Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 24 July 2013

Crossing the line at the ECB

Just how much should central bankers express views about fiscal policy? One reasonable response is not at all. Yet fiscal actions can have implications for monetary policy, so vows of silence are both difficult to sustain, and potentially withhold important information from the public.

For example, I have recently suggested that it is almost undeniable that fiscal austerity when interest rates are at the Zero Lower Bound (ZLB) makes it more difficult for monetary policy to do its job. If I was a monetary policy maker, I would want to make that clear to the public, if only to avoid getting all the blame when things go wrong. I have praised Ben Bernanke’s recent comments to that effect, which he reaffirmed more recently. Of course, outside the Eurozone, it would be seen as wrong for central bankers to condemn these policies, but it must be right for them to point out that it causes them difficulties.

So there should not be a taboo on central bankers talking about fiscal policy, when it influences their ability to do their job. Policy makers at the European Central Bank (ECB) are particularly fond of talking about fiscal policy and structural reform. Here is just one recent example, but the ECB’s own research confirms that “the ECB communicates intensively on fiscal policies in both positive as well as normative terms. Other central banks more typically refer to fiscal policy when describing foreign developments relevant to domestic macroeconomic developments, when using fiscal policy as input to forecasts, or when referring to the use of government debt instruments in monetary policy operations.”

So why does the ECB stand out here? One hypothesis that appears not to work is that the ECB has been dragged into commenting on fiscal issues by the Eurozone crisis. We could question, as Carl Whelan does (pdf), why the ECB is part of the Trioka? Was it dragged, or did it invite itself? However, as the ECB research cited above shows, the ECB’s unusual interest in making normative statements on fiscal policy predate this crisis period.

One strong clue is the nature of these interventions. Bernanke warns that excessive fiscal tightness could slow down the US recovery, and because of the ZLB the Fed’s ability to counteract this is at least uncertain. The ECB always urges European governments to make fiscal policy more restrictive. That suggests that it either has a completely different view about the macroeconomic conjuncture in the Eurozone compared to the US (unlikely), or that it believes in expansionary austerity (see below), or that it is concerned about something else (much more likely). The something else which many economists would point to is fiscal dominance.

The ECB and many other European policymakers seem obsessed by the fear that monetary policy will not be able to do its job because of excessive budget deficits in individual Euro member states. So how reasonable is this fear, and is the Eurozone special in this respect, so as to explain the ECB’s unusually vocal behaviour compared to other central banks? The answer is I believe quite clear - the ECB has less to fear from fiscal dominance than any other central bank!

It was partly to show this that I wrote two recent posts on budget deficits and inflation. In the first, I made the widely accepted point that monetary policy can always neutralise the impact of higher debt on inflation by raising interest rates, if fiscal policy makers raise taxes or cut spending sufficiently to stabilise debt. Once you eliminate market panics through OMT, then it is absolutely clear that all Eurozone countries are doing that. So there is no present threat of fiscal dominance.

But imagine there was. In a second post I looked at the possibility that a fiscal policy maker might not even attempt to stabilise debt. In that case, a conflict between fiscal and monetary policy could emerge. Yet I argued that in any resulting game of chicken, if the central bank was able and prepared to allow governments to default and not monetise the deficit, it could retain control of inflation. Now in nearly all countries the government has ultimate power, so it could force the central bank’s hand (although at perhaps a very high political cost). However the one exception is the ECB. The ECB is in a better position to resist fiscal dominance than any other central bank.

So we should see much less of a concern about budget deficits from the ECB than from other central banks, yet we actually see the opposite. I can think of only three explanations for this apparent contradiction. The first is that the ECB does not understand its own position. The second is that the ECB is really concerned about the distributional effects if countries pursue different fiscal paths. Yet if that was the case, they should be focusing on relative fiscal positions, rather than always suggesting lower deficits are good. The third possibility is that the ECB is using its position of authority to pursue other economic or political goals that have nothing to do with its mandate. The ECB is also fairly unique in its lack of accountability. Perhaps for that reason, it feels no inhibition in being free with its opinions on economic issues, even when they have no bearing on its ability to control inflation.

