A couple of days ago I read an interview with ECB’s former chief economist Otmar Issing about the euro crisis. I frankly speaking didn’t find the interview particularly interesting and Issing brings little new to the discussion.

Issing rightly repeats the worries about moral hazard problems and he is critical about the ECB’s credit policies even though it is clear that he fails to point to the difference between credit policies (which central bankers should stay far away from) and monetary policy (which central banks have a mandate to conduct).

Even more depressingly Issing completely fails to recognize the *monetary nature* of the euro crisis.

This is particularly depressing given Otmar Issing certainly knows his monetarist theory and he used to be know as *the* monetarist at the ECB.

It was Otmar Issing who famously put monetary analysis based on the *quantity theory of money* at the centre of thinking in the ECB’s early days. Hence, Issing was the main architect behind ECB’s so-called *two pillar strategy*. The one pillar was that the ECB should look at a broad range of economic indicators when assessing the monetary policy stance. The second pillar was the monetary pillar which emphasized monetary (essentially montarist) analysis.

**What happened to the reference value for M3 growth?**

At the core of the monetary pillar was what came to be known as the *reference value for M3 growth*.

This is how the ECB (read Otmar Issing!) used to define the reference value:

This reference value refers to the rate of M3 growth that is deemed to be compatible with price stability over the medium term. The reference value is derived in a manner that is consistent with and serves the achievement of the Governing Council’s definition of price stability on the basis of medium-term assumptions regarding trend real GDP growth and the trend in the velocity of circulation of M3. Substantial or prolonged deviations of M3 growth from the reference value would, under normal circumstances, signal risks to price stability over the medium term.

So what we are talking about here is the growth rate of M3, which over the medium-term will ensure 2% inflation given the trend-development in *money demand* (trend real GDP growth and trend-velocity growth).

We can operationalize this by looking at the *equation of exchange* (in growth rates):

(1) m + v = p + y

Where *m* is M3 growth, *v* is the growth rate of M3-velocity, *p* is inflation (in the GDP deflator) and *y* is real GDP growth.

If we define *v** as trend growth in M3-velocity and *y** as trend/potential real GDP growth and finally assume inflation should hit the inflation target of 2% then we can re-write (1):

(1)’ m + v* = 2% + y*

Re-arranging further we can get a target for M3 (m-target), which will ensure 2% inflation over the medium-term:

(2) m-target = 2% + y* – v*

The ECB used (2) to calculate the reference value for M3 growth by assuming v* was around -1/2% and y* was 2%, which would give you a reference value of 4.5%.

The ECB kept this target constant over time despite the fact that neither the trend in velocity nor the trend in real GDP growth are constant over time.

If we instead want to take into account changes in v* and y* over time we can try to “estimate” these variables by applying a *Hodrick–Prescott filter* (HP filter). Somewhat simply said a HP filter is just a sophisticated moving average.

*Introducing the policy-consistent M3 growth rate*

While Otmar Issing might have given up on monetary analysis I have not. In fact monetary analysis is at the core of the new publication on Global Monetary Conditions, which my advisory – Markets & Monetary Advisory – will start to publish in the coming months.

In this publication we in fact calculate what we term the *policy-consistent M3 (or M2) growth rate* for the 25-30 countries, which will be covered in the publication (see more here).

The graph below shows actual M3 growth (the blue line) in the euro zone compared with the policy-consistent M3 growth rate (the red line).

The grey bars are the a 3-year weighted moving averages of the difference between actual and policy-consistent M3 growth and as such is a measure of the monetary policy stance. Negative (positive) bars indicates that M3 growth is too slow (too fast) to ensure that the ECB will hit the 2% inflation target over the medium-term. We can here term this as the *‘money gap’*.

In our new monthly publication we will focus on four different monetary measures to put together one monetary conditions indicator (M3 growth, nominal GDP growth, interest rates and the exchange rate), but if we only focus on our measure of the policy-consistent M3 growth rate we nonetheless get great insight about monetary conditions in the euro zone.

Looking at the development in the ‘money gap’ we see that monetary conditions were broadly speaking from the euro was established in 1999 and until 2006. However, from 2006 monetary conditions clear became too easy.

That, however, change dramatically as M3 started to slow rather dramatically in early 2008 and already at the time should have been clear that soon the M3 would drop below the ECB’s reference value for M3 (and our policy-consistent M3 growth rate). Despite of this the ECB hiked its key policy rate in July 2008! This is of course was the first major policy major the ECB made in the crisis. More disastrous policy mistakes of course followed in 2011 when the ECB hiked interest rate twice!

Hence, had the ECB *only* focused on M3 the ECB would certainly have tightened monetary policy more aggressively in 2006 and 2007, but even more importantly it would never have hiked interest rates in 2008 and 2011. Rather judging from M3 growth relative to the ECB’s own (old) reference value or our policy-consistent M3 growth rate the ECB should have slashed interest rates aggressively in the Autumn of 2008 and in 2009 and should have initiated quantitative easing once interest rates hit zero.

*Otmar Issing should be angry (but for the right reasons)*

Hence, Otmar Issing *is indeed right* to be angry with the ECB, but he should be angry for the right reasons. Issing might point to problems of moral hazard and I certainly share these concerns, but what Otmar Issing really should be angry about is that the ECB complete have given up on taking Issing-style monetary analysis seriously as a result at least six years after 2008 monetary policy *far too tight!*

Unfortunately Issing seems to have given up on his own analysis as well. That is deeply regrettable. So we can only hope that Otmar Issing will go back to proper monetary analysis of the typical *‘Calvinist preaching’*, which unfortunately is so common among German policy makers – both in Frankfurt and Berlin.

If he did that he would continue to criticize the ECB for trying to distort bond market pricing and encouraging moral hazard, but he would also recognize that ECB chief Mario Draghi has been right pushing for quantitative easing and that it should be continued as long as necessary to keep M3 growth around at least 4.5-5% as this ensures that inflation will be close to ECB’s 2% inflation target.

PS I don’t think re-introducing the reference value for M3 growth would be the *best* policy framework for the ECB, but it certainly would be better than the present non-policy-framework and very much doubt that we would still would be talking about a euro crisis had the ECB taken the reference value serious.

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