Working Paper Series

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ECB Monetary Policy in the Recession: A New Keynesian (Old Monetarist) Critique

Robert L. Hetzel

Federal Reserve Bank of Richmond

Richmond, VA 23261

robert.hetzel@rich.frb.org

June 29, 2013

Working Paper No. 13-07

Abstract Use of the New Keynesian model to identify shocks points to contractionary monetary policy as the cause of the Great Recession in the Eurozone.

JEL classification code: E50

*The author is Senior Economist and Research Advisor at the Federal Reserve Bank of Richmond.

The author would like to thank Steven Sabol and Samuel Marshall for excellent research assistance. The views in this paper are the author’s not the Federal Reserve Bank of Richmond’s or the Federal Reserve System’s.

In A Program for Monetary Stability, Milton Friedman (1960) laid out his argument for a rule of steady money growth by comparing it with a reaction function in which the central bank responds directly to inflation. As summarized below in Section 1, Friedman argued that because of the existence of “long and variable lags,” the latter policy would destabilize economic activity. Implicitly, Friedman exposited a criterion for identifying monetary shocks. Section 2 uses the New Keynesian (NK) model to make explicit this monetarist criterion for identifying shocks. Using this framework, Section 3 argues that Friedman’s critique applies to the monetary policy of the European Central Bank (ECB) after 2007.

1. Friedman’s “long-and-variable lags” critique

Friedman launched his critique of activist policy in the early 1950s when he argued that actions undertaken to stimulate the economy would in practice destabilize it. Because of the lags involved, the difficulty of forecasting the effects of such actions would not “permit action to be taken in advance that would turn out to be correct when its effects occurred” (Friedman 1951 [1953], p. 129). In 1956, Friedman received from Anna Schwartz the historical time series for money growth and NBER cyclical turning points showing that turning points in money preceded turning points in the economy and that the timing of the relationship was variable.1 In A Program for Monetary Stability, Friedman reformulated his critique by criticizing a reaction function entailing a direct response by the central bank to a missed inflation target.

As expressed in the phrase “long-and-variable lags,” Friedman feared that such a reaction

function would cause central banks to change the setting of their policy instrument without regard to the lags involved. Given these lags, he worried about cumulative mistakes. That concern caused him to argue for a policy of steady money growth.2 In “The Role of Monetary Policy,” Friedman (1968 [1969]) made his critique relevant to the stop phases of stop-go monetary policy. A policy of responding directly to inflation in practice entailed an attempt to exploit a Phillips curve trade-off by creating a negative output gap. According to Friedman, and in a way formalized by Lucas (1972 [1981]), such an attempt would founder because the assumed trade-offs were not structural.

2. Recessions arise from central bank interference with the price system

The entry point into monetarist models is the association of monetary shocks with central

bank interference with the price system. Because central banks use the interest rate as their

1 Personal communication from David Meiselman. 2 Friedman (1960, p. 87-88) wrote:

While the stock of money is systematically related to the price level on the average, there is much variation in the relation over short periods of time…. [M]onetary changes have their effect only after a considerable lag and over a long period and that … lag is rather variable…. [T]he price level … could be an effective guide only if it were possible to predict, first, the effects of non-monetary factors on the price level for a considerable period of time in the future, second, the length of time it will take in each particular instance for monetary actions to have their effect, and third, the amount of effect of alternative monetary actions…. I find it virtually impossible to conceive of an effective procedure when there is little basis for knowing whether the lag between action and effect will be 4 months or 29 months or something in between (italics in original).

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instrument, this interference takes the form of setting rate targets in a way that is analogous to price fixing. The NK model elucidates the discipline required to avoid price fixing. This discipline appears in the correspondence between the two facets of an interest rate and the two equations of an abridged version of the NK model.

First, the nominal interest rate is the price of a dollar today in terms of a dollar tomorrow.

Because individual welfare depends only upon real variables, market forces do not render this price determinate. The central bank must provide nominal determinacy through the way in which it controls the actual and expected future creation of money. Central banks that focus exclusively on regulating financial intermediation to the exclusion of money lack a rule that provides a stable nominal anchor. Practically, without a nominal anchor in the form of stability in expected inflation, changes by a central bank to its rate target do not translate into predictable changes in the real interest rate. Second, although borrowers and lenders contract in terms of the nominal interest rate, their expectation of inflation translates the nominal rate into a real rate. Central bank interference with the market determination of this real interest rate constitutes price fixing. For example, as a consequence of maintaining a rate that is too high, the central bank must sell bonds and extinguish money in order to offset the resulting excess demand in the bond market.

Clarida, Gali, and Gertler (1999, p. 1665) exposit an abridged version of the NK model. (1) 1

et t t tygap uπ βπ λ+= + +

(2) 1 1( )e e

t t t t tygap R ygap gϕ π + += − − + + Inflation is tπ and the output gap is tygap ; the superscript e indicates expected. Inflation

shocks ( tu ) arise independently of the aggregate demand shocks ( tg ) that affect the output gap. An (ad hoc) empirical counterpart is relative price changes that pass through to the price level, such as when the price of oil rises sharply. tR is the nominal interest rate, which is the policy variable the central bank sets.

The model does not explicitly contain a money demand equation. As long as the central bank

follows a rule that provides a stable nominal anchor and allows the price system to determine real variables, given its rate target, money grows in line with the real quantity of money demanded. Money offers no additional information about the evolution of the economy. However, in episodes in which the central bank interferes with the operation of the price system and creates a difference between the natural rate of interest (the real rate consistent with perfect price flexibility) and the real rate of interest, the behavior of money becomes informative.3 In general, for forecasting purposes,

3 The above statement about the informativeness of money assumes that the central bank provides an accurate measure of the money stock. Unfortunately, that has not been the case in the United States since 1994, when the Board of Governors failed to measure the reservable deposits swept off bank balance sheets in order to avoid the tax imposed by non-interest-bearing reserve requirements. Moreover, the interest sensitivity of money demand means that money gives counterintuitive signals about nominal output. (Money growth increases when the economy weakens and interest rates fall.) Finally, in times of financial stress, funds flow from illiquid debt instruments into the demand

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the signal-to-noise ratio is very low for monetary aggregates. Nothing in that fact, however, bears on the validity (or invalidity) of the monetarist hypothesis that monetary control and a rule that allows the price system to work are inseparable concepts.

Equation (1) gives content to the idea that the central bank must provide a stable nominal

anchor. Through a rule that anchors fluctuations in expected inflation to an inflation target (assumed zero), the central bank limits fluctuations in current inflation. Equation (2) expresses the idea that either a positive aggregate demand shock ( 0tg > ) or an expected future output gap that is high

relative to the contemporaneous gap 1( )et tygap ygap+ > requires a “high” real interest rate

1( )et tR π +− to maintain output equal to potential today. That is, the central bank must allow the real

interest rate to vary to reconcile households (which desire to smooth consumption) to the uneven intertemporal distribution of consumption produced by shocks. Heuristically, in order to control the expectation of future money creation, equation (1) requires the central bank to follow a credible rule to control inflation. In order to control contemporaneous money creation, equation (2) requires the central bank to avoid interference with the operation of the price system.

These implications of the model receive empirical confirmation from a robust empirical

observation that has held since the creation of the Fed. Preceding recessions, the level of short-term interest rates has been unsustainably high. Before World War II, this situation arose because the Fed raised rates until the economy weakened in order to counter what it perceived as speculative activity in asset markets (Hetzel 2012, Chs. 3-5). After World War II, this situation arose because excessive money growth had raised inflation to a level higher than desired by the Fed (Hetzel 2008a, Chs. 23-25).4 In response, the Fed raised rates persistently until the economy weakened. In all cases pre- and post-World War II, the Fed then introduced inertia into the downward movement in interest rates while the economy weakened (Hetzel 2012, Chs. 6-8). Although central banks do not use the language of trade-offs, the Fed was creating a negative output gap in order to lower either asset prices or inflation. In the case of inflation, it was attempting to exploit a Phillips curve trade-off. Prior to 1981, when a monetary aggregate (M1) existed with an interest-insensitive, stable real demand function, monetary deceleration accompanied this policy-induced, interest-rate inertia.5

The attempt by the central bank to engineer a negative output gap in order to reduce either

asset prices or inflation can be a necessary condition for recession without also being a sufficient condition. The central bank may operate regularly with an activist rule in which it manipulates Phillips curve trade-offs but periodically is unlucky. The monetarist hypothesis, however, is that in order to avoid destabilizing the economy, the central bank must follow a nonactivist rule that allows

deposits of the too-big-to-fail banks and boost money growth with no implication for the stance of monetary policy. 4 This empirical touchstone for detecting central bank interference with the price system (introducing inertia into short-term interest rates while the economy weakens) can occur for other reasons. Although much more common for other countries, an example for the United States was the attempt that preceded the 1960 cyclical peak to prevent depreciation of the foreign exchange value of the currency and to limit a current account deficit (Hetzel 1996). In the 1920s and 1930s, the premier example was that of countries either going on the gold standard at an overvalued exchange rate or of attempting to maintain a fixed parity in the face of gold outflows (Hetzel 2002; 2012, Ch. 6). 5 See Hetzel (2008a; 2012, chapters 7 and 8) and Hetzel (2013).

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the price system to determine the real interest rate and, by extension, other real variables. Any attempt to manipulate an output gap is destabilizing. Demonstration of the validity of the monetarist hypothesis requires a demonstration that the transition from stability to instability represents episodes in which the central bank deviates from a nonactivist rule and actively attempts to manipulate an output gap. In the NK literature, there is a divergence over whether to explain the regular operation of the economy with an activist or nonactivist rule as the benchmark.

Clarida et al (1999, p. 1668) give the NK model an activist interpretation with the loss

function (3), which assumes the central bank possesses the ability to trade off in a predictable way between an output gap and deviations of inflation from target. Intuitively, real aggregate demand shocks produce deviations of output from potential, while inflation shocks produce deviations of inflation from target. The central bank possesses the ability to moderate extreme deviations in either variable by introducing some inverse variation in the other variable (by exploiting a Phillips curve trade-off). In particular, it can systematically reduce fluctuations in output by increasing fluctuations in inflation as expressed in the choice of a largerα in (3).

(3) 2 2

0

1max2

it t i t i

iE ygapβ α π

∞

+ +=

− + ∑

In contrast to Clarida et al (1999), Goodfriend and King (1997) and Goodfriend (2004) give

the NK model a nonactivist interpretation by assuming that the central bank follows a rule to maintain price stability. Price stability eliminates the distortion caused by the interaction of price stickiness with inflation. With price stability, the operation of the economy is consistent with the underlying real-business-cycle (RBC) core of the NK model. The monetarist assumption is that with such a rule, the RBC core, in which market forces determine real variables, provides significant macroeconomic stability. More generally, if the central bank follows a rule that separates the behavior of the inflation rate from the determination of real variables, the price system “works well.” Phrased negatively, attempts by the central bank to exploit Phillips curve trade-offs interfere with the operation of the price system and are destabilizing.

Activists emphasize the sticky-price features of the NK model. Nonactivists emphasize the

combination of rational expectations and forward-looking agents. In the design of an optimal rule, the decision to emphasize either sticky prices or the efficacy of the price system must be empirical. The sticky prices of the NK model (implemented, say, by Calvo price setting) are only a place holder for a deep, structural theory of monetary nonneutrality. The issue is whether the correlations in the data labeled “the Phillips curve” represent a structural relationship the central bank can exploit or emerge from the destabilizing interference of the central bank in the operation of the price system.

Evidence in favor of either the activist or the nonactivist view can be found in the policy rule

that better characterized monetary policy in the Great Moderation (the period including the post-disinflation tenures of Volcker and Greenspan as FOMC chairmen) when economic stability created a presumption of stabilizing monetary policy. In this period, did the Fed control inflation through exploitation of Phillips curve trade-offs or through a rule that created an environment of nominal expectational stability that coordinated the price setting of firms around a credible inflation target?

Because central banks use the language of discretion rather than rules, specification of the

policy rule requires solving a difficult problem in identification. Hetzel (2004; 2005; 2006; 2008a; 2008b; and 2012) argues that the rule that provided consistency in the Great Moderation constituted a

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search procedure for causing the real funds rate to track the natural rate of interest. That is, the rule was nonactivist in that market forces determined the real interest rate and, by extension, other real variables. Moreover, notwithstanding the Fed’s language of discretion, the emphasis was consistently on establishing credibility so that the expectation of inflation remained low and stable despite aggregate demand and inflation shocks.

Hetzel (2006, 268) uses (4) as the reaction function that provided consistency to monetary

policy in the Volcker-Greenspan (V-G) era.6 (4) 1 .25 .125( *)RU TR

t t t tR R I π π−= + + − ,

where the funds rate is tR ; trend inflation is TRtπ ; the inflation target is *π ; and RU

tI is an indicator variable. It takes on the value 1 if resource utilization is increasing, −1 if it is decreasing, and zero otherwise. In the first case, output is growing faster than potential in a sustained way (a positive growth gap). The terms 1 .25 RU

t t tR R I−= + capture the lean-against-the wind (LAW) part of policy in which the FOMC raised the funds rate above its prevailing value in a measured, persistent way as long as the rate of resource utilization was increasing, and conversely when resource utilization was decreasing. The coefficient on RU

tI of .25 was the standard size of funds rate changes.

Note that by using a growth gap rather than an output gap, the V-G reaction function abandoned the effort that had characterized the stop-go era of measuring the amount of slack in the economy. As emphasized by Orphanides and Williams (2002), using changes in the rate of resource utilization rather than the level reduces measurement error. Formula (4) contains the term ( *)TR

tπ π−in which TR

tπ is trend inflation. As reflected in its use of core measures of inflation, the FOMC did not respond to fluctuations in inflation perceived as transitory. Hetzel (2008, 2012) terms (4) lean-against-the-wind (LAW) with credibility.

Because the NK model assumes rational expectations, there is no learning. Credibility is

complete. For that reason, it is essential to emphasize the defining characteristic of the V-G era—the importance policymakers attached to behaving in a way that created an environment of nominal expectational stability. In this context, consider the LAW part of (4). The FOMC raised the funds rate in a measured, persistent way in response to sustained increases in the rate of resource utilization subject to an ongoing monitoring of bond markets. The FOMC watched for increases in bond yields indicative of market concern that the funds rate increases would not cumulate to the degree necessary to control inflation. Such concern by bond markets would appear as an increase in an inflation premium raising bond yields. Such instances of discrete, sharp increases in bond yields (inflation scares) would prompt the FOMC to make additional increases in the funds rate. (Hetzel 2006; 2008a, Ch. 21; 2008b).

6 There are two exceptions to this statement. First, in the post-Louvre Accord period starting in 1987, central banks around the world backed off from restrictive monetary policy. In 1988 and 1999, the Fed attempted to create a moderate negative output gap in order both to reverse the resulting rising inflation and to move to price stability. The period 1998-2000 represented a mini stop-go cycle (Hetzel 2008, Chs. 15 and 19).

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The forward solution of equations (1) and (2) shown as equations (5) and (6) flesh out this aspect of policy (Clarida et al 1999, p. 1666-1667). They illustrate that in the NK model “private sector behavior depends on the expected course of monetary policy, as well as on current policy” (Clarida et al 1999, p. 1662). Commitment to the LAW part of (4) meant that the public expected the real interest rate to vary in a way that countered contemporaneous and future aggregate demand shocks ( t ig + ) and thus maintained the contemporaneous output gap, tygap in (6), near zero.

(5) ( )0

ni e e

t t i t ii

ygap uπ β λ + +=

= +∑

(6) 10

( )n

et t i t i t i

iygap R gϕ π+ + + +

=

= − − + ∑

Firms setting prices for multiple periods then anticipate only moderate current and future nonnegative values of the output gap, shown on the right-hand side of (5). Fluctuations in inflation around the central bank’s inflation target will occur, but they will be transitory because fluctuations in the output gap will be anticipated to be of limited duration and inflation shocks are of limited duration. Of course, the central bank must maintain credibility for its inflation target. Firms will then make changes in their dollar prices intended to offset the effect of expected inflation on their markups based on a common assumption about the inflation target. In an environment of expected price stability, firms will make changes in dollar prices only in order to change relative prices.

The FOMC increased its monitoring dramatically during the period from 1979 through 1994

when it raised the funds rate in response to sharp increases in bond rates—inflation scares (Goodfriend 1993, Mehra 2001). More routinely, policymakers continually monitored the behavior of the term structure of interest rates. This term structure divides into a sequence of forward real rates and of expected inflation rates. Consider a “strong” payroll employment number, that is, a number significantly in excess of the market consensus. Policymakers would watch the market reaction in anticipation that the rise in the term structure would occur in the real part while leaving expected inflation unchanged. The introduction of TIPS facilitated this inference (Hetzel 2006).

Policymakers also used the market as a check on the appropriateness of their assessment of

whether the economy was growing faster than, equal to, or less than potential. They would have their own forecast of the appropriate path for the future funds rate. A market expectation of, say, a higher path read from the federal funds rate futures market and the Eurodollar market would send a message that policymakers were underestimating the strength in the economy. Policymakers formed their own assessment of the strength of the economy but checked it against that of the market.

The reason that this review of the role of market expectations is so important is that it

supports the implication of the NK model that the central bank can control trend inflation through the way in which its rule forms the expectational environment in which firms set prices. Individual firms that set dollar prices for multiple periods do so with the intention of preserving on average the optimal markup of price over marginal cost. This profit-maximizing incentive leads them collectively to coordinate on the central bank’s inflation target. Markup shocks will introduce noise into the price level along with the occasional concentrated relative price shocks such as oil price shocks. However, as long as its rule remains credible, the FOMC can allow that transitory noise to pass through into the price level while keeping trend inflation constant. With the exception of the period in the late 1980s with inflation at 4 percent when the FOMC decided to move to price stability, systematic review of FOMC procedures in the V-G era in Hetzel (2008) reveals no indication that the FOMC attempted to control inflation through manipulation of an output gap.

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If the Fed lacked credibility such that fluctuations in measured inflation influenced expected

inflation, the FOMC would respond directly to measured inflation. However, as long as the rule is credible and shapes the environment in which firms set dollar prices for multiple periods, the term ( *)TR

tπ π− in (4) will remain latent. During the Great Moderation, the Fed did not jolt the real economy in response to transitory fluctuations in measured inflation (Hetzel 2008, Chs. 13-15).

Unfortunately, the empirical Taylor rule literature has obscured the nature of the FOMC’s

reaction function in the V-G era. With a few exceptions, this literature does not distinguish between the reduced forms produced by empirical estimation and the desired structural relationship capturing the behavior of the FOMC. There exists a correlation between short-term interest rates, inflation, and cyclical movements in the economy. A standard Taylor rule regression involving the funds rate as the dependent variable and inflation and a cyclical measure of the output gap as independent variables will capture these correlations without expressing the desired unidirectional causation from the independent variables to the dependent variable (the funds rate). The failure to capture the way in which expectations influence the behavior of both the funds rate and the right-hand variables of inflation and output creates an omitted variables problem.

To illustrate, consider examples of how the empirical Taylor rule literature fails to solve the

simultaneous equations problem. Assume the true reaction function is (4) in which the FOMC moves the funds rate in response to sustained strength in the economy but does not respond to transitory fluctuations in inflation. Imagine a strong cyclical recovery in world output that raises the natural rate of interest. An increase in commodity prices passes through to prices raising headline inflation. The FOMC raises the funds rate in line with the increase in the natural rate of interest and maintains the output gap at zero. The increase in the funds rate will correlate with the increase in inflation but not with an output gap without reflecting any causal relation.

This example reflects the misspecification of Taylor rules coming from the assumption of a

constant benchmark interest rate built in as a constant term in the regression. As a second illustration, consider the early 1980s when markets began to expect a reduction in inflation. The absence of indexing in the corporate income tax meant that a decline in the expectation of inflation raised the expected return on capital in the corporate sector (Hetzel 2008, Ch. 12, Appendix). The natural rate of interest increased. However, given the constant term in Taylor rule regressions, the resulting increase in the funds rate in the early 1980s is captured by the inflation term. No doubt the Volcker FOMC pursued a contractionary monetary policy, but Taylor rules estimated over this period produce only a scrambled measure of that policy.

As a final example, consider a persistent, positive productivity shock. Given the sticky prices

of the NK model, the markup will decline and inflation will increase. The FOMC will raise the funds rate given the persistent strength in the economy and in doing so will track the natural rate of interest and maintain the expectation of future output gaps at zero. However, estimated Taylor rule regressions will spuriously attribute the increase in the funds rate to a direct response of the FOMC to inflation. When economists put such a Taylor rule into an activist model with exploitable Phillips curve trade-offs, it will appear that the Fed controls inflation through manipulating those trade-offs.

An estimated Taylor rule can still serve as an initial benchmark for evaluating a particular

funds rate. One can interpret its predictions as revealing the funds rate consistent with the cyclical behavior of the economy and inflation over the estimation interval. However, as one would expect of

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an intertemporal price such as the real interest rate, the appropriate funds rate will exceed or fall short of this benchmark value depending upon the particular circumstances that make markets optimistic or pessimistic about the future. What is important for the discussion here is that one understands that in the V-G era, as opposed to the prior stop-go era, the FOMC decisively moved away from responding to realized inflation and instead concentrated on achieving credibility with a rule that assured nominal expectational stability.

3. Contractionary monetary policy as the cause of the Great Recession

The Great Recession is an event study representing an additional episode of central banks attempting to manipulate a negative output gap in order to reduce inflation. It is a new data point against which to test a monetarist application of the NK model (Friedman and Schwartz 1991).

Proponents of credit-cycle theories point to the Lehman bankruptcy on September 15, 2008,

as the precipitating factor in the Great Recession. However, a serious recession was inevitable before any significant disruption in credit markets appeared. For the Eurozone, the United States, and the United Kingdom, Figure 1 shows annualized growth rates of domestic demand (final sales to domestic purchasers). For the U.S., the cyclical peak is 2007Q2 and for the United Kingdom and the Eurozone, it is 2007Q4. At the same time, changes in inventories, shown in Figure 2 for the Eurozone, remained strong. By summer 2008, the combination of weakening domestic demand and an excessively high inventory/sales ratio made severe recession inevitable (Hetzel 2012, Ch. 12).

Contractionary monetary policy offers a straightforward explanation of the Great Recession.

In 2004, a persistent inflation shock of unprecedented magnitude emerged. As shown in Figure 3 by the Commodity Research Bureau (CRB) index of the world price of commodities, there were two distinct peaks to this prolonged inflation shock, summer 2008 and year-end 2010.7 Initially, the inflation shock did not pass through to headline inflation (Figure 4). From the end of 2000 through mid-2007, headline CPI inflation fluctuated around 2 percent. One explanation for this lack of pass through is the negative inflation shock in the form of an appreciation of the euro. As shown in Figure 5, from 2002 until mid-2008, the euro appreciated from less than .9 dollars/euro to almost 1.6 dollars/euro.

However, from mid-2007 to mid-2008, CPI inflation jumped from 2 percent to 4 percent.

This inflation shock reduced the real income of households. Figure 6 shows the cessation in 2007Q2 of the prior steady increase in real disposable income. Figure 7 shows the decline in the growth rate of real retail sales (year-over-year changes in monthly observations smoothed with a 3-month moving average) that began after April 2007. Consumer confidence peaked in May 2007 (Figure 7). The pessimism of households about their future income prospects required a reduction in the real interest rate in order to maintain aggregate demand.

The ECB, however, concentrated on the headline inflation that had emerged after mid-2007

out of fear that it would exacerbate high wage growth (Figure 8). It was especially concerned by wage demands of German unions (Hetzel 2012, p. 221). As late as July 2008, the ECB raised its policy rate (the main refinancing operations rate or MRO). As shown in Figure 9, it became willing

7 The growth of countries like China, India, and Brazil accounted for the increase in the relative price of commodities. For example, in 2000, China accounted for 12 percent of global consumption of copper. In 2012, the number had grown to 42 percent (Financial Times, 6/3/13).

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to lower rates only when headline inflation fell. The result of maintaining a high level of interest rates while the economy weakened replicated the classic tight monetary policy of a stop phase of stop-go monetary policy. Money growth (M1) slowed starting in 2006Q3 and slowed sharply after December 2007 (Figure 10). A decline in nominal GDP followed (Figure 11), accompanied by a decline in real GDP (Figure 12).

Figure 10 highlights the often divergent behavior of M1 and M3. M3 includes a significant

amount of debt instruments.8 Banks issue debt to finance loan growth when loan demand is high. As shown in Figure 13, apart from 2002-2003 and 2012 when banks made up for weak loan demand by holding more government securities, M3 and loan growth move together. For this reason, it is hard to disentangle causation between growth in M3 and in the economy. M3 is best viewed as a contemporaneous indicator of the economy.

M1 growth is a better measure of transactions demand. The deceleration of M1 from 10

percent growth in mid-2006 predicted the recession that began after 2008Q1. Its deceleration captured the way in which the ECB maintained the real interest rate above its natural value (the value consistent with maintaining real aggregate demand equal to potential). However, in a time of financial turmoil when market participants desire liquidity, they transfer out of the illiquid debt instruments in the non-M1 part of M3 into the liquid demand deposits of M1. Figure 14 shows how in fall 2008 and in 2009 investors transferred out of illiquid deposits and debt instruments into demand deposits. Those flows inflated M1 without any implications for the stance of monetary policy. At these times, M3 becomes the better indicator because it internalizes these substitutions.

Accounting for the distortions arising from the flight from illiquid to liquid deposits, the

behavior of the monetary aggregates indicates that monetary policy was contractionary from mid-2006 through at least 2012. In 2011 and 2012, both M1 and M3 grew at rates around 3 percent. Figure 15 shows M1 and M3 velocity. Velocity declines for both aggregates. If money is a measure of the impact of monetary policy on nominal GDP growth, then declining velocity makes a given level of money growth more restrictive.

The growth rate of M1of 3 percent that prevailed in 2011 and 2012 when combined with

declining velocity leaves no room for real growth without deflation. A measure of the decline in velocity is the difference between the M1 growth and nominal GDP growth shown in Figure 11. Assuming historical relationships persist, M1 growth at 3 percent implies that nominal GDP growth will have to fall to zero. In order to sustain 2 percent real growth, the price level needs to decline by about 2 percent per year.9

8 M1 includes currency in circulation and overnight deposits. M3 includes M1 plus time deposits with maturity up to 2 years, deposits redeemable given notification up to 3 months, repurchase agreements, money market fund shares, and debt instruments with maturity up to 2 years. 9 As noted, the signal-to-noise ratio is low for the monetary aggregates. By early 2013, M1 growth had risen to almost 9 percent while M3 growth remained at 3 percent (Figure 10). Although loan growth of banks remained negative (Figure 13), bank purchases of government debt maintained M3 growth. M1 growth could be artificially stimulated because banks, in response to lack of loan demand, offered only minimal interest on their debt and time deposits. Investors then transferred funds from these deposits into the demand deposits of M1. Even if loan growth remains negligible, a signal of stimulative monetary policy would be a simultaneous increase in both M1 and M3 growth rates.

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What about the monetarist implications of the NK model from Section 2? First, in order to

avoid interfering with the price system, the central bank needs to control trend inflation through a credible rule that conditions the nominal expectational environment in which firms setting prices for multiple periods operate not through a direct response to measured inflation. Second, it needs to stabilize fluctuations in the markup of firms around the optimal markup by following lean-against-the-wind procedures that raise interest rates in a persistent fashion when the economy grows at a high rate that reduces rates of resource utilization, and vice versa for economic weakness. Consider each of these requirements in turn.

Figure 16 shows the ECB’s main refinancing operations (MRO) rate and inflation.

Consistent with the first LAW with credibility condition above, it reveals no systematic response of the policy rate to inflation. Using econometric techniques, Aastrup and Jensen (2010) conclude:

We show that the ECB’s interest rate changes during 1999-2010 have been mainly driven by changes in economic activity in the Euro area. Changes in actual or expected future HICP inflation play a minor, if any, role.

Figures 17 and 18 are relevant to evaluating the LAW character of ECB procedures. Figure 17 shows changes in the ECB’s policy rate and the purchasing managers’ index (PMI), which is a sensitive measure of economic activity.10 Figure 18 shows the comparable graph using the growth rate of industrial production in place of the PMI. These graphs show the LAW character of ECB monetary policy. Consider now the departure from these procedures in 2008.

The increase in rates at the start of 2006 took place when inflation was steady at 2 percent.

That fact suggests that the increase in rates was entirely real. The increase reflected the strong growth in the Eurozone economy. As shown in Figure 17, the level of the PMI around 55 percent indicated positive growth. The decline in unemployment rates indicated growth at a rate producing an increase in rates of resource utilization (Figure 19). Until mid-2007, the procedures of the ECB possessed the spirit of the LAW with credibility.

After mid-2007, concerned with high headline inflation, the ECB departed from those

procedures by failing to lower its refinancing rate when the economy weakened (Figure 17). Positive growth in industrial production continued until its peak in April 2008 (Figure 18), but as evidenced by the peak in real PCE growth in 2007Q2 (Figure 20), domestic demand had weakened earlier. Most of the increase in inflation in 2008 was transitory. As indicated by stability in long-term bond rates (Figure 21), the ECB retained credibility and expected inflation did not increase. Nothing in this inflation surge raised the natural rate of interest. The ECB did not lower rates until October 2008. In fact, it raised the refinancing rate in summer 2008. With a weakening economy, the interest rate consistent with full employment (the natural rate) declined. Just as in the United States, the central bank turned a moderate recession into a major one through failure to lower rates in line with the decline in the natural rate (Hetzel 2012).

The world economy began a sharp recovery in mid-2009 (Figure 1). The end of the

inventory decumulation that contributes to the dynamics of cyclical fluctuations stimulated growth (Figure 2). In the past, strong recoveries had followed deep recessions. It seems likely that optimism

10 The Markit PMI is available to the author only starting in 2006.

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for a V-shaped recovery also stimulated output. However, when the economy revived in mid-2009, commodity price inflation also rose and raised CPI inflation (Figures 3 and 4).

