the Fed’s QE1 programme on the stability of the US-euro long-term interest rate relationship by using a CVAR (cointegrated vector autoregressive) model and, in particular, recursive estimation methods. Using data gathered between 2002 and 2014, we find limited evidence that QE1 caused the break-up or destabilised the transatlantic interest rate relationship. Taking global interest rate developments into account, we thus find no significant evidence that QE had any independent, distinct impact on US interest rates.

The Greek debt trap: an escape plan. Bruegel Policy Contribution 2012/19, 7 November 2012

Without corrective measures, Greek public debt will exceed 190 percent of GDP, instead of peaking at the anyway too-high target ratio of 167 percent of GDP of the March 2012 financial assistance programme. The rise is largely due to a negative feedback loop between high public debt and the collapse in GDP, and endangers Greek membership of the euro area. But a Greek exit would have devastating impacts both inside and outside Greece. A small reduction in the interest rate on bilateral loans, the exchange of European Central Bank holdings, buy-back of privately-held debt, and frontloading of some privatisation receipts are unlikely to be sufficient. A credible resolution should involve the reduction of the official lending rate to zero until 2020, an extension of the maturity of all official lending, and indexing the notional amount of all official loans to Greek GDP. Thereby, the debt ratio would fall below 100 percent of GDP by 2020, and if the economy deteriorates further, there will not be a need for new arrangements. But if growth is better than expected, official creditors will also benefit. In exchange for such help, the fiscal sovereignty of Greece should be curtailed further. An extended privatisation plan and future budget surpluses may be used to pay back the debt relief. The Greek fiscal tragedy highlights the need for a formal debt restructuring mechanism

The effectiveness of the European Central Bank’s Asset Purchase Programme. Bruegel Policy Contribution issue 2016 10 June 2016

Since the end of 2014, inflation has been at or very close to zero. With very little ability to move the actual interest rate further into negative territory, the ECB has resorted to unconventional measures. The latest of these includes a programme to purchase corporate bonds, which started on 8 June 2016.

A sovereign wealth fund to lift Germany's curse of excess savings. CEPS Policy Brief No. 280, 28 August 2012

As an alternative to the present system of intermediation of the German savings surplus, this paper suggests that the risk-adjusted rate of return could be improved by creating a sovereign wealth fund for Germany (designated DESWF), which could invest excess German savings globally. Such a DESWF would offer German savers a secure vehicle paying a guaranteed positive minimum real interest rate, with a top-up when real investment returns allowed. The vehicle would invest the funds in a portfolio that is highly diversified by geography and asset classes. Positive real returns can be expected in the long run based on positive real global growth. Since, in this case, a significant amount of funds would flow outside the euro area, the euro would depreciate, which would help crisis countries presently struggling to revive growth through exports and to close their external deficits so as to recoup their international credit-worthiness. Target imbalances would gradually disappear and German claims abroad would move from nominal claims on the ECB to diversified real and nominal claims on various private and public foreign entities in a variety of asset classes.

So far apart and yet so close: Should the ECB care about inflation differentials? Bruegel Policy Contribution, Issue 2014/10 September 2014

Inflation rates can differ across regions of monetary unions. We show that in the euro area, the US, Canada, Japan and Australia, inflation rates have been substantially and persistently different in different regions. Differences were particularly substantial in the euro area. Inflation differences can reflect normal adjustment processes such as price convergence or the Balassa-Samuelson effect, or can reflect the different cyclical position of regions. But they can also be the result of economic distortions resulting from segmented markets or unsustainable demand and credit developments fueled by low real interest rates. In normal times, the European Central Bank cannot influence such developments with its single interest rate instrument. However, unconventional policy measures can have different effects on different countries depending on the chosen instrument, and should be used to reduce fragmentation and ensure the proper transmission of monetary policy. The new macro prudential policy tools are unlikely to be practical in addressing inflation divergences. It is crucial to keep the average inflation rate close to two percent so that inflation differentials are possible without deflation in some parts of the euro area, which in turn might endanger area-wide financial stability and price stability.

Comparing fiscal multipliers across models and countries in Europe. National Bank of Belgium Working Paper No. 278, March 2015

This paper employs fifteen dynamic macroeconomic models maintained within the European System of Central Banks to assess the size of fiscal multipliers in European countries. Using a set of common simulations, we consider transitory and permanent shocks to government expenditures and different taxes. We investigate how the baseline multipliers change when monetary policy is transitorily constrained by the zero nominal interest rate bound, certain crisis-related structural features of the economy such as the share of liquidity-constrained households change, and the endogenous fiscal rule that ensures fiscal sustainability in the long run is specified in terms of labour income taxes instead of lump-sum taxes.

What signal from the Fed? Should the ECB ease further? CEPS Commentary, 18 September 2015

The Federal Reserve left rates unchanged at its closely-watched meeting on September 17th, although many had argued that the real economy data, especially on the labour market, would have justified an exit (from the zero interest policy). In this CEPS Commentary, Daniel Gros observes that no similar decision on exit is in sight in the euro area, despite the fact that some have argued that the ECB should consider further easing measures (pushing the deposit rate deeper into negative territory or increasing the size of its asset purchase programme). He asks, in fact, whether further easing measures should be even discussed at this point.

