(18) Euro and Monetary Policy

What is the European Debt Crisis?

Europe in crisis? Despite everything, its citizens have never had it so good

COURSE - The Eurozone Crisis

European crisis: The markets are already there



Euro Indictment

The global credit bubble and its bursting during the first decade of the twenty-first century set off a search for the culprits. The investigation is fundamentally historical rather than criminal. The actions and flaws of institutions and individuals are coming under scrutiny. The investigators are also turning to wider social and economic forces which in combination might have been responsible for the disaster.

A search for the causes of economic and financial breakdown has some similarity with the pursuit of the blame for the eruption of war. The analogy is only partial because investigations into the breakdown of peace can lead to indictments of war guilt. The identified person or organisation could be due for punishment (sometimes posthumously in a purely hypothetical court process) for crimes against humanity or lesser charges. Crime and punishment are not at issue in the investigation of the economic debacle.

In general, blundering central bankers and finance ministers did not deliberately or knowingly stoke up the possibility of economic calamity in a wager from which there could have been handsome national (and personal) gains. Perhaps some of the economic policymakers at a rare moment during the phase of stimulus might have had a fleeting insight as to how things might all go very wrong. Maybe they should have acted on those insights by the exercise of greater caution. Even so, there was no target for their recklessness – no designated victim to pay for the potential gains, no enemy to be vanquished.

The main purpose of the investigation into economic calamity - and this is also an important purpose in war investigations – is the exposure of frailties and fault lines which allowed the catastrophe to occur. The hope of many investigators is that a better understanding of what went wrong can lead on to a set of remedies which will prevent anything similar happening in the future.

Historical investigations are decentralised. There is no chief prosecuting counsel. Rather, experts, politicians and commentators, undertake their own research and analysis, sometimes alone, sometimes in organised groups. In the example of such investigations into the global credit bubble and bust of 2003-2009, the areas of suspicion have included halfbaked or downright false monetary doctrines, regulatory regimes with no safeguards against the regulators falling asleep and which inadvertently overrode and distorted potential disciplinary mechanisms operating in the marketplace, financial intermediation based on systemic underestimation of risk and perverse standards of remuneration, severe inefficiencies in capital market pricing – embracing the crucial topic of how to value bank equities, Confucian tradition in East Asia and many others. In reflective moods, investigators have raised important doubts about inherent flaws in the functioning of Adam Smith’s ‘invisible hands’ – in particular those guiding the production and dissemination of reliable and insightful financial information, whether by stock market analysts or investigative business journalists.

Many of the eventually identified culprits and their defenders have responded by attempting to demonstrate that others were to blame. A sampling of the literature and media on the subject of blame would reveal that ‘indictments’ handed out so far by the decentralised investigation are far-reaching. In some ‘trials’ or pre-trials, the targets (of the indictment process) have been prominent central bank officials, all the way down from Alan Greenspan and Ben Bernanke (where the charge list starts with inducing severe monetary disequilibrium).

In other trial processes, it is collective entities or groups which stand accused – the government of China (for its exchange rate policy), East Asian households and businesses for saving too much, regulators - including prominently the SEC, BIS and central banks in Europe and the US – for being blithely unaware of what was occurring in the areas they were regulating, innovators for producing flawed financial products, business managers or clients who failed to spot the problems, analysts or journalists who failed to discover or uncover what was really going on (especially in terms of leverage and broader risk-taking) within the financial sector, investors who were blind to or in a state of delusion concerning the risks of leverage and who put an extraordinarily high probability on one particularly favourable scenario (without rationally making appropriately high estimates of probability weights for less favourable scenarios, or even thinking about these clearly). A big omission in the list of potential suspect areas has been the new monetary regime in Europe which replaced at the end of 1998 the previous regime headed by the Deutsche mark and the Deutsche Bundesbank. Correspondingly there has been no indictment either against European Monetary Union (EMU) or against the European Central Bank (ECB), or any leading euro officials.

The central theme of these texts is that the launch of the euro unleashed forces which played a critical, albeit not exclusive, role in generating the global credit bubble and in making the post-bubble period unnecessarily painful and wasteful, most of all in Europe. A succession of bad policy choices by the ECB is an integral part of that case.

As we shall discover in the course of the narrative, structural flaws in the new monetary union – some of which might have been reduced in size if the founders of the union had not handed responsibility for designing the framework of monetary policy to the just-created ECB (within which the secret committee in charge of the design project was headed by Professor Otmar Issing, appointed Board Member and Chief Economist, was given only a few weeks to complete the task) - and policy mistakes by its operatives (including crucially those at the ECB) combined to make the outcome so much worse. (The distinction between structural flaw and operating error cannot be hard and fast in that there are grey areas where the two are inseparable.)

