The continued embarrassment that is European monetary policy … economists?

In the summer 2008, when concerns were growing that a weaker economy was approaching, the ECB raised its rates – a step that had to be reversed pretty quickly as we know. Quite embarrassing.

And what happened this time? Another commodity boom “tricked” the ECB into raising rates at the worst possible time, even though there were no signs of a pass-through of the currently higher headline inflation to core inflation, and thus, to medium term headline inflation. Now, this step will probably be reversed quickly, too. Why? Because even Germany might be heading for a recession.

As Henry Kaspar has pointed out repeatedly on my (other) blog, I shouldn’t criticise the ECB for following its mandate. Even though we all know that the ECB broke its own rules in the past when there was a need to do so, there certainly is some truth to that. (Update: Karl Whelan points out in an email that the mandate of the ECB is “price stability”, so the ECB might actually have more discretion than is commonly assumed). So let me instead address those European economists that keep missing that monetary policy is a huge part of the problem, and potentially a big part of a shorter and longer term fix for the Eurozone.

First of all, what is monetary policy supposed to accomplish? Very broadly speaking: macroeconomic stability. An important aspect is to keep aggregate demand (AD) on a stable and predictable path. The reason is simple: prices and wages don’t adjust quickly enough to accommodate nominal changes that are caused by changes in the demand for the medium of exchange (aka money). So better keep the nominal values on a predictable and stable path, so that there is no need for across-the-board adjustments.

Usually, an inflation-based approach is sufficient, and it has stabilized inflation throughout a large part of the world, which is historically a big achievement. Whether it has contributed to the build-up of the current crisis is still an open question. In times of a severe crisis, however, this approach has clearly proved inadequate, as the focus on inflation has allowed AD to plummet 10% (!) below trend:

Such a drop in AD would be devastating for any economy, not only a currency union. It is time to realize that the policy of the ECB has been extremely tight since 2008, measured by the concept of macroeconomic stability and is therefore an important cause of the current mess.

Second, countries in a currency union experience asynchronous business cycles. This is a problem because monetary policy cannot be tailored to all different cycles. So even though there is some differentiation that the central bank can impose, a large part of the adjustment has to come through changes in prices and wages – a painful process as Germany learned during the first decade of the Euro. And as for anything else that is painful, there is one rule: get it over with quickly.

How can you overcome nominal rigidities quickly? Wages rarely decline nominally (see this Krugman post for some nice graphs), which means there is a(nother) zero lower bound. When some countries need to adjust wages and prices downwards, it is best to be further away from this threshold. The reason is simple: if the best you can do is to keep wages constant, the higher the general price increase, the more the decline in real wages. A higher nominal growth during normal times increases your room for manoeuvre during adjustment periods.

The essence of this: choose a higher inflation, or even better, nominal spending target the more diverse (read: suboptimal) your currency union is. For the Euro area, an inflation target of below 2% is inadequate. This seems so painstakingly obvious, and yet you will have a hard time finding European, let alone German!, economists who share this view – even though the evidence from the Gold standard era supports this argument, too.

Finally, economic historians like Kenneth Rogoff point out that we are currently in a situation of high debt and over-leverage that happens only rarely. When it does, the decline and adjustment usually takes many years – unless the central bank takes decisive action to prevent a severe drop in AD. This may entail temporarily higher inflation, as a period of deleveraging may hurt growth. But it is worth it, as Kenneth writes:

[In 2008] I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Of course, inflation is an unfair and arbitrary transfer of income from savers to debtors. But, at the end of the day, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning. … Some observers regard any suggestion of even modestly elevated inflation as a form of heresy. But Great Contractions, as opposed to recessions, are very infrequent events, occurring perhaps once every 70 or 80 years. These are times when central banks need to spend some of the credibility that they accumulate in normal times.

Higher nominal spending growth (or inflation) is therefore an important building block to solve the current, short term European crisis – even if you disagree with my argument above that monetary policy since 2008 is one of the major culprits for leading us into this mess. The ECB’s achievement to keep inflation at 2% is a Pyrrhic victory, as Ryan Avent ironically describes:

If the euro zone does fall apart, a fitting epitaph might read, “The ECB feared 3% inflation”.

I sincerely do hope that I read the wrong newspapers and missed all those European economists and commentators screaming all these things (or even better: that I am wrong). But whenever I try to hear something, there is just silence – or Axel Weber lashing out at Olivier Blanchard. Meanwhile, European policy makers and central bankers are wrecking one of the most fascinating projects in human history, the unity and friendship among the countries of Europe. This is beyond depressing. Way beyond.

French Candidates: What is this EU thing anyway?

Why do the leading candidates in the French presidential election seem to have utterly strange European policies?

Take Nicolas Sarkozy. He supposedly believes in “rupture” with old ways and a dash for a new free-market, hard-nosed, toughness cult future. And Euroscepticism is at the heart of this. But at the same time, he has promised to restore le productivisme – that is to say, the maximisation of volume – as the guiding principle of the Common Agricultural Policy.

