Beckworth on the ECB and the crisis

The main purpose of this post is to promote David Beckworth's recent paper, The Monetary Policy Origins of the Eurozone Crisis. He presents a "standard view" of the crisis: a 2008 financial panic, which originated in the US, spread to the Eurozone causing a recession. In fact, he plausibly argues the monetary policy errors by the ECB caused an economic slowdown, which then caused the sovereign debt crisis. I recommend the whole article. He says,

This paper has argued that the ECB’s tightening of monetary policy in 2008 and again in 2010– 2011 caused the Eurozone economic crisis...

The ECB’s big mistake was in responding to these changes in inflation as if they were symptoms of a demand shock when, in fact, they were symptoms of a supply shock.

I totally agree that ECB policy decisions played an important causal role in the Eurozone crisis, and I endorse the conclusion that an NGDP level target target would work better. 

My only gripe is that I believe the lions share of the blame should be placed on the monetary regime that they were following (i.e. inflation targeting), rather than the decisions being made within that regime. In other words I don't think that the ECB are really to blame.

It's true that within an inflation targeting regime, policy makers have discretion to "see through" obvious supply shocks. The Bank of England "saw through" a very long period of above target inflation from 2010-2013. But there's two crucial point of difference between the ECB and other central banks, which constrains its actions.

One is that it doesn't have the ability to buy sovereign debt from the Eurozone as a whole. The reason for the ECB's slow uptake of QE is primarily due to the political implications of choosing what portfolio of sovereign debt to buy. It's signficantly easier for the US, UK, Japan etc. So to some extent the ECB had its hands tied in terms of the tools at its disposal.

But the second crucial point of difference, and more relevant to the 2008 and 2010/11 decisions to raise interest rates, is the fact that the ECB is a new institution with an explicit inflation-only mandate (i.e. its target). In particular, the ECB was tasked with keeping inflation below 2%. For most of its early years, this was reasonably successful. In May 2001 inflation hit 3.1% (and interestingly they decided to see through it, so maybe my point is totally facile), but aside from that single month inflation was under 3% from their creation right up until November 2007. By July 2008 it has reached 4.1%, which is double the upper threshold of its target. So this is the first real test of the strength of independance. A decade of suspicion that the ECB would cave in to political considerations for easy money was now under scrutiny. They cannot refer to unemployment as part of any dual mandate, because they only have a single mandate. Saying that they will see through inflation is akin to saying they don't see it as a problem. I can understand why they raised rates because in a "One Target One Tool" framework that's what you do when inflation is high. Especially when you're trying to create a reputation for being inflation hawks.

The US is a great counterexample. Whilst Bernanke cashed in the Fed's credibility by appearing at joint press conferences with Paulson (and doing so much that he could be accused of making matters worse), the ECB did too little. But they didn't have the option of a joint press conference with a Eurozone Minister of Finance, and if they'd ignored their inflation-fighting mandate they'd have jeapordised their raison d'etre.

When David promoted his paper on Twitter, he said

Imagine ECB eased in 2008 & 2011 instead of tightening and did QE earlier. If so, would Brexit be a thing?

I glibly replied,

if ECB totally disregarded its mandate and opted against building credibility would *it* be a thing?

I believe that if they had eased it would have cast serious doubt on the ECB's independence. The impact of their decision was terrible, but I understand why they made it. Indeed if the lesson is that they should have exercised more discretion the implication is that we need different people in charge. On the contrary, we need a different regime. The ECB failed because they were set up to fail.

P.S. I've been listening recently to David's podcast "Macro Musings" - it is really good. I enjoy Econ Talk but when they're over an hour long I struggle to get through them quickly enough. And because I can't be bothered to spend time identiying the ones I have an interest in I've actually stopped listening. By specialising on monetary economics I know that I will want to listen to each new episode of Macro Musings, and it's quickly become a favourite podcast. It's a brilliant substitute for a faculty lounge for those of us outside academic econ departments, but David ensures that key terms are defined and content is provided so non academics can get a lot out of it. I can't recommend it highly enough.

P.P.S. I can't believe my last two posts have been criticising Lars and David, and defending Carney and the ECB. It's been a long academic year and I clearly need some rest!