Never reason from a price change – version #436552

This is ECB’s chief economist Peter Praet in an interview with Les Echos:

 “Normally, a fall in prices would be able to support purchasing power and, therefore, domestic demand. But demand has remained weak, including in the biggest euro area economies”

It seems like Praet is not entirely sure about the difference between supply and demand shocks, but let me just illustrate the dffference in two graphs (I don’t have much time so I did it by hand and with the help of an iPhone…)

ASAD

The European situation is the graph on the right.

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The un-anchoring of inflation expectations – 1970s style monetary policy, but now with deflation

In country after country it is now becoming clear that we are heading for outright deflation. This is particularly the case in Europe – both inside and outside the euro area – where most central banks are failing to keep inflation close to their own announced inflation targets.

What we are basically seeing is an un-anchoring of inflation expectations. What is happening in my view is that central bankers are failing to take responsibility for inflation and in a broader sense for the development in nominal spending. Central bankers simply are refusing to provide an nominal anchor for the economy.

To understand this process and to understand what has gone wrong I think it is useful to compare the situation in two distinctly different periods - the Great Inflation (1970s and earlier 1980s) and the Great Moderation (from the mid-1980s to 2007/8).

The Great Inflation – “Blame somebody else for inflation”

Monetary developments were quite similar across countries in the Western world during the 1970s. What probably best describes monetary policy in this period is that central banks in general did not take responsibility for the development in inflation and in nominal spending – maybe with the exception of the Bundesbank and the Swiss National Bank.

In Milton Friedman’s wonderful TV series Free to Choose from 1980 he discusses how central bankers were blaming everybody else than themselves for inflation (see here)

As Friedman points out labour unions, oil prices (the OPEC) and taxes were said to have caused inflation to have risen. That led central bankers like then Fed chairman Arthur Burns to argue that to reduce inflation it was necessary to introduce price and wage controls.

Friedman of course rightly argued that the only way to curb inflation was to reduce central bank money creation, but in the 1970s most central bankers had lost faith in the fundamental truth of the quantity theory of money.

Said in another way central bankers in the 1970s simply refused to take responsibility for the development in nominal spending and therefore for inflation. As a consequence inflation expectations became un-anchored as the central banks did not provide an nominal anchor. The result was predictable (for any monetarist) – the price level driffed aimlessly, inflation increased, became highly volatile and unpredictable.

Another thing which was characteristic about monetary policy in 1970s was the focus on trade-offs – particularly the Phillips curve relationship that there was a trade-off between inflation and unemployment (even in the long run). Hence, central bankers used high unemployment – caused by supply side factors – as an excuse not to curb money creation and hence inflation. We will see below that central bankers today find similar excuses useful when they refuse to take responsibility for ensuring nominal stability.

The Great Moderation – “Inflation is always and everywhere monetary phenomenon” 

That all started to change as Milton Friedman’s monetarist counterrevolution started to gain influence during the 1970s and in 1979 the newly appointed Federal Reserve chairman Paul Volcker started what would become a global trend towards central banks again taking responsibility for providing nominal stability and in the early 1990s central banks around the world moved to implement clearly defined nominal policy rules – mostly in the form of inflation targets (mostly around 2%) starting with the Reserve Bank of  New Zealand in 1990.

Said in the other way from the mid-1980s or so central banks started to believe in Milton Friedman’s dictum that “Inflation is always and everywhere monetary phenomenon” and more importantly they started to act as if they believed in this dictum. The result was predictable – inflation came down dramatically and became a lot more predictable and nominal spending/NGDP growth became stable.

By taking responsibility for nominal stability central banks around the world had created an nominal anchor, which ensured that the price mechanism in general could ensure an efficient allocation of resources. This was the great success of the Great Moderation period.

The only problem was that few central bankers understood why and how this was working. Robert Hetzel obvious was and still is a notable exception and he is telling us that reason we got nominal stability is exactly because central banks took responsibility for providing a nominal anchor.

That unfortunately ended suddenly in 2008.

The Great Recession – back to the bad habits of the 1970s

If we compare the conduct of monetary policy around the world over the past 5-6 years with the Great Inflation and Great Moderation periods I think it is very clear that we to a large extent has returned to the bad habits of the 1970s. That particularly is the case in Europe, while there are signs that monetary policy in the US, the UK and Japan is gradually moving back to practices similar to the Great Moderation period.