That’s not free-market, tough, eurosceptic, hard-nosed, liberal, or anything else, except for pure clientele politics. Better yet, it’s the kind of clientele politics that uses other people’s money. Yawn. Not that the peasants’ representatives believes in it – one of them recently said that “there are no cloned Chiracs available”.

Fascinatingly, he’s also now blaming the European Central Bank for its exchange rate policy – as is Ségoléne Royal. Sarko thinks the trouble at Airbus is all down to the bank’s “policy of over-valuation against the dollar.” Sego apparently asked for Angela Merkel to help change the ECB’s charter so that “its sole objective would not be the exchange rate.”

One problem – the exchange rate is not the objective of the ECB. The ECB does not target the exchange rate. This is, of course, all part of the game with the straining “Bretton Woods II” arrangement between the US and China pushing the adjustment burden our way. But – the ECB does not stock and does not sell exchange rate targets.

Eurozone Economy: When Paradigms Collide

When scientific paradigms collide everyone should duck, at least that is the best advice I can offer at the present moment. The provisional German retail sales for January are now in, and they don’t make especially pleasant reading:

European retail sales dropped for the first time in 10 months in January as spending in Germany slumped, adding to signs economic growth is slowing, the Bloomberg purchasing managers index showed…..German retail sales had the biggest drop in two-and-a-half years, with its index declining to 43.9 from 55.2 in December

Now for those who have been following the German economy in recent months none of this should be particularly surprising, since as is reasonably well known Angela Merkel’s government has just upped VAT from 16% to 19% in an attempt to address the ongoing federal deficit problems. And of course, one months data never offer a complete picture. But this decline in retail consumption in Germany forms part of a much longer ongoing weakness in domestic consumption (and here), one which many were arguing had finally come to an end in 2006. Some of us, however, seriously doubted that this was the case, and hence the initial significance of today’s reading. In particular what we may be faced with are changing structural characteristics of economies as median population ages rise. In particular – and following the well-known life cycle pattern of saving and consumption – more elderly economies may have a higher rate of saving and a lower rate of consumption increase than their younger counterparts.

Some more evidence to back this point of view comes from Japan, where today we learn that household spending in December declined for a 12th straight month, dropping 1.9 percent from a year ago. Yet the Japanese economy is not in recession, and output is actually rising. As Bloomberg say:

Japan’s factory production rose to a record and household spending fell, underscoring the central bank’s concern that growth has bypassed consumers and left the economy dependent on exports.

So please note: growth appears to have by-passed consumers, and the economy is ever more dependent on exports. The same goes for Germany, and this is why I talk about paradigm collision, since the neo-classical theory of economic growth – with its core conception of ‘steady state’ growth – was never built to handle median age related changes in economic performance and structural characteristics. Something new is clearly needed.

Over the coming weeks I will undoubtedly have more to say about all this, as we get to see more of the 2007 Eurozone data, but for now let me point you in the direction of Claus Vistesen, who has been patiently toiling away trying to work through a hypothesis which, in terms of the data we are now seeing, certainly seems more in keeping with current economic realities than the view we currently see emanating from the ECB. His arguments on Japan can be found in depth here, and his latest piece on the eurozone is reproduced below the fold.
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The Plot!

I’m not sure what Jerome is driving at here. It seems quite clear that, by promising a further referendum on whatever arises from Angela Merkel’s efforts to revive the Constitution, Ségoléne Royal is taking quite a risk, not least by betting on her ability to get the Laurent Fabius fanclub on side. I wouldn’t bet on a remixed Euroconstitution passing a referendum in France, but perhaps the argument is that the “non de gauche” was really a generalised protest vote and once the Left is back in power, the poison will have been drained from the issue.

Instead, the collectif antilibérale over there seem to think the whole thing is a British plot to get the Germans to stop the French from reviving the constitution, which is now a key document of multipolarity, solidarity, republicanism, laicité and other agreeable qualities. It used, of course, to be an Anglo-Saxon liberal conspiracy to subvert the French welfare state, but presumably that portion of the statement is no longer operative. Anyway, it’s not the French government that is reviving it, it’s the Germans. And it’s not the Left that is reviving it, but the Right, which begs the question why he is so annoyed by the possibility of its non-revival.
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Is Trichet’s Optimism Justified?

Our next anniversary guest post is from the estimable Mark Thoma.

