Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday, 30 August 2014

The ECB and the Bundesbank

There can be no doubt that some of the responsibility for the current Eurozone recession has to be laid at the feet of the ECB. Some of that might in turn be due to the way the ECB was set up. Specifically

1) That the ECB sets its own definition of price stability

2) This definition is asymmetric (below, but close to, 2%)

3) No dual mandate, or even acknowledgement of the importance of the output gap

4) Minimal accountability, because of a concern about political interference

It is generally thought that the ECB was created in the Bundesbank’s image. Tony Yates goes even further back in this post. Yet the irony is that the ECB abandoned the defining feature of Bundesbank policy, which could be providing significant help in current circumstances.

The defining feature of Bundesbank policy was a money supply target. Whereas the UK and US experience with money supply targeting was disastrous and short lived, the Bundesbank maintained its policy of targeting money for many years. There is little doubt that this was partly because the Bundesbank was in practice quite flexible, and the money target was often missed. Nevertheless the Bundesbank felt that maintaining that money target played an important role in conditioning expectations, and there is some evidence that it was correct in believing this.

When the ECB was created, it adopted a ‘twin pillar’ approach. The first pillar was the inflation target, and the second pillar involved looking at money. It was generally thought that the second pillar was partly a gesture to Bundesbank practice, and subsequently most analysis has focused on the inflation target.

There are very good reasons for abandoning money supply targets: they frequently send the wrong signals, and are generally unreliable in theory and practice. However a monetary aggregate should be related to nominal GDP (NGDP), and you do not need to be a market monetarist to believe there are much better reasons for following a NGDP target. What a NGDP target does for sure is make you care about real GDP, which would go a long way to correcting points (2) and (3) above. What it can also do, if you target a path for the level of NGDP, is provide a partial antidote for a liquidity trap, as I discuss here. More generally, it can utilise most effectively the power of expectations, which is why perhaps the most preeminent monetary economist of our time has endorsed them.

So do not blame the Bundesbank for the flawed architecture of the ECB. The ECB abandoned the critical aspect of Bundesbank policy, which was to target an aggregate closely related to nominal GDP. ECB policy has suffered as a result.

22 comments:

  1. As real domestic demand growth in the eurozone follows money (M1) supply growth with a lag (check it out), it would make sense to set up a money growth target in order to avoid stagnation or recessions. Traditional monetarism is forgotten today, but it should be reconsidered.

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  2. Money aggregate targeting rather than interest (federal funds rate type) targeting by the Bundesbank should provide useful case study in conducting "unconventional" monetary policy. What was the instrument they used? Was it direct loans/quantitative credit allocations to stabilise money growth, or was it things like open market operations?

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  3. You're getting closer to the real conflict of current Eurozone policy.
    They say that a compromise is an agreement neither side really likes. And that's what the ECB is. There is a long-standing rumour, actually partly confirmed and very credible, that Germany had to give up its Deutsche Mark in exchange for french acceptance of reunification. See here:
    http://www.spiegel.de/international/germany/the-price-of-unity-was-the-deutsche-mark-sacrificed-for-reunification-a-719940.html
    The general philosophy of the european unification project is very much of french origin. The "ever-deepening" unification process was originally meant as a containment strategy against Germany (quite understandable after World War II). You probably know that the original institutions that eventually formed the EU were meant to control Germany's coal industry. The strategy of how to achieve a deeper integration of several national economies was to force changes in times of crisis.
    In the previous thread you wondered why the european countries should give more power to the EU when it already failed to provide adequate institutions for the present crisis. Well, that's the strategy: Let things get so bad, that there HAS to be institutional reform. That's why, for example, the EU decided to admit ten more countries to the union at a time when it was already foreseeable that such a large union would immobilize its institutions. The architects of this strategy were Jean Monnet and Jacques Delors, both French.
    But France made a miscalculation. They underestimated the success of american nation-building in Germany. Germany really became a peaceful capitalist democracy. The Germans really wanted to be good capitalist democrats (and still do for the most part). The effects of de-Nazification, and the spread of American New Deal-capitalism led to the breakthrough of ordoliberalism and turned West Germany into an economic powerhouse. Again, the Germans really wanted to be good capitalists and good democrats, so they adhered to the rules and thought that the rules of economics and democracy ensured order (and they did, but then almost any time period would be more orderly than Germany from 1914 to 1945)
    Then, with the european unification process, the Germans (whose nationalism had became taboo) also wanted to become good Europeans. German Finance Minister Wolfgang Schäuble is one of the last representantives of the generation that grew up with World War II guilt and the idea that the Germans could only find forgiveness if they leave the idea of the german nation-state behind and accept a european identity. The same thought process made Helmut Kohl such an important european.
    So what is it that I want to say? Germans really wanted to be great Europeans. They gave up the Deutsche Mark in exchange for the Euro because they accepted it as an historic act of redemption. But they infused this grand French project with their own determination and love of order. The strong German economy pushed the power of France aside which is why there is now an uncomfortable mix of german and french policies. Germany basically said to the French: We accept your Euro, if you accept our rules. And that's why Germany is still trying to enforce rules right now. And there's again the idea that an existential crisis will lead to a greater integration of the european economies. Germany has accepted the Monnet/Delors strategy and so it tries to exploit this crisis to strengthen the institutional framework of the EU. Only now the other countries, with France sometimes as the head of the opposition, rejects further integration - because the Germans have turned the table. I think the german policy elites are in fact quite confused why their course is being rejected. They thought that the european unification process was the golden path towards democracy and wealth, the escape route from national guilt, but for France it was always a defensive strategy against german might.