So what are the similarities with the 1970s?

1) Central banks refuse to acknowledge inflation (and NGDP growth) is a monetary phenomenon.

2) Central banks are concerned about trade-offs and have multiple targets (often none-monetary) rather focusing on one nominal target. 

Regarding 1) We have again and again heard central bankers say that they are “out of ammunition” and that they cannot ease monetary policy because interest rates are at zero – hence they are indirectly saying that they cannot control nominal spending growth, the money supply and the price level. Again and again we have heard ECB officials say that the monetary transmission mechanism is “broken”.

Regarding 2) Since 2008 central banks around the world have de facto given up on their inflation targets. In Europe for now nearly two years inflation has undershot the inflation targets of the ECB, the Riksbank, the Polish central bank, the Czech central bank and the Swiss National Bank etc.

And to make matters worse these central banks quite openly acknowledge that they don’t care much about the fact that they are not fulfilling their own stated inflation targets. Why? Because they are concerning themselves with other new (ad hoc!) targets – such as the development in asset prices or household debt.

The Swedish Riksbank is an example of this. Under the leadership of Riksbank governor the Stefan Ingves the Riksbank has de facto given up its inflation targeting regime and is now targeting everything from inflation, credit growth, property prices and household debt. This is completely ad hoc as the Riksbank has not even bothered to tell anybody what weight to put on these different targets.

It is therefore no surprise that the markets no longer see the Riksbank’s official 2% inflation target as credible. Hence, market expectations for Swedish inflation is consistency running below 2%. In 1970s the Riksbank failed because it effectively was preoccupied with hitting an unemployment target. Today the Riksbank is failing – for the same reason: It is trying to hit another other non-monetary target – the level of household debt.

European central bankers in the same way as in the 1970s no longer seem to understand or acknowledge that they have full control of nominal spending growth and therefore inflation and as a consequence they de facto have given up providing a nominal anchor for the economy. The result is that we are seeing a gradual un-anchoring of inflation expectations in Europe and this I believe is the reason that we are likely to see deflation becoming the “normal” state of affairs in Europe unless fundamental policy change is implemented.

Every time we get a new minor or larger negative shock to the European economy – banking crisis in Portugal or fiscal and political mess in France – we will just sink even deeper into deflation and since there is nominal anchor nothing will ensure that we get out of the deflationary trap. This is of course the “Japanese scenario” where the Bank of Japan for nearly two decade refused to take responsibility for providing an nominal anchor.

And as we continue to see a gradual unchoring of inflation expectations it is also clear that the economic system is becomimg increasingly dysfunctional and the price system will work less and less efficiently – exactly as in the 1970s. The only difference is really that while the problem in 1970s was excessively high inflation the problem today is deflation. But the reason is the same – central banks refusal to take responsibility for providing a nominal anchor.

Shock therapy is needed to re-anchor inflation expectations

The Great Inflation came to an end when central banks around the world finally took responsibility for providing a nominal anchor for the economy through a rule based monetary policy based on the fact that the central bank is in full control of nominal spending growth in the economy. To do that ‘shock therapy’ was needed.

For example example the Federal Reserve starting in 1979-82 fundamentally changed its policy and communication about its policy. It took responsibility for providing nominal stability. That re-anchored inflation expectations in the US and started a period of a very high level of nominal stability – stable and predictable growth in nominal spending and inflation.

To get back to a Great Moderation style regime central banks need to be completely clear that they take responsibility for for ensuring nominal stability and that they acknowledge that they have full control of nominal spending growth and as a consequence also the development in inflation. That can be done by introducing a clear nominal targeting – either restating inflation targets or even better introducing a NGDP targeting.

Furthermore, central banks should make it clear that there is no limits on the central bank’s ability to create money and controlling the money base. Finally central banks should permanently make it clear that you can’t have your cake and eat it – central banks can only have one target. It is the Tinbergen rule. There is one instrument – the money base – should the central bank can only hit one target. Doing anything else will end in disaster. 

The Federal Reserve and the Bank of Japan have certainly moved in that direction of providing a nominal anchor in the last couple of years, while most central banks in Europe – including most importantly the ECB – needs a fundamental change of direction in policy to achieve a re-anchoring of inflation expectations and thereby avoiding falling even deeper into the deflationary trap.

