ECB policy

SCOTT SUMNER recently wrote a nice post entitled "The myth of the pro-German ECB". I disagree with his argument that the Balassa-Samuelson effect explains higher inflation rates in the European periphery (isn’t this effect based on productivity gains in the tradables sector?), but in my view he is right on his main point: monetary policy by the ECB was too tight for Germany. This contributed to the economic malaise from which Germany suffered between 1998-2006, and explains in part the slow pace of its internal devaluation.

Let's review in a little more detail the two most common criticisms about Germany and the monetary policy of the ECB.

1. ECB policy was right for Germany before the crisis.

David Beckworth has repeatedly made this point, as have many others, but I think it's mistaken. Germany experienced too-low inflation of around 1.5%, which Jean-Claude Trichet praised, in what was probably the weirdest moment of his tenure, as being “better than the Bundesbank”. Germany's core inflation was even lower, economic growth was not much higher, and unemployment rose to catastrophic levels (see the chart in Mr Sumner's post). From these facts alone, it is difficult to conclude that ECB policy was right for Germany. If you prefer Market Monetarist terms: nominal GDP growth for Germany was anemic. Some claim it was “on trend”, but one shouldn’t apply the trend argument too mechanically.

More rigorous analyses of the ECB's monetary policy are somewhat divided. Unfortunately, Mr Beckworth cites only those studies that, as far as I understand, use a simple backward-looking (or what Barclays Capital calls a “classical”) Taylor rule—something that Mr Beckworth would rightly criticise if it were used to explain, say, that monetary policy in America in late 2008 was just on target.

In his defense, the only study that I know of that has properly modeled and estimated a forward-looking Taylor-rule-like reaction function of the old Bundesbank and then used it to estimate the hypothetical interest rate setting for Germany after 1998 is in German. The conclusion of this Kiel Institute study is: ECB interest rates were up to 150 basis points too high for the German economy in the early 2000s (see the chart below; the label of the lower smooth curve reads "interest rate setting derived from the [estimated] reaction function").

Naturally, all these approaches have their weaknesses. For instance, the equilibrium interest rate setting is simply unknown, even in careful studies like the one by the Kiel Institute, not to mention the correct estimation of the output gap or inflation expectations. Still, it is hard to argue in my view that monetary policy was appropriate for Germany before 2006.

2. The ECB is consciously tailoring monetary policy to the current needs of the German economy.

It is an understandable claim to make, but I still think it is wrong if phrased like this. The ECB uses mainly the following input for its monetary policy decisions: current headline inflation, which is where the ECB wants it to be at the moment, taken as an average over the euro-zone economy as a whole, of which Germany is a large part. What seems like an ECB willingly tailoring policy to Germany's needs right now is just the result of this input.

Germany surely is lucky because it is not suffering from the lack of aggregate demand that the ECB is creating in the euro zone, God knows why. And it is this aspect of policy that should be criticised: why is the ECB letting aggregate demand fall so much below trend? Accusing the ECB of favouritism is not only false, in my view, it will also make the ECB turn a deaf ear on an otherwise very sensible position: namely, that its monetary policy is inappropriate for the euro zone as a whole.

All this said, the anchor country of a currency union is in a relatively good position, especially if it is a highly developed, massively capitalised and in terms of real estate probably saturated economy like Germany. This implies that monetary policy in this currency union is unlikely to deviate all too much from the needs of the anchor economy—unless this anchor economy has severe problems of its own (1998-2006) or the rest of the currency union is in severe trouble (2008 - ????).

What should strike monetary-policy makers as problematic is that policy is more or less on target for Germany. In the current situation, it clearly shouldn’t be!