In this first text, a set of accusations is levelled at EMU and specifically its institutions as the prime culprits. This forms the indictment. In the rest of the book the evidence to support the indictment is presented in full and so are the claims in defence of the accused (much of which takes the form of diverting blame to other targets). A balancing of accusation and counter-claims leads to a hypothetical judgement as to the best way forward for monetary union in Europe. This judgement includes an outline of remedies to contain the dangers posed by EMU both during the painful aftermath of the great bubble and the bust of 2003-2009 and well beyond.

The launch of European Monetary Union (in 1998) set off a sequence of monetary and capital market developments in Europe which seriously contributed to the global credit bubble and subsequent burst through its first decade (and beyond) with particularly damaging implications for the European economies.

Though the European Central Bank (ECB) undoubtedly faced big challenges and was handicapped by essential flaws in the architecture of monetary union, its poor design of monetary framework (even recognizing constraints due to public scepticism regarding its mission of achieving price level stability) and bad mistakes in policymaking, which magnified greatly the economic damage, were avoidable. We proceed to the charges in detail.

Faulty instrument board

The sequence of developments from the launch of the euro to the credit bubble-and-burst started with an almost total unreliability of the instrument board to be used by the pilots of monetary policy (the central bankers) in the newly created union.

The essence of the problem with the instrument board was the lack of basis for confidence that any chosen definition of money supply in the new union would be a reliable guide for policymakers seeking to achieve the aim of price level stability as mandated by the founding Treaty of Maastricht.

This absence of confidence stemmed from the fact that little was known about either the extent of demand (in equilibrium) for the new money (in the form of banknotes and bank deposits) or the dynamics of its supply (how vigorously the overall stock of bank deposits would expand for any given path of monetary base).

Even the best monetary engineers under skilful instruction could not have fully fixed that problem. We shall see later, though, how enhanced monetary base control together with modestly high reserve requirements might have partially fixed it.

With the passage of time the problem might have been expected to become less severe as learning took place. And it was reasonable to hope, moreover, that policymakers would devise extra checks and balances to contain the extent of monetary instability caused by the unreliability of the instrument board and thereby the ultimate damage which might result. Such hopes were dashed. Flawed monetary framework and incomplete mandate Right at the start of the monetary union, and indeed even in the half year before its formal start (from mid- to end-1998), the founder members of the ECB Council took a series of ill-fated decisions regarding the design of the monetary policy framework.

In seeking to understand how these mistakes occurred, we should not underestimate the difficulty of the task awaiting the founding policymakers of the ECB, especially in view of the defective instrument board.

The ECB Council, in the short time from the EU Summit of May 1998 (where the heads of state took the formal decision to proceed to the final stage of EMU) until the last date possible to have worked out a fully operational plan (autumn 2008) ahead of the euro’s launch (1 January 1999), had to decide how to interpret and implement the key Article 105 of the Maastricht Treaty with respect to the new monetary union.

Article 105 states:

The primary objective of the European System of Central Banks (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 Community with a view to contributing to the achievement of the objectives of the Community as laid down (in article 2).

The treaty left it to the ECB to interpret carefully what price stability should mean and how this could be achieved. As it turned out, the feasible time for deliberations stretched only over a few weeks. All of this was unfortunate.

The treaty writers should have set a clear set of guiding monetary principles. The guiding principles of the Treaty (the monetary clauses) should have included the goal of monetary stability alongside the aim of price level stability in the long run.

Monetary stability means that money does not become a source of serious disequilibrium in the economy (the proverbial monkey wrench in the complex machinery of the economy).

Money becomes a source of disequilibrium when it drives market interest rates far out of line with the neutral or natural rate level consistent with stable long-run equilibrium conditions and by more than any optimal control adjustment which well-functioning markets would produce (with long-run money supply growth anchored) in a starting situation of imbalance in the economy – for example, a severe recession. (In some severe recessions markets can be well functioning only if the ‘zero-rate barrier’ to nominal interest rates falling into sub-zero territory is removed). Monetary instability can occur without any symptom in the form of the price level for goods and services rising over the short or medium term. Instead the symptom might be temperature swings in asset and credit markets (in extremes these produce bubbles and bursts) driven in considerable part by the central bank first steering money interest rates far below the optimal path in a period of time when the economy is regaining balance (after a recession-shock) and later keeping them below the neutral level consistent with continuing overall equilibrium.

(The neutral level of interest rate is the natural rate plus the average annual rate of price increase expected over the very long run; in the gold standard world, that rate of increase was zero, and so economists originally made no distinction between the two terms.)

Monetary stability and price level stability in the very long run are partly overlapping concepts and are sometimes not mutually achievable. The goal of monetary stability has to be missed (to a moderate degree) over some medium-term periods so as to achieve the aim of long-run price stability.