This third explanation may also help explain the reluctance of the ECB to act as a sovereign lender of last resort. We had two years of an existential Euro crisis before OMT was introduced. The argument that is generally used to explain this reluctance is the ECB’s fear of fiscal dominance. However, as I have argued, the ECB has much less to fear on this account than others central banks, yet other banks were quick to undertake Quantitative Easing. As this piece reminds us, and as is noted by Peter Dorman here, pressure from the bond market can be very useful in helping achieve certain economic and political goals. So even though these goals have nothing to do with the ECB’s mandate, the ECB might be reluctant to see those pressures reduced by its own actions.

I would like to be wrong about this. But if I am not, I think it is important to understand what it reveals. To quote Peter Dorman: “In their own minds they probably see neoliberal reforms as self-evidently beneficial to the point that there is no need to spell them out or argue for them: everyone they know understands that this has to be the solution.” They are just giving good economic advice, advice that is needed because politicians too often respond to vested interests rather than sound economic reasoning.

If this reading is correct, then we have a serious problem. In this view about what is good economics, Keynes has completely disappeared. Not only the Keynes who showed why cutting government spending at the ZLB was a foolish thing to do, but also the Keynes who emphasised that prices in financial markets may not reflect fundamentals but instead just what market participants thought that other participants would do.[1] This is the Keynes whose ideas (or interpretation of those ideas) feature heavily, and very positively, in every economics textbook, including those used by those teaching in Eurozone countries. So what remains a real mystery to me is how the elite who make policy in the Eurozone can feel it is legitimate to promote a view about what is good economics which contradicts what economists in the Eurozone teach.

For central bankers to give advice on economic issues that are outside their remit but which pretty well every economist would sign up to is one thing. Of course central bankers will have their own private views on more controversial matters. However it seems to me that to give public advice on economic issues that are outside their remit which are also highly controversial (and contradict what is in the textbooks) seems to me to be crossing a line which it is very dangerous to cross.

[1] This is the insight behind the idea, emphasised by De Grauwe, that there may be a ‘bad equilibrium’ in the market for Eurozone government debt, which the ECB through OMT can help avoid. (For those unfamiliar with this idea, a good place to start is this piece by De Grauwe and Li.)  It is interesting that the ECB, in justifying OMT, tends to favour the argument that the market has unjustified fears of Euro break up, rather than that the market is not looking at fundamentals. It is using an argument that remains consistent with Ordoliberal ideas.


  1. The EU and with it the EZ and therefor the ECB is at the end of the day a legal construct. One would expect that basically the ECB therefor would assure that it operates within the rules. There is not much left of a legal construct when major players on important issues can simply ignore the rules.

    However as it as a badly set up construct the ECB did otherwise (some might say was forced to do otherwise).
    The mess it is in is caused because on several critical moments iso keeping an eye for the bigger picture and consistency etc it basically panicked and took the option to solve the situation at hand in the best way they saw at the time, but pure on an ad hoc basis.
    The rules as they were written, opinions and political situations of the major players (countries and CBs), market conditions) all had their influence on those particular situations.
    Make several ad hoc decisions on structural issues and coherence and consistency is gone.

    Look at their argumentation for OMT. The first 2-3 months hardly anybody mentioned transmission problems where they were supposed to be the solution for.
    One would have expected papers on these things nothing at that time. No scientific material and outside PR more than half the time focussed on rescuing countries.
    As said they simply panicked and went for the ad hoc solution and with a bogus reasoning. As they knew damm well that it was legally dodgy anyway and if the real reason was told most likely legally not allowed.

    There have been more of those moments. Earlier bondbuying schemes. ELA for totally dodgy governments that according to the markets were simply bust. Seniority falling out of the sky to avoid losses. Allowing banks to repo all sort of dodgy stuff as collateral (and so finance bankrupt governments). Being a LOLR for de facto bust banks not only in emergency situations but still now and probably growing by the day. Being part of the Troika (and let itself being pulled in the political game).