Events then unfolded as they had in 2008. The second inflation shock set off another decline

in real disposable income (Figure 6). Real retail sales peaked in September 2010 and consumer confidence peaked in February 2011. The PMI peaked in April 2011 (Figure 17). Concentrating on the increase in headline inflation, the ECB raised its policy rates twice in 2011. Figure 22 shows the interest rates the ECB set. In early 2009, the EONIA rate began to follow the rate on the deposit facility rather than the MRO rate.11 (The latter became the rate at which banks with funding problems borrowed.) The ECB raised the rate on the deposit facility from 0.5 percent in early 2011 to 1.5 percent by mid-2011. Weak money growth (Figure 10) limited the growth of aggregate nominal demand and the nascent recovery aborted.

In July 2012, the ECB did push the deposit rate to zero. However, an expansionary monetary

policy as opposed to the actual contractionary policy would have required the ECB in late 2010 to abandon any attempt to set interest rates. It would then have purchased packages of sovereign euro debt in whatever quantities were required to stimulate low money growth (Figure 10) and reverse the decline in nominal GDP growth (Figures 11 and 12).

4. Was the Great Recession a Credit Cycle?

Popular commentary attributes the Eurozone recession to deleveraging from a prior period of excessive accumulation of debt. For example, Jose Manuel Barroso, the president of the European Commission, argued (European Commission, 2013):

[O]ne of the reasons we have a rise of unemployment in Greece is because the Treaty was not respected by the Greek authorities and by other countries. We have a Stability and Growth Pact, we have rules and those European rules were not respected by the Greek authorities, so these unemployed people in Greece should be told that the authorities of their country did not respect the Treaties that they have signed. Not only that country…. The crisis was created by unsustainable public debt and by irresponsible behaviour in the financial markets…. The current policies are of course appropriate in terms of reducing the biggest challenge that we have today which is the challenge of unsustainable debt, public and private, the need to deleverage, the need to put Europe on a sound footing so that Europe can be more competitive and can have growth again, but growth that is sustainable, because what we have learned, and this is for me the biggest lesson of the crisis, and I think a lesson that we have not yet all completely drawn, is that growth based on debt is not sustainable. Growth based on unsustainable public or private debt is artificial growth and what we need is to have growth that is sustainable, namely based on increased competitiveness in Europe…. [O]ur response to the crisis, our policy proposals, has always been a comprehensive response. It is the structural reforms for competitiveness,

More succinctly, The Wall Street Journal (3/8/13) wrote:

11 EONIA (Euro OverNight Index Average) is the interest rate on overnight unsecured lending transactions in the interbank market.

12

[C]reating a rigid “Europe of Rules” is exactly the German-led strategy for managing the crisis. Berlin’s aim is to perfect the monetary union by ensuring countries adhere to rules designed to prevent future crises by addressing what are seen as the causes of the current one: government overspending and excessive risk-taking by banks.

During periods of growth and the associated optimism about the future, households and firms take on debt. During periods of recession, they attempt to reduce their debt. For centuries, popular commentators have turned correlation into causation based on speculative-excess causing unsustainable asset bubbles and debt accumulation followed by forced debt liquidation (Hetzel 2012, Ch. 2). The debt deleveraging of recessions is one manifestation of the pessimism about the future that causes individuals to want to increase savings during recessions. Keynes used this idea to argue for deficit spending during recession—excessive private saving could be countered by public dissaving. However, if Keynes was correct, given the political pressures to run deficits in recession, it is hard to explain why government aggregate-demand management did not eliminate recessions in the post-World War II era.

Despite their popular appeal, credit-cycle theories of economic fluctuations possess no

theoretical foundation. Phrased alternatively, the increased desire to save in recessions is an increased desire to transfer resources from the present to an uncertain future. Time is a resource. In a period of debt deleveraging, individuals should work harder. In response to the loss of wealth, there should be a surge in employment. An increase in unemployment is counterfactual to these theories. One could argue that output and employment fall because of a disruption to financial intermediation that prevents the transfer of funds from savers to investors with profitable investment opportunities. However, it is hard to reconcile that hypothesis with the data.

For example, loans to the private sector from banks (monetary financial institutions or MFI)

averaged 10.7 percent year-over-year from May 2006 through May 2008 (Figure 13). Only in June 2008 did loan growth begin to fall below 10 percent. In contrast, the decline in economic activity began earlier. As measured by domestic spending (real final sales to domestic purchasers) and output (real GDP), the economy started slowing in 2007Q4.12 Similarly, after the recovery took hold in 2009Q3, loan growth recovered steadily until peaking in September 2011 and then declining sharply. In contrast, the recovery in domestic demand aborted earlier. Growth in real final sales to domestic purchasers fell from 2.2 percent over the 2010Q2 to 2011Q1 interval to -1.1 percent in 2011Q2 (Figure 1).

Figure 23, which shows Eurozone government debt as a percentage of GDP, does not support

the idea of a credit cycle. Two sharp increases in this number occur, one starting in 2008Q4 and the other in 2012Q1. Both come well after the weakening in economic activity. For the Eurozone, there is no evidence of an unwinding of speculative excess that precedes the advent of the Great Recession. Figure 24 shows real house prices for a number of countries. Nothing in the series for the Eurozone suggests any speculative excess conducive to a credit cycle.

12 From 2005Q4 through 2007Q4, real final sales to domestic purchasers grew at an annualized rate of 2.8 percent. In 2008Q1, the number was 1.7 percent and in 2008Q1 it was -0.3 percent. From 2005Q4 through 2007Q4, real GDP grew at an annualized rate of 5.3 percent. In 2008Q1, the number was 3.7 percent and in 2008Q2 it was -1.3 percent.

13

What about the subprime crisis? In August 2007, cash investors ceased buying the commercial paper issued by banks to finance the holding of subprime mortgages in off-balance-sheet entities called structured investment vehicles, or SIVs (Hetzel 2012, p. 179). European as well as American banks held many of these mortgages (Hetzel 2012, p. 242). Uncertainty over the extent to which individual European banks held such mortgages lessened the willingness of European banks to lend to each other in the interbank market. Instead of relying on short-term loans to meet liquidity needs, European banks held additional excess reserves (Heider et al 2009). The ECB accommodated that increased demand. As shown in Figure 22, the EONIA rate remained fixed at the ECB’s MRO rate. Through its swap lines, the Fed provided the dollars to the ECB it then lent to European banks to replace the dollar funding no longer supplied by cash investors (Hetzel 2012, p. 244 and p. 267). In short, central banks made certain that funding pressures on European banks did not affect their intermediation function.

Attribution of the Eurozone recession to a debt crisis received popular support following

events occurring from mid-summer 2011 to mid-summer 2012 when investors fled the sovereign debt markets of Italy and Spain. The fear was of a negative, self-reinforcing cycle initiated by high interest rates on sovereign debt. Consider Italy, whose debt/GDP ratio was 120 percent. In summer 2011, there was fear of a negative feedback loop setting in between a sovereign debt crisis and a banking crisis. Italian banks hold large amounts of Italian government debt. If the sovereign debt burden became unsustainable in the eyes of financial markets, the value of Italian bonds would fall. The possibility of sovereign default meant that Italian banks could become insolvent. Depositors then would flee. For small countries like Ireland, Portugal and Greece, the Troika (the European Commission, the ECB and the IMF) provided aid. However, Italy is the third largest country in the Eurozone. The willingness of the core countries, especially Germany, to backstop the issuance of Eurobonds to bail out a country as large as Italy was problematic.13

Again, attribution of the recession to this debt crisis conflicts with the timing of events.

Figure 25 shows sovereign credit default swap spreads for Italy and Spain. They start their climb to alarming levels in mid-2011. In early July 2011, the spread of two-year yields on Italian over German debt climbed above 2 percent and reached 7 percent in late November 2011. However, the Eurozone economy had already begun to weaken earlier in 2011. The timing suggests causation going from the economic weakness to a debt crisis rather than the other way around.

An argument for a debt crisis as a precipitating factor in the euro crisis is an assumed

disruption of lending to small- and medium-sized enterprises. The Financial Times (6/5/13) wrote: It has been clear for some time that in parts of the currency union the monetary transmission mechanism is broken. Ultra-cheap interest rates engineered in Frankfurt do not reach businesses in countries like Italy and Spain…. The ECB now thinks that the best way to deal with the credit crunch is to ensure that the Eurozone banks are properly capitalized…. A

13 In summer 2012, the yield on Italian government debt reached unsustainable levels, almost 7 percent. Capital flowed out of Italy and the Eurozone faced collapse. The new ECB head, Mario Draghi, promised to buy the debt of countries like Italy and Spain in a program called outright monetary transactions (OMT). That action lowered sovereign debt yields. The promise of the ECB to buy debt directly from Italy or Spain required a Memorandum of Understanding (MoU) negotiated with the European Commission committing the country to fiscal austerity. At the time, the fear was that renewed political instability in Italy would render problematic the implementation of austerity.

14

more effective course of action might be for the ECB to purchase bundles of SME loans directly. While radical, this would be legal under the central bank’s mandate, which prohibits monetary financing of sovereigns….

Figure 26 shows interest rates on loans made to corporations in Germany, France, Spain, and Italy along with the spread between the average on loans in France and Germany and the average on loans in Spain and Italy. The spread begins to widen steadily in July 2011 along with, not prior to, weakening in the economy. As shown in Figure 19, in 2011, the unemployment rate starts to rise sharply in Italy and is already above 20 percent in Spain. It is not obvious that the spread shown in Figure 26 between German/French and Spanish/Italian loan rates exceeds a normal risk premium and is therefore indicative of a failure of financial intermediation.

5. What is the appropriate role of a central bank?

In discussions of ECB monetary policy, popular commentary frequently makes strong assumptions about the role of a central bank. These assumptions concern both the way in which the actions of a central bank influence economic activity (the transmission process) and the revenue from money creation (seigniorage). Consider the following:

[The ECB] cannot finance governments, which limits its ability to buy any country’s bonds. Mr. Draghi has argued that doing so in any case would not accomplish much in the euro zone because most countries get their credit from banks rather than by issuing bonds (New York Times, 5/29/13).

As suggested in the quotation, is the ECB an outsized financial intermediary, which is an important influence but still only one of many influences on the intermediation of credit? Alternatively, is it a creator of money with the role of providing a nominal money stock that grows in line with the growth in demand for real money in order to avoid changes in the price level?

How should the ECB handle the seigniorage revenues that come with money creation?

Seigniorage arises from the fact that the interest a central bank receives on its assets exceeds what it pays on its liabilities (currency and the deposits banks hold with it—the monetary base). Member countries contributed capital to the ECB based on their relative GDPs and their central banks receive seigniorage revenues from the ECB accordingly. Those central banks distribute the seigniorage to their national governments, which use it to retire debt. Note that this arrangement is the equivalent of procedures whereby the ECB would increase its asset portfolio by purchasing bundles of sovereign debt in these proportions. It would be distributing seigniorage just as it does now.

Monetary base creation implies seigniorage. Controversy arises with programs like the

Securities Market Program (SMP) created in May 2012 and the Outright Monetary Transactions (OMT) program created in August 2012 in which the ECB buys the debt of individual countries. The ECB then conducts fiscal policy by allocating seigniorage revenues to individual countries. The resulting clout that the ECB exercises over the fiscal policy of countries may be inappropriate for policymakers who are not popularly elected.

However, confusion over the issue of ECB seigniorage should not prevent debate over the

efficacy of monetary policy at low levels of interest rates. There is nothing special about the zero lower bound at which short-term interest rates are zero. The central bank still has the responsibility to create money. Given that pessimism about the future creates both the zero-lower-bound

15

phenomenon and a heightened demand for liquidity, the central bank’s responsibility to engineer adequate money growth is especially acute at such times.

The ECB lacks a coherent strategy for creating the monetary base required to sustain the

money creation necessary for a growing economy. In normal times with positive interest rates and strong demand for loans from banks, it can expand the monetary base by lowering the rate it charges on the refinancing operations with banks. Because the ECB has pushed the overnight deposit rate to zero, it cannot do that now without lending heavily to insolvent banks. (The ECB can and should make the overnight deposit rate negative.)

The ECB needs to overcome resistance to money creation caused by the link to the debt

extinction of governments. It should buy packages of government debt with weights set according to the relative GDPs of governments. Seigniorage is an inevitable concomitant of monetary base creation, but it does not have to be directed toward any particular government. The ECB should buy packages of government securities to whatever extent necessary to create strong growth in aggregate nominal demand. It can use nominal GDP growth as a target and M1 growth as an indicator.

