Thursday, January 27, 2011

The ECB is Getting Something Right

The ECB, according to Kantoos and Scott Sumner,  is effectively targeting a stable nominal GDP path for Germany.  Moreover, it is doing a fine job at it.  Kantoos further shows that nominal wage growth is being stabilized around 2% a year.  I take that to mean the ECB is not just effectively targeting nominal GDP, but nominal GDP per capita for Germany.  This comes close to what I think is an ideal goal for monetary policy for reasons discussed here

Now while the ECB's monetary policy may be great for Germany it is too tight for the periphery of the Eurozone.  Because this one-size-fits-all monetary policy makes it difficult for the the Eurozone  to solve its current problems, the European countries seemingly face the tough choice of giving up their currency union experiment or giving up their national sovereignties to make the currency union more functional. Ryan Avent notes, though, that there is a third way to solve this problem: have the ECB loosen monetary policy such that there is a real appreciation in Germany and real depreciation in the Eurozone periphery.  I liked his idea and followed up with this:
[H]ere is another option: more monetary easing by the ECB.  As Ryan Avent explains, further easing by the ECB would cause a real depreciation for the Eurozone periphery vis-a-vis the Eurozone core:
[T]he key to a relatively painless internal revaluation is inflation in tighter markets. And it's here that the European Central Bank could play a particularly useful role. Were the ECB to adopt a looser monetary policy, we would expect inflation to pick up first in the markets with the least excess capacity, and that would obviously mean rising prices for Germany.
Prices, therefore, would increase more in Germany than in the troubled periphery.  Good and services from the periphery would then be relatively cheaper.  Thus, even though the exchange rate among them would not change, there would be a relative change in their price levels.  This  would make the Eurozone periphery more externally competitive.  The relative price level change would not be a permanent fix to structural problems facing the Eurozone, but it would provide more time to address the problems. 
Of course, this option seems unlikely. My impression is that the one thing Germans hate more than Eurozone bailouts is Eurozone inflation. Any thoughts Kantoos?


  1. On Germans hating eurozone inflation –

    I've been wondering whether the ECB could implement such proposals while still complying with its statutory primary obligation of delivering price stability.

  2. David,
    I think it's helpful to go back to this post and look at kantoos’ graph of Eurozone NGDP:

    Notice how easy it is to place the trendline and what it reveals about the deviation in trend starting in late 2008. Notice also the very slight deviation below trend around 2005.

    I think it’s useful to remind oneself that Germany is part of a currency union, and effectively has been so since 1998. When I saw the graph of Eurozone NGDP and the graph of German NGDP I instantly wondered what the graphs of the NGDPs of other Eurozone members looked like.

    Well, as you might imagine, and as Scott suggested, the smaller members generally show relatively large deviations from trend. But what was interesting is that the graphs of the NGDP of France, Italy and Spain, which collectively account for nearly 50%of Eurozone NGDP, are each about as smooth as a baby’s bottom through early 2008. Their NGDPs behave exactly as you would expect, given relatively large nations and a minimally competent central bank.

    So putting all this together, it’s quite clear that Germany is the outlier in that it is a relatively large nation showing large deviations from Eurozone trend. Which brings me back to the graph of Eurozone NGDP. Remember that slight deviation below trend at around 2005? Well that can be accounted for almost entirely by Germany’s relatively slow NGDP growth around that time.

    So where would I place the German NGDP trendline? I wouldn’t place it below that apparent “bubble” like Scott and kantoos. I would place it in such a way that it most closely matches the facts of the overall Eurozone NGDP graph. In other words it would place it more or less tangent to the peak of German NGDP in early 2008.

    Are there other facts to make me think this is appropriate? Well, let me list a few:

    1) Real wages in Germany are lower now than they were 20 years ago at the time of reunification.
    2) RGDP growth over 1998-2007 averaged 1.6%, lower than any other Eurozone country save Italy.
    3) German unemployment was double digit from April 2004 through May 2006, peaking at 10.8% in March 2005.
    4) Most importantly, in 2010 Q3 employment was up 0.9% over 2008 Q1, hours per worker was down 0.8%, and total hours were up 0.1%. So it would appear that hours per worker has mostly recovered from worksharing. However, in the third quarter RGDP was still 1.8% below its previous peak in 2008 Q1. Putting the two facts together means that GDP per hour worked is still 1.9% lower than it was two and a half years ago. Furthermore, conservatively assuming a trend RGDP growth rate of 1.6% annually, that means that RGDP is about 6% below trend.

    In short, my evaluation of German NGDP growth is that it is probably only slightly better than the rest of the Eurozone core. I don't think the ECB is getting *anything* right. It's time to sack Trichet and get the ECB to bring the whole Eurozone back to its long run NGDP trend.

    I think Ryan Avent hits the nail on the head with respect to policy. But, unfortunately, I think you're absolutely right with respect to realism. Germany hates inflation just as much as it hates bailouts.