Failed monetary policy – (another) one graph version

It is no secret that I would prefer that the ECB would introduce an NGDP level target. However, that is obviously utopian – I might be a dreamer, but I am not naïve. Furthermore, I think less could do it. In fact I believe that the ECB could end the euro crisis by just simply returning to the old second pillar of monetary policy in the euro zone – the M3 reference rate – and sticking to that rather than the highly damaging focus on headline inflation (HICP inflation).

The equation of exchange – MV=PY – was the starting point of the ECB’s monetary pillar. Lets rewrite the equation of exchange in growth rates:

(1) m + v = p + y

m is the yearly growth rate in M3, V is the yearly growth rate in M3-velocity. p is yearly inflation (growth in the GDP deflator) and y is real GDP growth.

We can rearrange (1) to:

(1)’ m = p + y – v

The ECB used to calculate the M3 reference rate from a modification of (1)’:

(2) m-target = p-target + y* – v*

Where m-target is (was!) the ECB’s target of M3 growth (the reference rate), p-target is the ECB’s inflation target (2% – note the ECB did not pay attention to the difference between the GDP deflator and consumer prices), y* is trend-growth in real GDP and v* is the secular trend in velocity.

I have looked at the data from 2000 and onwards. M3-velocity on averaged dropped by 2.5% per year from 2000 and until 2007. I on purpose exclude the crisis-years as velocity has contracted sharply since the autumn of 2008. Normally trend real GDP growth is assumed to be 2%. That gives use the following M3-target:

(2)’ m-target = 2% + 2% – (-2.5%) = 6.5%

This is higher than the reference rate historically used by the ECB, which used to “target” 4.5% M3 growth. The difference reflect a difference in the assumption about trend-velocity growth.

I have plotted the actual level of M3 and a target path for M3 based on 6.5% M3 growth. I have assumed that monetary policy was “right” in the start of 2000. This is completely arbitrary, but nonetheless the result of this little exercise is striking. See the graph below:

We see clearly that M3 grew nicely along a 6.5% growth path from 2000 and until 2006. In this period inflation also behalf nicely and fluctuated around 2% and nominal GDP also grew at stable pace. However, from early 2006 actual M3 growth clearly was outpacing the 6.5% growth path. In fact the gap between the actual level of M3 and the 6.5% growth path reached nearly 10% in 2008 indicating an extremely easy monetary stance.

The increased gap between actual and “targeted” M3 (as defined here) from 2006 to 2008 not surprisingly increased imbalances in the European economy – acceleration in asset price growth, sharply larger current account deficits in countries like Spain and Ireland and increasing wage and inflation pressures. In the same period nominal GDP also increased well above the pre-2006 trend in some euro zone crisis This surely was the boom years. Had the ECB taken its M3 reference rate (at 4.5%!) serious then it would have tighten monetary policy much more aggressively in 2006-7 – instead the ECB spend a lot of time making up excuses in that period why the high growth in M3 should be disregarded.

However, when crisis hit in 2008 M3 growth started to slow sharply and the gap between actual M3 and the 6.5% growth path narrowed fast and was fully closed in Q2 of 2010. The timing of the closing of the “money gap” (the difference between actual M3 and the target M3) is extremely interesting. Even though Europe was hard hit by 2008-9 there was not much talk of an “euro crisis”. In 2008 the focus was on the “subprime crisis” and in early 2009 the focus changed to the crisis in Central and Eastern Europe  – however, nobody was talking about euro crisis before 2010 and since then the focus has nearly solely been on the euro crisis. Just take a look at Google searches for “subprime crisis” and “euro crisis”.  One can argue – and Austrians would undoubtedly do so and I have some sympathy for that – that the slowdown in M3 growth and the closing of the money gap during 2009 was a necessary correction to a monetary induced boom. This (as do my graph above) of course completely disregard the collapse in M3-velocity. However, even ignoring the collapse in velocity it is clear that at least from early 2010 European monetary condition – measured by the money gap – became excessively tight. In fact monetary policy became deflationary and it can hardly be a surprise that the ECB now for years have undershot a 2% growth path for prices measured by the GDP deflator (as I have documented in an earlier post).

The simple calculation should convince any old-school monetarist (and I hope most others) that monetary conditions are excessive tight in the euro zone and has been so at least for 2 years. One can especially wonder why the Bundesbank so stubbornly resist further monetary easing when M3 so clearly shows the deflationary pressures in the euro zone. After all it was the Bundesbank that originally got the ECB to target M3.

