I was intrigued by Munchau’s editorial on central bank independence, that appeared on today’s FT. Munchau argues that central banks’ choices are increasingly political in nature, especially if their mandate is broad, as is the case for example of the Fed. His argument is that a broad mandate implies tradeoffs, and as such it does not go well with central bank independence.
I must say I am unconvinced to say the least, on at least two levels.
First, I do not see how a strict mandate would make central bank choices less political in nature. It makes them more opaque, but by no means less political. I wrote about this in a paper on ECB action during the crisis, and more succinctly in an op-ed for Social Europe co-written with Yan Islam back in 2015. Let me quote a few excerpts from that piece:
A dual mandate requiring the central bank to pursue two, sometimes conflicting, objectives forces the institution to make inherently political choices. Far from being a shortcoming, this allows for a more flexible and unbiased monetary policy. A central bank following a dual mandate will always be able to take an aggressive stance on inflation, if it deems this necessary. Appropriate choice of the weights given to employment and inflation would allow incorporation of any combination of the two objectives. […]
Inflation-targeting central banks, such as the ECB, de facto also target growth but timidly and without explicitly saying so. This leads to low reactivity and opaque communication, hampering in turn the capacity of central banks to manage expectations and effectively steer the economy. A good case in point is the ECB that – compared to the Fed – did “too little and too late” from 2009, amid a constant debate on whether the inflation-targeting mandate was being violated. […]
ECB opacity is intrinsically linked to the confusion between its mandate and its activities in the real world, and as such it cannot lead to any meaningful discussion but only to legalistic disputes on the definition of price stability, of how medium is the medium term and the like.
The main merit of a dual mandate is in fact that it lets the political nature of monetary policy emerge without ambiguities. It is indeed true that monetary policy with a dual mandate requires hard choices, just like those debated these days, and hence is political by its very nature. The point is, so is monetary policy with a simple inflation-targeting objective. The level of inflation targeted, and the choice of the instruments to attain it, is anything but neutral in terms of its consequences on the economy. Thus, an inflation-targeting central bank is as political in its actions as a bank following a dual mandate, the only difference being that In the former case the political nature of monetary policy is concealed behind a technocratic curtain.
In a sentence, we argued that monetary policy choices are always political, and as such they should be incorporated in the policy mix, without hiding behind what Yan and I called a technocratic illusion.
Munchau’s link between the broadness of the mandate and its political nature, is simplistic and in my opinion strongly misleading. In fact, we concluded back in 2015 that it is linked to a specific intellectual framework
The profound justification of an exclusive focus on price stability can only lie in the acceptance of a neoclassical view in which virtually powerless governments need to make little or no choices. Once we dismiss that platonic view, monetary policy acquires a political role, regardless of the mandate it is given.
The second reason why Munchau’s argument is unconvincing is the conclusion, somewhat implicit in his piece, that a central bank making political choices needs to be a “government agency”. Why is it so, exactly? I fail to see it. What matters is not that the central bank is controlled by the finance ministry, but that it is accountable, like any other actor doing policy, in a system of well functioning checks and balances.
Once we recognize that a central bank has a political role, we need to make sure first, that its mandate is not falsely perceived as technocratic; and second, that its actions are properly embedded in a balanced policy mix, in which there is coordination with, not subordination to, the other branches of government. It seems to me that the US institutional system comes pretty close to this. The same cannot be said for the eurozone.
Life and work keep having the nasty habit of intruding into this blog, but it feels nice to resume writing, even if just with a short comment.
We learned a few weeks ago that the Bank of Japan has walked one extra step in its attempt to escape lowflation, and that it has committed to overshoot its 2% inflation target. A “credible promise to be irresponsible”, as the FT says quoting Paul Krugman.
This may be a long overdue first step towards a revision of the inflation target, as invoked long ago by Olivier Blanchard, and more recently by Larry Ball. This is all too reasonable: if the equilibrium interest rates are negative, if monetary policy is bound by the zero-or-only-slightly-negative-lower-bound, higher inflation targets would make sense, and 4% is an arbitrary target as legitimate as the current also arbitrary 2% level. Things may be moving, as the subject was evoked, if not discussed, at the recent Central Bankers gathering in Jackson Hole. We’ll see if anything comes out of this.
