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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 firstname.lastname@example.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.