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PS This post has been greatly inspired by re-reading a number of papers by Robert Hetzel on the Quantity Theory of Money and how to understand the importance of central bank credibility. In that sense this post is part of my series of “Tribute posts” to Robert Hetzel in connection with his 70 years birthday.

PPS Above I assume that central banks have responsibility for providing a nominal anchor for the economy. After all if a central bank has a monopoly on money creation then the least it can do is to live up to this responsibility. Otherwise it seems pretty hard to argue why there should be any central bank at all.

Money and credit confused…again, again and again

The debate over the latest policy actions from the ECB has once again reminded me about one of the oldest failures in monetary debate – the confusion 0f  money and credit. This has been very visible in the discussion about monetary policy over the past six years both in Europe and the US.

The confusion of money and credit again and again has caused central banks to make the wrong decisions implementing credit policies and mistaking it for monetary easing.

I should really write a blog post on this, but it has already been done. Our friend and Market Monetarist blogger Bill Woolsey did it back in 2009. Bill used to be a student of Leland Yeager who back in 1986 wrote the ultimate paper on this issue with Robert Greenfield - Money and Credit confused: An Appraisal of Economic Doctrine and Federal Reserve Procedure.

I stole this from Bill’s 2009 post Money and Credit Confused. Bill explains the crucial differences between money and credit very well:

Money is the medium of exchange. The quantity of money is the amount of money that exists at a point in time.

The demand for money is the amount of money that people want to hold at a point in time. To hold money is to not spend it.

The supply of credit is the amount of funds people want to lend during a period of time.

The demand for credit is the amount of funds that people want to borrow during a period of time.

An increase in the demand for money is not the same thing as an increase in the demand for credit.

An increase in the demand for credit means that households and firms want to borrow more. While it is possible that they want to borrow money in order to hold it, the more likely scenario is that they borrow in order to increase spending on some good or service, including, perhaps some other financial asset.

An increase in the demand for money could result in an increase in the demand for credit. People might borrow money in order to hold it. However, the more likely scenario is that people demanding more money will reduce expenditure out of current income, purchasing fewer other assets, goods, or services. Of course, they could also sell other assets.

An increase in the supply of credit isn’t the same thing as an increase in the quantity of money. While it is possible that new money is lent into existence, raising the quantity of money over a period of time while augmenting the supply of credit, it is also possible for the supply of credit to rise without an increase in the quantity of money. Purchases of new corporate bonds by households or firms, for example, adds to the supply of credit without adding to the quantity of money.

Because shifts in the share of the total supply of credit associated with money creation are possible, the quantity of money can rise over a period of time when the supply of credit is shrinking.

There are relationships between the supply and demand for money and the supply and demand for credit, both in disequilibrium and equilibrium. But money and credit are not the same thing.

As Bill notes – the first rule of monetary policy is not to confuse money and credit. Unfortunately central bankers do it all the time.

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Update: A friend of mine thinks the ultimate discussion is not Yeager, but this one: Currie, Lauchlin. “Treatment of Credit in Contemporary Monetary Theory.” Journal of Political Economy 41 (February 1933), 58-79.

The ECB should give Bob Hetzel a call

The ECB is very eager to stress that the monetary transmission mechanism in some way is broken and that the policy measures needed is not quantitative easing, but measures to repair the monetary transmission mechanism.

In regard to ECB’s position I find this quote from a excellent paper – What Is a Central Bank? – by Bob Hetzel very interesting:

For example, in Japan, the argument is common that the bad debts of banks have broken the monetary transmission mechanism. The central bank can acquire assets to increase the reserves of commercial banks, but the weak capital position of banks limits their willingness to engage in additional lending. As in the real bills world, the marketplace controls the ability of the central bank to create independent changes in money that change prices.

According to the quantity theory as opposed to the real bills view, a central bank exercises its control over the public’s nominal expenditure through money (monetary base) creation. That control does not derive from the central bank’s influence over financial intermediation. A commercial bank acquires assets by making its liabilities attractive to individuals who forego consumption to hold them. In contrast, a central bank acquires assets through the ability to impose a tax (seigniorage) that comes from money creation. It imposes the tax directly on holders of cash and indirectly on holders of bank deposits to the extent that banks hold reserves against deposits.

Bob wrote the paper while he was a visiting scholar at the Bank of Japan in 2003.

It is striking how the present position of the ECB is similar to the BoJ’s position at the time Bob spend time there. Maybe the ECB should invite Bob to pay a visit?

