GROWTH AND FDI

 GROWTH  AND FDI

A.K.Tiwari(2011) conducted an empirical analysis in the framework of a panel for 23 Asian countries by employing data from 1986 to 2008. He also incorporated a two-way effect model for the analysis, as the assumptions of fixed and random effects across countries and over time are extremely plausible. He also
examined nonlinearities associated with exports and FDI in the economic growth of Asian countries. Further, as he had studied a large sample of Asian countries, he tried to minimise the country-specific heterogeneity by imposing two-way dummies, i.e., in case of two-way fixed- and random-effect models by using time-country dummies. He has also checked the robustness of the results by analysing different models. However, by imposing dummies of
cultural aspects and religion he might have gotten more robust results, and an extended study in this area should incorporate these issues. There are studies which have found that cultural and religion aspects of a country have considerable impact on the economic growth on the respective countries (see, for example, Dieckmann 1996, Griffin 1999, Casson and Godley
2000, Marini 2004, Grier 1997, Blum and Dudley 2001 and Barro and McCleary 2003).
The results of his analysis show that FDI and exports enhance the growth of Asian countries and also that labour and capital help in that process. This implies that Asian countries that are moving ahead for globalization might choose to go ahead. However, when we analyzed the case of nonlinearity associated only with FDI, he found that this variable enhances growth. On the other hand, the investigation of the nonlinearity in both cases, i.e., exports and FDI, show a significant and positive impact of exports only on the economic growth of panel countries.
This suggests that to achieve a higher and higher growth path, moving ahead with exports is more feasible in Asian countries. This is true, particularly for countries that do not have sufficient resources to bring more advanced technology to private homes. The more advanced technology would create an attractive environment for FDI, but would also require an extensive investment for large improvements in the country’s infrastructure.
Further, there are studies that have found that FDI has a negative impact on economic growth and income distribution. Hence, he suggests an export-led growth path, particularly at the initial stage of growth, in the later period, dependence on FDI might be feasible option. This finding can be defended based on two arguments (see Afzal 2010). First, the exports promotion incentives determine a specialization of the economy accompanied by the scale benefices. Second, the augmented exports may stimulate the country to import high-value inputs, products and technologies. By consequence, these elements may have a positive impact on the productive capacity of the economy.

ON ECONOMIC CORRUPTION,POLITICAL CORRUPTION AND FINANCIAL CRISIS

ON ECONOMIC CORRUPTION, POLITICAL CORRUPTION AND FINANCIAL CRISIS

Full transcript of the video “On Economic Corruption, Political Corruption and Financial Crisis”: https://www.youtube.com/watch?v=4kot_GHdIMU (Excerpt from “The financial crisis, guilt of the market or the State?” -full video in Spanish-, discussion organized by Dante A. Urbina in the course of Macroeconomics II, Faculty of Economic Sciences of the Major National University of San Marcos (Lima - Peru) on November 28, 2013).

It is said that the State is a conglomeration of individual interests. Precisely there is a theory about this, which is the Public Choice Theory. Well, in this context it is assumed that each person is the best judge of his own welfare. The point is this: we realize that if each person is an agent seeking to maximize their welfare and may even be involved in corruption in order to maximize this welfare... if that is true regarding the State, why would automatically false regarding the market? Is there no corruption in the market? Or rather: is there not a systemic relationship between corruption in the market and corruption in the State? Are separate phenomena?

It was mentioned that some people in the State who had some particular economic interests had also important positions. But what is the problem here: the State itself, the institution itself, or rather the corrupt economic environment which dominates the State, the State capture?

It is said: “Banks take riskier positions because the State allows it”. Correct. But why the State allows it? The State allows it, for example in the U.S., because the lobby is legal. What is the lobby? It means that companies can “solve” their problems by giving money to Congress members so that they promote certain types of policies. And the same occurs in the Executive. When the crisis emerged there was a general problem of moral hazard. I mean, is not as simple as that the State is saying “Give me money, give me money to do what you want”. There is not only someone behind the door waiting for money to carry out corrupt actions but also there are also lots of private companies knocking on the door in order to corrupt. Where corruption exists there must be corrupt and corrupting people.

