Dear Northern Europeans – Monetary easing is not a bailout

If we want to explain the Market Monetarist position on banking crisis then it would probably be that banking crisis primarily is a result of monetary policy, but also that moral hazard should be avoided and a strict ‘no bailout’ policy should be implemented. However, the fact that Market Monetarists now for example favour aggressive monetary easing in the euro zone, but at the same time are highly skeptical about bailouts of countries and banks might confuse some.

I have noticed that there generally is a problem for a lot of people to differentiate between monetary easing and bailouts. Often when one argues for monetary easing the reply is “we should stop bailing out banks and countries and if we do it we will just create an even bigger bubble”. The problem here is that Market Monetarists certainly do not favour bailouts – we favour nominal stability.

I think that at the core of the problem is that people have a very hard time figuring out what monetary policy is. Most people – including I believe most central bankers – think that credit policy is monetary policy. Just take the Federal Reserve’s attempt to distort relative prices in the financial markets in connection with QE2 or the ECB’s OMT program where the purpose is to support the price of government bonds in certain South European countries without increasing the euro zone money base. Hence, the primary purpose of these policies is not to increase nominal GDP or stabilise NGDP growth, but rather to change market prices. That is not monetary policy. That is credit policy and worse – it is in fact bailouts.

As the ECB’s OMT and Fed’s QE2 to a large extent have been focused on changing relative prices in the financial markets they can rightly be – and should be – criticized for leading to moral hazard. When the ECB artificially keeps for example Spanish government bond yields from increasing above a certain level then the ECB clearly is encouraging excessive risk taking. Spanish bond yields have been rising during the Great Recession because investors rightly have been fearing a Spanish government default. This is an entirely rational reaction by investors to a sharp deterioration of the outlook for the Spanish economy. Obviously if the ECB curb the rise in Spanish bond yields the ECB are telling investors to disregard these credit risks. This clearly is moral hazard.

The problem here is that a monetary authority – the ECB – is engaged in something that is not monetary policy, but people will not surprisingly think of what a central bank do as monetary policy, but the ECB’s attempts to distort relative prices in the financial markets have very little to do with monetary policy as it do not lead to a change in the money base or to a change in the expectation for future changes in the money base.

That is not to say that the ECB’s credit policies do not have monetary impact. They likely have. Hence, it is clear that the so-called OMT has reduced financial distress in the euro zone, which likely have increased the money-multiplier and money-velocity in the euro zone, but it has also (significantly?) increased moral hazard problems. So the paradox here is that the ECB really has done very little to ease monetary policy, but a lot to increase moral hazard problems.

Unfortunately many of those policy makers who rightly are very fearful of moral hazard – normally Northern European policy makers – fail to realise the difference between monetary policy and credit policy. German, Finnish and Dutch policy makers are right in opposing a credit based bailout of South European “sinners”, but they are equally wrong in opposing an monetary expansion.

The paradox here is that Northern European policy markets by opposing monetary easing in the euro zone actually are increasing the problem with moral hazard and bailouts. Hence, when monetary policy is too tight nominal GDP (and likely also real GDP) collapses. As a result debt ratios increase – and this goes for both private and public debt. That will cause both sovereign debt crisis and banking crisis, which is perceived to threaten the future of the euro. The threat to the future of the euro so far has convinced Northern European policy makers to going along with bailouts and implicit and explicit guarantees to banks and countries around the euro zone. Hence, the ECB’s overly tight monetary policy likely have INCREASED moral hazard problems.

Europe needs to return to a system where insolvent banks and countries are allowed to default. We need to end the bailouts. The Northern Europeans are completely right about that. However, we also need to end the deflationary policies of the ECB, which greatly increases public debt and banking problems.

It is certainly not given that even if the ECB brought the NGDP level back to the pre-crisis trend everything would be fine. I am fairly convinced that the removal of implicit and explicit guarantees would force banks and countries to deleverage further.  Moral hazard problems and bailouts have led to excessive risk taking. There is no doubt about that, but if the ECB (and the Fed!) focuses on maintaining nominal stability we can get an orderly return to a market based financial system where credit risks are correctly priced.

And finally solvency problems should not be dealt with through monetary or credit policy. If a country is insolvent then the only answer is an orderly debt restructuring. Similarly if banks are insolvent orderly bank resolution is needed. Monetary policy at the same time should ensure that bank resolution and debt restructuring do not lead to a negative shock to monetary conditions. The best way to do that is to keep NGDP on track.


Update: This is a greeting to the University of Chicago Monetary Policy Reading Group. This week the group is reading and discussing Ben Bernanke’s classic 1983 paper “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression”. In this paper Bernanke discusses his creditist view of the Great Depression. I believe that  these views are what led the Bernanke Fed to initially response to the Great Depression with credit policies (trying to “fix” the banks) rather than through a focused increase in the money base and the money supply.

My challenge to the UoC Monetary Policy Reading Group they should discuss how Fed policy has evolved from initially to be strongly focused on credit policies (QE2) to moving towards a monetary expansion (the Bernanke-Evans rule) and comparing the Bank of Japan’s new policy which is much more focused on an expansion of the money base rather than an attempt to distort relative prices in the financial markets. This is Friedman versus Bernanke.