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    1. Oh, and I realize that this must sound a little disturbing to a British economist who thought that the EU was basically just a free trade agreement. It's a bit like coming over for dinner and accidentally watching the marital problems of your host.
      Just read something about De Gaulle's policy of the empty chair: http://en.wikipedia.org/wiki/Luxembourg_compromise

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  4. "In the previous thread you wondered why the european countries should give more power to the EU when it already failed to provide adequate institutions for the present crisis. Well, that's the strategy: Let things get so bad, that there HAS to be institutional reform. That's why, for example, the EU decided to admit ten more countries to the union at a time when it was already foreseeable that such a large union would immobilize its institutions. The architects of this strategy were Jean Monnet and Jacques Delors, both French."

    I think you really need to go over events at that time. It was actually the UK pushing for expansion of the EU. Delors and the French wanted a tighter union that could focus on convergence before any further expansion. The UK played the spoiling tactic. It did not want tighter integration that implied further concessions on sovereignty. It did not want French dominance of the political agenda. At the time the EU was forging ahead, even talking about defence and foreign policy unification. This alarmed Britain and its allegiance to NATO and the US alliance. There was also an ideological element. Britain really wanted a free market for goods. It saw Brussels, particularly led by the French as to socialistic. Also at the time American macro-economists, such as Feldman and Krugman were floating optimal currency and other such arguments around against European monetary integration. Many people were not too unhappy about leaving the ERM, including much of the neo-classical orthodoxy.

    The rushed integration of the East though has been a fiasco. It has alienated Russia and played to its hardliners. It has made the EU and even more unwieldy institution. It has stalled momentum. And with free labour flows it has caused a nightmare for established political parties. In the 90s most Europeans were in favour of the EU, including the UK. Now the majority in many countries are against.

    You are right though, the EU is a fundamentally about international security issues. It was created for that reason. Trade and other integration is a means to a political end, not the reverse. Unfortunately that does not fit into American neo-classical macro-economic models and a lot of people do not properly understand the link, which requires some knowledge of history or basic neo-liberal political science, which, correct or not, underlines the thinking of much of the foreign policy establishment behind it.

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    1. Of course, the entry of the UK gave EU politics another twist. One has to ask why the UK wanted to enter the EU if it thought that the policies were too socialist. I don't have the full UK perspective, but I see only two possibilities: the spoiling tactic, which if it existed even BEFORE UK membership, would imply that the UK wanted to throw a wrench into the ongoing establishment of a strong European Federation that would shut the UK out, or a genuine desire to participate in the European project, initiated by old-school Labour, which was pretty socialist itself.
      I guess both of them are possible, at the same time, each represented by one of the two major parties.
      About the eastern expansion, I guess both perspectives can be true, the UK pushed and the other countries willingly went along, knowing that the expansion might break the union (which would also be what the UK wanted), but hoping that the problems would be overcome. Paul Krugman, for example, has repeatedly stated that the one thing he got wrong during the Eurocrisis was his underestimation of the acceptance of the european population of more austerity, more pain, more internal devaluation. The Greeks had two chances to vote for the Grexit, but decided against it. The political desire to keep the european project going is real, and strong among the Europeans. The european leaders might have suspected that their peoples would accept many compromises to keep the union alive.

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    2. One has to ask why the UK wanted to enter the EU if it thought that the policies were too socialist.

      Again you need to understand a bit of neo-liberalism in political science. The idea was to keep some influence in Europe, and above all, keep the US engaged in Europe and stop Europe drifting off on its own course.

      "Krugman, for example, has repeatedly stated that the one thing he got wrong during the Eurocrisis was his underestimation of the acceptance of the european population of more austerity, more pain, more internal devaluation."

      Krugman has a lot to be thanked for, but he can sometimes really grate. One of the most annoying things he does is say to people when it comes to economics and austerity is "where is the model". On the other hand he rants on about Iraq and international relations issue with what??? Really, a few people need to put Dear Model away and start reading up on some history and basic political science theory. On your point, people in Greece and Italy prefer the Euro, because they do not want a return to the booms and busts and devaluations of the pre-Euro Drachma and Lira. They know the value of a hard currency.

      "About the eastern expansion, I guess both perspectives can be true, the UK pushed and the other countries willingly went along, knowing that the expansion might break the union (which would also be what the UK wanted), but hoping that the problems would be overcome."

      Yes I think you are right. I am not sure the UK wanted a breakup, just a more diluted free trade area. It was a big battle between France and the UK. Germany was to be the decider. In the end, I think, yes, it decided that it go with expansion, it put in some transitional controls for itself, and just hoped for the best.

