Et tu, Jean-Philippe! ECB Bashing latest

 

Maybe it is the warm winter air in Paris. Everybody in this city has recently had a go at the European Central Bank. Segolene Royal and Nicolas Sarkozy agree about nothing except the inadequacy of the ECB. Now the Paris-based OECD and its French chief economist Jean-Philippe Cotis have joined the fray with a report on the euro area that pulls no punches in its criticisms of the central bank.

 

Why on earth does the OECD get involved at this game? The OECD would not dream of inflicting such ritual abuse on the Federal Reserve, even though the Fed has been missing its inflation target, while the ECB has not.

 

There are three problems with the OECD's criticism of the ECB. First, the OECD is a credible institution to assess microeconomic policies, but surely not monetary policy. The OECD prepares its country reports only about every two years. It is a shame that it is wasted its 15 minutes of fame on an issue that is at best tangential to the problems of the eurozone. The OECD's criticism thus raises more questions about the OECD's remit than about the ECB.

 

Second, the comments are heavily influenced by the current French political debate, which again raises uncomfortable questions about the institution's perspective.

 

Third, and most importantly, the criticisms itself are extremely naive. While it is perfectly legitimate to question the use of monetary indicators in modern monetary policy, it is mischievous to ask the ECB to "describe more precisely and in more quantitative terms what today's money growth implies for future inflation". If the ECB were able to do that - to deliver a robust quantifiable relationship between today's money growth and tomorrow's inflation, the issue would be settled. There would be no two-pillar strategy, but a single pillar strategy. It would be called monetary targeting. No one would hate it more that the OECD and M Cotis.

 

But the ECB is not a monetary targeter. Like other central banks it relies heavily on its on internal inflation forecasts, and these forecasts are generated by New Keynesian economic models, similar to those used at the Bank of England or the Federal Reserve. What distinguishes the ECB from others is it is still taking an occasional peak at monetary statistics. Most ECB governors do not believe in a static and predictable relationship between money and prices. But even in the absence of such a static relationship, monetary indicators may still offer some useful information, for example about monetary transmission mechanisms.

 

The debate about the role of money in monetary policy has been one of the hardest fought in the history of economics. It is still capable of arousing passions today. Unfortunately, it has also led to extremism. Monetary targeting is no doubt extreme, but so is the total exorcism of money. It is true that the New Keynesian models only use output, prices and interest rates. Monetary aggregates are at best redundant, at worst misleading. But you have to have a strong belief in the stability of the models' parameters to assign monetary development to the dustbin.

 

I find the Federal Reserve's ignorance of money - to the extent that they have given up even on publishing monetary statistics - extremely arrogant and dangerous. First, there is some early evidence that the money demand is more stable in the euro area than previously suggested. What we may be seeing is Goodhart's Law in reverse: As the world's central banks have stopped targeting money, the relationship between money and inflation may become more stable. The correct response to this news is not to revert to monetary targeting - but to keep analysing monetary developments very carefully.

 

Furthermore, money is also useful as an early warning signal of financial instability, for example instability caused by bubbles. Since central banks cannot really be expected to price bubbles (also see our briefing note on this subject), it is much better for them to use a neutral intermittent indicator, such as money.

 

While I am defending the ECB's use of money, I am not defending the two-pillar strategy. Cotis is right to criticise that this strategy creates confusion. It would be much better to fold the monetary pillar into the economic pillar, and arrive at a unitary strategy - albeit one that includes money.

 

Unfortunately, with its ideologically broadside criticism, the OECD has done nothing to advance this debate - but a lot to fuel the flames of the debate in France.

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