But the FT also adds an interesting comment to the BoJ move, namely that the more serious risk is a blow to credibility. If it failed to lift the inflation to the 2% target, how can it be credibly believed to overshoot it?
This is a different sort of credibility issue, much more reasonable indeed, than the one we have been used to in the past three decades, linked to the concept of dynamic inconsistency. In plain English the idea that an actor has no incentive to keep prior commitments that go against its own interest, and hence deviates from the initial plan. Credibility was therefore associated to changing incentives over time (typically for policy makers), and invoked to recommend rules over discretion.
Today, eight years into the zero lower bound, we go back to a more intuitive definition of credibility: announcing an objective and not being able to attain it.
The difference between the two definitions of credibility is not anodyne. In the first case, the unwillingness of central banks to behave appropriately can be corrected through the adoption of constraining rules. In the latter, the central bank cannot attain the objective regardless of incentives and constraints, and other strategies need to be put in place.
The other strategy, the reader will not be surprised to learn, is fiscal policy. Monetary dominance is in fact a second tenet of the Consensus from the 1990s that the crisis has wiped out. We used to live in a world in which structural reforms would take care of increasing potential growth, monetary policy would be used to take care of (minor) demand-driven fluctuations, and fiscal policy was in a closet.
This is gone (luckily). Even the large policy making institutions now call for a comprehensive and multi-instrument policy making. The policy mix, a central element of macroeconomics in the pre-rational expectations era, is now back. Even the granitic dichotomy between short (demand driven) and long (supply driven) term, is somewhat rediscussed.
The excessively simplified consensus that dominated macroeconomics for the past thirty years seems to be seriously in trouble; complexity, tradeoffs, coordination, are now the issues discussed in academia and in policy circles. This is good news.
Readers of this blog know that I have been skeptical on the ECB quantitative easing program.
I said many times that the eurozone economy is in a liquidity trap, and that making credit cheaper and more abundant would not be a game changer. Better than nothing, (especially for its impact on the exchange rate, the untold objective of the ECB), but certainly not a game changer.
The reason, is quite obvious. No matter how cheap credit is, if there is no demand for it from consumers and firms, the huge liquidity injections of the ECB will end up inflating some asset bubble. Trying to boost economic activity (and inflation) with QE is tantamount to pushing on a string.
I also said many times that without robust expansionary fiscal policy, recovery will at best be modest.
Two very recent ECB surveys provide strong evidence in favour of the liquidity trap narrative. The first is the latest (April 2016) Eurozone Bank Lending Survey. Here is a quote from the press release:
The net easing of banks’ overall terms and conditions on new loans continued for loans to enterprises and intensified for housing loans and consumer credit, mainly driven by a further narrowing of loan margins.
So, nothing surprising here. QE and negative rates are making so expensive for financial institutions to hold liquidity, that credit conditions keep easing.
So why do we not see economic activity and inflation pick up? The answer is on the other side of the market, credit demand. And the Survey on the Access to Finance of Enterprises in the euro area, published this week also by the ECB, provides a clear and loud answer (from p. 10):
“Finding customers” was the dominant concern for euro area SMEs in this survey period, with 27% of euro area SMEs mentioning this as their main problem, up from 25% in the previous survey round. “Access to finance” was considered the least important concern (10%, down from 11%), after “Regulation”, “Competition” and “Cost of production” (all 14%) and “Availability of skilled labour” (17%). Among SMEs, access to finance was a more important problem for micro enterprises (12%). For large enterprises, “Finding customers” (28%) was reported as the dominant concern, followed by “Availability of skilled labour” (18%) and “Competition” (17%). “Access to finance” was mentioned less frequently as an important problem for large firms (7%, unchanged from the previous round)
No need to comment, right?
Just a final and quick remark, that in my opinion deserves to be developed further: finding skilled labour seems to become harder in European countries. What if these were the first signs of a deterioration of our stock of “human capital” (horrible expression), after eight years of crisis that have reduced training, skill building, etc.?