Structural reform is required to eliminate the current account deficits of the peripheral

countries given the inability to depreciate a domestic currency. However, the ECB has to be clear that surplus countries will experience inflation above 2 percent for extended periods of time. It will have to explain to the German public that such inflation is not a sign of a lack of the discipline that allowed Germany to achieve a current account surplus. Most important, the ECB needs to start by recognizing that Europe’s problems are more than structural. It needs to stop using monetary policy as a lever for achieving structural changes and to end its contractionary policy.

The monetarist critique continues to raise relevant issues. What is the fundamental role of a

central bank? Is its role to regulate the flow of credit from savers to investors? Accordingly, is the central bank responsible for the interest rate as a regulator of the price of credit? Alternatively, is its role to regulate the creation of money? Accordingly, is it responsible for the money stock as a regulator of the price of money (the price level)?

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Figure 1

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013-8

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Notes: Quarterly Observations of Quarter over Quarter annualized percentage changes in final sales to domestic purchasers. Final Sales to Domestic Purchasers is defined as GDP - Exports + Imports - Change in Private Inventories.Heavy tick marks indicate fourth quarter of year. Recession shading is for the U.S. Source: Haver Analytics.

Cross Country Final Sales to Domestic PurchasersPercent Percent

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Figure 2

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Euro Area Change in Inventories$Millions of Euros

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Figure 3

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Notes: Heavy tick marks indicate Fourth Quarter. CRB Spot Commodity Price Index: All Commodities (AVG, 1967=100) . Source: Reuters-CRB Commodity Index Report and Haver Analytics.

CRB Commodity Spot Price Index

1967=100 1967=100

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Figure 4

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Notes: Headline inflation is the harmonized CPI. Monthly observations of 12-month percentage changes. Core inflation excludes energy, food, alcohol and tobacco. Heavy tick marks indicate fourth quarter. Source: ECB and Haver Analytics.

Euro Area Headline and Core Inflation

year over year % change year over year % change

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Figure 5

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Notes: Heavy tick marks indicate Fourth Quarter. Source: Board of Governors of the Federal Reserve System,"Foreign Exchange Rates." H.10 (512) and Haver Analytics.

USD/Euro Exchange Rate

$/ Euro $/ Euro

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Figure 6

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Euro Area Real Gross Disposable Income Euros, bil

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Notes: Retail Sales Volume is a 3 month moving average of year-over-year percentage changes in real retail sales. The Economic Sentiment Indicator measures differences from the long-term average of 100. Haver Analytics.

Economic Sentiment and Retail Sales GrowthPercent Percent

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Figure 8

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Notes: Nominal hourly wages and salaries Year-over-year percentage changes in quarterly data. Heavy tick marks indicate fourth quarter. Source: EuroStat and Haver Analytics.

Wage InflationPercent Percent

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Figure 9

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Notes: Quarterly Observations of Quarter over Quarter annualized percentage changes in headline and core harmonized CPI. Heavy tick marks indicate fourth quarter of year. Haver Analytics.

Eurozone Inflation: Core and Headline and ECB Main Refinancing RatePercent Percent

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Figure 10

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Notes: Montlhy observations of twelve-month percentages changes in M1 and M3. Heavy tick marks indicate December. Haver Analytics.

Eurozone Money Supply Percent Percent

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Figure 11

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012-9

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Nominal GDPGrowth

Notes: Quarterly observations of four-quarter percentage changes. Heavy tick marks indicate fourth quarter. ECB and Bloomberg.

Eurozone M1 and Nominal GDP GrowthPercent Percent

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Figure 12

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Notes: Quarterly observations of four-quarter percentage changes. Heavy tick marks indicate fourth quarter. ECB and Bloomberg.

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Notes: Monthly observations of year-over-year growth in M3 and loans to private sector by MFIs. Heavy tick marks indicate December. Haver Analytics.

Eurozone Money Supply and Private Loan GrowthPercent Percent

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Notes: Monthly observations of 12-month percentage changes. Heavy tick marks indicate December. ECB and Bloomberg.

M1, M3 and Flight to LiquidityPercent Percent

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Figure 15

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Notes: Quarterly observations of M1/M3 Velocity: Nominal GDP divided by M1 and M3.Heavy tick marks indicate fourth quarter. Source: ECB and Bloomberg.

Euro Area Velocity of Money Percent Percent

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Figure 16

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Notes: Monthly observations of 12-month percentage changes in the HCPI. ECB Refinancing Rate is the Main refinancing Operations Rate. Heavy tick marks indicate December. Bloomberg

Inflation and ECB Percent

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Figure 17

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Notes: MRO is main refinancing operations rate. PMI is purchasing managers index. Heavy tick marks indicate December. ECB and Bloomberg.

Eurozone PMI and Rate ChangesPercent Percent

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Figure 18

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Notes: Montlhly observations of 12-month percentage changes in industrial production excluding construction. Policy Rate is one month difference in the ECB's main refinancing operations minimum bid rate. Heavy tick marks indicate December: ECB and Haver.

Eurozone Industrial Production and ECB Policy RatePercent Percent

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Figure 19

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GermanyFranceSpainItalyEuro Area

Notes: Heavy tick marks indicate Fourth Quarter. Source: EuroStat and Haver Analytics.

Euro Area Unemployment Rates

Percent Percent

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Figure 20

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Figure 21

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10 year euro govt bond

Notes: Heavy tick marks indicate December. Source: ECB and Bloomberg.

Euro Interest RatesPercent Percent

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EONIA

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Source: ECB and Haver Analytics

ECB Policy RatesPercent Percent

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Figure 23

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Euro zone Government Debt as a Percent of GDP

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Figure 24

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Notes: Quarterly data. Heavy tick marks indicate fourth quarter of year. Source: Haver Analytics.

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Euro-Area Sovereign Credit Default Swaps Spreads

Note: Weekly observations of 2 Year Credit Default Swaps on soverign debt as a spread to Germany soveriegn debt 2YR CDS. Source: Bloomberg

Italy

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Figure 26

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Notes: Heavy tick marks indicate Fourth Quarter. Spread is between the average of Italy + Spain and Germany + France. Source: ECB and Haver Analytics.

Average Interest On New Loans to Non-Financial Corporations Percent