Spotlight G20: Mario Draghing the Feet on Monetary Policy: Or what should central banks do

Matías Vernengo, part of our 2011 Spotlight G20 Series

Central Banks have been at the epicenter of the current crisis, and have been, for good and for bad, fundamental for the policy response mounted to avoid a new Great Depression. Recently Christina Romer argued that the Fed should start targeting nominal Gross Domestic Product (GDP) instead of inflation.  As I noted previously (see here), this is strange since it is far from clear that the Fed actually targets just inflation, or that targeting nominal output would make any significant difference.

Further, the idea that a central bank has the ability to actually hit a targeted level of output, or inflation for that matter, under the current circumstances in particular, is wishful thinking. Central banks can ease the credit conditions by reducing interest rates, a range of rates from the short to the long, to stimulate spending, and pump money into the system, fundamentally to avoid systemic crisis caused by bankruptcies. The ability of Ben Bernanke or Mario Draghi, the newly appointed head of the European Central Bank (ECB) that reduced the rate of interest in Europe as his first measure (see here), to further reduce interest rates and with that help the staggering recovery in the US or the free fall in the periphery of Europe is very limited.

Romer seems to still believe in some sort of Monetarist effect of increased money supply on expected inflation that would lead to even more negative real rates, stimulating spending. This kind of belief is perplexing, to say the least. It is important to emphasize that printing money or reducing the rate of interest cannot be inflationary under recessionary conditions when there is significant excess capacity.

If more money were pumped into the system agents would spend the money or pay their debts. If they pay previous debt, the money has no effect on the level of activity, and cannot increase prices or nominal output. On the other hand, if they spend and firms have extra capacity output must increase, but not prices. Note that firms normally have extra capacity, and can produce more at the same price, contrary to the textbook (U-shaped) cost curves.

Since it is clear that the economy is not at full capacity in the US or in any part of Europe, the real question is whether printing money or reducing interest rates, in the middle of crisis of debt deleveraging, in which indebted agents rush to pay old debts or simply go bankrupt, can lead to a significant increase in nominal output. If the US recent experience is a guide, the conclusion must be that monetary policy at this point is like what Marriner Eccles, the Fed chairman during the Great Depression, would have said: “pushing on a string.”

In that sense, Bernanke is not only doing pretty well, since he has also bought significant amounts of government bonds, helping to maintain the long term rate of interest at low levels, but he is right to argue that other Federal agencies should be doing more to help create jobs. In his words, he thinks: “it would be helpful if [the Fed] could get assistance from some other parts of the government to work with [it] to help create more jobs” (p. 9; see whole thing here). In other words, fiscal policy is needed.

The problem for developed countries is and continues to be the ECB. Mario Draghi’s reduction of interest rates is a timid first step in the right direction. The whole of the Greek crisis and the fears of contagion could be avoided if the ECB decided to buy small amounts of Greek debt (Greek debt is actually pretty small, see here).

The fears of inflation, and even moral hazard, associated with such a move are incredibly exaggerated. The ECB should take a page from Bernanke now, and Eccles during the Great Depression, and do some Quantitative Easing, buying more bonds from peripheral countries. The reasons this has not been done are purely political and have hurt the workers in Europe, particularly in the periphery, who have been forced to endure deflationary pressures, with the consequent stagnation of wages and increase in unemployment levels. But for now that seems increasingly difficult to envision. Hope springs eternal!

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