The “Weidmann rule” and the asymmetrical budget multiplier (is the euro zone 50% keynesian?)

During Christmas and New Years I have been able to (nearly) not think about monetary policy and economics, but I nonetheless came across some comments from Bundesbank chief Jens Weidmann from last week, which made me think about the connection between monetary policy rules and fiscal austerity in the euro zone. I will try address these issues in this post.  

This is Jens Weidmann:

“The euro zone is recovering only gradually from the harshest economic crisis in the post-war period and there are few price risks. This justifies the low interest rate…Low price pressure however cannot be a licence for arbitrary monetary easing and we must be sure to raise rates at the right time should inflation pressure mount.”

It is the second part of the quote, which is interesting. Here Weidmann basically spells out his preferred reaction function for the ECB and what he is saying is that he bascially wants an asymmetrical monetary policy rule – when inflation drops below the ECB’s 2% inflation target the ECB should not “arbitrary” cut its key policy rate, but when inflation pressures increase he wants the ECB to act imitiately.

It is not given that the ECB actually has such a policy rule, but given the enormous influence of the Bundesbank on ECB policy making it is probably reasonable to assume that that is the case. That in my view would mean that Summer Critique does not apply (fully) to the euro zone and as a result we can think of the euro zone as being at least 50% “keynesian” in the sense that fiscal shocks will not be fully offset by monetary policy. As a result it would be wrong to assume that the budget multiplier is zero in the euro zone – or rather it is not always zero. The budget multiplier is asymmetrical.

Let me try to illustrate this within a simple AS/AD framework.

First we start out with a symmetrical policy rule – an inflation targeting ECB. Our starting point is a situation where inflation is at 2% – the ECB’s official inflation target – and the ECB will move to offset any shock (positive and negative) to aggregate demand to keep inflation (expectations) at 2%. The graph below illustrates this.

ASAD AD shock

If the euro zone economy is hit by a negative demand shock in the form of for example fiscal tightening across the currency union the AD curve inititally shifts to the left (from AD to AD’). This will push inflation below the ECB’s 2% inflation target. As this happens the ECB will automatically move to offset this shock by easing monetary policy. This will shift the AD curve back (from AD’ to AD). With a credible monetary policy rule the markets would probably do most of the lifting.

The Weidmann rule – asymmetry rules

However, the Weidmann rule as formulated above is not symmetrical. In Weidmann’s world a negative shock to aggregate demand – for example fiscal tightening – will not automatically be offset by monetary policy. Hence, in the graph above the negative shock aggregate demand (from AD to AD’) will just lead to a drop in real GDP growth and in inflation to below 2%. Given the ECB’s official 2% would imply the ECB should move to offset the negative AD shock, but that is not the case under the Weidmann rule. Hence, under the Weidmann rule a tightening of fiscal policy will lead to drop in aggregate demand. This means that the fiscal multiplier is positive, but only when the fiscal shock is negative.

This means that the Sumner Critique does not hold under the Weidman rule. Fiscal consolidation will indeed have a negative impact on aggregate demand (nominal spending). In that sense the keynesians are right – fiscal consolidation in the euro zone has likely had an negative impact on euro zone growth if the ECB consistently has followed a Weidmann rule. Whether that is the case or not is ultimately an empirical question, but I must admit that I increasingly think that that is the case. The austerity drive in the euro zone has likely been deflationary. However, it is important to note that this is only so because of the conduct of monetary policy in the euro area. Had the ECB instead had an fed style Evans rule with a symmetrical policy rule then the Sumner Critique would have applied also for the euro area.

The fact that the budget multiplier is positive could be seen as an argument against fiscal austerity in the euro zone. However, interestingly enough it is not an argument for fiscal stimulus.  Hence, according to Jens Weidmann the ECB “must be sure to raise rates at the right time should inflation pressure mount”. Said in another way if the AD curve shifts to the right – increasing inflation and real GDP growth then the ECB should offset this with higher interest rates even when inflation is below the ECB’s 2% inflation target.