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See also Bob’s paper Japanese Monetary Policy and Deflation.

“God forbid that our policy should ever work”

This is Mario Draghi at the ECB’s press conference yesterday:

“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring.”

You got to ask yourself why you would ease monetary policy if you don’t want inflation expectations to increase. And ask yourself if the market will believe this will work if the ECB is so eager to say that the policy will not increase inflation expectations.

It all just feel so Japanese – pre-Kuroda…

HT Nicolas Goetzmann

 

The massively negative euro zone ‘money gap’ (another one graph version)

Earlier today I put out post with ‘one graph’ illustrating just how much behind the curve the ECB is in terms of needed monetary easing. At the core of that blog post was a graph of the ‘price gap’. I defined the price gap as the percentage difference between the actual price level (measured with the GDP deflator) and a 2% path.

David Laidler has asked me how the ‘two graph’ version of the post would have looked. The other graph of course being the (broad) money supply rather than price level.

David, take a look at this graph:

money gap euro zone

We know from my earlier post that the ECB prior to 2008 basically was able to keep the actual price level very close to the ‘targeted’ price level (the 2% path). Therefore, we will also have to conclude that the actual money supply (M3) level was more or less right. Hence, if we assume an unchanged trend in money-velocity then it reasonable to also assume that the pre-crisis trend is the trend in the money supply necessary to return the price level to the pre-2008 trend.

I define the ‘money gap’ the percentage difference between the actual M3 level and the pre-2008 trend-level. The graph is extremely scary – the ‘money gap’ is now -30%! Said in another way – the ECB needs to expand M3 by 30% to bring prices back to the pre-crisis trend level or the ECB needs to engineer a massive change in expectations to push up money-velocity.

Don’t tell me that the ECB doesn’t need to do massive QE to avoid deflation…

PS I have chosen to ignore commenting on ECB’s policy decision earlier today, but lets just say that today’s action is unlikely to do much about the deflationary risks in the euro zone. Outright QE is needed.

PPS I have earlier discussed the euro zone ‘money gap’. See for example here.

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The ECB is way behind the curve (the one graph version)

The ECB is today widely expected to introduce a number of measures to ease monetary conditions in the euro zone and it seems like the ECB is finally beginning to recognize the serious deflationary risks facing the euro zone.

But how far behind the curve is the ECB? There are a lot of measures of that, but if we look at the ECB’s own stated goal of 2% inflation then we will see that the ECB has basically failed consistently since 2008.

Below I look at the the level of the GDP deflator (which I believe is a better indicator of inflation than the ECB’s prefered measure – the HCIP inflation).

Price gap ECB

I think the graph very well illustrates just how big the ECB’s policy failure has been since 2008. From 1999 to 2008 the ECB basically kept the actual price level on a straight 2% path in line with its stated policy goal. However, since 2008 GDP deflator-inflation has consistently been well-below the 2%. As a result what I here call the price gap - the percentage difference between the actual price level and the 2% path – has kept on widening so the gap today is around 4%.

This is a massive policy mistake – and this is why the euro zone remains in crisis – and given the fact that we are basically not seeing any broad money supply growth at the moment the price gap is very likely to continue to widen. In fact outright deflation seems very likely if the ECB once again fails to take decisive action.

What should be done? It is really easy, but the ECB is likely to make it complicated 

At the ECB in Frankfurt they are happy to repeat Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon. So it should be really simple – if you have less than 2% inflation and want to ensure 2% inflation then you need to create more money. Unfortunately the ECB seems to think that it is in someway ‘dirty’ to create money and therefore we are unlikely to see any measures today to actually create money.

Most analysts expect a cut in ECB’s deposit rate to negative territory and maybe a new LTRO and even some kind of lending scheme to European SMEs. But all of that is basically credit policies and not monetary policy. Credit policy has the purpose of distorting market prices – and that shouldn’t really be the business of central banks – while monetary policy is about hitting nominal variables such as the price level or nominal spending by controlling the money base (money creation).

The ECB needs to stop worrying about credit markets and instead focus on ensuring nominal stability. So to me it is very simple. Today Mario Draghi simply should announce that the ECB has failed since 2008, but that that will now change.

He should pre-commit to bringing back the price level to the ‘old’ trend within the next two years and do that he should keep expanding the euro zone money base (by buying a basket of GDP weight euro zone government bonds) until he achieves that goal and he should make is completely clear that there will be no limits to the expansion of the money base. The sole purpose of his actions will be to ensure that the price level is brought back on track as fast as possible.