Someone might say: “Well, but why governments are not honest? Why don’t they stop the corruption?”. The issue is: the market is not an abstract entity; the market also exists in a set of power relations. Individuals who manage the big banks may also have control over media. If they have power over media, have the power to show the image of the governments to the people and, in a democratic system, as the people is ultimately who vote, this allows them to manipulate the image of the government. If the government behaves well with respect to their economic interests, their media will say that this government does things right, whereas if the government begins to contradict their economic interests, their media (in which they are the owners) could show the government in a negative way.

It was also mentioned that President Carter supported to leftists and forced the banks to give loans to insolvent people. But if we see a documentary like, for example, “Capitalism: A Love Story” by Michael Moore, we will find that the process of the current crisis can be understood from the deregulation which came in the 80s with Reagan, which was not supported by leftists but rather by rightists. He gave the banks free rein to do whatever they want.

The point is that government officials are also people who have been working on these big banks. Henry Paulson, the Secretary of the U.S. Treasury, was CEO of Goldman Sachs and, moreover, the President Reagan's chief economic adviser was Chairman of Merrill Lynch.

Well, then it’s very important understanding that exist an interrelationship between corruption in market and state corruption, they are not separate phenomena.

THE DEPOLITIZATION OF THE ECONOMICS

THE “DEPOLITIZATION” OF THE ECONOMICS (Part 3) 

 Dante Abelardo Urbina Padilla

The triumphant neoliberalism

On November 9, 1989 a historic event of great importance did happen in the world: the fall of the Berlin Wall. That same year Francis Fukuyama published his famous article “The End of History” in which he argues that “we are witnessing the end of history as such: that is, the end point of mankind's ideological evolution and the universalization of Western liberal democracy as the final form of government” (15). Thus, neoliberalism trumps all other alternatives civilizational and consecrated itself as the final form of political-economic organization of the “New World Order”.

In this context of globalization, the economic theory becomes a mere instrumental knowledge (technocracy) thinking itself essentially as a “tool-box”, constituted by models and theories to be conveniently used by economist to fix up the “mismatches” of economical machinery. No longer examines content issues of economics. Only the functional relationships are considered important. In other words, it does not matter to know what is X and what is Y but only how they relate functionally to manipulate variables “instrument” and thus achieve the desired results with the “target variables”. Hence the preponderance has Econometrics in the analysis and current economic policy.

This new approach of the economics as a knowledge essentially instrumental has clear epistemological implications because  not given importance to the explanatory power of theories -which necessarily lead us to the plane of Political Economy- but only to their predictive power. Therefore, it is not strange that a liberal economist as Milton Friedman hold that it is not necessary to consider the realism of the assumptions or the explanatory power of a theory when examining its scientific validity but only its “predictive power” because “positive economics is or may be an objective science in the same sense as any of the physical sciences”. (16)

The “depoliticization” of the Economics

After all this historical analysis of the evolution of economic theory and epistemology in the context of different social and political events, is that we can see clearly that the economists never could get separate science from ideology. The process of “depoliticization” of the economy was clearly an ideological process that sought to eliminate the explicit political element of economic analysis to replace it with an implicit (camouflaged) form of policy based on utilitarian individualism, the doctrine of minimum State and the liberalism bourgeois.

