The ECB is fiddling while Europe burns

If not quite burning yet, the eurozone is kindling. For once, most people agree why: money is very tight. The central bank's interest rate is low, yes, but this is not a good measure of the stance of monetary policy. What matters is the interest rate relative to the 'natural' interest rate - ie, what it would be in a free market. It's difficult to know what this natural rate is (as Hayek would tell us) but we can look at things like nominal GDP and inflation to help us guess. Both are way, way below levels that the market is used to. Deflation is back on the menu.

As Scott points out, whatever you think about the American or British economies since 2008, the Eurozone looks like a case study in central bank failure:

The eurozone was already in recession in July 2008, and eurozone interest rates were relative high, and then the ECB raised them further.  How is tight money not the cause of the subsequent NGDP collapse?  Is there any mainstream AS/AD or IS/LM model that would exonerate the ECB?  I get that people are skeptical of my argument when the US was at the zero bound.  But the ECB wasn’t even close to the zero bound in 2008.  I get that people don’t like NGDP growth as an indicator of monetary policy, and want “concrete steppes.”  Well the ECB raised rates in 2008.  The ECB is standing over the body with a revolver in its hand.  The body has a bullet wound.  The revolver is still smoking.  And still most economists don’t believe it.  ”My goodness, a central bank would never cause a recession, that only happened in the bad old days, the 1930s.”

. . . And then three years later they do it again.  Rates were already above the zero bound in early 2011, and then the ECB raised them again.  Twice.  The ECB is now a serial killer.  They had marched down the hall to another office, and shot another worker.  Again they are again caught with a gun in their hand.  Still smoking.

Meanwhile the economics profession is like Inspector Clouseau, looking for ways a sovereign debt crisis could have cause the second dip, even though the US did much more austerity after 2011 than the eurozone.  Real GDP in the eurozone is now lower than in 2007, and we are to believe this is due to a housing bubble in the US, and turmoil in the Ukraine?  If the situation in Europe were not so tragic this would be comical.

There is a point here. Economic news, by its nature, tends to emphasise interesting, tangible, 'real' events over things like central bank policy changes (let alone the absence of changes).

Of course that can be deeply misleading. The stance of money affects the whole economy (at least the whole economy that does business in nominal terms, which is pretty much everything except for gilt markets), and the Eurozone is experiencing exactly the sort of problems that the likes of Milton Friedman predicted that tight money would create.

Overall, the Euro looks like the most harmful institution in the world, except perhaps for ISIS or the North Korean govt. It may be unsaveable in the sense that it will never really be an optimal currency area, but looser policy (which free banking would provide) would probably alleviate many of the Eurozone's biggest problems. Instead, what Europe has is the NHS of money – big, clunking and unresponsive to demand.

And the ECB seems wilfully misguided about what it needs to do. The only argument against this is that surely—surely—Draghi and co know what they're doing. Well, what if they don't?

How to fix the Eurozone

It's rare that an economic question is clear cut. Nearly all issues are two sided, with substantial costs and benefits to all approaches. But the reason the Eurozone crisis has resumed is pretty obvious—'bad' disinflation and deflation almost universally across the bloc, and a failure of the European Central Bank to provide even the most basic monetary stability. The solution is equally obvious: meet the inflation target and commit to a level target to prevent future cock-ups. Household, firms and sovereigns take out (nearly all of) their debts in nominal terms, i.e. not adjusted for inflation. They are likely to build in expected inflation. However, if inflation is higher than expected, debtors incomes should rise faster than they expected, while their debt is still fixed, making the burden lighter. Of course, this means creditors receive less than they expected. It's the same on the other side.

If the central bank promises 2% inflation per year over the next ten years, and the markets believe it, then the yield of a gilt that matures in 10 years will take this into account. This goes (approximately) for all other assets in the economy, like mortgages, consumer credit, business loans and so on. If inflation departs from target it enriches one side at the expense of the other, contrary to what they all could have reasonably expected when they signed these contracts.

There is a complication: there is a difference between the inflation and deflation caused by supply shocks and that caused by demand shocks. When prices rise because everything really has become more costly to produce (a supply shock like an OPEC oil price hike) then this makes debts harder to pay, but worth no more. When prices fall because everything has become cheaper to produce (a supply shock like Chinese labour coming onto the world market) this makes debts easier to pay, but worth no less. But central bank expansions and contractions are demand shocks, not supply shocks.

This means that the national debt will be harder to pay if inflation comes in lower than target for monetary reasons. Inflation has been below the European Central Bank's target for nearly two years, and is falling further below it. Twelve countries have either zero inflation or deflation. Unless there were massive supply-side improvements across the Eurozone—which we would see in the form of impressive real GDP growth or productivity improvements—this would usually mean that firms will find it hard to make good on their investments, and governments will find their national debts increasingly hard to manage. This is exactly what we are seeing.

As I said above the weird thing about this situation is we actually have an easy-ish solution. Commit to meeting the inflation target, making up the deficit of the past few years and targeting a level path of inflation (or total income) in the future. That means that if the ECB makes a mistake and 'undershoots' its target, it doesn't allow this to distort the economy but does a little extra inflation in the next few months; if the ECB 'overshoots' it does a little less. This is not baleful central bank 'intervention' or 'disortion'—the distortion was letting the rules of the game depart so far from those they signed all of their contracts expecting.

The alternative is a 'lost quarter century' of stagnation while everyone slowly adjusts to the new monetary arrangements they have been hit with.