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.
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.