    General line:
    -They try to bring it within the mandate (as close as possible at least (often leading to bogus reasoning)).
    -Trying not to piss off major players, mainly Buba and Germany.
    But all ad hoc, fully focussed on the particular situation. And as said make a couple of these important ad hoc decisions and all logic in the set up of things is gone. Plus you run a chance that at one time you hit the wall. You cannot bogus yourself out of situation A with reason A, while say lateron the situation F requires absolutely not-A.

  2. Part 2.

    This is not standard logic; coherence; consistency. It is a situation that is grown historically. Short period of time just a few years. It obeys that (line of ad hoc decisions) (like most countries btw, nobody is telling me that the set up of say the UK is completely logical). But definitely not by one well considered big strategy.

    Which will make getting back to such a strategy increasingly difficult as increasingly roads will be closed because of earlier decisions.

    They have the luck that the other side of the huge conflict of interest, that are there, are either doing things only for the homecrowd or are not very competent. Why does Germany have to organise SME loans while OMT is supposed to fix that? Or why are SME loans still not happening in the South, while there is a OMT? (R?)asmussen should have been pulled to pieces in the case before the German Constitutional Court, did not happen.

    The ECB simply because of all this has ended up in a huge mainly political mess. For which it likely gets the blame by the politicians if things go wrong (and they probably will go wrong, the only issue is the scale thereof).
    Basically caused by the fact that when rules didnot seem to work, they didnot change the rules first or took care they were covered. As politics decided also fully ad hoc solve the present problem, kick the can. Also a fully incoherent/inconsistent theatre.
    Draghi might have discussed OMT with Merkel. But Merkel will drop him the minute it would be required to eg win a German election.

    In a nutshell a crap set up; impossible to change and problems are solved via the kick the can method by all involved, without any structure.

  3. Clearly the ECB worries about fiscal transfer, not fiscal dominance. The possibility of fiscal transfer is opened when the ECB buys or otherwise endorses government debt.

    In the U.S., the Fed never buys or endorses state/local debt. It's understood that this debt has default risk, which rises in recessions. So the Fed is much stricter about fiscal policy than the ECB!

  4. Prof. Simon,

    Here is an answer to your initial question you probably weren’t expecting. The conventional split of responsibilities between central banks and treasuries is very defective, and the solution is to merge monetary and fiscal policy. One of the submissions to the Vickers commission argued for that, and I agree. See:

    The system advocated in that paper would allow strictly political decisions (like what proportion of GDP is allocated to public spending) to remain entirely with politicians, while the decision as to how much stimulus to implement would be entirely in the hands of an independent committee of economists like the BoE MPC.

  5. Could it be that in the 1950s when the Germans got their central bank back from the Americans, they chose to focus on inflation because the myth had grown up that the hyperinflation of 1923 rather than the austerity of 1930-3 led to the Nazi takeover?

    Germany has been very good in the last couple of generations at reflecting their historical role in the Holocaust, but has paid far less cultural attention to the period leading up to WW1 and WW1 itself - which is where the hyperinflation originated, along with Versailles 1919 (back to Keynes' wisdom again).

    Could it be that inflation rather than austerity is culturally and politically more convenient for German politicians and economists for historical reasons, and is likewise convenient for the French who have used the Euro as a way of moving on from that period of French Revolution, Napoleonic Wars, Franco-Prussian War, WW1, and WW2?

    If I am right, then Austerity as a historical concept is a Euro taboo.

  6. A more simple explanation is that central banks in general reasonably worry about fiscal deficits because the resulting debt burden is likely to mean increased pressure on them from governments to err on the inflationary side, but of the major-economy central banks, the ECB has been the least cowed into submission by the politicians, thanks to the continuing vigilance by the Germans.