This means that there is full monetary offset if fiscal policy is eased. Therefore the Sumner Critique applies under fiscal easing and the budget multiplier is zero.

The Weidmann rule guarantees deflation 

Concluding, with the Weidmann rule fiscal tightening will be deflationary – inflation will drop as will real GDP growth. But fiscal stimulus will not increase aggregate demand. The result of this is that if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).

This is of course exactly what we have seen over the past five years. But don’t blame fiscal austerity – blame the Weidmann rule.

NGDP euro zone USA

PS I should really acknowledge that this is a variation over a theme stressed by Larry Summers and Brad Delong in their paper Fiscal Policy in a Depressed Economy. See my discussion of that paper here.

I am sick and tired of hearing about “currency war” – and so is Philipp Hildebrand

Milton Friedman used to talk about an interest rate fallacy – that people confuse low interest rates with easy monetary policy. However, I believe that we today are facing an even bigger fallacy – the exchange rate fallacy.

The problem is that many commentators, journalists, economists and policy makers think that exchange rate movements in some way are a zero sum game. If one country’s currency weakens then other countries lose competitiveness. In a world with sticky prices and wages that is of course correct in the short-term. However, what is not correct is that monetary easing that leads to currency depreciation hurts other countries.

Easing monetary conditions is about increasing domestic demand (or NGDP). In open economies a side effect can be a weakening of the country’s currency. However, any negative impact on other countries can always be counteracted by that country’s central bank. The Federal Reserve determines nominal GDP in the US. The Bank of Mexico determines Mexican NGDP. It is of course correct that strengthening of the Mexican peso against the US dollar can impact Mexican exports to the US, but the Fed can never “overrule” Banxico when it comes to determining NGDP in Mexico. This of course is a variation of the Sumner Critique – that the fiscal multiplier is zero if the central bank directly or indirectly targets aggregate demand (through for example inflation targeting or NGDP level targeting). Similarly the “export multiplier” is zero as the central bank always has the last word when it comes to aggregate demand. For a discussion of the US-Mexican monetary transmission mechanism see here.

At the core of the problem is that most people tend to think of economics in paleo-Keynesian terms – or what I earlier have termed national account economics. Luckily not everybody thinks like this. A good example of somebody who is able to understand something other than “national account economics” is former Swiss central banker Philipp Hildebrand.

Hildebrand has a great comment on FT.com on why there is “No such thing as a global currency war”.

Here is Hildebrand:

As finance ministers and central bankers make their way to this week’s Group of 20 leading nations meeting in Moscow, some of them may find it impossible to resist the temptation to grab headlines by lamenting a new round of “currency wars”. They should resist, for there is no such thing as a currency war.

This is because central banks are simply doing what they are meant to do and what they have always done. They set monetary policy consistent with their domestic mandates. All that has changed since the crisis is that central banks have had to resort to unconventional measures in an effort to revive wounded economies.

 So true, so true. Central banks are in the business of controlling nominal spending in their own economies to fulfill whatever domestic mandate they have.
Over the last couple of months the Federal Reserve and Bank of Japan have moved decisively in the direction of monetary easing and all indications are that the Bank of England is moving in the same direction. That is good news. Hildebrand agrees:

In the US, for example, the unemployment rate is 2 percentage points above its postwar average. In the UK, output remains 3 per cent below its level at the end of 2007.

In both of these countries, the remits given to the central banks make their responsibility clear: to take action to provide economic stimulus. The US Federal Reserve, for example, has responsibility to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”. In the UK, the Bank of England’s main objective is to maintain price stability. But subject to that, it is required to “support the economic policy of Her Majesty’s government, including its objectives for growth and employment”.

Japan’s problems are different in nature, and longer in the making. Japanese inflation has been negative, on average, for well over a decade. It is an environment that would not be tolerated in any other developed economy. The recently signalled desire for inflation of 2 per cent is hardly a leap towards monetary unorthodoxy, let alone an act of war.