When sooner or later the crisis will really be over, it will be worth keeping an eye on “Availability of skilled labour” for quite some time.
Tell me again that story about structural reforms enhancing potential growth?
I read, a bit late, a very interesting piece by Simon Wren-Lewis, who blames central bankers for three major mistakes: (1) They did not see the crisis coming, while they were the only one in the position to see the build-up of leverage; (2) They did not warn governments that at the Zero Lower Bound central banks would lose traction and could not protect the economy from the disasters of austerity. (3) They may be rushing in declaring that we are back to normal, thus attributing all the current slack to a deterioration of the supply side of the economy.
What surprises me is (2), for which I quote Wren-Lewis in full:
Of course the main culprit for the slow recovery from the Great Recession was austerity, by which I mean premature fiscal consolidation. But the slow recovery also reflects a failure of monetary policy. In my view the biggest failure occurred very early on in the recession. Monetary policy makers should have said very clearly, both to politicians and to the public, that with interest rates at their lower bound they could no longer do their job effectively, and that fiscal stimulus would have helped them do that job. Central banks might have had the power to prevent austerity happening, but they failed to use it.
The way Wren-Lewis writes it, central banks were not involved in the push towards fiscal consolidation, and their “only” sin was of not being vocal enough. I think he is too nice. At least in the Eurozone, the ECB was a key actor in pushing austerity. It was directly involved in the Trojka designing the rescue packages that sunk Greece (and the EMU with it). But more importantly, the ECB contributed to design and impose the Berlin View narrative that fiscal profligacy was at the roots of the crisis, so that rebalancing would have to be on the shoulders of fiscal sinners alone. We should not forget that “impeccable disaster” Jean-Claude Trichet was one of the main supporters of the confidence fairy: credible austerity would magically lift expectations, pushing private expenditure and triggering the recovery. He was the President of the ECB when central banks made the second mistake. And I really have a hard time picturing him warning against the risks of austerity at the zero lower bound.
And things are not drastically different now. True, Mario Draghi often calls for fiscal support to the ECB quantitative easing program. But as I argued at length, calling for fiscal policy within the existing rules’ framework has no real impact.
So I disagree with Wren-Lewis on this one. Central banks, or at least the ECB, did not simply fail to contrast the problem of wrongheaded austerity. They were, and may still be, part of the problem.
The problem is one of economic doctrine. And as long as this does not change, I am unsure that removing central bank independence would have made a difference. Would a Bank of England controlled by Chancellor Osborne have been more vocal against austerity? Would an ECB controlled by the Ecofin? Nothing is less sure…
Yesterday I was asked by the Italian weekly pagina99 to write a comment on the latest ECB announcement. Here is a slightly expanded English version.
Mario Draghi had no choice. The increasingly precarious macroeconomic situation, deflation that stubbornly persists, and financial markets that happily cruise from one nervous breakdown to another, had cornered the ECB. It could not, it simply could not, risk to fall short of expectations as it had happened last December. And markets have not been disappointed. The ECB stored the bazooka and pulled out of the atomic bomb. At the press conference Mario Draghi announced 6 sets of measures (I copy and paste):
- The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.
- The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.
- The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.
- The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April.
- Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.
- A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility.
Items 1-3 depict a further decrease of interest rates. Answering a question Mario Draghi hinted that rates will be lower for a long period, but also that this may be the lower bound (sending markets in an immediate tailspin; talk of rational, well thought decisions). The “tax” the ECB imposes on excess reserves, the liquidity that financial institutions keep idle, is now at -0,4%. Not insignificant.
But the real game changer are the subsequent items, that really represent an innovation. Items 4-5 announce an acceleration of the bond buying program, and more importantly its extension to non-financial corporations, which changes its very nature. In fact, the purchase of non-financial corporations’ securities makes the ECB a direct provider of funding for the real sector. With these quasi-fiscal operations the ECB has therefore taken a step towards what economists call “helicopter money”, i.e. the direct financing of the economy cutting the middlemen of the financial and banking sector.