  7. If Keynes falls by the wayside eventually in the academic/career path European central bankers typically take, and their class interests and those of their typical social/academic circles align with austerity in some way such that they're in a strongly reinforcing environment, it would explain why they could come to believe that their partisan views are obviously correct and worth strongarming into place.

    Speaking as someone in favour of the EU concept, the European project from the outside has struck me and others as having a very technocratic air, as if it was the clearly correct path chosen by the great and the good to which public opinion can at worst be a minor implementation obstacle, rather than a legitimate opposition. The reaction to elements of the project being impeded by the awkward intrusion of democratic or economic reality is to declare the impedance wrong and override or bypass it, rather than reconsider any part of the project. They're still trying to get people to join the Euro.

    I have recently wondered if there's a deep-seated suspicion of democracy among the Euro elite, a combination of democracy being relatively young on much of the continent, some notably unstable or flawed democracies like Italy, Greece or Hungary, and the memory of fascism (blaming fascism purely on that damned democracy is a good get-out if you're a member or inheritor of the oligarchies that enabled it).

  8. "So what remains a real mystery to me is how the elite who make policy in the Eurozone can feel it is legitimate to promote a view about what is good economics which contradicts what economists in the Eurozone teach."

    Why is that a mystery? Krugmnan has made that exact point about Bernanke and concluded that just being head of the Fed was in itself a significant constraint on what views Bernanke can express.

    The Fed is an institution. Institutions have to retain an aura of solidity. Academics who become heads of institutions like the Fed can't express all the kinds of policies they could in graduate seminars, for fear of eroding the credibility of the institution they are head of.

  9. I'm not sure how it's obvious to anyone who has been following recent debates while struggling to understand issues like the zero lower bound what to do? We have strange equilibria in which a hiring subsidy to employers would somehow end up being contractionary, the more you increase the proportion of government on the economy without any concern what the spending is for, the bigger the economy, and the more flexible price adjustment the more aggregate demand shocks have bigger effects. This is the world of Eggertson and Krugman and some of the recent IMF fiscal policy advice (more simply a type 1 ZLB equilibrium). Except if firms are really paying attention to what's happening and price flexibility increases sufficiently, or if the Aggregate demand curve is flat enough (can easily occur in an world with relatively flexible aggregate investment), then you switch to another equilibrium in which more price flexibility is stabilising for aggregate demand shocks again, hiring subsidies are expansionnary and government spending multipliers are small, and maybe negative if you you try to finance it using debt and financial markets don't like you anymore. This is often called a type 2 ZLB equilibrium. It's dismissed by some because it's unstable under some simple learning schemes, but why would simple learning schemes be appropriate as an expectations model in these confusing times? Actually there's a paper by Corsetti et al from 2012 showing with feedback from goverment default risk to private sector credit spreads, fiscal expansion may not work in type 1 equilibrium either. And there's a paper by Johannes Wieland showing in keynesian models with household credit constraints supply shocks are expansionnary in the type 1 ZLB- and a properly executed fiscal consolidation can act like a positive supply shock, but whatever...). Oh, and some of the best theories of price and wage rigidities suggest they don't matter so much for determining quantities (because price and quantity rigidities tend to go together: prices are not necessarily rigid when quantity adjustments are required). And we have a dozen or so different mechanisms for how a financial crisis, or a confidence/animal spirits crisis can happen even under flexible price and wage adjustments. And those models can also generate quite low real interest rates, without keynesian policy conclusions that the government should just spend more or without forward guidance being much more than a positive placebo (people expect the government to do something: government action suggests it somehow has some control. Therefore people are more optimistic- but this can backfire)
    The textbooks will have to be rewritten someday. Right now, they're behind the times. It's now a confusing but exciting time to do macroeconomic analysis. And no, it's far from obvious like in some undergraduate textbook

    1. I think a discipline that has a model for pretty well anything is not in a very healthy state, as I discussed here:
      However, if you take appropriate account of evidence I think the picture is a lot less confusing than you suggest. But I do not see how this justifies what the ECB does in its advice, where there appears to be a complete absence of doubt about the appropriate direction of fiscal policy.