Obviously the side effect of monetary easing from the major central banks of the world (with the horrible exception of the ECB) is that other countries’ currencies tend to strengthen. That is for example the case for the Mexican peso as I noted above. With currencies strengthening these countries are importing monetary tightening. However, that can easily be counteracted (if necessary!) by cutting interest rates or conducting quantitative easing. Hildebrand again nails it:

One can sympathise with emerging economies with floating exchange rates, which may feel they are bearing too much of the burden of adjustment. But surely the answer is not for developed economy central banks to turn away from their remits. Rather, it is for emerging economies to focus their own monetary policy on sensible domestic remits, with their exchange rates free to be determined in the market.

There is one small and particularly open economy where sustained currency movements were not merely the consequence of conventional or unconventional monetary policy measures but where the central bank opted to influence the exchange rate directly. In September 2011, when I was chairman of the Swiss National Bank, it announced that it would no longer tolerate an exchange rate below 1.20 Swiss francs to the euro – and to enforce that minimum rate it would be prepared to buy foreign currency in unlimited quantities.

If Mexico had a problem with US monetary easing then Banxico could simply copy the policies of SNB – and put a floor under USD/MXN. However, I doubt that that will be necessary as Mexican inflation is running slightly above Banxico’s inflation target and the prospects for Mexican growth are quite good.

Hildebrand concludes:

The monetary policy battles that have been fought and continue to be fought in so many economies are domestic ones. They are fights against weak demand, high unemployment and deflationary pressures. A greater danger to the world economy would in fact arise if central banks did not engage in these internal battles. These monetary battles are justified and fully embedded in legal mandates. They are not currency wars.

 Again Hildebrand is right. In fact I would go much further. What some calls currency war in my view is good news. We are not in a world of high inflation, but in a world of low growth and quasi-deflationary tendencies. The world needs easier monetary policy – so if central banks around the world compete to print more money then this time around it surely would be good news.
Unfortunately in Europe central bankers fail to understand this. Here is Bundesbank chief Jens Weidmann:
“Experience from previous, politically induced depreciations show that they don’t normally lead to a sustained increase in competitiveness,” Weidmann said. “Often, more and more depreciations are necessary. If more and more countries try to depress their currency, it will end in a depreciation competition, which will only produce losers.”
Dr. Weidmann – monetary easing is not about creating hyperinflation. Monetary depreciation is not about “competitiveness”. What we need is easier monetary policy and if the consequence is weaker currencies so be it. At least the Bank of Japan is now beginning to pull the Japanese economy out of 15 years of deflation. Unfortunately the ECB is doing the opposite.
Maybe Dr. Weidmann could benefit from studying monetary history. A good starting point is Ralph Hawtrey. This is from Hawtrey’s 1933 book “Trade Depression and the Way Out” (I stole this from David Glasner):

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . .

How much better the world would be had the central bankers of today read Cassel and Hawtrey and studied a bit of monetary history. Hildebrand did, Weidmann did not.

PS if the Fed and the BoJ’s recent actions are so terrible that they can be termed a currency war – imagine what would happen if the Fed and the BoJ had decided appreciate the dollar and the yen by lets say 20%. My guess is that we would be sitting on a major sovereign and banking crisis in the euro zone right now. Or maybe everybody has forgot the “reverse currency war” of 2008 when the dollar and the yen strengthened dramatically. Look how well that ended.

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Related posts:

Is monetary easing (devaluation) a hostile act?
Bring on the “Currency war”
The Fed’s easing is working…in Mexico
Mises was clueless about the effects of devaluation
The luck of the ‘Scandies’
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons
Fiscal devaluation – a terrible idea that will never work

“Meantime people wrangle about fiscal remedies”

The other day I wrote a piece about the risks of introducing politics (particularly fiscal policy) into the central bank’s reaction function. I used the example of the ECB, but now it seems like I should have given a bit more attention to the Federal Reserve as Fed chief Bernanke yesterday said the follow:

“Monetary policy is not a panacea, it would be much better to have a broad-based policy effort addressing a whole variety of issues…I’d be much more comfortable if, in fact, Congress would take some of this burden from us and address those issues.”