Leave a comment


  1. felipe

     /  April 22, 2013

    the ECB’s attempts to distort relative prices in financial markets have very little to do with monetary policy

    The implication of the above is that the central bank should not buy only short term sovereign debt, but rather buy every possible asset in proportion to their current market values.
    How do we decide which assets the central bank should use to conduct monetary policy?

    • Felipe, I believe on has to make a pragmatic decision and construct a monetary policy instrument, which is as “neutral” as possible. I have earlier suggested that the ECB should buy a GDP weighted basket of 2-year government bonds from all of the euro zone countries. That I believe would be close enough to call it a neutral.

  2. Tommy Dorsett

     /  April 23, 2013

    Good post. It would also seems as if the Northern Europeans fail to grasp the fact the the more the ECB fails on NGDP stability, the greater the need/demand/desire for fiscal transfers from North to South.

    • Tommy, thanks for the comment. This is exactly the point – by refusing to expand the money base the Northern Europeans effectively undermine their own opposition to bailouts.

  3. troopa

     /  April 23, 2013

    I think we must not forget the social “costs” as radicalization on both sides of political spectrum, people loosing faith in market economy and loosing hope all together – all which is a call for more interventionist policies by governments. There is a threat that these interventions will seriously damage Europe’s prospects for long term growth in the future as ever more regulations and taxes are piled up on the people and the economy with devastating results!

  4. James in London

     /  April 23, 2013

    A great post, and a really tricky situation the ECB have got themselves in.

    “Banking” just doesn’t work in a negative NGDP environment. The liabilities are mostly nominal and need to be repaid at par, but the assets are backed by income streams and assets that can fall in value in a negative NGDP environment. Banks will go bust, and the countries that back them too. Banks become the front line of declining NGDP.

    And it will get worse and worse as the countries shrink in size of NGDP while those pesky liabilities (deposits, funding) need to be repaid at par, or will run and run, or will have to be cut in value. That seems to be the true lesson of Cyprus.

    It is a story that will come back to haunt Northern Europe too unless the ECB changes course. Unemployment and inflation numbers (lower and lower ones) are horrible in The Netherlands. The Northern Europeans need to talk to their bankers and ask them to stress test for negative NGDP growth, and not just a normal negative RGDP recession.

  5. Benjamin Cole

     /  April 23, 2013

    We have a similar problem in the USA, where there is a demented afflatus that “tight money” is morally and economically superior, and that “loose money” is not only with loose morals but with big federal budget deficits.

    There has been some progress—the AEI, a right-wingish think tank did have a forum on MM, and some other right-wingers have come into the fold.

    But everyday, in blogs and the media, you can find genuflections to gold and price stability, and the evil of central banks planning to bring bring about ruinous inflation.

    PR-wise, the MM movement might want to publicly embrace balanced national budgets as part of MM, even though it is really not.

  6. James in London

     /  April 23, 2013

    And monetary policy de facto tightened on the news, as the currency jumped up on lower expectations of a rate cut. Great! (irony)

  7. Lars,

    Strikes me you have ignored the basic reason why periphery countries got into debt in the first place, namely that they became uncompetitive as compared to core countries.

    Simply wiping out periphery debts and effecting stimulus in periphery countries (or ending the “deflationary policies of the ECB” as you put it) won’t solve the competitiveness problem.

    What WILL SOLVE that fundamental problem is several years of austerity: that will bring periphery costs down relative to core costs. Of course it’s a horrendously expensive way of solving the problem in terms of social costs. But that’s just an inherent characteristic of common currencies.

    And the evidence is that periphery costs ARE COMING DOWN.

    • I dont think they were “going into debt because they were uncompetitive”. They were going into the debt because debt was cheaper than before and because they didn’t do any reforms to be competitive at all – they just rode the wave of cheap credit and bloated they public sectors along the way. Why do other uncompetitive countries have much less debt/gdp than Greece?
      And this austerity they are doing now, where they are more focused on revenue side than cutting spending and privatizing is in a way exacerbating the problem and not clearing the market (not to say there have been no positive moves, though)

  8. James in London

     /  April 23, 2013

    Ralph, the evidence is that Spanish unit labour costs are coming down but have a long way to go yet, and Cyprus shows the consequences of getting there nominally. Italy’s aren’t budging. And Germany, using a base of 1999, is still way ahead.

    • Agreed – more or less. I saw a chart recently that showed periphery costs had declined by about half the amount they need to decline by in order to get their competitiveness back on course. So they’re half way through the pain, as you might say.

      • james in london

         /  April 23, 2013

        I did do a chart from the data showing the key countries. The tragedy of Spain is that they have a bad duality in their labour market with large numbers of protected state, state industry and semi-state industries {like utilties, banks, at least the not yet bust ones, telcos, etc} that have strong job protection. So the pain of the falling labour cost has particularly hit the outsiders, not the insiders at all. A decent discussion, but not really bringing out the problem is here:

        Click to access paper_jimeno.pdf

  9. Ravi

     /  April 24, 2013

    Very interesting find, James – cheers.

  10. James in London,

    Thanks for the link. I’ve known about the “duality” in the Spanish labour market for some time. Also of interest is the fact that unemployment in Spain has been on the high side for a very long time: since well before they joined the EU. I’ve always been puzzled as to the reasons. Maybe it’s the duality.

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