Saturday, April 5, 2008

C'mon, Trichet

Two complementary articles on Project Syndicate target the European Central Bank, one directly, the other indirectly. Brad DeLong argues that the contraction of the U.S. economy will make itself felt throughout the world and that governments need both to stimulate demand as in the good old days of Keynesianism and "increase the private sector's effective risk-bearing capacity."

The world economy, as John Maynard Keynes put it 75 years ago, is developing magneto trouble. What it needs is a push – more aggregate demand. In the US, the weak dollar will be a powerful boost to net exports, and thus to aggregate demand. But, from the perspective of the world as a whole, net exports are a zero-sum game. So we will have to rely on other sources of aggregate demand.

The first source is the government. Fiscal prudence is as important as ever over the medium and long term. But for the next three years, governments should lower taxes – especially for the poor, who are most likely to spend – and spend more.

The second source is private investment. The world’s central banks are already cutting interest rates on safe assets, and will cut them more as the proximity and magnitude of the likely global slump becomes clear.

But low interest rates are entirely compatible with stagnation or depression if risk premia remain large – as the world learned in the 1930’s, and as Japan relearned in the 1990’s. The most challenging task for governments is to boost the private sector’s effective risk-bearing capacity so that businesses have access to capital on terms that tempt them to expand.

Melvyn Krauss meanwhile notes that the ECB is "obsessed" with the short run and is at the moment pretending that Europe is somehow "decoupled" from economic conditions in the United States in order to dissuade the market from its rational expectation that the bank will be obliged to lower interest rates in the near future. Oddly, Krauss links this argument to the observation that Jean-Claude Trichet has developed a habit of signaling future bank policy by using coded language in his pronouncements. The apparent paradox is resolved when we realize that Trichet's code has always been used to signal either firmness or tightening at times when the market may have been expecting easing. Indeed, the ECB seems to interpret its mission as administering punishment repeatedly until any expectation of a "political" response to the business cycle in the form of monetary easing to counter contractions in output is extinguished. Unlike Delong, however, Krauss seems, despite his impatience with Trichet, to share his belief in the value of punishment:

The ECB should be preparing Europeans for what many of its own officials admit in private: Europe has not “de-coupled” from the US. On the contrary, America’s current economic difficulties will hit Europe hard, but with a time lag – the best guess being 2009.

This is not to argue, of course, that the ECB should cut interest rates now. On the contrary, the Bank’s current policy of fighting inflationary pressures by slower growth, a stronger euro, and the credit crunch seems just about right for the time being.

But, after all the happy talk about the European economy, how much credibility will the ECB have if Europe eventually succumbs to recessionary pressures from abroad? The ECB’s independence is still a contentious political issue in Europe. It is more prudent that it voice concern for Europe’s future economic prospects today than face a deceived and angry public tomorrow.

Contrast DeLong:

Many today are complaining about Alan Greenspan’s monetary stewardship, which kept these three locomotives stoked: “serial bubble-blower” is the most polite phrase that I have heard. But would the world economy really be better off today under an alternative monetary policy that kept unemployment in America at an average rate of 7% rather than 5%? Would it really be better off today if some $300 billion per year of US demand for the manufactures of Europe, Asia, and Latin America had simply gone missing?

This is the point in the argument at which someone will no doubt inject the phrase "moral hazard." Didn't the "serial bubble-blowing" encourage the imprudent lending that is at the root of today's contraction? No doubt. But surely there are better ways of punishing imprudent lenders than ensuring that demand for loans will dry up and that job creation and output will wither and crumble in the ensuing drought.

No comments: