Scott Sumner  

Bloggers >>>>>>>>>> Central banks

Nathaniel Branden, RIP... Robert Murphy on the 1920-21 D...

Over the past 6 years the blogging world (especially market monetarists) has been highly critical of central banks. Outsiders might have trouble discerning who's right. After all monetary policy is highly complicated. Why should we care about the views of a bunch of guys wearing pajamas, sitting in their basement typing away with two fingers? Central banks are full of talented economists from elite universities.

But this isn't one of those he said/she said situations. We know who has been right, because the central bank have consistently changed policy, and done so in the direction the market monetarists (and to be fair some Keynesians as well) recommended. First the Fed. Then the Bank of England and the Bank of Japan. More recently the Riksbank admitted it screwed up. And today we see the ECB admitting that they have messed up badly:

FRANKFURT (Reuters) - The European Central Bank slashed its forecasts on Thursday for growth and inflation over the next two years, saying the outlook had deteriorated since its last staff forecasts were published in September.

It forecast 2014 inflation at 0.5 percent, rising slightly to 0.7 percent next year and 1.3 percent in 2016.

The ECB is a bit vague about their inflation target, but it's believed to be around 1.9%. So their policy will continue to fall well sort of this target, as it has in recent years. We told you so. (And they are still too optimistic.)

I don't think this is just luck. The blogging world is highly competitive, whereas central banks are cumbersome monopolies. After a while people tune out bloggers than consistently cry wolf, predicting hyperinflation. In contrast, failed central banks face no competition. The following quotation is a perfect illustration of why we must take monetary policy out of the hands of government bureaucrats, and let market forces set interest rates and the money supply:

By lowering its forecasts, which show how the ECB expects the economy to develop, the euro zone central bank will heighten expectations that it will take further steps to bolster the bloc's flagging economy.

ECB President Mario Draghi recently threw the door open for drastic measures to prevent growth and inflation from sliding further and expectations are rising that a move could come as soon as the first three months of next year.

As soon as next year, eh? Under a "target the forecast" policy regime, central banks would not lower their inflation target; they'd change their monetary policy enough so that they still expected to hit their target. It would be analogous to a ship captain who adjusted the steering as soon as she noticed the ship drift off course. The actual ECB is like a captain that takes a three-hour nap before getting around to adjusting the steering, and then does so far too passively. The BOJ is far from perfect, but at least they moved quickly when they saw inflation falling below target. But even Japan could do better with a market-based policy regime, as the markets in Japan saw that monetary policy would undershoot 2% inflation well before the central bank did.

Of course it's unlikely that we'll be able to abolish central banks in the near future. Is there any policy regime that would overcome bureaucratic inefficiencies? Fortunately there is---it's called level targeting. Under level targeting, market forces begin to push prices and NGDP closer to target whenever policy accidentally drifts off course. It's a near perfect policy for a world of incompetent central banks. In contrast, hoping for better leaders will not work. People like Ben Bernanke and Mark Carney are as qualified as anyone in the world to run a central bank. But central banks are bigger than any individual, and can only work effectively with the right policy regime in place. That means NGDP targeting, level targeting.

BTW, the ECB also predicts that Europe will never recover from the recession:

Staff cut their prediction for economic output in the euro zone to 0.8 percent this year, 1.0 percent in 2015 and 1.5 percent in 2016.
Ten years ago Europe was much poorer than the United States. In recent years, it has fallen even further behind. And the ECB now predicts that in the years to come Europe will fall still further behind. Europe was once an inspiring model for the American left. Now it seems stuck in a semi-permanent depression.

Shorter version of post: MMs believe in market forecasts. Anyone who thinks we are wrong can get rich betting against us. What other school of thought will make that offer?

Comments and Sharing

COMMENTS (8 to date)
Kenneth Duda writes:
"The actual ECB is like a captain that takes a three-hour nap before getting around to adjusting the steering, and then does so far too passively."

