The ECB’s new macroe­co­nomic re­al­ism

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The Euro­pean Cen­tral Bank has fi­nally launched a pol­icy of quan­ti­ta­tive eas­ing (QE). The key ques­tion at this stage is whether Ger­many will give the ECB the free­dom of ma­neu­ver needed to carry out this mon­e­tary ex­pan­sion with suf­fi­cient bold­ness.

Though QE can­not pro­duce long-term growth, it can do much to end the on­go­ing re­ces­sion that has gripped the eu­ro­zone since 2008. The record-high stock-mar­ket lev­els in Europe this week, in an­tic­i­pa­tion of QE, not only in­di­cate grow­ing con­fi­dence, but are also a di­rect chan­nel by which mon­e­tary eas­ing can boost both in­vest­ment and con­sump­tion.

But some ob­servers, such as Nobel Lau­re­ate Paul Krug­man and for­mer US Trea­sury Sec­re­tary Larry Sum­mers, con­tinue to doubt whether QE can re­ally be ef­fec­tive. As Krug­man re­cently put it, a “de­fla­tion­ary vor­tex” is drag­ging down much of the world econ­omy, with fall­ing prices caus­ing an in­escapable down­ward spi­ral in de­mand. The World Bank and In­ter­na­tional Mon­e­tary Fund seem to agree, as both re­cently low­ered their growth forecasts a few notches.

Pes­simists ar­gue that the world econ­omy suf­fers from an in­sur­mount­able short­age of ag­gre­gate de­mand, lead­ing to a new “sec­u­lar stag­na­tion.” Mon­e­tary pol­icy is seen to be rel­a­tively in­ef­fec­tive, owing to the no­to­ri­ous zero lower bound (ZLB) on nom­i­nal in­ter­est rates. With pol­icy in­ter­est rates near zero, the ar­gu­ment goes, cen­tral banks are more or less help­less to es­cape the de­fla­tion­ary vor­tex, and economies be­come stuck in the in­fa­mous liq­uid­ity trap. In this sce­nario, the de­mand in­suf­fi­ciency feeds on it­self, push­ing down prices, rais­ing real (in­fla­tion-ad­justed) in­ter­est rates, and low­er­ing de­mand fur­ther.

This per­spec­tive has been prom­i­nent among Key­ne­sian econ­o­mists in the United States and the United King­dom since 2008. Krug­man ar­gues that Ja­pan was only the first of the ma­jor economies to suc­cumb to chronic de­fla­tion, back in the 1990s, and has now been fol­lowed by the Euro­pean Union, China, and most re­cently Switzer­land, with its soar­ing franc and fall­ing prices. The US, in this view, re­mains near the vor­tex as well, prompt­ing the Key­ne­sians’ re­peated calls for more fis­cal stim­u­lus, which, un­like mon­e­tary pol­icy, is seen by the pes­simists to be es­pe­cially ef­fi­ca­cious at the ZLB.

In my view, the pes­simists have ex­ag­ger­ated the risks of de­fla­tion, which is why their re­cent forecasts have missed the mark. Most no­tably, they failed to pre­dict the re­bound in both the US and the UK, with growth ris­ing and un­em­ploy­ment fall­ing even as deficits were cut. With­out a proper di­ag­no­sis of the 2008 cri­sis, an ef­fec­tive cure can­not be pre­scribed.

The pes­simists be­lieve that there has been a large de­cline in the will to invest, some­thing like the loss of “an­i­mal spir­its” de­scribed by Keynes. Even with very low in­ter­est rates, ac­cord­ing to this view, in­vest­ment de­mand will re­main low, and there­fore ag­gre­gate de­mand will re­main in­suf­fi­cient. De­fla­tion will make mat­ters worse, leav­ing only deficits able to close the de­mand gap.

But the causes of 2008’s deep down­turn were more spe­cific, and the so­lu­tions must be more tar­geted. A large hous­ing bub­ble pre­ceded the 2008 cri­sis in the hard­est-hit coun­tries (the US, the UK, Ire­land, Spain, Por­tu­gal, and Italy). As Friedrich Hayek warned back in the 1930s, the con­se­quences of such a process of misplaced in­vest­ment take time to re­solve, owing to the sub­se­quent over­sup­ply of spe­cific cap­i­tal (in this case, of the hous­ing stock).

