Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 6 May 2012

What the ECB needs to do

                What would a hypothetical Eurozone government (or, to use jargon, a Eurozone social planner) do with monetary and fiscal policy in the current crisis? An initial discussion along these lines involving  Kantoos and myself has widened recently (e.g. Kantoos, Tim Duy and others in Kantoos). Although this may appear a purely academic exercise, I think it is very useful, because it indicates what the ECB is failing to do.
                Let us start with two blocs, Germany and non-Germany, and recognise that there is a competitiveness gap between them which is unsustainable. Let this gap in terms of consumer prices be labelled G. The first choice the government/social planner has is how quickly to reduce this gap: in years, call this y. For simplicity assume this is done in a uniform way, which implies that inflation in Germany has to be G/y above that in non-Germany for the next y years. The next choice the social planner has is the aggregate inflation rate for the area as a whole: call this x%. These two choices give us the targets for inflation in the two parts of the Eurozone: x+G/2y in Germany and x-G/2y in non-Germany.
                The two choices (of x and y) are not independent because of the difficulties in achieving very low, or even negative, inflation rates. If x, the average Eurozone inflation rate, is only 2%, then it probably makes sense to try and reduce the competitiveness gap slowly, so that x-G/2y does not become too low or negative. In other words, 3% and 1% over a protracted period may be less costly than 4% and 0% over a shorter period.
                Having established the targets, how should they be achieved? The average inflation rate x is set by the ECB. Conventionally we think that this is all monetary policy can do, but in the current situation this is not the case. First, the debt crisis means that monetary policy is tighter in many non-German countries, and the ECB has the power to influence, and probably control, what these risk premiums are. Second the Bundesbank and other countries may soon have the ability to at least influence domestic monetary conditions through various financial controls.
                Fiscal policy comes in to the extent that the targets cannot be achieved by monetary policy. For the average inflation rate x, fiscal policy may be required because of familiar zero lower bound problems. National fiscal policies play a more conventional (if neglected) role in determining inflation differentials. Whatever monetary policy cannot do, fiscal policy can fill the gap. (In retrospect I think the initial disagreement between myself and Kantoos related not to the choice of x and y, but to the question of what particular instrument adjustments are likely to be required to achieve them.)
                But, you may be thinking, what about the government debt crisis. Isn’t the whole point about the Eurozone that government debt is issued by national governments who do not have their own currency, and so are at much greater risk of default? Yes and no. No, because the ECB can act as each country’s central bank. Once this is recognised, the importance of the debt crisis in the Eurozone becomes the same as in the US, or the UK: in other words it need not prevent policy achieving its conventional stabilisation objectives x and y.
                There is just one caveat to this argument, and it is called Greece. There the actions of the Greek government before the credit crunch may have made default inevitable. However Greece is the exception, not the rule. Government debt only looks unsustainable elsewhere if you assume crisis levels of interest rates forever, or that austerity eliminates growth, or that national banking sectors are completely bailed out by national governments. None of these three things need happen. None will happen if the ECB does what it needs to do.
                This is why this ‘academic’ exercise of imagining a Eurozone social planner is so revealing. Although there is no such government, there are institutions and mechanisms that could approximate it, and in particular there is the ECB. It helps us see that, contrary to the thoughts of some who should know better (as reported here and here), the current strategy is flawed (see here and here), and there is an alternative. What the ECB needs to do is the following:

1) Make 2% a symmetrical target, rather than the target being 2% or less. (We might wish something higher than 2% for a while, but I’m being realistic.)

2) State publically that this implies 3% inflation in Germany for a protracted period, rather than suggesting otherwise. (Jean Pisani-Ferry makes the same point here.)

3) Announce a form of QE which aims to prevent interest rates on government debt exceeding, say, 4% in each Eurozone country.

4) If the current recession suggests that forecasts for aggregate Eurozone inflation are likely to fall below 2% because short term interest rates cannot be reduced further, publically state that aggregate fiscal policy is preventing the ECB from fulfilling its mandate. (If the situation was reversed, and fiscal policy was leading to rising inflation and interest rates, would the ECB be silent then?)

It is only if (4) comes to pass, and German inflation is below 3%, might the fact that the Eurozone is not one country get in the way of achieving the targets outlined above. While the debate referenced at the beginning of this post largely focuses on this case, it should not distract from current failures in monetary policy. Policy makers at the heart of Europe need to change the way they think about the situation they are in. Perhaps they need to think about the Eurozone as one country.


  1. Bravo! I hope Hollande's people read this.

  2. Bravo indeed. I think you slightly understate your case. Yes we generally assume central banks affect only inflation, but we generally assume nonsense for simplicity. For example we generally assume one price level per currency, so we generally assume that there can not be a competitiveness problem within the Euro block (or UK or US and this is always false).

    I guess that central banks affect inflation via interest rates -> investment - a Phillips curve of some sort > inflation.
    The only affect average inflation follows from strong assumptions certainly including the assumption that the Phillips curve of some sort is linear. It isn't in any data. I just don't see how looser monetary policy is supposed to cause Spanish inflation to accelerate. If it is very hard to get negative inflation, as you correctly write, then uniform monetary policy with uniform risk premia will have different effects on countries that are vs are not stuck on the downward extreme nominal rigitity bound.

    Also what happened to Kantoos? Is it the Zeitgeist or something in the German water system ?

  3. Nice academical exercise. But, I have some questions on my mind.

    Isn't euro a form of world money? And by that I mean, isn't euro an international reserve currency? It is clear to me that this is the reason for austerity in peripheral economies. How would this policy effect the ability to compete against dollar?

    Also, competitiveness in the internal market depends on productivity growth and labour costs in each country. By looking at the evolution of nominal labour costs (AMECO) it's clear that the core gained competitive advantages against the periphery. Should fiscal policy influence this part of productivity? And how?


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