End the euro crisis now with a 10% M3 target

This is Michael Steen in the Financial Times:

Inflation in the eurozone dropped unexpectedly to an annual rate of 0.7 per cent in October, far below the European Central Bank’s target of close to but below 2 per cent, and significantly increasing the chances of an interest-rate cut.

The so-called “flash” estimate by Eurostat, the EU’s statistical office, showed that the rate at which prices rise had slowed further since September, when it was 1.1 per cent, which is roughly what economists had expected for October.

A sharp outright fall in energy costs, by 1.7 per cent, drove the slowdown in the harmonised indices of consumer prices, which the ECB targets, but “core inflation”, which strips out energy, food, alcohol and tobacco, also fell to 0.8 per cent from 1 per cent.

I must say I am not the least surprised by the fact that the euro zone is heading for deflation. This is what I told The Telegraph’s Ambrose Evans-Pritchard back in March:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

It is tragic, but what we are seeing now in Europe is exactly the same as we saw in Japan in the mid-1990s – a central bank that pursued extremely tight monetary policies, while it continued to maintain that monetary policy was indeed very easing. We all know the result of the Bank of Japan’s failed policies was 15 years of stagnation and deflation – and sharply rising public debt levels. The ECB unfortunately is copying exactly the policies of the (old) BoJ instead of learning the lesson from the new BoJ’s effective anti-deflationary policies.

As I have earlier argued the development in velocity and money supply growth in Europe today is very similar to what we saw in Japan around 1996-97. Not surprisingly the outcome is the same – extremely weak nominal GDP growth and deflationary tendencies. In fact the outcome is much worse. Unemployment in the euro zone just keep on rising – contrary to the situation in the US, where the Fed’s monetary easing over the past year has helped improve the labour market situation.

In fact the latest unemployment numbers for the euro zone published yesterday (Thursday) shows that unemployment in the euro zone has reached a record-high level of 12.2% in September and even worse youth unemployment is now 24.1%. It is hard not to conclude that the ECB is directly responsible for the millions of European being without a job. Yes, there are serious structural problems in Europe, but the sharp increase in unemployment levels in the euro zone since particularly since the ECB’s misguided rate hikes in 2011 is nearly totally the fault of the ECB’s extremely tight monetary policy stance.

We are heading for deflation

But lets get back to why deflation looks more and more likely in the euro. This is what I had to say about the matter back in March:

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y

<=>

(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, it is really that simple and the policy makers in the ECB should of course have realized this long ago.

End the euro crisis now with a 10% M3 target

There is only one way to avoid deflation in the euro zone and that is an aggressive monetary policy response in the form of a significant and permanent expansion of the euro zone money base within a clearly defined rule-based framework.

I would obviously prefer that the ECB implemented an clear NGDP level targeting rule, but less might do it – and a lot of other policy options would be preferable to the present mess.

The “easy” solution would be for the ECB to re-instate its former two-pillar monetary policy – a money supply (M3) growth target and an inflation target. Therefore, I suggest that the ECB imitiately issues the following statement (I have suggested it before):

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

That would end the euro crisis, while also ensuring inflation around 2% in the medium-term. There would be no bailing out or odd credit policies. Only a clear and rule based policy to ensure nominal stability. How hard can it be?

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9 Comments

  1. Such bond-buying would constitute monetary financing of budget deficits which is VERBOTEN. This POLICY could only be adopted after the anti-austerity bloc has taken over the ECB governing council. It hangs on political leadership from France, Italy and Spain. Hence, it will require a much deeper depression and three new regimes.

    Reply
  2. James in London

     /  November 1, 2013

    Spain HICP at minus 0.1% in October. Lucky that flash 3Q RGDP showed a growth of 0.1%. Those Austerians would be happy I suppose, rising RGDP and falling prices, a paradise on earth no less. Just ask the unemployed, underemployed and emigrants fleeing the Spanish garden of Eden,

    Reply
  3. Gordon

     /  November 1, 2013

    Lars, in an earlier post on your blog, you state that the Great Recession may have started in Europe due to mismanagement by the ECB in growth of the euro supply. This led to greater demand in Europe for U.S. dollars and this led to a sharp drop in the dollar’s velocity. Do you see the news today as putting further pressure on the dollar’s velocity?

    Reply
  4. Benjamin Cole

     /  November 4, 2013

    The premise that central banks should be independent grows weaker every day.

    Reply
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