Yet far more dev­as­tat­ing than the hous­ing bub­ble was the fi­nan­cial panic that gripped cap­i­tal mar­kets world­wide after the col­lapse of Lehman Brothers. The decision by the US Fed­eral Re­serve and the US Trea­sury to teach the mar­kets a les­son by al­low­ing Lehman to fail was a dis­as­trously bad call. The panic was sharp and se­vere, re­quir­ing cen­tral banks to play their fun­da­men­tal role as lenders of last re­sort.

As poorly as the Fed per­formed in the years pre­ced­ing the Lehman Brothers’ col­lapse, it per­formed splen­didly well af­ter­ward, by flood­ing the mar­kets with liq­uid­ity to break the panic. So, too, did the Bank of Eng­land, though it was a bit slower to re­act.

The Bank of Ja­pan and the ECB were, char­ac­ter­is­ti­cally, the slow­est to re­act, keep­ing their pol­icy rates higher for longer, and not un­der­tak­ing QE and other ex­tra­or­di­nary liq­uid­ity mea­sures un­til late in the day. In­deed, it re­quired new lead­ers in both in­sti­tu­tions – Haruhiko Kuroda at the BOJ and Mario Draghi at the ECB – fi­nally to set mon­e­tary pol­icy right.

The good news is that, even near the ZLB, mon­e­tary pol­icy works. QE raises eq­uity prices; low­ers long-term in­ter­est rates; causes cur­ren­cies to de­pre­ci­ate; and eases credit crunches, even when in­ter­est rates are near zero. The ECB and the BOJ did not suf­fer from a lack of re­fla­tion­ary tools; they suf­fered from a lack

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fis­cal of suit­able ac­tion.

The ef­fi­cacy of mon­e­tary pol­icy is good news, be­cause fis­cal stim­u­lus is a weak in­stru­ment for short-term de­mand man­age­ment. Iron­i­cally, in an in­flu­en­tial 1998 pa­per, Krug­man ex­plained why. He ar­gued at that time, and rightly in my view, that short-term tax re­duc­tions and trans­fers would be partly saved, not spent, and that pub­lic debt would mul­ti­ply and cre­ate a long-term shadow over the fis­cal bal­ance and the econ­omy. Even if in­ter­est rates are cur­rently low, he noted, they will rise, thereby in­creas­ing the debt-ser­vice bur­den on the newly ac­cu­mu­lated debt.

With all ma­jor cen­tral banks pur­su­ing ex­pan­sion­ary mon­e­tary poli­cies, oil prices fall­ing sharply, and the on­go­ing revo­lu­tion in in­for­ma­tion tech­nol­ogy spurring in­vest­ment op­por­tu­ni­ties, the prospects for eco­nomic growth in 2015 and beyond are bet­ter than they look to the pes­simists. There are ris­ing prof­its, rea­son­able in­vest­ment prospects for busi­nesses, a large back­log on in­fra­struc­ture spend­ing almost ev­ery­where in Europe and the US, and the op­por­tu­nity to fi­nance cap­i­tal­go­ods ex­ports to low-in­come re­gions, such as Sub-Sa­ha­ran Africa, and to meet the world­wide need for in­vest­ment in a new, low-car­bon en­ergy sys­tem.

If there is a short­fall of pri­vate in­vest­ment, the prob­lem is not re­ally a lack of good projects; it is the lack of pol­icy clar­ity and com­ple­men­tary long-term pub­lic in­vest­ment. Euro­pean Com­mis­sion Pres­i­dent Jean-Claude Juncker’s plan to fi­nance long-term in­vest­ments in Europe by lever­ag­ing rel­a­tively small amounts of pub­lic funds to un­lock large flows of pri­vate cap­i­tal is there­fore an im­por­tant step in the right di­rec­tion.

Ob­vi­ously, we should not un­der­es­ti­mate the ca­pac­ity of pol­i­cy­mak­ers to make a bad sit­u­a­tion worse (for ex­am­ple, by press­ing Greek debt ser­vice beyond the lim­its of so­cial tol­er­ance).

But we should recog­nise that the main threats to growth this year, such as the un­re­solved Greek debt cri­sis, the Rus­si­aUkraine con­flict, and tur­moil in the Mid­dle East, are more geopo­lit­i­cal than macroe­co­nomic in na­ture. In 2015, wise diplo­macy and wise mon­e­tary pol­icy can cre­ate a path to pros­per­ity. Broad re­cov­ery is within reach if we man­age both in­gre­di­ents well.

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