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    3. krugman may be grating at times; he even admits it. But his point that one needs to have a model rather than merely make random statements is on target.

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    4. Well if he thinks that is true, he can start doing that with international relations and political science issues too.

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  5. Article 127(1) of the Treaty defines the primary objective of the Eurosystem:

    “The primary objective of the European System of Central Banks […] shall be to maintain price stability”.

    Article 127 continues as follows: “Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union.”

    The primary objective was not economic success, high employment, growth, etc. And maintaining inflation below 2% is too close to deflation to be stable, in the long run (whereas inflation can always be cut down with high short term interest rates, and a little recession, no powerful tools exist to terminate deflation. Full deflation is a depression, and has no obvious solution. Thus it is extremely dangerous to flirt with deflation, as the ECB does.)

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    1. I agree. But does the ECB have any choice? It seems they are trying unconventional measures already because nothing else seems to work?
      Taking the fiscal policy as a given are there any better options?

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    2. should they have started in 2008 when the magnitude of the problem was evident?

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  6. This is an interesting and plausible perspective on the bundesbank.

    @Simon Wren-Lewis: What papers would you recommend to get a better understanding of the bundesbank policy?

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    1. @Anonymous31 August 2014 06:46

      Two articles from 1990s: First one by Clarida/Gertler
      http://www.nber.org/chapters/c8890.pdf
      second by Bernanke and Mishkin
      https://www0.gsb.columbia.edu/faculty/fmishkin/PDFpapers/w5893.pdf
      In German there is a pretty good book by Rudolf Richter, Deutsche Geldpolitik 1948-1998: Im Spiegel der zeitgenössischen wissenschaftlichen Diskussion, Tübingen: Mohr-Siebeck, 1999.
      And this is a working paper of the ECB on monetary policy of the BuBa:
      http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1020.pdf

      Have a nice time!

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    2. Thanks for these papers. They helped answer my question (the second comment on this blog.). One thing that might be helpful, however, is that we get more German perspective. Ie papers written by German authors - although I suspect the best of these are in German.

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    3. I forgot to mention two books by David Marsh on the Bundesbank. David Marsh was for some time correspondent of the FT reporting from Germany and France. Both books are very informative.

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  7. The Euro-zone is going nowhere until it has a proper Treasury to handle the "fiscal" policy, that is the spending of new Euros into existence and the subsequent taxing of those Euros to control aggregate demand. The ECB would then operate "monetary" policy alone instead of trying to do both jobs as now. Remember that the ECB operates with a balance sheet that has access to a bottomless pit of Euros. An EU Treasury would operates a sovereign fiat currency system that has no such balance sheet constraint from the same bottomless pit of Euros. Its only fear is spending faster than goods and services are produced and made available for sale, hence, encouraging inflation.

    Simon has a chart that shows UK GDP loss against the last decades trend. You will see that the UK was pulling out of the dive in the second quarter of 2010. The UK Treasury was running an 11% "fiscal" deficit at the time and it was looking good. Then Osborne happened and the slash and burn the public sector, flat-lined the economy for three years!

    The same but worse has happened in the Euro-zone where they all use a foreign currency and there is no Treasury to get a grip on that single currency debt instruments and a single currency tax and a large Barnett Formula type transfer system.

    http://multiplier-effect.org/can-a-euro-treasury-end-the-crisis/ . ATB Acorn

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  8. It's quite interesting to observe German NGDP:
    https://drive.google.com/file/d/0B4e1RBANe0uVTUF1VEVUaDc1cG8/edit?usp=sharing

    It seems that they have very competent central bank. It even allows slight overshoot to drive down the unemployment. I wish we also had that kind of central bank.

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  9. Dear Sir,

    as I understand it, the Bundesbank targeted the expected growth (mid-term) in potential output and not NGDP. And they were actually targeting inflation through that, not caring about growth, whether real or nominal.

    German ordoliberalism is quite strict in its seperation of concerns: inflation rate management is for the central bank, unemployment rate is subject to negotiations of unions with business associations and both growth and resources allocation are the realm of politics (technically also the current account but maintaining balance there was neglected). Of course, in reality it is never quite as strict as in theory. Yet, in my understanding, the goal of that approach was to take out the inflation rate as a concern for business people due to its predictability. Such reliability was perceived as a huge boon for the economy.

    But, as mentioned in another comment, the actual issue today is one of trust and not of economics: Can the German public trust that caving in on current policies will not lead to a Euro-Lira? That is the key question. Another commentator remarked that if current policies will not be abandoned, the Euro will cease to exist. There is no doubt in my mind that to the German public this would be preferable to a Euro-Lira.

    So again: Can the German public be reassured that relenting on either monetary or fiscal policy will not lead to the end of the Euro-DM? How - given that France asks time and time again for more time to get debt levels under control? Germany's partners seem unreliable, not keeping their promises and never having embraced the requirements of a DM-like currency except as lip service.

    THAT is the root of the problem from a German point-of-view. And it's not easily solved given current economic conditions.

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  10. Wow, Great post. This article is really very informative and effective. I think it will be helpful for us. Thanks to the author for sharing this article

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