The Fed and the ECB have different economic outlooks for the U.S. and European economies. For instance, the Financial Times reports:

Fed and ECB diverge on economic outlook, by Chris Giles and Ralph Atkins, Financial Times: The Federal Reserve and the European Central Bank painted contrasting pictures of the US and European economies… Together, the statement by Jean-Claude Trichet, ECB president, and the speech by Mr Bernanke indicated that European interest rates were likely to rise while there was no urgency for further US rate rises.
Mr Bernanke gave an optimistic assessment of the US economy’s ability to continue rapid economic growth without triggering further inflationary pressures. … Across the Atlantic, Mr Trichet announced big upward revisions to the ECB’s inflation forecasts … and called for “strong vigilance” to defend price stability – code words used to signal an interest rate increase in early October. … Mr Trichet’s comments followed the unexpected strength of the eurozone recovery in the second quarter, and ECB fears about the impact on inflation
in 2007… Eurozone consumers’ fears about inflation increased in August to the highest level since the introduction of euro notes and coins in 2002…

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Saving The Euro

Do you want to save the Euro? Well one idea for how to do it has been proposed by University of Missouri-St Louis history professor John Gillingham: reissuing the 12 national currencies that were replaced with just one, while at the same time retaining the euro as a parallel currency that finds its market value in competition to reissued national currencies (podcast here).
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Is The ECB Measured-Pace Cycle Over?

Well, not unexpectedly, the ECB decided to leave its main refinancing rate unchanged at 2.25% yesterday. Rather more surprisingly (for some at least) the German Federal Statistical agency reported that German economic growth ground to a halt at the end of 2005.

According to the Financial Times:

Johann Hahlen, president of the federal statistics office, said that growth last year had been based largely on exports, with domestic demand remaining weak. “Broad and self-supporting growth is still not being observed”.

Again according to the FT, Herr Hahlen’s comments “surprised economists, who had expected growth to continue and have become increasingly upbeat about the outlook in 2006”. I’m surpised the FT can be so blazé in saying ‘economists’: they certainly didn’t surprise me. I think it was reasonably clear that this was coming. If I am surprised by anything it is that it has come so quickly.

So where do we go from here? Well Jean-Claude Trichet, the ECB president, has been trotting out the party line to the effect “we have to be vigilant as regards inflation”, but with inflation now falling back (in December the harmonised rate slipped back a fraction to 2.2% from the 2.3% in the year to November) and with virtually no ‘second round oil rise’ effects in evidence this argument is going to sound increasingly hollow. Couple this with the ongoing ‘low- growth’ environment in the Eurozone (we’re still awaiting the sort of news from Italy which will again I imagine surprise ‘economists’) and you can see that there will be few reasons to justify any serious interest rate rises. At the limit we may just see one more quarter point rise squeezed-in before year’s end. Aside from that the ECB tightening cycle is, as I suggest, just about done.

Since it has recently become fashionableto try to predict the future, below the fold are my 2006 forecasts.
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The Most Bizarre Monetary Policy DecisionOf Recent Times?

This was Wolfgang Munchau writing in the Financial Times a week ago:

The pre-announced interest rate rise that the European Central Bank is due to agree this Thursday must rank as one of the most bizarre monetary policy decisions of recent times. The economic recovery in the eurozone remains fragile, as last week’s German confidence indicators have shown. Even the ECB’s own forecast for headline inflation is relatively optimistic, while core inflation remained unchanged at 1.5 per cent in October.”

and he issued a warning:

“It is still not too late to propose ECB reform as part of the next treaty revision. For as long as EU leaders maintain the status quo, they have the central bank they deserve.

Central bank independence seems to be once more ‘a l’ordre du jour’, and the ECB may well live to find to its cost that there is one thing worse than actually playing the game, it’s playing the game and losing. Now why?
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To Raise Or Not To Raise?

European Central Bank (ECB) president Jean-Claude Trichet’s indication last Friday that eurozone interest rates are about to rise continues to make waves.

Yesterday the EU Observer had a piece indicating the Eurozone finance ministers were not amused, and today we have a retaliatory piece were Trichet explains theat the ECB is the ‘listening’ people bank, which is simply responding to citizen concern about ongoing price rises.

The FT made clear yesterday that the decision to raise just now was not going down well in Berlin, where the incoming government now faces the prospects of introducing a strict fiscal policy at a time of monetary tightening, and when the impact of the recent oil price rise is likely to be pinching the already pinched pocket of the German consumer.

Meantime, as the FT today explains, Trichet is feeling the heat, since he has come out and stated that the ” European Central Bank has no plans to implement a series of interest rates rises” (ie no US-style measured pace).

Plenty of material here for an Afoe post if I find the time later today.

Promises, Promises, But More Than A Technical Detail

Well the eurozone government deficit problem has hit the agenda with a thud again in the last few days. Yesterday the FT ran a story about how the ECB has decided that it will not accept government paper (bonds) in the future from any country which has not maintained at least an A- rating from one or more of the principal debt assesment agencies. (Dave Altig at MacroBlog has also covered the story here, and Nouriel Roubini here). Today the FT has another story about how Trichet has confirmed the policy, and how the Commission too plans to get tough (well they would, wouldn’t they, since this may now become a credibility auction).

This topic must appear appaulingly technical and yawn-provoking to the non-economist. In fact nothing could be further from the truth. Let me explain a bit.
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