Scott Sumner  

Central banks do not deserve our respect

The Swamping that Wasn't: The ... From the Vault: Reply to the V...

Nor (in my view) do they deserve our contempt. They should be viewed skeptically. They are trying to do a good job, but often fall well short. One such occasion occurred in 2011 when the ECB tightened monetary policy. Prior to 2011 the US and eurozone had similar unemployment rates, just under 10%. Now we have 6.7% unemployment and they have 12%. The result of the ECB's tight money policy in 2011 was utterly predictable from any basic EC101 textbook. Falling NGDP growth tends to reduce RGDP and raise unemployment. And unlike with 2008, no unconventional "market monetarist" assumptions are needed. They were not at the zero bound. The target rate was 1.0% when 2011 started, and they increased their target several times, up to 1.5%. In this case mainstream New Keynesian models predict exactly the same outcome as market monetarist models. Fiscal austerity was actually slightly more intense in America (since 2011) than in the eurozone, so that can't explain the difference. It's about as well established a fact as we have in macroeconomics; tight money by the ECB caused the double-dip recession.

The ECB has now woken up to their error, and even the Germans are talking about the possible need for QE. But I don't believe that the press, or economists as a group, have yet acknowledged that the ECB caused the double-dip recession. And I think that might be because pundits show too much deference to central banks. Here's an example:

This sort of mini-tempest isn't unique. Investors, traders, financial writers, and policymakers have developed a startling dependency on what the head of the Federal Reserve does or does not say. Europeans have their own version of it surrounding the declarations of the head of the European Central Bank, but the syndrome is particularly acute for the Fed and Americans.

What Yellen said was fairly innocuous, and should have been taken as such. That it was not speaks to an unhealthy infantilization of finance-land that treats the Fed as some sort of in loco parentis. Yellen becomes the all-powerful mother, whose casual utterances and observations assume oracular weight.

So the central bank is the serious parent, and the markets are spoiled babies. And yet if the ECB is going to be creating catastrophic recessions for no good reason at all, why shouldn't markets hang on their every word? If I lived in a confined space with a rogue elephant, I might watch every little twitch of the elephant's body with great interest, alert for future movements of the beast.

The real problem is that the author (like most other pundits and economists) confuses firefighters with arsonists. The central bank is viewed as a hero, which rescues the economy from unstable markets:

The very notion that Fed policy--or any central bank policy--is the primary determinant of the global financial system should be questioned. Yes, central banks have a played a vital role in staving off crises in 2008-09 and again in the fall of 2011 surrounding the possible departure of Greece from the eurozone.
With all due respect, the suggestion that the ECB's behavior in 2011 was somehow heroic actually boggles the mind. But I do think this is the conventional wisdom among the VSP. And the reference to the Fed in 2008 is equally indefensible. In September and October 2008 the markets were screaming about the risk of deflation and plunging NGDP, even as the Fed seemed more worried about inflation. Only in late October did the Fed finally acknowledge that the markets were right and that deflation was the real risk.

If we are forced to use silly parent/infant metaphors, the markets are the parents and the central banks are the infants, who would be wise to listen closely and learn from the parents.

PS. I admit that it's possible I am wrong about the ECB's role in the recession. But if I am wrong then we should rewrite all our textbooks. After the microeconomic section we should have a single page saying; "economists know nothing about macroeconomics." And that's because if I'm wrong then all our AS/AD and Ms/Md models are completely wrong, and we basically know nothing at all about this recession or the Great Depression.

HT: Ramesh Ponnuru

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COMMENTS (10 to date)
Maurice de Sully writes:

This post seems to assume that the only function of a CB is to increase RGDP.

Is that an accurate reading of this post? If so, what is that assumption based on?

Garrett M writes:

I think the assumption is that the function of the CB should be to stabilize NGDP growth, not RGDP.

Capt. J Parker writes:

The ECB's charter is to maintain price stability, period. So, I would think the first question to answer is: Did they maintain price stability? I'm guessing the answer is yes they did and they did it with a much smaller balance sheet than the Fed ended up with. AND the euro didn't die like Krugman was rooting for AND ALSO Greece is still on the euro. So, relative to their charter the ECB acted competently which is what we should all expect from a central bank - competence. Yes, lots of unemployment pain but, employment isn't part of ECB's charter.

