Is the ECB making “rookie mistakes?”

Vaidas sent me an interview with ECB board member Benoit Coeure.  Here’s the sort of quotation that I’ve made fun of in the past:

On the definition of medium term:

“There is an academic definition of ‘medium term’ which is the Milton Friedman definition. That’s 18 months. But it has always been recognized by the ECB, from inception, that the path through which inflation reverts back to the 2 percent number depends on the nature of the shock and it depends on the type of nominal rigidities that you have in the economy. In the current situation, where you have this enormous structural adjustment going on and enormous deleveraging pressures that are obviously weighing a lot on prices, contributing to the subdued price pressures, it is only normal that we see inflation coming back more slowly to the medium term objective. That’s compounded by the fact that a number of European countries are going through a relative price adjustment which is a necessary adjustment, since it’s part of regaining competitiveness. This is temporary, and should not be confused with deflation. Mechanically, this relative price adjustment weighs down on the average euro-zone inflation number. For all these reasons, inflationary pressures will be very subdued for an extended period of time. The definition of medium term is probably more extended now than it could have been in other circumstances because of the situation the euro area economy is in. And we have to acknowledge it.”

It’s hard to imagine an American macroeconomist saying it’s healthy for inflation to be running below target because the economy is so weak.  On second thought . . .

At least it would be correct to say that Paul Krugman and many other American pundits have picked on the ECB for making statements like this in the past.  So what could be going on here?

It occurred to me that this is exactly the sort of thing that people at the Fed used to say in the first few decades of its operation, when it hadn’t yet figured out what it was doing.  We went from a classical gold standard to a managed gold standard to Bretton Woods to a pure fiat regime, and each time a new approach to monetary policy was needed.  Often the Fed was stuck in its old way of thinking, old rules of thumb, and did not rise to the challenge.

You might assume that the Europeans already had plenty of central banking experience, so the ECB should have done fine.  But perhaps that’s exactly the problem.  They had lots of experience, but of the wrong kind.  Maybe they thought that running the ECB would be like running the central bank of a small open economy, whereas it’s more like running the central bank of a large closed economy.  More like the Fed.  But over in the eurozone they don’t yet realize that fact.  They are running years behind the Fed in figuring out how to do things.

Think about what’s wrong with that quotation.  The emphasis on weak economies cutting costs. That’s not a bad way of looking at things when you run a central bank in a small open economy, and need to make your economy more competitive. In that setting, however, when things get way out of line you devalue—that’s how you make the domestic economy competitive.  But the individual members of the eurozone no longer have the ability to devalue, and the ECB doesn’t seem to realize that the only way for the eurozone as a whole to become more “competitive” is to raise the inflation rate. Counterintuitive, but true.

PS.  I have a new post at Econlog.

PPS.  Marcus Nunes has a post on a different Coeure interview.

 


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14 Responses to “Is the ECB making “rookie mistakes?””

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    17. January 2014 at 12:25

    Scott:
    “…You might assume that the Europeans already had plenty of central banking experience, so the ECB should have done fine. But perhaps that’s exactly the problem. They had lots of experience, but of the wrong kind. Maybe they thought that running the ECB would be like running the central bank of a small open economy, whereas it’s more like running the central bank of a large closed economy. More like the Fed. But over in the eurozone they don’t yet realize that fact. They are running years behind the Fed in figuring out how to do things…”

    One key to understanding the extraordinary weirdness of European macroeconomics is Walter Euken. In the 1930s, Euken founded a school of economics at the University of Freiburg that came to be known as Ordoliberalism. Ordoliberalism combines a commitment to free markets with a belief in strong government, but its primary concern is economic stability.

    A German obsession with economic stability is probably understandable in a country that suffered the experience of hyperinflation in the 1920s, deflation and depression in the 1930s, followed by the abuses of state power by the Nazis, which led to a highly destructive and nearly complete economic collapse upon their defeat and occupation at the end of WW II.

