Eurozone Meltdown

This is the first in a new series of regular briefing notes on important issues facing the euro area. In this briefing note we are asking whether the euro area could ever break up. We think not. But we are not as certain as we used to be.

Should a modern central bank still care about money?

Does money still matter for modern monetary policy? If you thought the beast was dead, you could not be more wrong. The subject of whether monetary aggregates matter for a central bank remains one of the big issues of modern monetary economics, but the discussion about this subject differs fundamentally from the discussion several decades agoThis is a distinctly European issue in the sense of the major central banks in the world, only the European Central Bank still makes explicit reference to money in its policy formulation. The ECB has adopted a two-pillar strategy, in which standard economic analysis, based on a neo-Keynesian forecasting model, forms the first pillar, while monetary analysis constitutes the second pillar of policy. The ECB is sometimes described as monetarist, partly because it tried to model itself on, and borrow credibility from, the German Bundesbank.But this is not a 1960s or 1970s style discussion about monetarism. No one in the right mind would want to target the money supply, given the experience of money supply targeting in the past. The proponents of money have a far more moderate goal. They argue that money sends some useful signals that a non-monetary analysis might not pick up, and that this would justify a separate analysis of monetary trends. This is the framework of the debate that is currently taking place – and the subject of a remarkable conference organized by the European Central Bank in Frankfurt on November 9-10.The modern economist view on money is best summarized by Larry Meyers, a former governor of the US Federal Reserve, who was quoted by Mervyn King : “Money plays no explicit role in today's consensus macro model, and it plays virtually no role in the conduct of monetary policy.”Most modern central banks, including the ECB itself, employ neo-Keynesian models in their economic analysis. These models have no explicit reference to money. Some old-fashioned monetarists have argued that these models are by definition incomplete. Since inflation is a monetary phenomenon, they surely cannot capture the true cause of inflation. Other have voiced the concerned that a cash-less model would ultimately lead us to the high inflationary period of the 1970s.Michael Woodford of Columbia University summarised those misgiving in a paper he presented at the conference.

There are a variety of misgivings that one might have about the soundness of cashless models as a basis for policy analysis. One sort of doubt may concern their theoretical coherence, or at least their consistency with a fundamental principle of economic theory, the neutrality of money. One might suppose that a model that makes no reference to money must either be inconsistent with monetary neutrality, or leave the general level of prices indeterminate so that such a model could not be used to predict the consequences for inflation of alternative policies. Alternatively, one might suppose that the models are coherent as far as they go, but that they are incomplete.

Woodford goes on to show that the standard neo-Keynesian model, even though it makes no reference to money, can determin the rate inflation. Furthermore, as Woodford writes:

Does the fact that this model determines the equilibrium price level without any reference to the money supply imply a violation of the long-established economic principle of the neutrality of money? It does not. The most important aspect of monetary neutrality, and the one that represents a genuinely deep principle of economic theory, is the proposition that decisions about the supply and demand of goods and services should (if decision makers are rational) depend only on the relative prices of different goods, and not on the absolute price (price in terms of money) of anything. This has an important implication for the theory of inflation, which is that one cannot expect there to be a theory of the general price level (at least, not one founded on rationality and intertemporal general equilibrium) for a world without government in the way that one can, for example, speak of what the relative price of oil would be in a hypothetical world in which there were no government petroleum reserves or other government interventions in the market for oil. The equilibrium price level, or alternatively the real purchasing power of the monetary unit, depends crucially on government policy, and more specifically on monetary policy: it is only the fact that the central bank's actions are not independent of the absolute price level that gives a nation's currency unit any specific economic significance.

Another argument frequently used in defence of the ECB “monetary pillar” is the credibility it has inherited from the Bundesbank, which used to be, or rather pretended to be a monetary targeter. While the credibility argument has some merit, it can at best justify the use of money in the early days of the ECB, or as Woodford put it:

But however prudent such a choice may have been when the new institution's strategy was first announced, in 1998, it hardly follows that it should never be possible to dispense with pious references to monetary aggregates. At some point, the institution should have earned its own credibility and no longer need to borrow this from an association with past policies of another institution. Of course, it will remain important that the ECB not appear to change its strategy abruptly or capriciously, if its own past successes are to count as a basis for confidence in the institution in the future. But evolution of the details of its strategy should be possible without risking the credibility of the Bank's core commitment to price stability, especially when this evolution can be explained as a result of improved understanding of the means that best serve that unchanging end.

Can there be still a justification for money in the light of Woodford’s devastating critique? If it can, then it is not due to the alleged short-coming of the neo-Keynesian framework inability to take proper account of inflation. One has to find real-world phenomena that the neo-Keynesian is incapable to generating. One such phenomenon is a boom-bust cycle in the stock market. The debate moves on the transmission chanels of monetary policy.

Larry Christiano, with Robert Motto, and Massimo Rostagno, argued that an inflation targeting central bank can actively contribute to a boom-bust cycle. This argument reflect a frequent criticism of the policy of the Federal Reserve according to which the central bank did too little to prick the asset price bubble (see also a separate Eurointelligence Briefing Note on this subject). They write:

Our results are as follows. We find that - within the confines of the set of models we consider - it is hard to account for a boom-bust episode (an episode in which consumption, investment, output, employment and the stock market all rise sharply and then crash) in a model that abstracts from nominal frictions. However, when we introduce an inflation targeting central bank and sticky nominal wages, a theory of boom-busts emerges naturally. In our environment, inflation targeting sub-optimally converts what would otherwise be a small economic fluctuation into a major boom-bust episode. In this sense, our analysis is consistent with the view that boom-bust episodes are in large part caused by monetary policy.

The argument in favour of money in some respects relates to the areas the neo-Keynesian models cannot reach. Money matters because the transmission mechanisms themselves may have a live of their own. This argument was elegantly summarised by Lucas Papademos, vice-president of the ECB.

The strong conclusions on the irrelevance of money in the conduct of monetary policy derived from the New Keynesian models are not a consequence of the key and attractive features of those models – the role of expectations and the more solid microfoundations – but they reflect underlying assumptions concerning the role of...

Should Central Banks target asset prices?

One of the most controversial issues in modern macroeconomics is the question whether the central should prick, target, take an interest or ignore asset price bubbles. It is a multi-faceted subject, on which no consensus has yet emerged, which is in part a reflection of much ongoing research in this area. This briefing note is in part related to the briefing note about whether money has a role to play in modern central bank. Some of the arguments are parallels, and pro-bubble-pricking advocates also tend to favour to rely on monetary aggregates, at least to some extent.

Interest in this subject was sparked by the Federal Reserve's monetary policy in the mid-to-late 1990s, a period characterised by Alan Greenspan, former governor of the Fed, as one of "irrational exuberance" as early as 1996. Yet, despite this titulation, Greenspan has been one of the loudest advocates against pricking bubbles, and the monetary policy of the Federal Reserve is largely associated with that position.

There are different strands in the literature. One of the seminal papers in this field is Bernanke and Gertler (1999), on the basis of non-optimising models of monetary policy, where the cofficients of interest rates on inflation and GDP is chosen in an ad-hoc way. Bernanke and Gertler deliberately chose this type of policy to be consistent with real-world central bank behaviour.

The Bernanke and Gertler result is that the central banks should disregard asset prices in their policy formulation. As Adam Posen (2006) has argued: "Central bankers should not try to prick asset price bubbles simply because it is not worth it." In the words of Bernanke and Gertler:

Conditional on a strong policy response to expected inflation, we found little if any additional gains from allowing an independent response of central bank policy to the level of asset prices.  In our view, there are good reasons, outside of our formal model, to worry about attempts by central banks to influence asset prices, including the fact that (as history has shown) the effects of such attempts on market psychology are dangerously unpredictable.  Hence, we concluded that inflation-targeting central banks need not respond to asset prices, except insofar as they affect the inflation forecast.

