Friday, April 1, 2011

Is This How The ECB Thinks?

J├╝rgen Stark is a member of the executive board of the European Central Bank.  He has a piece in the Financial Times that makes me wonder if the ECB really understands what it is doing.  Stark goes after commentators who question whether the ECB's monetary policy has been appropriate for the Eurozone.  He may be responding to folks like Ryan Avent, Kantoos, and myself who have argued that easier monetary policy would be in the best interest of preserving the Eurozone.  Doing so would cause a real appreciation for Germany and France while allowing a much needed real deprecation for the Eurozone periphery.  Unfortunately, he misses this important point and makes some rather astounding claims.  This one in particular was amazing:
My first reason for rejecting the commentators’ view is that in a monetary union, when setting interest rates, the central bank cannot do any better than take an area-wide perspective. This applies to any central bank. Consider the Federal Reserve: it cannot tailor its interest rate to the specific economic conditions in, say, Texas or California. Likewise in Europe, any attempt to favour national over eurozone developments would jeopardise the remarkable success of the single monetary policy in the eurozone: price stability in 17 countries and for 331m people. 
This is absurd.  It is widely known that ECB monetary policy does not take an area-wide perspective,  but rather targets the German and French economies because of their disproportionate size in the currency union.  Studies have shown the ECB does a good job stabilizing these core economies, but is destabilizing when it comes to the currency union's periphery. David Wessel recently made this point with the following figure.  It shows the difference between the Taylor Rule interest rate and the actual short-term interest.  The smaller the difference the more appropriate the stance of monetary policy. 

As you can see the interest rate gap is small for France and Germany and large for the troubled peripheries.  In fact, monetary policy was too loose in the early-to-mid 2000s and probably fueled some of the economic imbalance buildup in the peripheral economies.  Now monetary policy is too tight for them.  Does Stark really think the ECB was ever targeting anything other than the core countries? If he does and if his views are representative of the ECB leadership then the Eurozone days truly are numbered.

So what is Stark's solution to the current Eurozone crisis? Here are his solutions:  
All eurozone countries need to implement the long overdue structural economic and financial reforms, enhance their competitiveness and rapidly restore sustainable public finances... [this] requires downward unit labour cost adjustments in countries with high unemployment and major competitiveness problems; it also requires all national fiscal and supervisory policies to avoid any build-up of imbalances and boom-bust cycles. 
In other words the peripheral countries need to suck it up and endure some structural and deflationary pain.  Never mind that some of these countries imbalances were acquired because of the inappropriate monetary policy in past years.  Is this really the way the ECB thinks? I hope not.


  1. Unfortunately, David, that's the way the ECB thinks. We will find that for sure this Thursday at the ECB policy meetings but the chances are they will go ahead and raise rates. They have to, not because the economic data or the actual anecdotical reality justifies that, as you rightly point out in your numerous posts, but because the markets "dictate" them to. Their credibility, not the one which calls the economy right - in fact the ECB rarely does that - you see, calling the economic reality right is not part of their mandate, rather the one that they stick to their word, so that credibility will be shattered if they do not raise rates - and the markets will punish them - probably selling the EUR. If it was just the ECB only... It seems that majority of the Fed's governors have also gotten the hawkishness bug - it seems Dudley, and I hope, Bernanke are the last ones (doves) standing. If the Fed also embarks on the lunacy of raising rates this year, with all the fiscal austerity measures splashing around both sides of the Atlantic, and with the Chinese way ahead in the game of tightening... Well if that happens, this global policy mistake would seriously throw us back into depression economics...

  2. Great post.

    But I have to disagree with this one:

    'endure some structural and deflationary pain'

    Spain needs about 5 to 10 years of 4 to 5% GDP growth to solve its unemployment problem. There is no way such a rate of growth will be accomplished in 2011 or 2012. such a growth rate will also need accompanying government investments, as it requires the development of entire new economic sectors - but the government doesn't have the money to enable this. In the meanwhile, U-5 unemployment is about 25% and youth unemployment is almost 50%.

    And Spain is not the only country having problems...

  3. Anonymous:

    Just to be clear, when I said "endure some structural and deflationary pain" I was attempting to summarize Stark's view. My own view described in the links above is that the ECB could do some good--though it wouldn't solve all the problems--with more expansionary monetary policy.

  4. The basic fact is that the monetary and fiscal needs of the various EU countries are wildly different, and Wessel's graph makes this abundantly clear.

    Even in good times, the Euro concept was suspect. In tough times, there really are no good solutions.

    This is the inevitable result of a flawed policy decision.


  5. "Structural adjustment" requires that PIIGS bondholders absorb losses; bondholder losses lead to credit tightening; and therefore the ECB is dragged along to bail out bondholders at 100 cents on the dollar. Should Merkel face the German voters after proposing a sufficiently-large PIIGS bail-out, or should she wait for the ECB to ride to the rescue? I think we know the answer.

    This was essentially the point of Kocherlakota's recent speech: in theory the central bank is independent of a "reckless" fiscal authority (he didn't mention reckless shadow banks); in practice, it is not. The question is, in the long run, does a stabilization regime (such as NGDP targeting) dampen or feed this dynamic?

  6. isn't the point that the european system is incomplete. The ECB targets the core, as the periphs are economically insignificant. it is doing what i ought to do.

    I don't think the ECB ought to use monetary policy to try and paper over the failings at the fiscal level. by focusing on its 'narrow' mandate in this way, it may force the fiscal authrities to complete Europe's fiscal infrastructure - of course, it may also cause it to crack