Isn't the ECB more like a captain who ignores the weather forecast, then takes a nap, and, when he wakes up and realizes he's off course, decides to change the destination for his ship? "Well folks, I know we were trying to get to Alaska, but ... well, how about Oregon instead?"


Kenneth Duda
Menlo Park, CA

James in London writes:

To be a little bit kinder to Draghi personally, and not to his entire dysfunctional ECB, he has successfully talked down the currency vs the USD over the last few months. Way more to go, to be sure, but it ain't easy with the structures with he has to work.

Counterfactually, it could have been so much worse if Trichet had still been around. Several times Draghi's managed to save the day by mere talk, eg the invisible "OMT".

Todd Kreider writes:

"Ten years ago Europe was much poorer than the United States. In recent years, it has fallen even further behind."

Can we have data to back this up?
I get GDP/capita (ppp)

Trading Economics GDP/capita (ppp)=
Euro Area U.S.
2004 $34,200 $47,200
2014 $35,800 $51,500


2004: 72% of US 2014: 70% of U.S.
(almost no change)


Japan 2004: $32,700 2014: $35,500

69% of U.S. 69% of U.S.

Yancey Ward writes:

So, why is the ECB's claimed target of 1.9% inflation better than the actual inflation rate they get? Would you be ok with them setting a target of 0.5% and hitting it? Would you be ok with NGDP targeting of 2%?

In short, what I am asking is this- is the hitting of a target that is good, or is there something special about some targets over others?

Scott Sumner writes:

Ken, Yes, I went too easy on them.

James, Yes, it's not really about Draghi, it's about the entire institution. I would add that the low inflation numbers are a reaction to an earlier slowdown in NGDP. So the problem actually occurred earlier, but it's now showing up in the variable that the ECB actually targets. You are right that the recent currency depreciation is a (small) step in the right direction. Of course the euro is still appreciating against the yen.

Todd, I have no reason to dispute your data. Of course the decline you cite has mostly occurred in the past few years. That's not that surprising, what is a bit surprising is that no recovery is anticipated, instead the relative decline will almost certainly continue. I'd consider 70% to be "much poorer." Note that in the year 2000 blacks in America made about 70% as much as the average American, and most people considered blacks to be "much poorer" than average. If the income ratio had stayed at 72%, then today Europeans would have a real GDP/person about 3% higher than the actual number. Three percent is actually a lot, equivalent to the US defense budget. But I suppose this is all in the eye of the beholder. Given the wealth of human capital in Europe and Japan, I'm surprised their incomes aren't closer to US levels. Obviously they are still developed countries with lots of good features, but I still think the GDP performance is rather poor, and voters in Europe seem to agree.

Yancey, That's a complicated question. In most cases monetary policy is more effective if credible. If you set targets and don't hit them, it can create unneeded business cycles. Now if pressed I'd agree that there are potential targets so crazy that it would be better not to hit them (say minus 99% inflation.)

As far as the best target, I'd prefer NGDP to inflation. But if they insist on inflation targeting of 1.9%, it's better that they hit the target rather than miss. An inflation rate of 0.5% might not be bad if it was their target, but it's really, really bad if the target is 1.9%. And if they plan to shift the target to 0.5% inflation (not a good idea), it should be done gradually over 14 years.

The ratio Eurozone/US is actually slightly improving (for EU side) up until 2012, then it starts to diverge rapidly. I'd call it "too early to say" in terms of long term trends. Not that I'm optimistic, but the data isn't there yet to make the claim that "Eurozone is diverging from US".

Njnnja writes:
In contrast, failed central banks face no competition.
I dunno about that. Euro breakup 2015?

Of course, that would be the exception that proves the rule.

J.V. Dubois writes:

One additional thing, there were several countries that joined eurozone since 2004 with combined population of around 12 millions (out of 333 millions now) - so around 3.7%.

Additionally average per capita GDP of those countries is less than $20k with Eurozone average around 40k. So almost whole slide in relative strength can be explained just by this. But I agree that the trend is pretty bad.

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