Target 10% M3 growth until the end of 2014

As I said above I have no illusions that the ECB will start targeting the NGDP level or even the price level. However, I could hope that at least the ECB would start taking its monetary pillar serious and once again introduce a proper target for M3. Furthermore, the ECB should acknowledge that M3 growth has strongly undershot what would have been a proper target of M3 in recent years and that monetary policy therefore needs to be eased to make up for this policy mistake.

As the money gap is negative at the moment the “new” M3 target needs to be higher than 6.5% growth. In fact I believe that the ECB should announce that it will target 10% M3 growth until the end of 2014 or until the money gap has been closed. If indeed the ECB where to ensure 10% y/y growth in M3 from now and until the end of 2014 then that would be sufficient to close the money gap (See the green line in the graph above). And my guess is that most likely that would end the euro crisis. How hard can it be? (and yes, the ECB can easily increase M3 growth and it could start by announcing the new M3 target).


Related posts:

Jens Weidmann, do you remember the second pillar?
Failed monetary policy – the one graph version

PS back in 2006-7 I was not screaming for monetary easing in Europe. In fact in my day-job I was screaming about the need for monetary tightening and the risk of boom-bust in countries like Iceland and the Baltic States and South East Europe.

Leave a comment


  1. Lars, it´s amazing how well the “trend analysis strategy” works.
    In 2006-08, while Spain and Ireland were importing like hell (generating large CA deficits), Germany was exporting like hell, with NGDP in Germany rising high.

    • Marcus, I fully agree. It is simple. So it is incredible the ECB is not able to master it…

      However, my graph also illustrates (or at least indicates) that the European monetary policy was excessively easy in 2006-2008. That gives some support to the boom-bust hypothesis. Obviously my analysis also clearly shows that any “bubble” element is long gone…

      • That´s right. The Boom in Germany was reflected in an above trend NGDP. In Spain the boom was visible in the CA deficit.

  2. flow5

     /  July 25, 2012

    Shity, shity, shity. Vi & M3 are fucking bogus. VI is a contrived figure. Vi (at times) moves in the opposite direction of Vt (transactions velocity). And M3 is mud pie (like Keynes formulated, confuses money & liquid assets).

    From the standpoint of monetary authorities, charged with the responsibility of regulating the money supply, none of the current definitions of money make sense. The definitions include numerous items over which the Fed has little or no control (e.g., M2), including many the Fed need not and should not control (currency). The definitions also assume there are numerous degrees of “moneyness”, thus confusing liquidity with money (money is the “yardstick” by which the liquidity of all other assets is measured). The definitions also ignore the fact that some liquid assets (time deposits) have a direct one-to-one relationship to the volume of demand deposits (DDs), while others affect only the velocity of DDs. The former requires direct regulation; the latter simply is important data for the Fed to use in regulating the money supply.

    Money should be defined exclusively in terms of its means-of-payment attributes. The present array of interest-bearing checking accounts has confused the distinction between means-of-payment accounts (the primary money supply) and saving-investment accounts and created a dilemma as to what portion, if any, of these interest-bearing accounts should be considered as savings. This dilemma is resolved when the transactions velocity of demand deposits is taken into account; i.e., deposit classifications are analyzed in terms of monetary flows (MVt). Obviously, no money supply figure standing alone is adequate as a “guide post” to monetary policy.

    The real impact of monetary demand on the prices of goods and serves requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt. Milton Friedman’s Income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M). The product of MVI is obviously nominal GDP. So where does that leave us? In an economic sea without a rudder or an anchor. A rise in nominal GDP can be the result of (1) an increased rate of monetary flows (MVt) (which by definition the Keynesians have excluded from their analysis), (2) an increase in real GDP, (3) an increasing number of housewives selling their labor in the marketplace, etc. The income velocity approach obviously provides no tool by which we can dissect and explain the inflation process.

    But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M.

    Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal “engine” of inflation – which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds. Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. The (MVt) figure encompasses the total effect of all these monetary flows (MVt).

  3. I beg to point out one thing… in the equation MV=PY, V & Y are fixed in the short term. That is why when M goes up, asset prices (or commodity prices or both) go up not production or velocity. If you incorporated those assumptions, you’ll find that the conclusion you draw is likely to be very different.

  1. Between the money supply and velocity – the euro zone vs the US « The Market Monetarist
  2. Friedman’s Japanese lessons for the ECB « The Market Monetarist
  3. Help me locate the ECB’s “monetary pillar” « The Market Monetarist
  4. The euro zone is heading for deflation | The Market Monetarist
  5. A simple monetary policy rule to end the euro crisis | The Market Monetarist
  6. The massively negative euro zone ‘money gap’ (another one graph version) | The Market Monetarist
  7. Orphanides also wonders what happened to the ECB’s monetary pillar | The Market Monetarist
  8. ‘Draghi’s framework’ – a step in the right direction | The Market Monetarist

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