The element of the trade-off between the two aims here – monetary stability and price stability in the very long-run – shares some appearances with the trade-off in the much discussed dual mandate of the Federal Reserve, which is charged by Congress to pursue price stability and full employment. But that dual mandate is in a main part phoney, based on a Keynesian notion of higher employment rates being attainable via the engineering of inflation. As we see below, the dual mandate of monetary stability and price stability in the long-run, though harder to grasp, is of greater substance.

The friction between the requirements of monetary stability and long-run price stability is an essential and perennial source of disturbance in the modern economy. The Treaty makers should have provided some guidelines for the ECB to manage the friction. The friction arises from the fact that the aim of price level stability over the very long run might require the deliberate creation of some limited monetary instability. Moreover, the pursuit of monetary stability should involve sometimes the generation of short- and medium-term price level instability even though this might induce some concerns about the likely attainment of price level stability in the very long run. For example, during a spurt of productivity growth or terms of trade improvement, the price level should be allowed to fall. If by contrast, the central bank tries to resist the forces driving down prices it might fuel a credit-and-asset bubble (symptoms of severe monetary disequilibrium). Similarly, if the central bank resists price level rises driven by real sources, such as sudden energy shortage, an abrupt fall in productivity or in the terms of trade, it would generate monetary disequilibrium with the symptoms of asset and credit deflation (among other symptoms also). Moreover, some price level fluctuation up and down with the business cycle is part of the benign process by which the capitalist economy pulls itself out of recession and should not be resisted by a central bank mistakenly zealous about achieving price level stability over too short a time period. It is not possible, though, even without such zeal to exclude totally some episodes of monetary instability if serious about the purpose of attaining price level stability in the very long run.

It may be that the price level has drifted through time well above or below the guidelines consistent with long-run stability, even though there has been no serious episode of monetary instability. For example, most of the real shocks (such as productivity growth, terms of trade improvement) may have been in the direction of driving the price level downwards. In that case, there has to be some deliberate injection of controlled monetary disequilibrium towards achieving the long-run price level target. This can be done in a context of decades rather than years – as was indeed the case with the functioning of automatic mechanisms under the gold standard (see Brown, 1940).

No attempt to construct automatic money control mechanism In our monetary world outside the golden Garden of Eden (a romanticization of a complex reality!) from which we were expelled in 1914, a replacement-stabilizing mechanism (for fine-tuning the extent of monetary disequilibrium to be created towards attaining price stability in the very long run), as automatic as possible, has to be constructed. The likely delicate mechanism has to be capable of opening more fully or partially closing the tap of new monetary base supply as required so as to maintain monetary stability and yet go easy on that objective to the minimum extent necessary to sustain price stability in the very long run. The drafters of the Treaty did not mention at all the fundamental juxtaposition of monetary stability with the aim of long-run price level stability. They did not specify how the best automatic mechanism should be designed for limiting the essential degree of monetary instability required for long-run price level stability. This big omission left the way clear for fatal errors in the design of the monetary framework and in subsequent policymaking. The Treaty should have provided for a much more comprehensive review surrounding the design of the monetary framework and for this to take place in an open, not secret, forum. There should have been ample time (perhaps one year between the EU Summit deciding to proceed with EMU and on which countries would be founder members to the actual start, rather than just six months) for the design process and even longer to allow for needed institutional modifications (especially as regards reserve requirements) to occur towards creating the best possible money control system.

There was a wide range of suggestions available from the well-known literature of monetary economics for the ECB framework-design committee (under Professor Issing) to take on board in the course of their work.

Botched output from the secret ‘Issing Committee’ No available evidence indicates that the ECB at the start undertook an appropriate review of alternative ways in which the Treaty’s albeit imperfect specification of price level stability as the ultimate aim should be made operational, even if an impossibly short time-framework for final decisions on monetary framework was amply to blame. One possibility (choice 1) would have been the targeting of a trajectory for money supply growth over time at a low average rate (deemed to be consistent with the price level being ‘broadly stable’ over the very long run, albeit with considerable swings possible up or down over multi-year periods and also with considerable short-term volatility).

The ‘central path of the price level’ (abstracting from white noise and transitory disequilibrium) would be determined by equilibrating forces (which would balance supply and demand for money as for all other goods in general equilibrium). The price level would be one variable among many to be solved in the process of achieving general equilibrium. In the short-run, there could be considerable disequilibrium! This monetary targeting might have been coupled with the setting of a quantifiable guideline for price level stability in the very long run (say a ten-year average price level – calculated for the present and previous nine years – which is 0–10% higher than the previous ten-year average for the period 10–20 years ago) so as to monitor that this ultimate aim is indeed likely to be achieved. (Perhaps the broadest of all price indices, thoroughly revised on the basis of new evidence about the past, the GDP or private consumption deflator, would have been used in this calculation). Signs that the price level path might be going astray relative to the aim of stability in the very long run would lead to a twigging of the monetary targeting – meaning a revision in particular to the rule specifying the expansion rate.