So it is not surprising that economists now called “neoclassical” decided to change the name of economic science from “Political Economy” to simply “Economy”, so that the separation between economics and politics, between market and State, is final. Thus, the Economy become a “pure” science. But that claim is clearly an ideological choice that, as Immanuel Wallerstein explains, “has to do with the dominant ideology during the nineteenth century. Basically, the dominant view of liberalism worldwide was that the State, market and society were three distinct entities. They operated with different logical and therefore should be studied separately, and in a sense, stood apart in the real world. So the scholars had to segregate their knowledge of such aspects. Overall this was what happened, and what was already established in 1945 as an organizing principle for the social sciences at leading universities”. (17)

However, as it explains Oscar Lange “the ideological element in scientific research is not necessarily an obstacle in obtaining results with objective validity” to the point that “the ideological motive can also stimulate the development of science” (18). Therefore, to make an objective judgment about the legitimacy (or illegitimacy) of neoclassical economists's attempt to eliminate the political factor of the Economy will be examined, to speak in terms of epistemology lakatiana, if from this are built scientific research programs “progressives” or “regressives”. (19)

To answer this question it will be necessary to understand the nature of the relationship between economics and politics and then examine the epistemological and practical implications that flow from this.

In general terms we can define economics as the discipline that studies the management of resources to meet human needs and politics as the art of government. However, since resources are limited, there will always be needs that will remain unmet and this will lead to individuals to make decisions about how to distribute and use these resources. This has to do necessarily with the political structure of society in terms of the organization, distribution and institutionalization of the power of the different agents interacting in it, which obviously leads to the plane of politics and, therefore, can be said of consistently that the economy is intrinsically linked to the political and, consequently, that economic theory -if it want to be realistic- must become inescapably in Political Economy.

The epistemological implications of the above line of reasoning are extremely important because it follows that the only coherent and consistent way to study economic phenomena is through of a multidisciplinary analysis because in reality there are no “economic”, “sociological” or “political” problems but only “social problems” and they all have an irreducible complexity, it being understood it as that none of the aspects (political, psychological, ethical, economic, etc.) that compose it can be analyzed in isolation with respect to the other because each one of them have always and necessarily a constant and intrinsic relationship with the others.

The traditional way that neoclassical economists have to get rid of these difficulties has been and still is say that they work only with so-called “economic factors”. But taking into account the above we can say that it is absolutely wrong because it is not logically possible to isolate a part of reality denominating it simply as “economic” when in fact exist as such only insofar as it are interrelated with the legal and the political structure (institutional) of society. Moreover, the appeal to the isolation of the “economic factors” as a criterion of demarcation does not solve anything because it is like a pettitio principi falacy. And is that the single definition of “economic factors” involves scrutiny of all the factors involved, including the “non-economic”, which is only done once defined a priori the concepts used.

With respect to the practical implications of recovering the political approach in Economic theory we have to say they are as or more important than epistemological. As the prestigious epistemologist argentine Mario Bunge says, any study of Economics as if an autonomous and isolated is doomed. Clear example of this is the unfortunate experience they have had and still have several Third World countries with economic planners who ignore the non-economic components of society and the system of values and norms inherent therein. Most development plans designed for these countries are due to economists who have ignored the circumstances and the cultural and political values of those societies, deliberately sacrificing their cultural and political aspirations in order to reach one goal all costs: industrialization, stabilization of the currency or some other purpose of economic policy. No wonder, then, that such plans have usually lacked popular support and, in most cases, have not achieved their goals. A successful development plan should be considered only as a component of a much broader, inclusive and comprehensive social plan.

In conclusion, it is absolutely necessary to recover the political dimension of economics to deal explicitly with greater accuracy, breadth and depth the problems we face. In this sense, the pretension of neoclassical economists to construct an economic theory "chemically pure" is nothing more than an counterproductive ideological attempt which conceals the political nature of the economy in order to avoid the uncomfortable political consequences (for certain group) that could result from economic analysis.

Therefore, the kind of economist who need the world of the future and that should be taught in our universities should be like that Keynes's describing, in his biography of Marshall, when wrote that “has to reach far in different directions and must combine powers natural which is not always found together in the same individual. He must be in some degree mathematician, historian, statesman and philosopher. He must understand symbols and speak with ordinary words. He must contemplate the particular in terms of the general and the abstract and concrete touching on the same flight of thought. He must study the present in the light of the past and facing the future. No part of man's nature or his institutions must be completely out of his consideration. He must be simultaneously intentional and selfless as idealistic and as incorruptible as an artist, yet sometimes as near the earth as a politician”. (20)

References

15. Francis Fukuyama, “The End of History”, The National Interest, No. 16, Summer 1989, p. 4.

16. Milton Friedman, Essays in Positive Economics, Chicago University Press, Chicago, 1953, p.10.

17. Immanuel Wallerstein, "Open the Social Sciences", lecture delivered on 24 October 1995 for the Social Science Research Council in New York.