Once the price level is brought back to the old trend it should be kept on this 2% trend path.

How hard can it be?

PS Yes, I fundamentally would like the ECB to target the nominal GDP level, but targeting the GDP deflator price level would be pretty close to my preferred policy.

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The Casselian-Mundelian view: An overvalued dollar caused the Great Recession

This is CNBC’s legendary Larry Kudlow in a comment to my previous post:

My friend Bob Mundell believes a massively over-valued dollar (ie, overly tight monetary policy) was proximate cause of financial freeze/meltdown.

Larry’s comment reminded me of my long held view that we have to see the Great Recession in an international perspective. Hence, even though I generally agree on the Hetzel-Sumner view of the cause – monetary tightening – of the Great Recession I think Bob Hetzel and Scott Sumner’s take on the causes of the Great Recession is too US centric. Said in another way I always wanted to stress the importance of the international monetary transmission mechanism. In that sense I am probably rather Mundellian – or what used to be called the monetary theory of the balance of payments or international monetarism.

Overall, it is my view that we should think of the global economy as operating on a dollar standard in the same way as we in the 1920s going into the Great Depression had a gold standard. Therefore, in the same way as Gustav Cassel and Ralph Hawtrey saw the Great Depression as result of gold hoarding we should think of the causes of the Great Recession as being a result of dollar hoarding.

In that sense I agree with Bob Mundell – the meltdown was caused by the sharp appreciation of the dollar in 2008 and the crisis only started to ease once the Federal Reserve started to provide dollar liquidity to the global markets going into 2009.

I have earlier written about how I believe international monetary disorder and policy mistakes turned the crisis into a global crisis. This is what I wrote on the topic back in May 2012:

In 2008 when the crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused by both a contraction in velocity and in the money supply, reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to meet the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss francs – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss francs will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over…

…I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also led to a monetary contraction in especially Europe. Not because of an increased demand for euros, lats or rubles, but because central banks tightened monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as members of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

So there you go – you have to see the crisis in an international monetary perspective and the Fed could have avoided the crisis if it had acted to ensure that the dollar did not become significantly “overvalued” in 2008. So yes, I am as much a Mundellian (hence a Casselian) as a Sumnerian-Hetzelian when it comes to explaining the Great Recession. A lot of my blog posts on monetary policy in small-open economies and currency competition (and why it is good) reflect these views as does my advocacy for what I have termed an Export Price Norm in commodity exporting countries. Irving Fisher’s idea of a Compensated Dollar Plan has also inspired me in this direction.

That said, the dollar should be seen as an indicator or monetary policy tightness in both the US and globally. The dollar could be a policy instrument (or rather an intermediate target), but it is not presently a policy instrument and in my view it would be catastrophic for the Fed to peg the dollar (for example to the gold price).

Unlike Bob Mundell I am very skeptical about fixed exchange rate regimes (in all its forms – including currency unions and the gold standard). However, I do think it can be useful for particularly small-open economies to use the exchange rate as a policy instrument rather than interest rates. Here I think the policies of particularly the Czech, the Swiss and the Singaporean central banks should serve as inspiration.

One step closer to euro zone deflation

This is from CNBC:

Euro zone consumer inflation came in lower than expected in December, adding to concerns that the euro zone could be heading towards a period of deflation.

Consumer prices rose by 0.8 percent year-on-year in December, below the 0.9 percent expected by economists. It comes after inflation increased by 0.9 percent in November.

Day by day it is becoming more and more clear that the euro zone is heading for deflation and despite of this the ECB so far has failed to act and it is blatantly obvious that the ECB is in breach of its own mandate to secure “price stability” defined as 2% inflation.

The failure to act is also a clear demonstration that the ECB in fact has an asymmetrical monetary policy rule (what I have called the Weidmann rule). The ECB will tighten monetary policy when inflation increases, but will not ease when inflation drops.

Depressing…

The “Weidmann rule” and the asymmetrical budget multiplier (is the euro zone 50% keynesian?)

During Christmas and New Years I have been able to (nearly) not think about monetary policy and economics, but I nonetheless came across some comments from Bundesbank chief Jens Weidmann from last week, which made me think about the connection between monetary policy rules and fiscal austerity in the euro zone. I will try address these issues in this post.  