Monitoring signs of potential difficulties in meeting the aim of price level stability in the very long run and of achieving monetary stability in the present were bound to be challenging in the new monetary union given the lack of knowledge about the nature of the demand for money (technically the money demand function). The accumulation of evidence that the aim (of long-run price level stability) might well be in danger or that monetary instability was forming would feed back to a review of the rule used to determine the targeted path for the chosen monetary aggregate. There would be the key issue of what particular definition of money to select, with the possibilities ranging from narrow to wide.

Later in these texts, the argument is presented that the narrowest of definitions would be best, subject to a revamp of reserve requirements (so as to foster a more stable demand for reserves).

In effect the target would be set for high-powered money (reserves plus cash in circulation) – alternatively described as monetary base – and not for any wider aggregate. The revamp of reserve requirements, however, which would be essential towards the success of a monetary base targeting system, was not feasible, even if deemed as optimal, in the rushed circumstances of summer 1998. (The UK, so long as it kept open the option of being a founder member of EMU, had blocked all discussions of this issue. But in May 1998 the UK had made the final decision against becoming a founder member.)

Choice 1 (of a method to make the Treaty’s ultimate aim of price stability operational) would have been consistent with the propositions of Milton Friedman (even though he did not recommend that his famous x% p.a. expansion rule should apply to monetary base but to a wider aggregate and he would have been cool to the suggested variation of including a guideline for the price level in the long run), who in his famous collection of essays under the title of The Optimum Quantity of Money (Friedman, 2006) had rejected the setting of a price level target in favour of a money supply target. (In technical jargon the money supply would be the intermediate target selected so as to achieve the long-run aim of price level stability.) Choice 1 might also have found favour with the Austrian School economists, providing that the process for setting money supply targets was sufficiently flexible.

The ‘Austrians’ (see, for example, Hayek and Salerno, 2008) argued that the price level consistent with monetary stability (including money performing its function of reliable long-run store of value) could vary up or down by significant amounts over the short- or medium-run if productivity growth and/or the terms of trade shifted considerably. Also, the price level should fluctuate in accordance with the business cycle, with a wide span of prices (most of all in the cyclically sensitive industries) falling to a low point during the recession phase and picking up into the recovery phase.

This pro-cyclical movement of prices is indeed in principle a key automatic stabilizer – inducing consumption and investment spending by the financially fit households and businesses during the recession (as they take advantage of transitorily low prices) and in encouraging some households and businesses to postpone spending in the boom phase of the cycle (in the expectation that prices will be lower during the cooler next phase). In a situation where there are firm expectations of the price level rising by say 2% p.a. on average over the very long run, it may be that the benign cyclical fluctuation of prices should be expressed in terms of the rate of price rise falling below long-run average in recession and rising above during say the early recovery phase or later in the boom phase. These cyclically induced changes in the pace of price level increase should not be interpreted as signifying monetary disequilibrium. These key insights of the Austrian School were referred to earlier in this indictment.

According to the Austrian School (see Hayek and Salerno, 2008, and von Mises, 1971) the overriding principle of monetary management should be that money does not become the ‘monkey-wrench’ in the economic machinery (the phrase attributed to J. S. Mill and famously re-quoted by Milton Friedman – see Friedman, 2006). This means (as highlighted in an earlier indictment) that money interest rates should not be allowed to get far out of line with neutral or natural levels (which in turn fluctuate through time according to such influences as the range of investment opportunity or propensities to save). Monetary stability is defined by the money not becoming the monkey wrench. The big problem for the Austrian School is how practical policymakers can interpret this prescription when the neutral or natural rate might vary considerably over time and be hard to estimate with any precision. And what meaning should be given to ‘far out of line’. When an economy is in the severe recession, ideally the normal self-recuperative forces in a capitalist economy should produce a path for interest rates which for some time would (with long-run money supply growth firmly anchored) be well below the neutral or natural rates which would prevail in long-run equilibrium. (As we shall see this ideal might run into conflict with a zero rate boundary).

The famous ‘Taylor rule’ stems from an attempt to discover the optimal path for interest rates relative to the natural or neutral rate through all-too-common periods of economic disequilibrium without having to depend on market revelation and using instead the black box of econometrics and optimal control theory. But among other problems, this rule requires knowledge of the neutral rate of interest and the exact degree of slack in the economy, and like all econometric hypotheses depends on the stability of the underlying relationships estimated. The Austrians could concur with those monetary economists from other schools who argue that the most practical way forward would be to target high-powered money (defined as the total of bank reserves and currency in circulation; high-powered money is the same as what is sometimes described as monetary base), while allowing as much scope as feasible for markets to determine even short-term interest rates.



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