ASI paper “The Real Problem was Nominal” released as an exclusive with The Daily Telegraph

New ASI paper “The Real Problem was Nominal” was released as an exclusive with The Daily Telegraph. 

The Real Problem was Nominal” - written by Prof Scott Sumner, a leading economist who was a key inspiration for the Federal Reserve’s QE3 programme - explains how the European Central Bank  is repeating the mistakes that the Fed and Bank of England made in the 2008 crisis—trying to plan credit and micromanage the financial sector, when the real issue is excessively tight monetary policy.

The paper argues that Eurozone quantitative easing will not reverse the Eurozone’s decline unless it is open-ended and tied more explicitly to the ECB’s inflation target. Targeting nominal GDP—the total amount of spending in the economy, also known as aggregate demand—would be even better, the paper argues, guaranteeing more stability when unexpected supply-side shocks like oil price movements make inflation targeting trickier.

From The Daily Telegraph:

In his paper “The Real Problem Was Nominal”, Mr Sumner finds that tight monetary policy by the Bank and Fed worsened the Great Recession, and is now responsible for the protracted eurozone crisis.

He now recommended that the ECB eases its policy further to achieve its targets, ensuring stability for households and firms.

The central bank should go a step further by target the price level, rather than inflation, so that entrepreneurs can be sure that if the ECB misses its targets this will be compensated for in future.

An ever better option for the ECB to drop its inflation target in favour of a regime of nominal GDP (NGDP) level targeting, requiring policymakers to maintain the growth of total spending in the economy.

Such a system would have prevented the ECB from increasing its interest rates in 2011 when inflation rose because of VAT increases. Tighter policy caused the eurozone crisis to flare up again, from which the bloc has not fully recovered.

Lars Christensen, a senior fellow at the ASI, said: “The ECB needs to end the deflationary policies and hoc credit policies and instead introduce a clear and transparent rule-based monetary policy regime – an NGDP target.”

“This would save the Eurozone from the debt-deflation spiral and would at the same time greatly increase financial stability across Europe,” he added.

Read the full article here.

Author of the report, Professor Scott Sumner, also wrote an op-ed for The Daily Telegraph:

First, let’s clear up a few misconceptions. The recent eurozone recession was not caused by the “zero interest rate” problem. Some economists argue that central banks cannot stimulate demand when their policy rate is very close to zero, as the Bank of England’s has been for close to six years.

But even if this can be a problem, it could not have been between 2007 and 2012, when eurozone interest rates were not at zero. They were consistently above this level and the European Central Bank (ECB) was doing “normal” monetary policy, raising and lowering interest rates to keep inflation on target.

If the eurozone had a shortfall in demand then – and it most certainly did – it’s because the ECB intentionally created it to keep inflation under 2pc. In retrospect, it was a mistake to give the ECB an inflexible inflation target. For instance, when eurozone countries adopted fiscal austerity and raised VAT rates, the ECB decided – in 2011 – to tighten monetary policy to prevent inflation from running above 2pc.

Read the full op-ed here.

Download “The Real Problem was Nominal” for free here.

Press Release: Eurozone QE is not enough for recovery, says US economist behind QE3

For further comments or to arrange an interview, contact Communications Manager Kate Andrews: kate@adamsmith.org / 07584 778207

Eurozone quantitative easing (QE) will not reverse the Eurozone’s decline unless it is open-ended and tied more explicitly to the European Central Bank (ECB)’s inflation target, according to a new paper from the Adam Smith Institute.

The paper, “The Real Problem Was Nominal”, written by Prof Scott Sumner, a leading economist who was a key inspiration for the Federal Reserve’s QE3 programme, argues that the ECB is repeating the mistakes that the Fed and Bank of England made in the 2008 crisis—trying to plan credit and micromanage the financial sector, when the real issue is excessively tight monetary policy.

Instead of trying to micromanage the economy by using credit policy – lending to governments and banks – the ECB simply needs to do ease policy enough to achieve its inflation target, so that firms and households can create wealth in a stable macroeconomic environment.

Targeting nominal GDP—the total amount of spending in the economy, also known as aggregate demand—would be even better, the paper argues, guaranteeing more stability when unexpected supply-side shocks like oil price movements make inflation targeting trickier.

Such a policy would automatically generate more inflation during recessions, to stabilise the macroeconomy, and less inflation during booms, to prevent excess price rises.

The paper debunks the existing analysis of the 2008 financial crisis by illustrating that interest rates are a poor measure of the stance of monetary policy, so just because the ECB has dropped rates to zero does not mean its monetary policy is ‘easy’.

It uses historical data to show that tight money policies by the BoE and the Fed hugely worsened the Great Recession, and is now stopping Europe from recovering. It also shows that monetary policy and fiscal policy work through the same channels of aggregate demand and inflation, explaining why austerity in the UK and US has not hurt economic growth.

The paper calls on the ECB to replace the one-sided inflation target with a target for total incomes, to stop debt crises and automatically incorporate supply-shocks rather than relying on the judgement of ECB officials. This should be based on a target of the market forecast, whether of total nominal income, or of inflation. The bank should also stop doing credit policy, which distorts specific markets without solving the monetary disequilibrium that is the heart of the problem.

Senior Fellow at the Adam Smith Institute Lars Christensen said:

More and more Eurozone countries are now facing outright deflation and there is no doubt that the ECB’s overly tight monetary stance is primarily to blame for this.

Therefore there is a serious need for reform of the ECB’s policy instruments and targets.

The ECB needs to end the deflationary policies and hoc credit policies and instead introduce a clear and transparent rule-based monetary policy regime—a nominal GDP target.

An NGDP target would save the Eurozone from the debt-deflation spiral and would at the same time greatly increase financial stability across Europe.

Director of the Adam Smith Institute Dr Eamonn Butler added:

Central banks are always over-tightening or over-loosening things. They created a huge bubble that ultimately ended in the financial crash. Now they are plunging countries into damaging deflations.

Central banks should be abolished and interest rates left to the market. As a second best, we need strict rule-based targeting, such as Professor Sumner proposes.

Notes to editors:

Download a free copy of “The Real Problem was Nominal” here.

For further comments or to arrange an interview, contact Kate Andrews, Communications Manager, at kate@adamsmith.org / 07584 778207.

The Adam Smith Institute is an independent libertarian think tank based in London. It advocates classically liberal public policies to create a richer, freer world.

“Should Samantha Cameron give up her day job?” – Dr Eamonn Butler argues no in The Observer

Director of the Adam Smith Institute, Dr Eamonn Butler, took part in The Observer‘s weekly debate, arguing that Samantha Cameron should not resign from her position at Smythson, regardless of her husband’s position on tax avoidance.

Eamonn exchanged e-mails with Heather Stewart, The Observer’s economics editor, who argued that she should step down.

Eamonn’s first response:

Stop beating up innocent people. David Cameron is not his wife’s custodian, nor she his. She should be commended for going out and getting a job, where she at least might pick up some understanding of the issues facing business and the everyday tribulations of people in work – useful, given how insulated our politicians are. She is an employee, a creative adviser, not one of the bosses who makes decisions about her employer’s finances. No doubt if she worked on the checkout in Tesco you’d be telling her to resign over the company’s financial fraud investigation or the moans about how it treats its suppliers. Smells like pure politics. Focus on the real issue. What’s wrong here is our high and complicated taxes that drive firms to base themselves abroad. It’s a free world and that’s perfectly legal, but who can blame them?

Read the full debate here.