…Scott Sumner believes that arguments against austerity are not just wrong, but impossible:
1. The eurozone needs to move away from austerity to boost growth.
2. The ECB cannot do monetary stimulus because of its inflation mandate.
Statement 2 might be false, in which case the ECB should do monetary stimulus to boost growth. Or it may be true, in which case ending austerity will not boost growth (due to monetary offset.) But either way, the European consensus seems to be making an EC101-level error in logic. How a continent of 500 million highly educated people could make such a costly error without almost anyone noticing is beyond my comprehension.
He’s right that there is a paradox, operating under only the two given statements. But there’s an important third: (3) The ECB cannot do monetary stimulus because it can’t convince anyone that it can do monetary stimulus. One of the more glaring flaws of liberal commentators is to suggest that monetary policy has failed because even a puffed-up monetary base hasn’t resulted in robust growth. However, that’s not the key transmission mechanism at play, indeed there are two shining examples to the contrary: consider Switzerland and Japan. The former is (surprisingly) rather subdued in monetarist discussions (or perhaps I don’t have a close-enough ear to the debate).
Remember in 2010/11 when everyone was scared the Swiss franc’s (CHF) rapid appreciation would turn into a deflationary spiral? Indeed, as the Swiss National Bank’s (SNB) purchase of foreign reserves failed to depreciate the CHF sufficiently, we were all worried that the central bank is fundamentally limited in its capacity to effect aggregate demand.
But then, one fine day, the SNB promised it would keep the CHF at 0.83 Euros – no questions asked. And, as if by magic, this worked. Monetarists have argued for some time the driving force behind central bank policy is its message not necessarily action thereof. Naturally, if action is not sufficiently coincident with message, credibility is threatened – but that’s another story. By targeting a Euro exchange rate, the SNB emphasized its ability to mint currency at will, assuaging market worries with regard to deflation. Policy was no longer tethered to ownership of foreign reserves. Problem solved.
The story of Abenomics is so saturated in today’s blogosphere that I’ll avoid any serious detail. But its victory doesn’t stem from any action as much as Shinzo Abe’s perseverance and conviction, bordering on a threat to central bank independence itself. Markets didn’t soar soon after his expected victory because he got together with the Bank of Japan (BoJ) to print some of ’em yens. Rather, his party’s overwhelming victory suggested that he could and would threaten BoJ incompetence and hence independence if necessary. Remember, the BoJ had actually tried “exotic” action before, but no one believed it would credibly tolerate inflation. We (and I mean liberals) want to measure monetarism by how fast a man’s feet are moving and how long his strides are (monetary base and interest rates). We tend to ignore whether he’s running on ice (BoJ pre Abe), gravel (SNB), or a vertical hill (ECB).
But the problems facing SNB and BoJ are very different from the Fed. And still more different from the ECB. Both SNB/BoJ (and the Fed too) are national banks. Even if central bank independence is far more cemented today than during the disaster of Arthur Burns, it’s clear that political forces play a big role. The primary concern of SNB and BoJ is economic prosperity in their respective countries. If the Fed was ever hurting America, Congress would step in. Neither are not crippled by a fallacy of composition.
The ECB faces distributional and compositional challenges: Germans are unwilling to tolerate above-trend inflation to help their Greek “kin”. Markets understand this political, cultural, and social bind and are hence unwilling to believe that the ECB can optimize long-run growth for the Eurozone as a whole.
But wait, “whatever it takes” you say? The ECB – as the chief guardian of, well, the Euro – credibly promised to stabilize markets (and, ipso facto, did) last summer when it seemed EZ breakup was a serious possibility. I, perhaps counterintuitively, argue that this betrays its fundamental flaw. Eurozone nations are now thrust into an uncomfortable purgatory. If political situations deteriorate so as to threaten ECB’s existence, the bank promises to keep the currency together. But it cannot credibly commit to an economically optimal policy, Maastricht be damned. In this sense, it’s a little like a gold standard.
So far, nothing refutes Sumner’s paradox that if the ECB holds fast to its inflation target fiscal expansion will be offset. And if the ECB governors were an open market incentivized by their vote, he would still be right. But they’re not. There’s a difference between consciously taking inflationary action by increasing the target and not doing anything if just Germany overheats. With a growing consensus in the German political elite that a devastated generation of Southern European youth is not a good thing, to say the least, there is reason to believe central banks will not fully offset expansionary policy. This is irrational – but until unless ECB policy is decided on a thick and open market, we’ll have to deal with that.
The American problem is different still, a profound mismanagement of expectations. Ben Bernanke did not even attempt to convince the market that the Fed can do anything. About the Fiscal Cliff he had to say:
I hope it won’t happen, but if the fiscal cliff occurs, as I’ve said many times, I don’t think the Fed has the tools to offset that event
Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant.
Suffice to say a non-negligent portion of the market does not believe the Federal Reserve can, has, or will offset fiscal consolidation. That the sequester was a random surprise just further seeds this belief. In this world, fiscal expansion is not self-defeating.
So far we have:
- SNB/BoJ that successfully controlled expectations: +1 for market monetarism.
- ECB which can only commit to keeping the EZ in a perpetual purgatory: -999 for the idea behind a common currency in a non-OCA. (If you’re a monetarist, -999 for not listening to Milton Friedman)
- The Fed which mismanaged expectations royally: -1 for fiscal consolidation (= +1 for stimulus)
And there’s one more. The Bank of England whose erstwhile boss Mervyn King advocated austerity, and argued that he could and would offset negative effects on growth. He couldn’t or the MPC wouldn’t. So:
- The Bank of England managed expectations and promised monetary offset. It did not work: -0.5 for market monetarism.
Look, the key insight monetarists have suggested is that interest rates at the ZLB and a nominal GDP target is sort of analogous to an appreciating currency against depleting bank reserves and an exchange rate target. But the complexity of fiscal expansion (read: uncertainty) and inability to set the right expectations underscore the staying power of fiscal policy.
There’s also another facet of monetary offset that is little talked about in monetarist circles, presumably because of a libertarian bent thereof. Government purchases represent real goods with distributional value for the poor. The discussion of quantity has drowned the eminently more important quality of government goods and services. Low interest rates are a good time as ever to engage in large endeavors with positive spillovers – a smart power grid, and vast investment in basic research.
The expectations channel is a powerful mechanism, rusted by the compositional structure of the European Central Bank. The efficient market hypothesis suggests where exists irrationality, there exists a free lunch. A less than rigorous application might be between national fiscal planners and the European Central Bank.