photo: Theophilos Papadopoulos
The ‘unconventional’ monetary policies implemented by central banks seem to have failed. Quantitative easing, zero interest rates and – more recently – negative interest rate policies have not been able to bring inflation and growth targets back to ‘normal’ levels. On the contrary, the world’s major economies are close to deflation. The European Monetary Union is a typical case in point: after more than a year of quantitative easing – totalling more than 700 billion euros throughout 2015 and early 2016 (equal to roughly 7 per cent of the monetary union’s GDP) – the eurozone’s inflation rate has actually fallen back into negative territory, while inflation expectations indicators have fallen to record-low levels.
The flipside of this is that some leading economists and commentators are beginning to question the effectiveness of monetary policy, particularly in a ‘stag-deflationary’ environment such as the one that most advanced economies are mired in today. A good overview of the debate about ‘the impotency of central banks’ was recently penned by Jérémie Cohen-Setton at Bruegel (Cohen-Setton 2016). Regrettably, except for a few notable exceptions – Adair Turner, Larry Summers, Martin Wolf, Wolfgang Münchau (Turner 2016, Summers 2014, Wolf 2013, Münchau 2016) and other usual suspects – most critics of central bank policies fail to grasp the essence of the problem: the lack of, and need for, fiscal expansion. They in fact continue to base their analyses on the assumption that central banks can influence inflation and growth rates, it’s just a question of figuring out how to do so.
A good example is the revival of interest in the so-called ‘nominal GDP targeting rule’. Most central banks today employ a so-called ‘inflation targeting rule’ – whereby the central bank sets a target rate for the yearly rate of inflation (‘below, but close to, 2 per cent’, in the case of the ECB) and tries to attain it by adjusting its key interest rates or by influencing the market interest rate through open market operations (such as quantitative easing). The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability. Throughout the Great Recession, though, central banks have failed to achieve their inflation targets – spectacularly so, in the ECB’s case. This has generated a renewed interest in the concept of nominal GDP targeting, whereby, as the term implies, the central bank would aim to achieve a nominal GDP growth rate, not adjusted for inflation, instead of a given inflation rate (see, among many others, Economist 2015). Proponents of nominal GDP targeting argue that this rule would have mitigated the effects of the Great Recession and could today help countries that adopt it to regain the rate of growth prior to the crisis more quickly. One of the reasons put forward is that the nominal GDP targeting rule would prompt the central bank to react to variations in real GDP and the rate of inflation with the same intensity, whereas other and more celebrated rules, including the so-called ‘Taylor rule’, make the monetary authority more sensitive to changes in inflation than in real GDP, and therefore less capable of responding to adverse supply shocks.
Apart from these differences, the nominal GDP targeting rule, the Taylor rule and all the traditional inflation targeting rules share the assumption that management of interest rates and other monetary policy tools makes it possible to stabilise the movements of aggregate expenditure around given targets. They do not consider the possibility that the sole use of the interest rate and any other conventional or unconventional monetary policy tool could prove inadequate for the management of aggregate expenditure and the attainment of the target variables incorporated into the same rules.
A forthcoming paper in the Journal of Post-Keynesian Economics finds new and compelling evidence in support of this inadequacy (Brancaccio, Fontana, Lopreite, Realfonzo 2015). The authors used a VAR model in first differences with quarterly data for the euro area over the 1991-2013 period to ascertain whether variations of the market interest rate or the refinancing interest rate set by the European Central Bank contributed to the stabilisation of nominal GDP around a given target trend. The model shows that the deviation of the nominal GDP growth rate from the target GDP growth rate is not influenced by variations in the interest rate. The same estimation also shows, however, that the variation in the interest rate is positively influenced by deviations of the nominal GDP growth rate from its target. In other words, there is empirical evidence of a possible influence of GDP on the interest rate, but not the other way round.
This empirical result challenges the simplistic argument that the central bank has the role of stabilising inflation, real GDP or nominal GDP around a certain equilibrium level. In this sense, the outcome does not support interpretations of the behaviour of the monetary authorities in the light of the nominal GDP targeting rule, the Taylor rule or all the other traditional monetary policy rules. Rather, the empirical analysis appear to be in line with those alternative lines of research that give the central bank a much more complex role, which is the management of financial stability and solvency of economic units by fixing interest rates on the basis of the dynamics of GDP and related incomes.