So what is Bernanke saying – well he sounds like a Keynesian who believes that we are in a liquidity trap and that monetary policy is inefficient. It is near-tragic that Bernanke uses the exact same wording as Bundesbank chief Jens Weidmann used recently (See here). While Bernanke is a keynesian Weidmann is a calvinist. Bernanke wants looser fiscal policy – Weidmann wants fiscal tightening. However, what they both have in common is that they are central bankers who apparently don’t think that nominal GDP is determined by monetary policy. Said, in another other way they say that nominal stability is not the responsibility of the central bank. You can then wonder what they then think central banks can do.

What both Weidmann and Bernanke effectively are saying is that they can not do anymore. They are out of ammunition. This is the good old  “pushing on a string” excuse for monetary in-action.  This is of course nonsense. The central bank can determine whatever level for nominal GDP it wants. Just ask Gedeon Gono. It is incredible that we four years into this mess still have central bankers from the biggest central banks in the world who are making the same mistakes as central bankers did during the Great Depression.

Yesterday Scott Sumner quoted Viscount d’Abernon who in 1931 said:

“This depression is the stupidest and most gratuitous in history!…The explanation of our anomalous situation…is that the machinery for handling and distributing the product of labor has proved inadequate. The means of payment provided by currency and credit have fallen so short of the amount required by increased production that a general fall in prices has ensued…This has not only caused a disturbance in the relations between buyer and seller, but has gravely aggravated the situation between debtor and creditor. The gold standard, which was adopted with a view to obtaining stability of price, has failed in its main function. In the meantime people wrangle about fiscal remedies and similar devices of secondary importance, neglecting the essential question of stability in standard of value…The situation could be remedied within a month by joint action of the principal gold-using countries through the taking of necessary steps by the central banks.”

It is tragic that the same day Scott quotes d’Abernon Ben Bernanke “wrangles about fiscal remedies”. Bernanke of course full well knows that the impact on nominal GDP and prices of fiscal policy depends 100% on actions of the Federal Reserve. Fiscal policy does not determine the level of NGDP – monetary policy determines NGDP (Remember MV=PY!).

The Great Depression was caused by monetary policy failure and so was the Great Recession (See here and here). In the 1930s the Lords of Finance Montagu, Norman, Meyer, Moret, Stringher, Hijikata and Schacht were all wrangling about fiscal remedies and defended their failed monetary policies. Today the New Lords of Finance Bernanke, Shirakawa, Draghi and Weidmann are doing the same thng. How little we – or rather central bankers – have learned in 80 years…

UPDATE: Maybe our New Lords of Finance should read this Easy Guide to Monetary Policy.

“The gold standard remains the best available monetary mechanism”

< UPDATE: See an updated version of this piece here >

This is from the Bank of International Settlements third annual report publish in May 1933:

“For the Bank for International Settlements, the year has been an eventful one, during which, while the volume of its ordinary banking business has necessarily been curtailed by the general falling off of international financial transactions and the continued departure from gold of more and more currencies, culminating in the defection of the American dollar, nevertheless the scope of its general activities has steadily broadened in sound directions. The widening of activities, aside from normal growth in developing new contacts, has been the consequence, primarily, of a year replete with international conferences, and, also, of the rapid extension of chaotic conditions in the international monetary system. In view of all the events which have occurred, the Bank’s Board of Directors determined to define the position of the Bank on the fundamental currency problems facing the world and it unanimously expressed the opinion, after due deliberation, that in the last analysis “the gold standard remains the best available monetary mechanism” and that it is consequently desirable to prepare all the necessary measures for its international reestablishment.”