Finally, item 6, a new series of long-term loan programs, with the important innovation that financial institutions which lend the money to the real sector will obtain negative rates, i.e. a subsidy. This measure is intended to lift the burden for banks of the negative rates on reserves, at the same time forcing them to grant credit: The banks will be “paid” to borrow, and then will make a profit as long as they place the money in government bonds or lend to the private sector, even at zero interest rates.
To summarize, it is impossible for the ECB to do more to push financial institutions to increase the supply of credit. Unfortunately, however, this does not mean that credit will increase and the economy rebound. There is debate among economists about why quantitative easing has not worked so far. I am among those who think that the anemic eurozone credit market can be explained both by insufficient demand and supply. If credit supply increases, but it is not followed by demand, then today’s atomic bomb will evolve into a water gun. With the added complication that financial institutions that fail to lend, will be forced to pay a fee on excess reserves.
But maybe, this “swim or sink” situation is the most positive aspect of yesterday’s announcement. If the new measures will prove to be ineffective like the ones that preceded them, it will be clear, once and for all, that monetary policy can not get us out of the doldrums, thus depriving governments (and the European institutions) of their alibi. It will be clear that only a large and coordinated fiscal stimulus can revive the European economy. Only time will tell whether the ECB has the atomic bomb or the water gun (I am afraid I know where I would place my bet). In the meantime, the malicious reader could have fun calculating: (a) How many months of QE would be needed to cover the euro 350 billion Juncker Plan, that painfully saw the light after eight years of crisis, and that, predictably, is even more painfully being implemented. (b) How many hours of QE would be needed to cover the 700 million euros that the EU, also very painfully, agreed to give Greece, to deal with the refugee influx.
FT Alphaville‘s Matthew Klein goes back to the issue of financial stability and monetary policy. A recent speech of Bank of Canada’s Timothy Lane is the occasion for Klein to reassess monetary policy before the crisis, when policy makers (in particular he refers to Ben Bernanke, but the Fed chair was in good company) dismissed fears of asset price bubbles, thus failing recognize, and to counter, the buildup of the crisis.
What I find interesting in Lane’s speech is the acknowledgement that monetary policy alone is vastly insufficient to attain the many interrelated objectives of today’s policy makers. This in turn calls for reassessing the drift of academic economists (in the 1990s and 2000s) towards a vision of the world in which all policy objectives could be attained by “Maestros“, almighty technocrats skillfully using monetary levers to reach multiple objectives at once.
With a few colleagues we recently challenged the “conventional wisdom” that inflation targeting central banks can effectively attain financial stability as well, simply by “leaning against the wind”. We highlighted that this violation of Timbergen’s principle (“one instrument per policy objective”) is allowed by an analytical trick, a “divine coincidence”, buried within the hypotheses of the standard model. Asessing policy analysis in a framework in which low and stable inflation goes hand in hand with low unemployment and stable asset prices, will lead to conclude that (what a surprise!!) targeting inflation helps attaining all these objectives at once. Our work (among others) shows that price and financial stability exhibit no stable correlation; similarly, the debate on the “return of the Phillips Curve” (if ever it left) shows that a tradeoff usually exists between inflation and unemployment objectives. Thus, in the end, inflation targeting is mostly effective in, well… targeting inflation. There is no magics here. The Consensus buried Timbergen way too soon.
The debate on the effective use of instruments to attain sometimes conflicting objectives is particularly interesting in general and, I argue, relevant for the EMU. As the readers of this blog know, I have been obsessed by the excessive focus of (mainly) European economists and policy makers on monetary policy. Especially in the current situation of liquidity trap, the stubborn refusal to fully deploy fiscal policy can only be explained by ideological anti-Keynesianism.
But as Timothy Lane’s speech suggests, the problem extends beyond the current exceptional circumstances. As normal times will (eventually) resume, we should go back to Timbergen and acknowledge that monetary policy alone cannot cure all ills. Fiscal policy and effective regulation need to be used as aggressively as interest rates and monetary instruments to manage business cycle fluctuation. A trivial and yet often forgotten lesson from the old times.