18. Oscar Lange, “Field and Method of Economics” (1945-1946), in: Economic Quarter, No. 58, Fondo de Cultura Economica, Mexico.

19. See: Imre Lakatos, The methodology of scientific research programs, Alianza, Madrid, 1989, p.9.

20. John M. Keynes, “Essays on Biography”, in: The Collected Writings of John Maynard Keynes, vol. X, Macmillan, London, 1972.


You can contact the author of this article in: “Dante Abelardo Urbina Padilla” (Facebook) and dante.urbina1@gmail.com (email)

THE MYTH OF THE PRODUCTION FUNCTION

THE MYTH OF THE PRODUCTION FUNCTION

(This is an extract from chapter 2 of the unpublished book “Economics for Heretics: Debunking the Myths of Orthodox Economics” by Dante A. Urbina. You can see this and other articles by the same author in his blog "The Heretical Economist": http://thehereticaleconomist.blogspot.com/).

And with what produce?: ecologist criticism of the production function

Let us imagine for a moment that the production function that sustains the orthodox economics is valid. Furthermore, let us imagine that, in fact, we have to carry out an actual production process based on it. Let us think, for example, in the production of a cake. What do we need to do? According to the neoclassical production function –which has the general notation Q = f (K, L)- we would need capital and labor. Get together, then all elements of capital (defined as the set of instruments used to produce): jars, bowls, trays, pallets, oven, pans, knives, etc. Now we gather the elements of the labor factor: basically be our own labor (or the of a chef) incorporated with all the abilities to make cakes. Then, given a technological configuration, ie, an established relationship between the factors of production bringing together the elements of capital (K) and labor (L) which we have listed, we get the product, that is a cake. But we get nothing! It’s not possible... there has to be an explanation...

We try with an intensive increase of productive factors: we get much bigger bowls (K) and we hire several chefs (L)... but still not we get a single cake! “Why?”, we ask ourselves.

The answer is very simple: nothing is produced because there is nothing with what to produce! No matter how many bowls we get or how many cooks we hire if there's no cake dough to cook! In effect, on the basis of the neoclassical production function, we have gathered all the elements of capital and labor but we have not had any account of the raw material. We have listed several things, right. But at no time we have mentioned flour, sugar, eggs, etc. Thus, based on the neoclassical production function, we have tried to be God: we wanted to create something out of nothing! However, it becomes patently absurd in this context: cannot make cake without cake dough. Cannot produce without raw material.

Well, it is precisely on this basis that the great economist Nicholas Georgescu-Roegen, initiator of the ecologist approach, raises his criticism of the production function and orthodox economics. He begins by analyzing the physical basis of the production process (1) and immediately realizes the implications of the First Law of Thermodynamics (according to which “the matter is not created or destroyed, only transformed”): not possible to produce without a material basis. Consequently, the neoclassical production function becomes inconsistent and absurd for not taking into account the nature factor.

And this was to be expected. In the nineteenth century, when was born the neoclassical school, the modernists believed in the “theory of indefinite progress” and they claimed that the resources of nature were endless. Orthodox theorists assumed that belief and built on this basis in economic theory. So, the most essential factor of the economic process was relegated to the sidelines : the ecological factor. However, as rightly said Max Neef: “There is no economy possible regardless the services provided by ecosystems. This is so absolutely clear and so absolutely obvious that is truly a epistemological scandal that in any economics textbook, if you go to index words, may be find the words “ecosystem”, “nature” or “thermodynamics”. They do not exist! Simply they do not exist. Why? Because the economy that is taught is conceived as a closed system in itself that is not related to any other system (...) when obviously it is embedded in a bigger system called biosphere and around which are all services provide the elements of that biosphere. Where would be the economist if it ends the photosynthesis? Economists do would not exist! What would happen with the economy if suddenly all the bees died? There would be no pollination... But no economist presumes that he has to know that. (...) All this happens in a gigantic sea of ignorance on the part of the economy” (2). In other words, there can be no economy without ecology and orthodox economics still does not know it.