Squaring the cycle: capital flows, financial cycles, and macro-prudential policy in the euro area. Bruegel Working Paper 2015/14, November 2015

• Before the financial and economic crisis, monetary policy unification and interest rate convergence resulted in the divergence of euroarea countries’ financial cycles. This divergence is deeply rooted in the financial integration spurred by currency union and strongly correlated with intra-euro area capital flows. Macro-prudential policy will need to deal with potentially divergent financial cycles, while catering for potential cross-border spillovers from domestic policies, which domestic authorities have little incentive to internalise. • The current framework is unfit to deal effectively with these challenges. The European Central Bank should be responsible for consistent and coherent application of macro-prudential policy, with appropriate divergences catering for national differences in financial conditions. The close link between domestic financial cycles and intra-euro area capital flows raises the question of whether macro-prudential policy in the euro area can be compatible with free flows of capital. Financial cycle divergence had its counterpart in the build-up of macroeconomic imbalances, so effective implementation of the Macroeconomic Imbalance Procedure would support and strengthen macro-prudential policy.

Is there a need for additional monetary stimulus? Insights from the original Taylor Rule. CEPS Policy Brief No. 342, April 2016

Central banks in the developed world are being misled into fighting the perceived dangers of a ‘deflationary spiral’ because they are looking at only one indicator: consumer prices. This Policy Brief finds that while consumer prices are flat, broader price indices do not show any sign of impending deflation: the GDP deflator is increasing in the US, Japan and the euro area by about 1.2-1.5%. Nor is the real economy sending any deflationary signals either: unemployment is at record lows in the US and Japan, and is declining in the euro area while GDP growth is at, or above potential. Thus, the overall macroeconomic situation does not give any indication of an imminent deflationary spiral. In today’s high-debt environment, the authors argue that central banks should be looking at the GDP deflator and the growth of nominal GDP, instead of CPI inflation. Nominal GDP growth, as forecasted by the major official institutions, remains robust and is in excess of nominal interest rates. They conclude that if the ECB were to set the interest rate according to the standard rules of thumb for monetary policy, which take into account both the real economy and price developments of broader price indicators, it would start normalising its policy now, instead of pondering over additional measures to fight deflation, which does not exist. In short, economic conditions are slowly normalising; so should monetary policy.

A simple model of multiple equilibria and default. CEPS Working Document No. 366, 16 July 2012

This Working Document by Daniel Gros presents a simple model that incorporates two types of sovereign default cost: first, a lump-sum cost due to the fact that the country does not service its debt fully and is recognised as being in default status, by ratings agencies, for example. Second, a cost that increases with the size of the losses (or haircut) imposed on creditors whose resistance to a haircut increases with the proportional loss inflicted upon them. One immediate implication of the model is that under some circumstances the creditors have a (collective) interest to forgive some debt in order to induce the country not to default. The model exhibits a potential for multiple equilibria, given that a higher interest rate charged by investors increases the debt service burden and thus the temptation to default. Under very high debt levels credit rationing can set in as the feedback loop between higher interest rates and the higher incentive to default can become explosive. The introduction of uncertainty makes multiple equilibria less likely and reduces their range.

The Determinants of Country Risk in Eastern European Countries. Evidence from Sovereign Bond Spreads. Bruges European Economic Research (BEER) Papers 8/November 2006

The paper studies country risk in two Central and Eastern European countries - Bulgaria and Poland. The long run relationship between the yield differential (spread) of Eastern European national bonds (denominated in US dollars) over a US Treasury bond on one the hand and the country’s fundamentals as well as an US interest rate on the other hand, is examined. The cointegrated VAR model is used. First, the yield differentials are analyzed on a country by country basis to extract stochastic trends which are common for all bonds in a given country. Thereafter, the risk is disentangled into country and higher level risk. This paper is among the first ones which use time series data to study the evidence from sovereign bond spreads in Eastern Europe.

Les enjeux de la libéralisation des comptes de capital dans les pays du sud de la Méditerranée. = Challenges arising from Capital Account Liberalisation in the Countries of the South Mediterranean Region. MEDPRO Technical Report No. 11/March 2012

This MEDPRO Technical Report confirms the importance of commercial openness and macroeconomic performance (i.e. the control of inflation and stability of current account balance and exchange rate) on growth dynamics in the south Mediterranean countries. In particular, the positive impact of capital account liberalisation is conditioned by the imperative reinforcement of institutional quality, country risk reduction, and government stability. An examination of the Tunisian case shows that only sectors subject to tariff dismantlement within the framework of the Association Agreement with the EU appear to benefit from capital account liberalisation. Furthermore, the report shows that a scenario of capital account liberalisation requires the anticipation of monetary policy reaction functions. It follows that the mechanisms for interest rate adjustment, or inter alia, the interest rates’ reaction to price fluctuations, are weakly volatile. In turn, the analysis shows that an active control of inflation mismatches occurs essentially through exchange rate corrections, thus highlighting the greater interest central banks have in exchange rate stability over real stability. A capital account liberalisation scenario would hence impose a tightening of monetary policy.

Time for the ECB to bite the bullet. CEPS Commentary, 19 January 2015

This Commentary summarises the main reasons why the ECB can no longer delay launching a massive bond-buying programme, also including sovereigns of eurozone member countries, and why such interventions will indeed be effective in raising inflation, thus restoring the ECB’s credibility and spurring economic activity. A credible programme must continue either until an explicit inflation target has been achieved or the ECB balance sheet has reached the €2 trillion target already announced by the ECB’s Governing Council. Regardless of how such interventions will be undertaken, they will reduce interest-rate spreads between eurozone markets, but it is nevertheless important that the ECB designs its operations so as to avoid any implication of direct support or deficit financing facilitation for the eurozone’s most indebted countries. Finally, some kind of guarantee against first losses by the ECB on its sovereign bonds may be appropriate, while entrusting open market operations to each national central bank for their own sovereigns could threaten the very survival of monetary union.