This is Jens Weidmann:

“The euro zone is recovering only gradually from the harshest economic crisis in the post-war period and there are few price risks. This justifies the low interest rate…Low price pressure however cannot be a licence for arbitrary monetary easing and we must be sure to raise rates at the right time should inflation pressure mount.”

It is the second part of the quote, which is interesting. Here Weidmann basically spells out his preferred reaction function for the ECB and what he is saying is that he bascially wants an asymmetrical monetary policy rule – when inflation drops below the ECB’s 2% inflation target the ECB should not “arbitrary” cut its key policy rate, but when inflation pressures increase he wants the ECB to act imitiately.

It is not given that the ECB actually has such a policy rule, but given the enormous influence of the Bundesbank on ECB policy making it is probably reasonable to assume that that is the case. That in my view would mean that Summer Critique does not apply (fully) to the euro zone and as a result we can think of the euro zone as being at least 50% “keynesian” in the sense that fiscal shocks will not be fully offset by monetary policy. As a result it would be wrong to assume that the budget multiplier is zero in the euro zone – or rather it is not always zero. The budget multiplier is asymmetrical.

Let me try to illustrate this within a simple AS/AD framework.

First we start out with a symmetrical policy rule – an inflation targeting ECB. Our starting point is a situation where inflation is at 2% – the ECB’s official inflation target – and the ECB will move to offset any shock (positive and negative) to aggregate demand to keep inflation (expectations) at 2%. The graph below illustrates this.

ASAD AD shock

If the euro zone economy is hit by a negative demand shock in the form of for example fiscal tightening across the currency union the AD curve inititally shifts to the left (from AD to AD’). This will push inflation below the ECB’s 2% inflation target. As this happens the ECB will automatically move to offset this shock by easing monetary policy. This will shift the AD curve back (from AD’ to AD). With a credible monetary policy rule the markets would probably do most of the lifting.

The Weidmann rule – asymmetry rules

However, the Weidmann rule as formulated above is not symmetrical. In Weidmann’s world a negative shock to aggregate demand – for example fiscal tightening – will not automatically be offset by monetary policy. Hence, in the graph above the negative shock aggregate demand (from AD to AD’) will just lead to a drop in real GDP growth and in inflation to below 2%. Given the ECB’s official 2% would imply the ECB should move to offset the negative AD shock, but that is not the case under the Weidmann rule. Hence, under the Weidmann rule a tightening of fiscal policy will lead to drop in aggregate demand. This means that the fiscal multiplier is positive, but only when the fiscal shock is negative.

This means that the Sumner Critique does not hold under the Weidman rule. Fiscal consolidation will indeed have a negative impact on aggregate demand (nominal spending). In that sense the keynesians are right – fiscal consolidation in the euro zone has likely had an negative impact on euro zone growth if the ECB consistently has followed a Weidmann rule. Whether that is the case or not is ultimately an empirical question, but I must admit that I increasingly think that that is the case. The austerity drive in the euro zone has likely been deflationary. However, it is important to note that this is only so because of the conduct of monetary policy in the euro area. Had the ECB instead had an fed style Evans rule with a symmetrical policy rule then the Sumner Critique would have applied also for the euro area.

The fact that the budget multiplier is positive could be seen as an argument against fiscal austerity in the euro zone. However, interestingly enough it is not an argument for fiscal stimulus.  Hence, according to Jens Weidmann the ECB “must be sure to raise rates at the right time should inflation pressure mount”. Said in another way if the AD curve shifts to the right – increasing inflation and real GDP growth then the ECB should offset this with higher interest rates even when inflation is below the ECB’s 2% inflation target.

This means that there is full monetary offset if fiscal policy is eased. Therefore the Sumner Critique applies under fiscal easing and the budget multiplier is zero.

The Weidmann rule guarantees deflation 

Concluding, with the Weidmann rule fiscal tightening will be deflationary – inflation will drop as will real GDP growth. But fiscal stimulus will not increase aggregate demand. The result of this is that if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).

This is of course exactly what we have seen over the past five years. But don’t blame fiscal austerity – blame the Weidmann rule.

NGDP euro zone USA

PS I should really acknowledge that this is a variation over a theme stressed by Larry Summers and Brad Delong in their paper Fiscal Policy in a Depressed Economy. See my discussion of that paper here.

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