“But the problem is easy to solve!”, orthodox economists will say. “We add the variable R (natural resources) in the production function and ready!”. What ignorance! One ignorance comparable only with that ignorance that orthodox economists also show when claim to have understood the process of technological change just because they incorporate a variable “A” to the production function (3).

Let us see. Given a variant “Solow-Stiglitz” (as it is called to the artifice upon which it has been tried solve the problem) of the production function we have that in the form Cobb-Douglas this will be:

Q = K^a.L^b.R^c

such that: a + b + c = 1

As this is a Cobb Douglas production function, this implies complete substitutability of factors, ie, that can be replaced one factor by another (or others) while maintaining the same level of production. But it is precisely where the inconsistency resides. Mathematically, if R (natural resources) tends to zero the reduction may be compensated by increases in K or L maintained the same level of production. The structure multiplicative of the function allows it. However, it is inconsistent in the facts because if R tends to zero necessarily have to do so at some time K and L. First, because they depend on R: the capital goods are products of a previous process which presupposes the nature factor and, in turn, the labor force needed of natural resources to sustain itself  (can anyone imagine what would happen with our productivity if we drank only one glass of water a month?). Second, because the quantity of product that capital and labor can generate depends always and necessarily of the flow of inputs to transform (no matter how quick work the cook or how big is the bowl which has, if he has only one gram of mass he can not do a single cake).

Thus, Georgescu-Roegen criticism to the production function shows clearly that the economy has ecological limits. And that brings us to the central concept of his analysis: “entropy”. Basically the entropy means that the availability of a certain amount of energy, once it has been used, not retains throughout time to the same properties to create useful work. Thus, as soon as the natural resources are transformed, they pass from a state of low entropy to a high entropy and, consequently, it is increasingly difficult transform them into products useful to man. Ergo, the use of our the natural resources have a objective limit: capital and labor can not exploit the nature indefinitely because this is also subject to the Law of diminishing returns.

And that not to mention the problem of the environmental pollution brought about by any production process. In effect, given that, because of the law of entropy-is impossible to achieve 100% efficiency, produce something always and necessarily generate a residue or waste (4) which should be treated. That is, after making a cake you need to clean the kitchen. And the same applies for the whole planet.

Nevertheless, orthodox economics has systematically left aside all this. According to this ecological factor is purely exogenous. But “economics” etymologically means “administration of the house” (5). And our house is ultimately the planet earth. But orthodox economics has shown as evidently a bad manager because, to leave out the ecological factor analysis, necessarily have a large part of guilt in the current global warming problem that we are facing. Conclusion: orthodox economics is a bad economics.

References:

1. Nicholas Georgescu-Roegen, The Entropy Law and the Economic Process, Harvard University Press, Cambridge, 1971.

2. Manfred Max Neef, “Economy and Environment”, conference at the Universidad Austral de Chile, Valdivia, on May 28, 2010.

3. For more details on this misery see the famous Solow growth model in any manual of “advanced” macroeconomics (!).

4. Cf. Nicholas Georgescu-Roegen, The Entropy Law and the Economic Process, Harvard University Press, Cambridge, 1971, p. 231.