I suppose you could then ask the next question: Wouldn't a different charter that allows more price flexibility and seeks to stabilize the path of NGDP lead to better RGDP growth? But, I would think that before damming the ECB for not having such a policy you need to ask how realistic it would be for the EU member states to agree to it especially given that the Fed sets such a rotten example with its Star Chamber approach to accomplishing its dual mandate. The ECB will never be able to achieve the same results as the Fed until the EU is as politically and economically integrated as the US. Given European's desire to kill one another given half a reason I think the pain they seem willing to suffer to foster some semblance of economic union deserves a medal.

Rajat writes:

Great post.

Michael Byrnes writes:


The ECB failed to meet its single mandate (price stability). More of a focus on price stability would have called for more expansionary policy.

Scott Sumner writes:

Maurice, In my view the central bank should pay no attention to RGDP, instead they should focus on NGDP.

Parker, That's a common misconception. Stable prices is not the ECB's only mandate. I would add that the outcome in Europe was extremely bad (despite the euro not collapsing), and would have been much better with sound monetary policy. Of course Greece would have had lots of problems with even sound monetary policy. But Greece is tiny, and plays almost no role in the 12% unemployment rate.

Edgar writes:

Yes, the ECB has maintained price stability as mandated. Talk about deflation is non-sense. For example, today Spanish newspapers report that annual inflation in the past 12 months has been -0.2% and claim that there is a threat of deflation. This is the kind of nonsense that reporters write thanks to some macroeconomists that have been crying wolf without any serious reference to past experiences of deflation and to how the economy works today in comparison with those experiences.

Also, the idea that ECB should be assessed in terms of NGDP is irrelevant to judge compliance with its current mandate. More important, to assess the ECB or any other central bank in terms of NGDP first one would have to show that it is a relevant criterion as a value that must be achieved even at some cost or regardless its cost and as an objective that a central bank can achieve (I mean a central bank as the ones we have known for the past 100 years, not just an Econ-101 central bank).

theyenguy writes:

[Comment removed for policy violations. --Econlib Ed.]

TravisV writes:

Clearly, "The ECB has now woken up to their error." Have you seen the headlines this week? The ECB is even considering negative Interest on Reserves!! Stock prices have quickly surged as a result of those new headlines:

Stock index price increases since Monday:

MADX: 3.9%
IBEX: 4.0%

HDAX: 3.8%
DAX: 4.1%

STOXX 50: 3.5%
Bloomberg Euro 500: 2.7%

I calculated those increases using

[comment edited with permission of commenter--Econlib Ed.]

Mark A. Sadowski writes:

With respect to the ECB's mandate, the relevant part of the Treaty on the Functioning of the EU is Article 127(1):



Article 127 (ex Article 105 TEC)

“1. The primary objective of the European System of Central Banks (hereinafter referred to as ‘the ESCB’) shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on European Union. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 119…”

And the relevant part of Article 3 of the Treaty on the EU is Section 3:



Article 3 (ex Article 2 TEU)

“3. The Union shall establish an internal market. It shall work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment. It shall promote scientific and technological advance…”

So not only can the ECB concern itself with unemployment, provided price stability is assured the ECB is obliged to contribute to full employment.

Moreover, nowhere in the EU Treaties is the meaning of “price stability” ever defined. So what constitutes price stability is entirely up to the discretion of the ECB.

The Governing Council of the ECB in October 1998 defined price stability as inflation of around 2%, “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%” and added that price stability “was to be maintained over the medium term”. The Governing Council confirmed this definition in May 2003 following a thorough evaluation of the ECB’s monetary policy strategy. On that occasion, the Governing Council clarified that “in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term”.

In short, the Governing Council is at liberty to change the price stability mandate anytime it wishes to. It could for example make the inflation rate target symmetric, it could raise the inflation rate target or it could do away with the inflation rate target altogether and institute a Price Level Target (PLT).

Michael Woodford’s ideal monetary policy target is what he calls an “output gap adjusted price level target” (OGAPLT):

But he agrees that OGAPLT and NGDPLT are similar enough that they can be considered alternatives.

So OGAPLT might be considered a compromise, between the price stability mandate of the EU Treaties, and NGDPLT.

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