    The Bundesbank reeks of Ordoliberalism and German central bankers can’t utter a single sentence without expressing one of its easy nostrums. But the odd thing to me is how easily the Ordoliberal economic philosophy has come to dominate the rest of Europe, in particular Southern Europe. From my experience Italians, Spaniards and the Portuguese are just as dismissive of aggregate demand stimulus as the Dutch and the Germans, if not more so. If you engage them in a discussion about the situation in their countries it quickly devolves into a bizarre display of national self-loathing. All of the problems in their countries it seems are the fault of their poor institutions, or even their inferior cultures. If you try and convince them using quantitative empirical evidence that it is simply a demand side problem they will correct you, insisting that it is mostly a supply side problem: their inefficient tax systems, regulations, labor markets, corruption, poor work ethics etc.

    And I’m beginning to wonder if there has been some atrophy in the knowledge of macroeconomic stabilization policy in the eurozone simply due to the foundation of the European monetary system. For example, the Dutch guilder was effectively pegged to the mark from 1983 until the creation of the euro. Thus it’s been over 30 years since the Netherlands has had an independent economic policy.

    It’s almost as though Europe is the Darkest Continent in this Dark Age of Macroeconomics, and that they insist on rediscovering everything they once knew in the hardest and most painfully self-flagellating way possible.

  2. Gravatar of Vaidas Urba Vaidas Urba
    17. January 2014 at 12:46

    Here is another, older Coeure quote:
    “As I read it, the employment dimension of the Fed’s dual mandate
    is not meant to influence the structural path of unemployment. In
    fact, as I said before, it serves as an explicit acknowledgement that
    the central bank will be wary of employment dynamics when steering
    output back to its structural path after economic shocks have
    perturbed labour market conditions. But, as I just explained, the
    ECB’s price stability definition and policy horizon also allow for
    substantial flexibility in calibrating the policy response to shocks.
    Due to this flexibility, the ECB can pursue its long-term price
    stability objective without triggering socially costly short-run
    fluctuations in output and employment. In this regard, it is in line
    with the key purpose of the Fed’s dual mandate.”

    It is hard to see how these two quotes are compatible. Hard, but not impossible.

  3. Gravatar of Luis Pedro Coelho Luis Pedro Coelho
    17. January 2014 at 14:41

    It makes perfect sense: to keep inflation in Germany below 2% and have other countries deflate relative to it, then overall inflation in the Eurozone will be lower than 2%. It’s a mathematical necessity.

    Already Germans are grumbling about inflation and it’s not even 2% in Germany. I don’t think they would tolerate the 3% that might be necessary to get the whole of the eurozone up to 2%.

    *

    “””In that setting, however, when things get way out of line you devalue””that’s how you make the domestic economy competitive.”””

    Et tu, Scott?

    Isn’t devaluation just another name for raising NGDP?

  4. Gravatar of Tom Brown Tom Brown
    17. January 2014 at 15:06

    Mark, O/T: What is your reaction to this statement:

    “The US most certainly is insolvent, as its unfunded liabilities amount to tens of trillions of dollars and are increasing at an astronomical rate. There is no possibility of these liabilities ever being paid off without immense inflation.”

  5. Gravatar of benjamin cole benjamin cole
    17. January 2014 at 15:30

    It is interesting that the People’s Bank of China, which has less history and which is not independent, has outperformed all Western central banks for the last 20 years. The PBOC engineered growth through the 2008 global financial collapse. Yes, that’s all.
    It is worth noting that PBOC offivials have made derisive comments regarding the Bank of Japan’s performance 1992-2012.
    You would think the Fed might be curious about the PBOC’s success. Or perhaps a few Western economists.
    I detect little interest.
    The way we do it here and now is the best way.

  6. Gravatar of Vaidas Urba Vaidas Urba
    17. January 2014 at 15:41

    Here is how Bernanke has answered a similar question in the latest press conference (“Mr. Chairman, your inflation forecasts never get back to 2 percent in the time horizon that you cover here, out to 2016”):

    “Well, even under optimal control, it would take a while for inflation””inflation is quite””can be quite inertial. It can take quite a time to move. And the responsiveness of inflation to increasing economic activity is quite low. So””and particularly given an environment where we have falling oil prices and other factors that are contributing downward forces on inflation, it’s difficult to get inflation to move quickly to target. But we are, again, committed to doing what’s necessary to get inflation back to target over the next couple of years.”