5. From the Greek: oikos = house; nomos = order, administration.

You can contact the author of this article in: “Dante Abelardo Urbina Padilla” (Facebook) and dante.urbina1@gmail.com (email)

The policy dimensions of FDI

The Policy Dimensions of FDI

An analysis is now made of the different FDI policy dimensions in which PIs are made to be

implemented by host countries. It is important to note here that governments of developing

countries choose PIs – generalized as incentives – to attract FDI in relation to their overall

economic development goals. Thus, different dimensions of incentives can be depicted. First,

incentives can be either general or specific (with a discretionary perspective). A second

dimension is the durability of incentives. Indeed, according to the host country’s priorities,

incentives could be either permanent or temporal. However, pragmatically speaking, PIs related

to incentives need to change in duration so as to encourage the kinds of FDI and industrial

specialization the country desires. And therefore it is useful to think of these PIs as windows of

opportunity which open and close. Another dimension exists at the geographic – or spatial –

level since IP policies can target FDI either at a local, national level or regional level. Local

incentives can be used to promote specific regions of a country that are poorer or in greater need development. Further, incentives can be used to attract foreign investors to the whole economy or only to certain sectors or subsectors, according again to the specific needs of the country. In the past, this has carried the rubric ‘negative’ or ‘positive’ lists which cordoned off strategic sectors of the economy to foreign investors and reserved others for national firm.26 Finally, at the firm level, incentives can focus either on all FDI, or only on specific investors. These dimensions are depicted in figure 4, A Framework for Operationalizing FDI Policy Dimensions and Instruments.

To say that policy craft – creating policy coherence out of the conflicting demands from modal

neutrality, market contestability, as well as scaling and measuring the factors and variables

which must be considered in policy research and analysis – is a challenge, is an understatement.

This paper makes early reference to the growing importance of investment and business climate

benchmarking as a guide to policy-making. However, econometrically, as every factor or

variable (or their combinations) has its own FDI inflow- and stock-elasticity, IPAs and policy

makers with limited resources should concentrate their policy craft on those FDI factors and

variables with the highest FDI-elasticities . In rank order, these are: (i)

growth-competitiveness, which combines macroeconomic and technology variables, with an FDI inflow elasticity of 0.63; (ii) economic freedom, combining government intervention, property rights, wages/prices and regulation variables, with an FDI inflow-elasticity of 0.56; (iii) taxation and regulation with an FDI inflow-elasticity of -0.50; (iv) quality of telecommunication services with FDI inflow-elasticity of -0.28;28 and (v) labour market regulation with FDI inflow-elasticity of -0.26. Furthermore, these elasticities have short- medium- and long-term adjustment rates.

This approach begins to lay out the choices available to policy makers in making viable PIs in a

systematic manner based on rigorous analysis. Hence, from a fourth-generation IP perspective, a focus on the macroeconomic environment stability and technology policies to increase the rates of innovation and transfer by PIs that facilitate licensing and franchising, for example, would be needed. In a similar vein, harmonizing taxation regulation across regional space would be a viable policy.

All these elements and issues in figure 4 reflect the need for sequencing and switching PIs and

incentives, both in space and time. In other words, while FDI policy-making is increasingly more complex and diverse, host governments, according to their development needs, have to adapt to the MNEs dynamic activities by sequencing and switching (in a predictable manner) their FDI PIs. Moreover, these different policy dimensions also indicate the importance for host

governments to create different levels of policies: the meta- or supra-national level, the macro or national level, the meso or regional and cluster level, the micro or industrial sector and subsector level and the firm level of organizational strategy and competitiveness . The complexity of FDI host policy-making is obvious but the policy dimensions have to be chosen and established in harmony with the general development goals set up by the government.

Whereas industrialized countries typically utilize financial incentives, such as grants, developing countries usually use fiscal incentives, such as reductions in the base rate of corporate income tax, tax holidays and import-duty exemptions and drawbacks (Oman, 2000). Incentives are widely used to attract MNEs and thus create a climate of policy competition for FDI. Fiscal incentives might be successful for attracting MNEs, but incentives-based competition also creates some problems. Indeed, the first problem of incentives is that they represent opportunity cost of resources to host governments. Secondly, there can be a significant lack of transparency regarding incentives, which leaves space for corruption and other kinds of rent-seeking behaviour. Finally, given the dimension choices in figure 4, incentives also provoke market distortions. Among them, the major ones are the fact that incentives tend to favour large corporate investors to the detriment of small ones, as well as foreign over the domestic firms because of their lower risk profile and higher bargaining power. The distortion would tend to disappear (over time) in countries adopting fourth generation of IP, as they would treat foreign and domestic firms equally with regard to incentives.