Take a look at the report. The whole thing is outrageous – the world is falling apart and it is written very much as it is all business as usual. More and more countries are leaving the the gold standard and there had been massive bank runs across Europe and a number of countries in Europe had defaulted in 1932 (including Greece and Hungary!) Hitler had just become chancellor in Germany.

And then the report state: “the gold standard remains the best available monetary mechanism”! It makes you wonder how anybody can reach such a conclusion and in hindsight obviously today’s economic historians will say that it was a collective psychosis – central bankers were suffering from some kind of irrational “gold standard mentality” that led them to insanely damaging conclusions, which brought deflation, depression and war to Europe.

I wonder what economic historians will say in 7-8 decades about today’s central bankers.

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Reading recommendation of the day: Lords of Finance – The (Central!) Bankers who Broke the World

Completely unrelated take a look at this story about Bundesbank chief Jens Weidmann.

Meanwhile in Greece you have this and in Hungary you have this.

Draw your own conclusions…

Jens Weidmann, do you remember the second pillar?

Today the ECB is very eager to stress it’s 2% inflation target. However, a couple of years ago the ECB in fact had two targets – the so-called two pillars of monetary policy. The one was the inflation target and the other was a money supply target – the so-called reference value for the growth rate of M3.

The second pillar in many ways made a lot of sense – at least as a instrument for monetary analysis. The second pillar was put into the ECB tool box by the Bundesbank which insisted that monetary analysis was as important as a pure inflation target. Read for example former ECB chief economist and Bundesbanker Otmar Issing’s defense of the two-pillar set-up here.

The starting point for calculating the reference value for M3 was the equation of exchange:

(1) MV=PY

or in growth rates:

(2) m+v=p+y

(2) of course can be re-written to:

(2)’ m=p+y-v

If we assume trend real GDP growth (y) is 2% you can calculate the reference value for m that will ensure 2% inflation over the medium term. You of course also have to make an assumption about velocity. ECB used to think that trend growth in v was -0.5 to -1%.

This give us the following reference growth rate for M3 (m-target):

(3) m-target=2+2-(-1)=5% (4.5% if you assume velocity growth of -0.5%)

Said in another way if the ECB keeps M3 growing at 5% year-in and year-out then inflation should be around 2% in the medium term. An yes, this is of course exactly what Milton Friedman recommend long ago.

2.5% M3 growth is hardly inflationary

Today we got the latest M3 numbers for the euro zone. The calvinists should be happy – M3 decelerated sharply to 2.5% y/y in April. Half of what should be the reference growth rate for M3 – and that is ignoring the fact that velocity has collapsed.

What does that tells us about the inflationary risks in the euro zone? Well, there are no inflationary risks – there are only deflationary risks.

Using the assumptions above we can calculate the long-term inflation if M3 keeps growing by 2.5% – from (2)’ we get the following:

(4) p=m-y+v

(4)’ p=2.5-2+(-1)=-0.5%

So it is official! Monetary analysis as it used to be conducted in the Bundesbank is telling you that we are going to have deflation in the euro zone in the medium term! And don’t tell me about monetary overhang – the ECB is in the business of letting bygones be bygones (otherwise the ECB would target the NGDP LEVEL or the price LEVEL) and by the way the ECB spend lots of time in 2004-7 to explain why money supply growth overshot the target.

Jens Weidmann – monetarist or calvinist?

The Bundesbank brought in monetary analysis and a money supply focus to the ECB so I think it is only fair to ask whether Bundesbank chief Jens Weidmann still believe in monetary analysis? If he is true to the strong monetarist traditions at the Bundesbank then he should come out forcefully in favour of monetary easing to ensure M3 growth of at least 5% – in fact it should be much higher as velocity has collapsed, but at least to bring M3 back to 5% would be a start.

I hope the Bundesbank will soon refind it’s monetarist traditions…please make Milton Friedman and Karl Brunner proud!

