A simple monetary policy rule to end the euro crisis

It is extremely depressing. After about half year of calm in Europe – mostly due to the efforts of the Federal Reserve and the Bank of Japan – European policy makers have once again messed up and the euro crisis is back on top of the headlines in the financial markets. It is time for the ECB to finally take bold actions and end this crisis once and for all. And no I don’t suggest anymore bailouts or odd credit policies and new weird policy instruments. I have a much simpler suggestion and I am pretty sure it would end the crisis very fast.

My suggestion is that the ECB immediately issues the following statement:

“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.”

The ECB used to have a M3 reference rate. It is time to reintroduce it. In fact it is needed more than ever. So Mario Draghi what are you waiting for? And no you don’t have to ask the Bundesbank for permission.

PS See here to see why the M3 growth target should be 10%.

Leave a comment


  1. Lars for ECB president!

    • Thanks Marcus…but I am afraid that European policy makers have fall in love with the crisis so no management changes are likely…despite of the numerous failures.

  2. Good idea, but how about a better way to add money to the economy. Let the ECB pay a portion of the VAT until the output gap is closed. This is a more direct way to insert money into the economy. It doesn’t rely on bankers taking the money from bonds and doing something constructive with it. It spreads the money evenly throughout the economy in a non-distortionary way since it relies on actual sales.

    • Russ that is certainly a possibility. To me it is important that we do not institutionalize monetary finance of public finances and it is not really important how money creation is done – just as long as nominal spending expectations are increased to once again ensure nominal stability in Europe.

  3. Chun

     /  March 29, 2013

    Do you think bank runs will not occur without bail-outs to failed banks? I have thought this one for a while. As long as a central bank is willing to keep increasing high-powered money through continously purchasing assets from good banks, then people who have deposits in those good banks will not be eager to withdraw money because they can believe those banks have ability to pay for their deposits. Therefore, the central bank will not have to bail out the failed banks and can let them just die. They may bail-out small depositors with deposit insurance, though.

    • Chun,

      I generally believe that bank runs can be avoided by ensuring that the central bank stand ready to act as lender of last resort to solvent banks. Furthermore, the likelihood of banking crisis is greatly reduced if nominal spending is kept ‘on track’.

      The present policies of the ECB unfortunately do not ensure nominal stability. In fact euro zone monetary policy is presently deflationary and that is a key – if not the main – cause of both banking and public finance concerns in Europe.

      A policy to ensure nominal stability in the euro zone will obviously not solve Europe’s great structural problems, but at least a collapse of the currency union can be avoided.

      And yes, you are completely right – no bailouts of banks or governments are needed when the central bank ensures nominal stability.

      • There are in my mind two problem with the ‘Lender of Last Resort’ ideas. First, if the bank is solvent and montary policy is not in deflationary disequillibrium the private banking sector would probebly do a pretty good job at this. The second is more of a political economy problem, I fear that in 95% of the the cases the CB would probebly prope up a bad bank.

        It seams to me that only in times of tight money might saving banks be a good idea, but then again if the central bank is to stupid to provide a smart montary policy why should they do much better at saving banks?

        Walter Bagehot had this right a 100 years ago.

  4. frank

     /  March 29, 2013

    Why stop at 10%? If you can magically create growth simply by printing money, why not go all out?

  5. nickik,

    I certainly share your fear that the LOLR function of central banks including the ECB will be politicized. In fact that has already happened to a very large extent. That is extremely unfortunate.

    In my view liquidity should under no circumstance be made available to insolvent banks.

    I would prefer a system, where liquidity is provide to the market rather than directly to individual banks in the way the ECB’s LTRO system works. The principle should the ECB will provide euro liquidity against collateral (including a haircut) at a market rate plus premium. I my views on this is very much inspired by George Selgin. See here: https://marketmonetarist.com/2012/02/05/l-street-selgins-prescription-for-money-market-reform/

  6. Go to the economist house prices and you will see that whole Europe except Germany and possibly Switzerland sits on a housing bubble until 2011, often financed by excessive debt. In some countries absolutely the same situation as the U.S. in 2008.

    The European leaders are doing the absolutely right things.
    1) Reduce current account deficits and risk and the same time the transfer union –> successful
    2) Reduce moral hazard against hedge funds or banks –> successful
    3) Give strong signals that banks need to be recapitalized –> successful
    4) Do the moral hazard reduction in a moment of broad optimism –> successful with some limited side effects that were clear

    At the same time the Fed and BoJ go for deficit spending and higher current account deficits and reduced global risk. US and Japan do not live in a transfer union.
    The mixture of global central bank actions was nearly perfect, just some losses in employment, but by far not as much as in the U.S. in 2008/2009.

    Now slowly the bubble needs to deflate. M3 will come back, but it will need time to achieve competitiveness in France and Southern Europe.
    Long-term stability is more important than short-term growth.

    • George,

      I am sorry, but this is kind of views that have doomed Japan to 15 years of deflation and caused the Great Depression to drag out for a decade.