This is result is challenged among others by two author groups, Stephen Cecchetti, Hans Genberg, John Lipsky, and Sushil Wadhwani (2000),who arrive at different results using an optimizing policy rule but a more restricted set of shocks, while Andrew Filardo (2004) addresses some of the short-coming of either approach with an optimizing general model. He finds that:

The baseline model suggests that central banks should systematically respond to asset price developments generally and asset price bubbles specifically. Indeed, there are good reasons for the central bank to focus only on asset price bubbles, rather than the fundamental component of asset prices, when calibrating its monetary policy response. This general result does not depend on the volatility of asset prices per se or necessarily on the ability to distinguish fundamental movements in asset prices from asset price bubbles.

What all authors agree on is the need for further research is needed on the nature of asset price bubbles, their effect on the economy, and the effect of policy on bubbles.

In another strand of research, Adam Posen looked at the relationship between periods of monetary easing and bubbles, and found the theory that monetary easing would lead to bubbles unsupported. He said in just over one third of instances a period of monetary ease was followed by an asset price boom. He found that property bubbles were normally associated with a period of monetary easing.

He asks:

should central bankers forego monetary easing justified by the usual macroeconomic criteria because of a one-in-three chance that such easing might allow a real estate boom (and a one-in-four chance an equities boom)—especially when equity if not real estate bubbles can arise anyway, even under less than easy monetary conditions? Only if the probability-weighted costs of allowing such a bubble to arise and then burst would be greater than the loss from the foregone monetary ease. If a condition other than monetary loosening itself is what makes a bubble likely or costly, like poor bank capitalization and supervision for example, then the appropriate policy response would be to fix that other condition rather than distorting monetary policy.

A further argument against pricking bubbles, used by Posen, is that monetary policy is too blunt a tool. He said monetary tightening is a highly inefficient tool to prick a bubble, and cites several instances where this has failed. He writes:

Given the well-established fact that central banks today directly influence only a small portion of capital markets with their open market operations and setting of short-term interest rates, and that the primary means of transmitting monetary policy is through expectations, it is difficult to see why there should be a mechanical connection between tighter monetary conditions and investor behavior. If investors truly believe that there is money to be made in a bubble, and usually are counting on making large amounts of money (which is why it is a bubble in the first place), it seems strange to think that a marginal rise in interest rates would be sufficient to alter their actions. If the central bank were truly the only source of liquidity in town, cutting investors off when they had too much credit or were deemed to be taking on too much risk might be effective.

But central banks, and the commercial banks they lend to, are not investors’ only source of liquidity. Just as drunkards or gambling addicts who have less money will forego basic needs or sell personal items to continue their binges, investors who wish to ride a boom upward will sell or mortgage safer assets to do so, or they will look abroad for credit, as necessary. If investors believe in supra-normal market returns being available to them, a mere rise in short-term interest rates will only tell them they need to invest more.

Nouriel Roubini counters Posen’s arguments that only one third of monetary easing periods resulted in a bubble by retorting that this was to be expected, since monetary easing’s usually accompany recessions, and one would not necessarily expect a bubble to grow out of that. He argues that:

the issue is not whether easy money causes a bubble, as sometimes, bubbles can be triggered by financial rather than monetary factors. The relevant issue is whether, whatever the bubbles are caused by, monetary policy should react to a bubble.

He also criticized the Federal Reserve’s asymmetric response to bubbles, which consists of not reacting during a bubble, but to ease monetary policy aggressively after the bubble has burst (“mop up after” in Fed jargon). Posen and others have retorted that asymmetry is inherent in economics, for example, monetary policy is less effective when interest rates are close to zero. Summing up, Roubini presents the following six arguments in support of his claim that central bank should prick asset price bubbles.

1. Analytical models suggest that optimal monetary policy rules imply targeting of asset prices on top of inflation and growth in the monetary policy reaction function.

2. Optimal monetary policy should react to asset prices even when there is uncertainty about the existence and extent of an asset bubble.

3. Uncertainty as to whether bubbles affect the economy does not reverse the result that monetary policy should react to asset bubbles.

4. Monetary authorities should attempt to carefully “prick” a bubble.

5. A monetary policy that reacts to asset bubbles does not need to lead to severe economic contraction. It may instead appropriately control a bubble that may become damaging if left to grow without control.

6. It is inconsistent and non-optimal...