Monday, July 9, 2012

The ECB is guilty of malpractice

There is a theory (known as market monetarism) that central banks can control nominal growth. Predicated on the Quantity Theory of Money,  it asserts that the central bank, by controlling M (with V assumed to be within a bounded range) can control nominal GDP*.

Politicians can tune up the engine and improve efficiency (the supply side), but they do not control the throttle (aggregate demand); only the central bank does.

If one steps back and looks at the developed countries today, what is the #1 problem that they all have in common? Answer: low nominal growth, resulting in inadequate employment and tax revenue.

Global nominal growth levels have been falling for thirty years. During the non-recessionary years of the Clinton-Bush era, the US enjoyed nominal growth of >6%%. Today, post-crash, the US remains stuck in second gear at 4%, which had been considered recessionary.

Southern Europe, which used to enjoy modest nominal growth, now has zero nominal growth almost four years after the crash. To paraphrase a prominent market monetarist, you can’t have 5% real growth with 0% nominal growth.

I will now introduce a derivative thesis, which is that fiscal deficits are not primarily caused by the government’s failure to raise taxes and cut spending, but rather by inadequate nominal growth. This is certainly true of the world today. Nominal growth and nominal government revenue growth are historically quite low for a “recovery”, causing high unemployment and fiscal deficits. Higher nominal growth would automatically translate into lower deficits and lower unemployment.

Obviously, real growth is not a linear function of nominal growth, any more than agricultural output is a linear function of rainfall. There can be too little, just the right amount, or too much. It appears that, for modern economies with inflexible labor markets, low nominal growth is not enough, 5-7% is just right, and double-digits is inflationary. Right now, no major developed economies have nominal growth in the optimal range, and most are far below, especially in the eurozone.

The market monetarist theory is potentially Copernican in its implications. If accepted intellectually, it means that fiscal policy is much less important than previously believed, and that central bank policy alone can create or retard growth. It also means that the single central bank mandate of “price stability” is inadequate, since it can be satisfied with very low nominal growth.

We could profitably discuss the Fed and the BoJ in this context, but right now their economies are not on the verge of a collapse. That would be the eurozone, where monetary policy will make the difference between survival and depression.

Today, the ECB has one positive mandate (price stability) and one negative mandate: no fiscal monetization, even if governments cannot otherwise finance themselves.

The evidence suggests that the ECB’s governing council is not divided on this issue. They all would appear to agree that not only do they have only one mandate, but also that there should be only one mandate. Although the Fed has a growth mandate, the ECB doesn’t have one and doesn’t want one--not even now, with the eurozone in extremis.

Draghi told the European Parliament this morning (July 9th) that "I think to have one mandate is already so difficult that to have another would make our life even more impossible”. God forbid that one would want to make the ECB council’s job more difficult, what with all the other important things that they have to do, such as picking out the drapes for their new conference room.

If central banks control nominal growth, and weak nominal growth causes unemployment and fiscal deficits, then the ECB’s governing council and its chairman are guilty of monetary malpractice (which goes beyond nonfeasance since it is deliberate). This is not about arcane technical issues; it is about millions of lives and the futures of nations. The ECB council cannot shirk its moral duty because it is too busy, or because unorthodox monetary policies are “risky”. What we know for certain is that the ECB’s orthodox policies are not only risky, they are suicidal.

If the eurozone is to be saved, it will require a responsible central bank. To stay in the zone, Southern Europe will need at least 5% nominal growth as well as fiscal monetization (yield targeting). These goals are compatible. If fiscal monetization expands the monetary base too quickly, the ECB can mop up excess liquidity up by issuing its own bonds and thus limit the impact.

This would require a decision to amend or ignore the ECB's charter, just as the eurozone has ignored the fiscal and debt provisions of the Maastricht treaty. Such treaties were made to be ignored when necessary. The ECB can provide the eurozone with adequate nominal growth while limiting government bond yields, if it so chooses.

It would be one thing if the ECB council attributed its helplessness to its charter; it is quite another when it explicitly asks that its charter not be changed. That’s the criminal part.
*The “market monetarist” thesis* is a derivative of the classical Fisherian quantity theory of money, which can be summarized as M x V = P x T, or (Money supply) x (money Velocity) = (Price level) x (real economic Transactions).

If V (velocity) is held within a bounded range, then changes in M can bring about changes in P x T, which is nominal GDP. Therefore, the central bank, by controlling the quantity of money in the economy, can control the level of nominal GDP (NGDP).

Scott Sumner’s seminal paper on market monetarism:


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