PS I of course still want the ECB to introduce a NGDP level target, but less would make me happy – a 5-10% target range for M3 (the range prior to the crisis) and a minimum price on European inflation linked bonds would would clearly be enough to at least avoid collapse.

Maybe Jens Weidmann and Francios Hollande should switch jobs

There seem to be two main positions on how to solve the European crisis. One represented by Bundesbank chief Jens Weidmann and that is that monetary policy should not be eased anymore and fiscal policy needs to be tightened (this is the Calvinist position). The other position is held by the new French president Francios Hollande who wants to spur European growth by easing fiscal policy (this is the keynesian position)

I would claim that both positions are wrong. At the core of the European crisis is rising public debt ratios in Europe. The public debt ration (d) is defined in the following way:

(1) d=D/NGDP

Where D is public debt in euros and NGDP is nominal GDP.

Anybody with rudimentary monetarist insights would inform you that D is determined by the fiscal authorities, while NGDP is determined by monetary policy (remember MV=PY).

If you want to stabilize or reduce d then you have to either decrease D and/or increase NGDP. So what you basically need is fiscal tightening and monetary easing.

Unfortunately Weidmann is basically arguing for reducing NGDP and Hollande is arguing in favour of increasing D. Both positons will lead to an increase in d and hence worsen the crisis. Hence, it would be better if the two gentleman switched jobs  – at least mentally. It would be a lot more productivity if Weidmann argued for monetary easing and Hollande argued for fiscal consolidation. That would do the job and the crisis would come to an end fairly fast.

Between the need for fiscal tightening and the need for increasing NGDP I have no doubt that it is much more important to increase NGDP. The public debt ratios in Europe has not primarily increased because fiscal policy has been eased, but because NGDP has collapsed. In that sense the crisis is not a debt crisis, but a monetary crisis.

….

Note to the two gentlemen:

To President Hollande (The keynesian): Fiscal policy cannot increase NGDP. Recommend reading: There is no such thing as fiscal policy

To Bundesbank chief Weidmann (The Calvinist): Monetary policy is a panache and it can increase NGDP as much as you like it to be increased. Recommend reading: “Ben Volcker” and the monetary transmission mechanism

Hjalmar Schacht’s echo – it all feels a lot more like 1932 than 1923

The weekend’s Greek elections brought a neo-nazi party (“Golden Dawn”) into the Greek parliament. The outcome of the Greek elections made me think about the German parliament elections in July 1932 which gave a stunning victory to Hitler’s nazi party. The Communist Party and other extreme leftist also did well in the Greek elections as they did in Germany in 1932. I am tempted to say that fascism is always and everywhere a monetary phenomenon. At least that was the case in Germany in 1932 as it is today in Greece. And as in 1932 central bankers does not seem to realise the connection between monetary strangulation and the rise of extremist political forces.

The rise of Hitler in 1932 was to a large extent a result of the deflationary policies of the German Reichbank under the leadership of the notorious Hjalmar Schacht who later served in Hitler’s government as Economics Ministers.

Schacht was both a hero and a villain. He successfully ended the 1923 German hyperinflation, but he also was a staunch supporter of the gold standard which lead to massive German deflation that laid the foundation for Hitler’s rise to power. After Hitler’s rise to power Schacht helped implement draconian policies, which effectively turned Germany into a planned economy that lead to the suffering of millions of Germans and he was instrumental in bringing in policies to support Hitler’s rearmament policies. However, he also played a (minor) role in the German resistance movement to Hitler.

The good and bad legacy of Hjalmar Schacht is a reminder that central bankers can do good and bad, but also that central bankers very seldom will admit when they make mistakes. This is what Matthew Yglesias in a blog post from last year called the Perverse Reputational Incentives In Central Banking.

Here is Matt:

I was reading recently in Hjalmar Schacht’s biography Confessions of the Old Wizard … and part of what’s so incredible about it are that Schacht’s two great achievements—the Weimar-era whipping of hyperinflation and the Nazi-era whipping of deflation—were both so easy. The both involved, in essence, simply deciding that the central bank actually wanted to solve the problem.

