Its a Central Banking Crisis Too

Much like Frances Coppola, I like charts. I think in pictures and words not numbers; I find it significantly easier to translate graphs into reality. But, unlike Frances, I hold the ECB peculiarly responsible for the Eurozone crisis, where she places more blame on the banking sector in general. I hope to present some graphs to convince Frances that the ECB is the real bad guy in Europe.

I have repeatedly called the European Central Bank insane for failing to save the Euro. That might be a little unfair, lots of banks acted insane during the 2000s, but the ECB’s monomaniacal and slavish adherence to inflation targeting led the bank to make two specific policy errors which have had grave consequences.

These policy errors exaggerated the errors of Europe’s banks and turned a balance of payments problem into a triple currency, banking and sovereign debt crisis. It wasn’t debt or deficits that sent the Eurozone periphery into crisis it was consistently importing more than they exported.

Such a lopsided Eurozone demanded flexible demand management, the right amount of demand for Germany had clearly been to inflationary for Ireland et al. However, when the crunch came the ECB was found wanting. Four times the ECB focussed too heavily on short term inflation and raised rates, or failed to cut rates, in error. Below is a graph of Eurozone interest rates as set by the ECB.

In 2008, rapid growth in the developing world pushed up commodity prices and headline inflation around the world. Simultaneous with this the world financial system had begun to blow up. In July 2008 the ECB hiked rates despite it being well aware it was operating in a period of acute financial stress (see chart 2). That is the first error, an over reaction to headline inflation. This error was felt across the world, as described by Lars here.

A few months later, in September, Lehman Brothers collapsed. In September the ECB did not alter its headline interest rate, it waited until October to cut rates. As a consequence of this passive tightening expected inflation in the Eurozone fell well below the ECB’s target rate (see chart 5) and the financial crisis began proper. That was the second error, it was quickly regretted and over the next eight months interest rates were cut to 1%, but no lower.

In April 2011, the ECB once again began to increase interest rates in April 2011 to fight higher inflation. This proved to be a mistake which was reversed between October and December 2011. The consquences of this mistake are plain to see. The below graph was cribbed from Tim Duy and shows the subsequent increase in unemployment.

The cause of this increase in human misery was  decrease in aggregate demand and expected future aggregate demand. Caused by the same demand shock, the borrowing costs of the Eurozone periphery spiked compared with the borrowing costs of Germany. Greece’s ten year borrowing costs spiked from being 9.49% higher than Germany’s to 12.64% higher. Similar movements can also be seen for Ireland, Portugal and Spain by comparing this data from late March 2011, with this data from May 2011.

The ECB’s fourth and enduring mistake is keeping interest rates at 1%, rather than cutting all the way to zero, and in failing to communicate that they will continue to be as accommodative as is necessary to boost growth. The ECB has failed to use the conventional tools and has actively sabotaged itself by failing to convince anyone it is willing to be as accommodative as is necessary to rescue the Eurozone from crisis.

This isn’t entirely the ECB’s fault, they’ve been given a very narrow mandate to maintain price stability. But mandates can be reinterpreted as necessary and blowing up the world financial system and throwing millions out of work to keep a lid on poorly recorded, probably inaccurate, inflation rate is an insane way to interpret a mandate for price stability. So I’ll probably keep calling the ECB insane.


3 thoughts on “Its a Central Banking Crisis Too

  1. I knew you’d do an ECB post before I did!

    I agree with you on the effect of the ECB’s narrow interpretation of its mandate. I have also made the same criticism of the Bank of England, which focused too narrowly on CPI inflation in the years running up to the collapse of Northern Rock and therefore failed even to notice let alone do anything about the asset price bubble. If there is one lesson we should learn from the 2008 crisis, it is that systems of economic management that target one economic indicator at the expense of the rest are inadequate. The ECB, in mistakenly regarding inflation as the principal risk, has actually caused deflation.

    However, it really isn’t possible for the ECB to adjust monetary policy to accommodate internal imbalances within the Eurozone, as you suggest. The fact is that one-size-fits-all monetary policy does not work unless there is either economic convergence, which there never has been and which is now further away than ever, or fiscal union, which is politically unacceptable. So, for example, various people are suggesting that the ECB should cut rates to zero and do QE. That would help the peripheral countries, especially Spain – but it would be likely to create a housing bubble in Germany (there are already signs that this is beginning to happen, and the Bundesbank is pressuring the ECB to RAISE rates). In my view, in the absence of economic convergence and/or fiscal union, national central banks need to have the power to make local adjustments to monetary policy, such as doing QE to counter the effect of central interest rates set too high for their economies.

    1. Hello Frances, always nice to have you in my comments.

      I find the ECB and BOE apologism wrong headed. Yes they both have narrow mandates, but they both have get out clauses within their legal mandates along the lines of support to economic objectives of the government” so they either has a lot more flexibility than they are willing to use. It is a cultural thing about wanting to remain “sober” and “credible”.

      If they completely abandoned inflation targeting they may have difficulty a few year down the lines after legal challenges, but by then, if they’ve been successful they would be in a position of strength to say institutions, rule or mandates need to change, not them.

      If you’re in a currency union then yes, some regions or sectors will over simulated half the time. If the Germans are worried about a housing/stock bubble they can up transaction costs, ruin the supply side a little in the housing market by upping the downpayment required. It’ll annoy some young Germans, but not as much as the Eurozone and world economy collapsing will.

      There are ways around a monetary regime somewhat too expansionary for the Eurozone core which will be only minimally disruptive, but there are no solutions to deflation in the periphery that don’t cause a crisis. All central banks have sufficient leeway to save the world economy even if they claim the are unwilling to use it. Saving the world buys you a lot of leeway.

      1. Easy to be wise after the event, isn’t it! The BoE didn’t pay enough attention to financial stability and the ECB didn’t pay enough attention to demand asymmetry. And both of them responded to the financial crisis far too late and with inappropriate measures (the BoE also raised interest rates when demand was already falling, if you remember). I think we can both agree on that.

        Now it’s gloves off time – not for you but for the people who are really responsible for this sorry mess. The ECB has the Bundesbank breathing down its neck, and it is painfully obvious to me at any rate who REALLY decides economic policy in the Eurozone. “We must never forget Weimar….” The Brussels eurocrats have allowed Germany to dictate monetary policy to the detriment of the rest of the Eurozone, and are now compounding this by allowing Germany to dictate fiscal policy, too. And Germany has forgotten how serious the effects of deflationary policies in a fixed currency regime can be. They would do well to study their own history – not the 1920s, which they remember every day (but fail to understand), but the 1930s.

        Regarding the BoE, I can criticise King – and have, severely – for his inadequate management of the UK economy and weak response to the crisis. I wonder why he still has a job, frankly. But he was taking his orders from a UK government that was enjoying the fruits of the credit bubble and didn’t want there to be any tightening. It’s very hard to take away the punchbowl against the host’s wishes.

        I accept that the central banks have contributed to the Eurodisaster. I still don’t think you give enough weight to the reckless lending and rent-seeking of commercial banks. But the real culprits are politicians and bureaucrats.

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