End Europe’s deflationary mess with a 4% nominal GDP (level) target

From the onset of the Great Recession in 2008 the ECB has been more afraid of doing “too much” rather than too little. The ECB has been obsessing about fiscal policy being too easy in the euro zone and about that too easy monetary policy would create bubbles. As a consequence the ECB was overly eager to hike interest rates in 2011 – way ahead of the Federal Reserve started to talk about monetary tightening.

The paradox is that the ECB now is in a situation where nobody can imagine that interest rates should be hiked anytime soon exactly because the ECB’s über tight monetary stance has created a deflationary situation in the euro zone. As a consequence the ECB under the leadership (to the extent the Bundesbank allows it…) of Mario Draghi is trying to come up with all kind of measures to fight the deflationary pressures. Unfortunately the ECB doesn’t seem to understand that what is needed is open-ended quantitative easing with proper targets to change the situation.

Contrary to the situation in Europe the financial markets are increasing pricing in that a rate hike from the Federal Reserve is moving closer and the Fed will be done doing quantitative easing soon. Hence, the paradox is that the Fed is “normalizing” monetary policy much before the ECB is expected to do so – exactly because the Fed has been much less reluctant expanding the money base than the ECB.

The tragic difference between monetary policy in the US and Europe is very visible when we look at the difference in the development in nominal GDP in the euro zone and the US as the graph below shows.


The story is very simple – while both the euro zone and the US were equally hard hit in 2008 and the recovery was similar in 2009-10 everything went badly wrong when the ECB prematurely started to hike interest rates in 2011. As a result NGDP has more or less flat-lined since 2011. This is the reason we are now seeing outright deflation in more and more euro zone countries and inflation expectations have dropped below 2% on most relevant time horizons.

While the Fed certainly also have failed in many ways and monetary policy still is far from perfect in the US the Fed has at least been able to (re)create a considerable degree of nominal stability – best illustrated by the fact that US NGDP basically has followed a straight line since mid-2009 growing an average of 4% per year. This I believe effectively is the Fed’s new target – 4% NGDP level targeting starting in Q2 of 2009.

The ECB should undo the mistakes of 2011 and copy the Fed

I believe it is about time the ECB fully recognizes the mistakes of the past – particularly the two catastrophic “Trichet hikes” of 2011. A way forward could be for the ECB to use the performance of the Fed over the last couple of years as a benchmark. After all the Fed has re-created a considerable level of nominal stability and this with out in any having created the kind of runaway inflation so feared in Frankfurt (by both central banks in the city).

So here is my suggestion. The ECB’s major failure started in April 2011 –  so let that be our starting point. And now lets assume that we want a 4% NGDP path starting at that time. With 2% potential real GDP growth in the euro zone this should over the cycle give us 2% euro zone inflation.

The graph below illustrate the difference between this hypothetical 4% path and the actual level of euro zone NGDP.

EZ NGDP path 4pct

The difference between the 4% path and the actual NGDP level is presently around 7.5%. The only way to close this gap is by doing aggressive and open-ended quantitative easing.

My suggestion would be that the ECB tomorrow should announce the it will close ‘the gap’ as fast as possible by doing open-ended QE until the gap has been closed. Lets pick a number – lets say the ECB did EUR 200bn QE per month starting tomorrow and that the ECB at the same time would announce that it every month would monitor whether the gap was closing or not. This of course would necessitate more than 4% NGDP growth to close the gap – so if for example expected NGDP growth dropped below for example 6-8% then the ECB would further step up QE in steps of EUR 50bn per month. In this regard it is important to remember that it would take as much as 8% yearly NGDP growth to close the gap in two years.

Such policy would course be a very powerful signal to the markets and we would likely get the reaction very fast. First of all the euro would weaken sharply and euro equity prices would shoot up. Furthermore, inflation expectations – particularly near-term inflation expectations would shoot up. This in itself would have a dramatic impact on nominal demand in the European economy and it would in my opinion be possible to close the NGDP gap in two years. When the gap is closed the ECB would just continue to target 4% NGDP growth and start “tapering” and then gradual rate hikes in the exact same way the Fed has done. But first we need to see some action from the ECB.

So Draghi what are you waiting for? Just announce it!

PS some would argue that the ECB is not allowed to do QE at all. I believe that is nonsense. Of course the ECB is allowed to issue money – after all if a central bank cannot issue money what is it then doing? The ECB might of course not be allowed to buy government bonds, but then the ECB could just buy something else. Buy covered bonds, buy equities, buy commodities etc. It is not about what to buy – it is about increasing the money base permanently and stick to the plan.

PPS Yes, yes I fully realize that my suggestion is completely unrealistic in terms of the ECB actually doing it, but not doing something like what I have suggested will condemn the euro zone to Japan-style deflationary pressures and constantly returning banking and public finances problems. Not to mention the risk of nasty political forces becoming more and more popular in Europe.

Leave a comment


  1. Arne

     /  September 11, 2014

    I really like your blog and I am in complete agreement with you that the ECB should start buying something – anything. But you know, the Germans and their inflation phobia etc. I would love to see your analysis why the German have forgotten about their own debt deflationary episode from 1929 to 1933 (actually the depression started in 1928 in Germany).

  2. Chris Papadopoullos

     /  September 11, 2014

    How long do you think it will take the Eurozone economies to adjust to the new trend of NGDP growth, which looks to be around 2%? The debt overhang will be an issue for a long time but labour markets are showing signs of clearing, especially in Spain. If the current trends continue they might experience “deflationary growth” as money becomes neutral.

  3. What are the de facto political constraints on the ECB? Who benefits from tight money?

  4. Ravi Varghese

     /  September 12, 2014

    Lars – won’t surprise you to know that I totally agree. The only minor point of difference – why do you think the Euro will weaken substantially?

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