      The EU and the ECB have failed completely. There has been now rule based monetary policy and the banking resolution set-up has been terrible. There are massive moral hazard problems combined with massive deflationary pressures. If M3 growth do not soon accelerate then we will soon have deflation in the euro zone.

      The Bundesbank influence on monetary policy in Europe is terrible. Unfortunately it seems like Jens Weidmann and his advisors never read Milton Friedman or any monetary history.

      Germany today is France of 1932. So far things are fine, but the insane commitment to deflationary monetary policy will sooner or later spell massive problems for the German economy as was the case in France in 1935/36

  7. The real estate bubble in Japan is a special case. It was far bigger than ones in the U.S. or in Europe now. (I will provide you a graph by Steve Keen).

    I wonder that somebody from Denmark says this. Denmark or the Netherlands have managed to deflate substantially from their bubbles.
    France, Spain and possibly Italy have not yet, so let them do this.

    What the ECB wealth reports showed was that wealth but also house prices and in particular income to home price are still inequal over Europe.
    Why should a house in the middle of nowhere in France be worth far more than in Eastern Germany?

    After the elimination of tail risks and the strong rise of salaries by 3% and more, Germans will soon start to consume, continue build houses. German house prices will rise, M3 will rise (but maybe just in Germany). They will attract workers from other parts of Europe, many Spaniards will learn German and move there.
    A real European union.

    Still demographically it is possible that many countries will follow Japan.

    • troopa

       /  March 30, 2013

      Mundell was optimistic like that as well…Friedman knew better (obviously)

  8. Peter

     /  March 29, 2013

    The root cause of the problem is in the fundamental flaws in a number of different EU countries, which is oversized collective sectors, weak and/or corrupt governments, weak and polarised politics, uncompetitive economies, and real estate bubbles. This is basically no different in the US or UK, so to pretend this problem has anything to do with the euro as such is not seeing the real problem. None of these will be solved by any monetary policy, and certainly printing money while the problem has been veiled by money being to cheap in the past, is really the last thing that should be done. There is simply no easy way out. We can choose either a hard landing by rigoously cleaning out all shitty balance sheets , weed out government sectors, and take it on the chin, or postpone payback by creating money and hereby likely making things worse and possibly unmanageable in the future. I wonder how on earth the US is going to deal with their problem as they now steal growth from the future by blowing up the Fed’s balance sheet to monstruous proportions. I really don’t see this as a solution. The current Cyprus crisis is basically caused by an oversized banking sector that was unsustainable by any means. The option of leaving the euro like Krugman suggests will not solve their problem, as they will have no acces to capital markets and what’s left of their assets will be wiped out. A decrease of 25% in their GNP is inevitable in any case as it was a Ponzi-scheme to begin with. Cyprus will simply return to their original state of a small Island in the Mediterranean with very few inhabitants, living off local agriculture and tourism. Nothing wrong with that though. Simple truth is that our welfare state economies, and that includes the US and the Uk, are not sustainable in the current globalised world, whether it be with or without a monetary union is not that relevant.

  9. Inflation has already been above 2% several times, for nontrivial periods. Your plan would involve a complete disavowal of the ECB constitution. Which is fine, really; they haven’t been following it since 2007, so the honest thing to do would be just to jettison it.

    Lars, I think there are some other plans that might work better. Is yours modeled to be operable within current political constraints, or do you see this is pretty much the best way forward?

    • Alex,

      No this is surely not a first best or even a second or third best solution, but it is a solution that I believe would reestablish some kind of nominal stability in the euro zone and at the same time would pull Europe out of the crisis. And at the same time this is completely within the constrains of the ECB’s operational framework.

      But despite I think this is not very radical it might still be extremely unrealistic given the Bundesbank’s other insane commitment to deflationary policies.

  10. Ravi

     /  March 29, 2013

    Paul Einzig, writing about the 1930s: “On the ruins of the wealth, prosperity and stability of other nations, France has succeeded in establishing her politico-financial hegemony over Europe.” If only the likes of Weidmann would understand the lessons of history. Yours is a simple and effective solution, Lars – and therefore, wholly unlikely to be adopted!

  11. Benjamin Cole

     /  March 30, 2013

    A terrific proposal, and better still due to its simplicity.

    BTW, simplicity is the result of thought. When you see Rube Goldberg solutions, that is usually a sign of bad policy.

    My guess is that unless the ECB pretty much does as Lars says, we won’t see a Euro in 10 years. Why should a Spain, Greece, Portugal etc. stay on a monetary union that is suffocating them?

    BTW, real incomes in the USA rose 30 percent in the 1960s, and in the last year of the great decade, inflation poked its head above 5 percent.

    We can stand a little moderate inflation, especially en route to rapid real growth.

    Japan is the object lesson, and the real future for Europe, unless Lars is listened to.

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  3. The depressing state of European monetary “thinking” | The Market Monetarist
  4. ‘Draghi’s framework’ – a step in the right direction | The Market Monetarist

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