Sunday, September 23, 2012

They did it again

One of my basic analytical principles is that things reveal their nature in history (including the history that has not happened yet -- that is, what has happened is not the sum of possibilities). If one wishes to understand current events, then cultivate a sense of history for the past is the cause of the present and the beginning of the future.

So, it was both revealing and depressing to read Jorg Bibow's 2003 paper On the 'Burden' of German Unification (also here) (via). Revealing, because the paper shows how destructive the Bundesbank's monetary rectitude could be; depressing because Bibow's analysis of events during the decade before the publication of his paper provides such a depressingly consistent template for events 6 or so years after the publication of the paper.

The unification of West and East Germany in 1991 was the absorption of East Germany by the Federal Republic. Since the infrastructure, technology, firms and level of marketable skills of the East were at a significantly lower level than that of the West, the costs of unification for the German Federal budget were considerable.

Which led to a significant increase in the Federal budget deficit. This, the Bundesbank disapproved of because of its potential inflationary implications. So, the Bundesbank engaged in restrictive monetary policy and public pressure to get the fiscal deficit back down. Which led to the German Federal Government raising taxes to improve the fiscal balance because of Bundesbank pressure while the Bundesbank's monetary policy led to a lowering in economic activity which acted to decrease government revenues and increase government expenditure (i.e. tended to increase the budget deficit).

This became completely farcical when the Bundesbank contracted monetary policy to counteract the effect on the price level of the tax rises it had pressured to occur. That is, the German Federal Government raised taxes to increase revenue only to have the Bundesbank engage in restrictive monetary policy to counteract the price impact of said tax increases thereby effectively negating any effect of the same on the budget balance. So the budget deficit did not improve significantly, but economic activity was below its previous trend.
It was a complete failure of policy coordination.

The Bundesbank did manage to push the German economy onto a lower economic growth path. What an achievement for monetary rectitude.

Once more, with feeling
Fast forward 10 or so years. The Eurozone has been created, with the European Central Bank (ECB) being basically the Bundesbank on steroids. In the words of political scientist Walter Russel Mead, it has become the world's first sovereign central bank. The point of the Euro, apart from achieving "ever closer union", was a Deutschmark for everyone.

Which meant that, until recently, the Bundesbank was calling the shots within the ECB. Which meant doing, in the name of monetary rectitude, deeply stupid things such as including tax increases in the inflation target, with the result that the ECB is not reaching its inflation target, it is systematically undershooting it. Worse, when Eurozone government raise taxes (!!!!) during a prolonged economic downturn to reduce their fiscal deficits, the ECB engages in restrictive monetary policy to counteract the "inflationary" effect of such tax increases, thereby driving down economic activity, so spending, so income, so government revenues and driving up government expenditure.

In other words, just like the Bundesbank in 1992-7, the ECB completely undermines the efforts of Eurozone Governments to reduce their fiscal deficits. All in the name of "price stability".

And doing so while not even managing competent inflation targeting, as the results show.

But the problem is not merely that the ECB has been negating, or worse than negating, any economic stimulus effect from the budgetary deficits. Nor is it even that it undermines the attempts of Eurozone governments to reduce their budget deficits by its monetary austerity.

It is worse than that; its restrictive monetary policies have made their public debt levels much worse. Which has both stressed the European financial system and further undermined the ability to reduce budget deficits (by increasing the cost of servicing public debts.)

If income crashes, one's debt burden gets worse. This is elementary.

If income increases, one's existing debt burden lessens. Which is the classic way to deal with public debt (apart from some form of default) -- to grow one's way out of problems, as outlined in Evsey Domar's 1944 article. As the economy increases, the existing public debt burden lessens.

But if, in the name of "price stability", the central bank engages in restrictive monetary policies to block any surge in activity that "threatens" the inflation target, then that route is blocked.

It is truly astonishing, how apparently indifferent so many "hard money" advocates are to the level of risk to the financial system they are apparently willing to tolerate to block any danger that inflation might get to the dizzying heights of, say, 4%pa. But, of course, we have also been here before. Adherents of the gold standard in 1928-32 were willing to sacrifice both price stability and the financial system to the sacred doctrine of gold. It is as if money stops being a tool for transactions and becomes some sacred principle to which all else must be sacrificed at whatever cost.

As for regarding increases in the monetary base as an example of "loose" monetary policy presaging some inflationary, or even hyperinflationary breakout, the history of the US monetary base in the interwar period shows what nonsense that is.

More recently, the evidence is that ECB President Mario Draghi has decided that monetary union is not, in fact, a suicide pact. While US Federal Reserve's statement of open-ended asset purchases to get unemployment down is a sign that even the Fed has decided that there is a limit to the economic misery to be imposed in the cause of ostentatious monetary rectitude.

The good news is that the Fed has decided to have something like a clear and open target and has apparently accepted that expectations about spending matter as well as those about price stability.
Monetary turnover ("velocity")
Old-style Monetarism relied on the assumption that monetary turnover (how quickly money moves through transactions, what economists call 'velocity'; a very confusing usage to those of us for whom high school Science took a little too strongly) was basically stable. This turned out not to be true. Which turns the focus on expectations, since they drive behaviour -- including whether people hold onto money or spend it. The more insecure people are in their expectations of income, the more they tend to hoard money rather than spend it, and the more the turnover ("velocity") of money drops.

In extremis, this can lead to a severe fall in monetary turnover, so a crash in transactions.
So, expectations about price stability matter, but so do expectations about income (i.e. spending). (Which is why Australia has not had a recession for 21 years; because Reserve Bank of Australia policy manages both price and spending expectations.) It is good that the Fed (and to a lesser extent the ECB) are beginning to get with the program.

What is less good is that the Fed is targeting a "real" (i.e. non-monetary) variable, unemployment. Central banks have great power over monetary matters (price level, spending, etc). They have much less over non-monetary matters. As several econbloggers have pointed out, using monetary instruments to keep employment up and unemployment down is precisely what lead to the "Great Inflation" of the 1970s.

Prominent econblogger Scott Sumner's comments about the limited understanding of so many central bankers appear to be not less than the truth.

Note for non-economist readers:Nominal GDP = GDP in money terms = NGDP = aggregate demand = Price level (P) times output (y) = Py.

[Cross-posted at Skepticlawyer and at Critical Thinking Applied.]


  1. It´s always in their minds:

    1. Hubristic overreach; not their business. The most central bankers are entitled to do is to alert politicians to the monetary consequences. That is what the RBA confines itself to,

  2. This quotation, from an essay titled "Why I am not a Libertarian", could perhaps be generalized to "hard money" fanatics in general:

    "The fixation that some extreme right-wingers have with precious metal is interesting. The stock of precious metal hasn't expanded nearly as fast as the total GNP in recent decades. So basically these people want to hold onto inert metal they themselves did not mine, and see its value skyrocket as other people work to advance technology and build infrastructure. All the while, presumably, complaining righteously about freeloaders who want money without working."