A recent example of this alternative view is the so-called ‘solvency rule’ discussed in the Cambridge Journal of Economics (Brancaccio and Fontana 2013). This rule posits that monetary authorities are well aware that they cannot directly control fluctuations of inflation, production or nominal GDP through interest rate adjustments; on the other hand, they know that by setting interest rates on the basis of GDP trends, monetary policy influences the amount of the sums that debtors must repay to creditors in every single period, and thereby affects the solvency conditions of the economic system. In light of this ‘solvency rule’, it has also been shown that, in the context of a monetary union, the interest rate set by the central monetary authority can influence the allocation of ownership of existing physical capital among the member countries of the monetary union. In this sense, monetary authorities perform the crucial role of ‘regulators of a social conflict’ between solvent firms capable of accumulating profits higher than interest rate payments due on their debts and firms that make losses and tend to become insolvent. Since the former are obliged to sell capital in order to remain solvent, other things being equal, the central monetary authority can influence the ‘centralisation’ of capital within the monetary union, i.e. the transfer of ownership of capital from ‘peripheral’ to ‘central’ countries through cross-border mergers and acquisitions. Moreover, it has been argued that deflationary policies, contrary to mainstream claims, tend to exacerbate this process: on the one hand, deflation reduces the value of capital and thus can force firms to sell a greater amount of physical capital in order to remain solvent; on the other, fiscal austerity policies hinder the ability of governments to guarantee the solvency of national firms, thus amplifying the transfer of ownership of capital from some countries to others (Brancaccio and Fontana 2015).
Applying these analyses to the scenario of the euro area, one can conclude that the post-crisis policies implemented in the euro area are bound to lead to an increased centralisation of European capital, characterised by a gradual concentration of capital in Germany and other core countries, and more in general to an increasingly imbalanced relationship between the stronger and weaker countries of the union. A good indicator of this is the increasing divergence in insolvency rates of European firms. Between 2010 and 2014 Germany and the Netherlands registered a -25 and -7 per cent decrease respectively in the number of insolvencies. Over the same period there was an increase of 60 per cent in Italy, 40 per cent in Portugal and 31 per cent in Spain (Creditreform 2015).
If left unchallenged, this process will inexorably lead to an increased centralisation of capital in the hands of core countries. Capital in the periphery will tend to largely disappear or be absorbed by that of the core. In view of this, some economists and policy-makers have suggested that abandonment of the monetary union and consequent currency devaluation could be a more effective way to hold the solvency condition true. While this may be true under certain conditions, it should be noted that that the resulting depreciation of the domestic currency lowers the relative wealth of domestic firms, potentially leading to foreign acquisitions of domestic capital assets of an even greater magnitude (Brancaccio and Fontana 2015, from an intuition of Krugman 2000). In other words, there is no guarantee that an exit-and-devalue strategy in itself would halt the current process of capital centralisation in Europe.
Brancaccio, E., Fontana, G. (2013). ‘“Solvency rule” versus “Taylor rule”. An alternative interpretation of the relation between monetary policy and the economic crisis’, Cambridge Journal of Economics, Vol. 37, No. 4.
Brancaccio E., Fontana, G. (2015) ‘“Solvency Rule” and Capital Centralisation in a Monetary Union’, Cambridge Journal of Economics, advance access online, 29 October.
Brancaccio, E., Fontana, G., Lopreite, M., Realfonzo, R. (2015), ‘Monetary Policy Rules and Directions of Causality: A Test for the Euro Area’, Journal of Post-Keynesian Economics, Vol. 38, No. 4.
Cohen-Setton, J. (2016), ‘The impotency of central banks’, Bruegel, 23 February.
Creditreform (2015), Corporate insolvencies in Europe 2015/15.
Economist (2015), ‘After the hold, be bold’, 26 September.
Krugman, P. (2000), ‘Fire-Sale FDI’, in S. Edwards (ed.), Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, University of Chicago Press.
Münchau, W. (2016), ‘European Central Bank must be much bolder’, Financial Times, 6 March.
Summers, L. (2014), ‘Why public investment really is a free lunch’, Financial Times, 7 October.
Turner, A. (2016), ‘Are Central Banks Really Out Of Ammunition? What About Helicopter Money?’, Social Europe Journal, 10 March.
Wolf, M. (2013), ‘The case for helicopter money’, Financial Times, 12 February.