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.

5 thoughts on “The continued embarrassment that is European monetary policy … economists?

  1. While I agree to your argument, I think that there is another problem:
    In order to have the positive effects of inflation, we need to have “inflation in wages”.
    This is important because sheer inflation in the price of goods wouldnt help to reduce leverage.
    But with high levels of unemployment, there is a big downward pressure on wages.
    Also, at least in Italy where I live, but I think also in the rest of the Eu, since at least the 80s the government implemented policies that were supposed to boost “competitivity” and that, in pratice, weakened a lot labor’s bargaining power.
    Thus, in order to have “inflation in wages”, the various european governments should apply a coordinated “expansionary” and pro labor policy.
    But this would be a complete reversal of the politics and of the political economy of the last 30 years.

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  4. But in a currency union higher inflation also implies a transfer, in this case from German and other northern savers to south European recipients of public spending.
    That is as unacceptable as direct transfers to the northern public.

  5. In order to have the positive effects of inflation, we need to have “inflation in wages”.

    This. It’s far more respectable to argue for inflation (or QE3, or ECB vs. Squid, or N-GDP targeting, all of which in present conditions mean inflation) than it is to argue for wage-led growth.

    But it’s still necessary. If labour’s bargaining position is so godawful it doesn’t even get indexation, the squeeze on household budgets takes away the aggregate demand with one hand as the inflation creates it (by eroding Great Bubble debts) with the other.

    I don’t think the advocates of inflation are willing to follow their own logic through to the finish.

    PS, Oliver: inflation also implies a transfer from South European consumers to North European exporters, but, y’know, don’t look at the whole of the BDI behind the curtain.

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