Tuesday, February 28, 2017

A Phillips (of the curve, not the company) View of the Eurozone

With an update of the Phillips hydraulic model after the jump.

From FT Alphaville:

A ‘Phillips’ view of the euro
This guest post is from Michael O’Sullivan, chief investment officer for Europe and emerging markets at Credit Suisse Wealth Management…
Well before he was celebrated for his work on the link between unemployment and inflation, Bill Phillips built an extraordinary machine that pumped coloured water through glass vessels in order to demonstrate how money flows around an economic system. Levers in the machine permitted users to simulate the effect on the system of fiscal policy changes and such was the intuitive appeal of the machine that major universities like Harvard and Oxford ordered their own versions.

In today’s algorithmic, QE driven markets such a machine might seem well out of place, but now that the Greek situation has reared its head, again, and with some politicians in Europe campaigning on the basis of euro exit, policymakers in Brussels could do a lot worse than build their own version of Phillips’ machine. Indeed, such a contraption might aid a much needed period of introspection into the workings of the euro and may shine light on the areas missed by the rather tame 2015 Five Presidents Report.

In the spirit of Phillips’ machine, picture the euro-zone as a system where liquidity passes through nineteen different vessels, at different speeds and causing very disparate pressures on each of them. A few like Greece, are too weak economically and politically to withstand these pressures.

More broadly, it is now clear that in the absence of counter balancing mechanisms or safety valves, a common monetary policy can have a different impact on say, the Portuguese economy as compared to the Finnish one. This much was clear in the early 2000’s when a monetary policy that was set for a recovering German economy granted negative real interest rates to Ireland and Spain, where banks and consumers then deployed cheap cash with vigour.

In this respect, the engineers of the euro need to figure out how to accommodate a single monetary policy within different economies. The Commission should consider the inveterate Greek crisis as a warning to resist the urge to further expand euro membership and smother its adherents with fiscal uniformity. Instead they must cleverly redevelop the way it is engineered so that it is harmonious within its existing member economies and transmission mechanisms within thin these.

There are at least ways in which this can be done, the most important being fiscal policy. The principal suggestion here is to revise the restrictive set of fiscal rules to give more emphasis to a framework where national governments have fiscal flexibility. Importantly, they would be bound by the advice of independent fiscal councils and through restrictions on debt issuance, to run fiscal policies that are on balance countercyclical to euro-zone monetary policy and that are economically productive rather than political in their aim. Using fiscal policy to complement monetary policy would help to ensure the euro-zone’s economies, especially the smaller ones, do not become ‘too hot’ or ‘too cold’ in the fashion of Bill Clinton’s ‘Goldilocks’ economy.

This would also demand plenty of policy innovation at the macro-prudential level and euro-zone countries like Ireland could fine tune their structural recovery in this way. Doing so in a structured way, rather than say populist ‘moral suasion’ makes more sense and would permit greater policy engagement in how the moving parts in a small open economy work together. Ideally, a body like the national central bank should oversee the transmission of lending to households, in a way not unlike it did before the euro. Additionally, instead of harmonising fiscal rules, the EU may want to harmonise the processes required to set up a new business, or create a quicker pan-European approach to this.

There is a second engineering challenge facing the euro version of the Phillips machine, which is that very different levels and forms of indebtedness mean that a common monetary policy flows in distinct paths across euro-zone economies, or in some cases doesn’t flow at all. Here the EU might look to China where the authorities have ordained a program of financial restructuring that privatises much of the debt held by local and national authorities....MORE
November 2012
Like Phillips, Irving Fisher Was a Plumber: Hydraulic Models of the Economy
March 2011
The computer model that once explained the British economy (and the new one that explains the world)

...Schematic diagram of the Phillips machine. ( Click to enlarge.)

And here's the latest incarnation:


Genius squared.

The second schematic is from a post on GE's Mark I nuclear reactor at ZeroHedge!