ECB FACES HURDLE FOR MONETARY POLICY

ECB FACES HURDLE FOR MONETARY POLICY

With growth picking up only gradually and inflation likely to remain below target for the foreseeable future, it would be premature to rule out further monetary easing in the euro area. But following this week’s hawkish press conference, the hurdle for further action is probably higher than we thought.
We had thought there was a good chance that the European Central Bank (ECB) would cut interest rates at this week’s Governing Council meeting. In the end, though, it seems that data released over the last month have pushed the ECB further from easing than we thought and that the Governing Council did not give any serious consideration to a rate cut. Moreover, the tone of yesterday’s press conference was hawkish, suggesting that the probability of a rate cut in April is also lower than we previously expected.
The ECB’s explanation for not cutting rates this week was fairly straightforward. First, data released over the past month have tended to confirm its baseline forecast for a moderate but sustained recovery in euro-area output growth and, “by and large,” have been stronger than expected. Moreover, while the ECB still thinks the outlook is subject to downside risks, neither of the two contingencies that would trigger an immediate policy response—an unwanted tightening of money-market conditions or a sudden worsening of the medium-term outlook for price stability—has been met.
None of this is particularly surprising. What we did find surprising, though, was the renewed emphasis that the ECB put on the strength of recent survey data—like the composite Purchasing Managers’ Index, which reached a two-and-a-half year high in February (Display 1)—and the relaxed stance adopted towards persistently low inflation. Earlier this week, ECB president Mario Draghi warned that the longer inflation remained low, the greater the risk that it would not return to target in any “reasonable” time frame and that inflation expectations might become “disanchored.” Yesterday, the ECB left interest rates on hold despite the fact that its new staff forecasts show inflation below target for at least the next three years (Display 2).



Overall, the ECB now seems to be more confident that the recovery will push inflation back towards its target of “below but close to 2%” and no longer feels compelled to hasten this process. In our view, there are clear echoes here of the old, reactive, ECB from the pre-Draghi era.
Focus on Spare Capacity
We also detected an important change of tone when the ECB president was asked whether any of his colleagues wanted to ease policy this week. After saying that there had been a “broad discussion“on changes in interest rates and other policy tools, Draghi said that if he had to “flag a key point“ in the discussion, it was the importance that the Governing Council attached to the large amount of spare capacity in the economy. This, he added, would allow the ECB’s monetary policy stance to “stay in place” even after the economy had started to improve.
The focus on spare capacity was probably intended to reinforce the ECB’s forward guidance—that the Governing Council expects interest rates “to remain at present or lower levels for an extended period of time.” In our view, though, the underlying message is surprisingly close to the one currently being sent by the Bank of England. In other words, it sounds more like a central bank trying to manage its exit strategy than one thinking about injecting fresh monetary stimulus.
Where Now?
Given the speed with which the ECB cut interest rates in response to low inflation last November, the dovish inclinations of many Council members and the subdued nature of the recovery, we think it is too early to rule out further monetary easing in the euro area. Indeed, the ECB stressed again yesterday that it was willing to use “all instruments available to us” and that it would “take further decisive action if required”.
But following yesterday’s press conference, it looks as if the hurdle for further action is higher than we thought. With inflation set to hit a new low in March, a rate cut at April’s Council meeting is still possible. But the probability is lower than we thought and it may now require a more significant deviation from the ECB’s central forecast, or marked appreciation of the euro— which received particular attention at yesterday’s press conference—to trigger additional action. Moreover, barring a wholesale change in the outlook, the market’s hopes for more aggressive policy moves, such as quantitative easing, seem to be well wide of the mark.