Governments don't create problems, they solve problems
By Scott Sumner
Yes, I’m being sarcastic. I associate this view with American liberals. It often seems that when there is a problem such as the 2008 financial crisis, they immediately assume “the market” is to blame, and “more regulation” is the answer. On closer inspection it’s also a view of policymakers, whether liberal or conservative.
A good example is central bankers. Milton Friedman liked to point out that Fed officials never accepted the blame for bad outcomes (in real time), but took credit for good outcomes. During the 1930s Fed officials did not accept the view that they had caused the Great Depression, or even the severe deflation of 1929-33. During the 1960s and 1970s they did not accept the view that they had caused the Great Inflation. But Fed officials did assert that improved policy had led to the Great Moderation of 1984-2007. They did willingly accept the duty of targeting inflation at roughly 2%, and took credit when inflation averaged roughly 2% in recent decades. The same is true of other central bankers. On the other hand, Fed officials did not accept responsibility for the fact that NGDP in 2009 fell at the sharpest rate since 1938.
I thought of this pattern when reading a recent interview of Peter Praet, a top official at the ECB:
Unlike growth, the inflation figures are not in line with your scenarios. How do you explain this?
We have had to significantly revise our inflation forecasts for 2014, trimming them from 1.1% to 0.7% since December 2013. Low inflation is no longer caused purely by adjustments in certain euro area countries, and by lower energy and food prices. Normally, a fall in prices would be able to support purchasing power and, therefore, domestic demand. But demand has remained weak, including in the biggest euro area economies.
My immediate reaction was “never reason from price change.” Lars Christensen had the same reaction. The response is poorly worded; for instance he confuses “demand” with “quantity demanded.” But lots of people make that mistake. Is there a nugget of truth in this remark?
Perhaps the official was trying to say that “normally” the ECB is quite effective at keeping core inflation close to 2%. If successful, a fall in headline inflation to less than 1% would be caused by lower food and oil prices, presumably due to a rise in aggregate supply. In that case the lower inflation rate would be associated with higher output (a higher “aggregate quantity demanded.”) In this particular case, however, aggregate demand has fallen (the line shifted), along with the lower inflation. That’s not normal.
That is the most charitable reading I can give to the quotation. But unfortunately it doesn’t really help, because Mr. Praet also says the following:
What are the brakes on growth?
Monetary policy cannot do it all. France has been affected by the slowing growth of its neighbours. But basically, it’s investment that is causing a particularly serious problem. Another factor is the relative weakness of its export capacity.
This answer needs to be interpreted in the context of my charitable interpretation of the preceding quotation. (The alternative, the idea that top ECB officials don’t know the difference between AS and AD, is too horrible to contemplate.)
So we can assume from the first quotation that the ECB believes the eurozone has an AD deficiency, and this is causing the sub-2% inflation. It’s not the “normal” positive AS shock. But isn’t an AD-generated shift in inflation exactly what an inflation targeting central bank can and should control? Of course it is. Like the Fed, the ECB has eagerly accepted the notion that it has the ability and duty to keep inflation near to 2%. And like the Fed, when inflation is near to 2% it takes all the credit.
So why is Mr. Praet so pessimistic about the ability of monetary stimulus to boost AD in France? The answer he gives is truly astonishing. Monetary policy cannot boost AD sufficiently because the real problem is:
3. The weak economy of France’s (eurozone) neighbors
I see this sort of bizarre reasoning all the time, but rarely in such a stark form. Open any textbook and look at how eurozone monetary stimulus would be expected to help France. Here are the transmission mechanisms you will see:
1. More eurozone investment (lower real interest rates)
2. More eurozone exports (weaker currency)
3. More French exports (stronger economy in other eurozone countries.)
In other words, the ECB official has claimed that a lack of monetary stimulus is not the problem, because the real problems are precisely the sectors that would be helped by monetary stimulus.
Keep in mind that this is merely an extreme example of a thought process that occurs in central banks all over the world, almost all the time. It goes far beyond American liberalism. Indeed the ECB central bankers are relatively conservative. Rather it is deeply embedded in human nature. People who make decisions are very reluctant to acknowledge that subsequent bad outcomes are the result of those decisions. (Think Iraq.)
For you math jocks, here is a mathematical translation of the absurdity:
NGDP = M*V
NGDP = C + I + G + NX
Increases in the money supply obviously cannot boost NGDP, because the real problem is excessively low consumption, investment, government spending, and net exports. Don’t think top government officials would ever be so blind as to think this way? Think again.
PS. Here’s the equation that they should put in principles textbooks:
M*V = C + I + G + NX
It will never happen—as it might get students thinking dangerous thoughts.
HT: Nicolas Goetzmann