To step back to the hyperinflation. You might ask yourself how things could possibly have gotten that bad. And the answer really just comes down to refusal to admit that a mistake had been made. To halt the inflation, the Reichsbank would have to stop printing money. But once the inflation had gotten too high for Reichsbank President Rudolf Havenstein to stop printing money and stop the inflation would be an implicit admission that the whole thing had been his fault in the first place and he should have done it earlier…

…So things continued for several years until a new government brought Schacht on as a sort of currency czar. Schacht stopped the private issuance of money, launched a new land-backed currency and simply . . . refused to print too much of it. The problem was solved both very quickly and very easily…

…The institutional and psychological problem here turns out to be really severe. If the Federal Reserve Open Market Committee were to take strong action at its next meeting and put the United States on a path to rapid catch-up growth, all that would do is serve to vindicate the position of the Fed’s critics that it’s been screwing up for years now. Rather than looking like geniuses for solving the problem, they would look like idiots for having let it fester so long. By contrast, if you were to appoint an entirely new team then their reputational incentives would point in the direction of fixing the problem as soon as possible.

Matt is of course very right. Central banks and central banks alone determines inflation, deflation, the price level and nominal GDP. Therefore central banks are responsible if we get hyperinflation, debt-deflation or a massive drop in nominal GDP. However, central bankers seem to think that they are only in control of these factors when they are “on track”, but once the nominal variables move “off track” then it is the mistake of speculators, labour unions or irresponsible politicians. Just think of how Fed chief Arthur Burns kept demanding wage and price controls in the early 1970s to curb inflationary pressures he created himself by excessive money issuance.  The credo seems to be that central bankers are never to blame.

Here is today’s German central bank governor Jens Weidmann in comment in today’s edition of the Financial Times:

Contrary to widespread belief, monetary policy is not a panacea and central banks’ firepower is not unlimited, especially not in the monetary union. First, to protect their independence central banks in the eurozone face clear constraints to the risks they are allowed to take.

…Second, unconditional further easing would ignore the lessons learned from the financial crisis.

This crisis is exceptional in scale and scope and extraordinary times do call for extraordinary measures. But we have to make sure that by putting out the fire now, we are not unwittingly preparing the ground for the next one. The medicine of a near-zero interest rate policy combined with large-scale intervention in financial markets does not come without side effects – which are all the more severe, the longer the drug is administered.

I don’t feel like commenting more on Weidmann’s comments (you can pretty well guess what I think…), but I do note that German long-term bond yields today have inch down further and is now at record low levels. Normally long-term bond yields and NGDP growth tend to move more or less in sync – so with German government 10-year bond yields at 1.5% we can safely say that the markets are not exactly afraid of inflation. Or said in another way, if ECB deliver 2% inflation in line with its inflation target over the coming decade then you will be loosing 1/2% every year by holding German government bonds. This is not exactly an indication that we are about to repeat the mistakes of the Reichbank in 1923, but rather an indication that we are in the process of repeating the mistakes of 1932. The Greek election is sad testimony to that.

PS David Glasner comments also comments on Jens Weidmann. He is not holding back…

PPS Scott Sumner today compares the newly elected French president Francois Hollande with Léon Blum. I have been having been thinking the same thing. Léon Blum served as French Prime Minister from June 1936 to June 1937. Blum of course gave up the gold standard in 1936 and allowed a 25% devaluation of the French franc. While most of Blum’s economic policies were grossly misguided the devaluation of the franc nonetheless did the job – the French economy started a gradual recovery. Unfortunately at that time the gold standard had already destroyed Europe’s economy and the next thing that followed was World War II. I wonder if central bankers ever study history…They might want to start with Adam Tooze’s Wages of Destruction.

Update: See Matt O’Brien’s story on “Europe’s FDR? How France’s New President Could Save Europe”. Matt is making the same point as me – just a lot more forcefully.

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