  10. I don't think Draghi meant to express his opinion as some sort of certainty. I'm just saying his position, and that of many economist at the EC is a lot easier to defend than you seem to imply. The reduced form evidence from e.g VAR's doesn't seem very conclusive to me, and anyways we don't have enough observations from ZLB regimes. As you yourself pointed out in your lecture notes on methodology, the data in macro is rarely decisive to allow us to decide without exploring different models. I'd say we're in as healthy a state as can be given the (often underestimated) complexity of the subject matter. People like Mertnes and Ravn, or the Wieland paper, or the people studying how financial frictions, matching frictions (both in labour and product markets- you should look at Rios Rull and co. for product market frictions, and Bob Hall has 1 of the more recent working papers taking a labour market matching frictions approach to the great recession)and "animal spirits" can generate recession with flexible prices (look up papers by Marios Angeletos and co if you haven't already) are not just producing arbitrary models of everything. They're producing coherent models of how movements in the natural/flex price output level can produce potentially severe recessions without assuming technological regress. My sense of many of the most prominent New Keynesians is that they haven't taken the time to sufficiently process some of the "deeper" research on things like incomplete financial markets, search frictions they underestimate shifts in the natural output level. All this is grounds for a perfectly legitimate debate with models helping us to better structure the debate. Not sure it's any more unhealthy than the debates between people like Friedman and Tobin.


    1. I'm not sure how it's obvious to anyone who has been following recent debates while struggling to understand issues like the zero lower bound what to do?

      It seems odd then that, given this confusion, the ECB feels able to be so forthright in continually advocating fiscal policy which looks to the uninitiated like doctrinaire neoliberalism. It is also convenient that most of these new models offer a potential theoretical justification for what the ECB already seemed inclined to do and advocate.

      I think given the performance of the Eurozone economies under the ECB's tender if not expert care it is more plausible to chalk up their interest in exploring strange new models to their political discomfort with what existing models, historical experience (and current foreign experiments) suggests they should do than some special insight into macroeconomic complexity.

      Lastly, though I am sure its not your intention, it is a common tactic of the economic right to suggest that the debate over some policy choice is extremely complex and will need to resolve before taking action that doing nothing is in often their preferred policy. Sometimes what is framed as a healthy debate is merely a delaying tactic.

  11. I believe the second possibility is the more important one: "ECB is really concerned about the distributional effects if countries pursue different fiscal paths". This type of concern is not present in other central banks because, say, the Fed is a national central bank, not a supra-national one with representatives from 19 different countries. Members from the governing council, for instance, Jens Weidmann, are not maximizing an "eurozone social welfare" function. Instead, they are trying to pull ECB's policies in the direction that favors their own countries. It seems likely that different national interests fight within the governing council, say, Germany pushes for keeping or contracting the monetary policy stance, while Spain and Portugal may well argue for expansionary policy. In order to accomodate all these national differences, while not having the possibility to run many different policies adequate to each country specifically, the final discourse of the ECB must prescribe some fiscal policies. These are the policies the ECB believes would solve the essential problem of one single monetary policy for different countries with different needs (need for higher inflation in debtor countries, monetary moderation in Germany). If all countries applied fiscal moderation or contraction, then "confidence" would set in Southern Europe, at which point spreads would go down; and in Germany, any inflationary pressures would be contained. With downward pressure on Southeuropean spreads, and downward pressure on German prices, the ECB might keep its policy unchanged, and that will be compatible with all countries. The problem, of course, is whether austerity leads to more confidence and lower spreads in the South; and whether for Eurozone's sake Germany should contain any inflationary pressures instead of letting wages and prices go up faster relative to the South.

    It is of course difficult to second-guess ECB's actions and discourse when the generating mechanism is a wrong-minded view of policy (austerity leads to confidence, Germany's inflation is too high, etc.) which is trying to accomodate conflicting nationalist interests within the ECB itself.


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