  7. Gravatar of Troy Troy
    17. January 2014 at 16:21

    Scott, you misunderstand the nature of the ECB and the challenges it faces. Conducting monetary policy across economies which differ so dramatically in economic characteristics. This is the reason for the emphasis on the fiscal side as monetary policy conducted through a common currency is limited on what it can do in this kid of environment. Plus please explain the assertion that the ECB should raise rates?

  8. Gravatar of ssumner ssumner
    17. January 2014 at 17:21

    Mark, That sounds right. I can sympathize with Europeans who feel that supply-side or structural factors explain much of the difference between the North and the South. But what they don’t seem to be able to wrap their minds around is the idea that you can have that sort of an imbalance in per capita GDP, and ALSO HAVE a huge demand shortfall for the entire eurozone region considered as a whole. Too many economists want to boil it all down to either demand or supply-side, when it is often both.

    Vaidas, Very hard!

    Luis, Yes, but Europeans don’t think in NGDP terms.

    Vaidas, Yes, and notice Bernanke doesn’t say the below target inflation is helpful in restoring competitiveness.

    Troy, It’s very simple. The ECB should do policy based on the needs of the eurozone as a whole. Right now there is a huge AD deficiency in the eurozone as a whole. So they need to raise inflation. Of course I’d rather they target NGDP, but if they insist on inflation then they should raise it to 2% ASAP.

  9. Gravatar of Tom Brown Tom Brown
    17. January 2014 at 17:49

    Mark, O/T (continued): I guess that quote expressing concern over “unfunded liabilities” was referring to this WSJ article putting a number on that of $86T (SS, Medicare, Fed Gov retirement programs, etc):

    http://online.wsj.com/news/articles/SB10001424127887323353204578127374039087636

    Thoughts?

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    17. January 2014 at 18:21

    Tom Brown,
    Assuming the $86 trillion figure is correct, it is the present value of the additional resources that would be necessary to meet projected expenditures at current law levels for all those programs combined for the next 75 years.

    According to the Medicare Trustees report the present value of GDP for the next 75 years is $944 trillion (page 228):

    http://downloads.cms.gov/files/TR2013.pdf

    In short, yes it’s big, but the present value of GDP for the next 75 years is much bigger. Also, a lot can happen in 75 years. A small shift downward in cost projections and a small shift upward in revenue could make that scary sounding figure vanish completely.

    Who said this? Vincent?

  11. Gravatar of Tom Brown Tom Brown
    17. January 2014 at 19:03

    Thanks Mark. I’d actually looked at the 2012 edition of that doc, but didn’t see the GDP estimate.

    No it wasn’t Vincent, it was “technovelist” here:

    http://gyroscopicinvesting.com/forum/other-discussions/cullen-roche-interview/msg88956/#msg88956

    I passed along your thoughts

  12. Gravatar of Saturos Saturos
    17. January 2014 at 20:48

    “Mechanically, this relative price adjustment weighs down on the average euro-zone inflation number.”

    What does this mean? Why should average Eurozone inflation be lower because some Eurozone economies are expensive relative to others? If the Eurozone as a whole is uncompetitive, then the forex market will adjust, if the ECB is targeting domestic price stability. Why should the ECB back off domestic average price stability if some of the internal economies are expensive relative to others?

    “Maybe they thought that running the ECB would be like running the central bank of a small open economy…”

    I don’t see how this excuses their behaviour.

  13. Gravatar of Saturos Saturos
    17. January 2014 at 20:49

    On Econlog you seem very confident about the predicted stimulative effects of Japanese devaluation, even though you agreed that the Japanese problem was mostly supply-side, as it had to be without much in the way of recent demand shocks…

  14. Gravatar of ssumner ssumner
    18. January 2014 at 07:33

    Saturos, Agree on the quote. Regarding Japan, I do expect them to fail to hit their 2% inflation target in the long run. And I do think most of their problems are supply side. But to the extent that they are partly demand side, this policy has helped address those problems.

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