The ECB Is the Odd Central Bank Out

The European Central Bank is the last major central bank without an aggressive monetary easing program. 

And then there was one.

The European Central Bank is the last major central bank without an aggressive monetary easing program. The last few years of stuttering economic recovery have forced its counterparts -- the Bank of Japan, the Federal Reserve and the Bank of England -- one by one into action.

Consider all that's happened over the last few months alone. Japan's central bank lifted its inflation target to2 percent and launched a massive bond-buying plan of 7.5 trillion yen per month. The U.K. Treasury tweaked the Bank of England's remit to confirm that temporary overshoots of its inflation target were permissible. (Its incoming governor Mark Carney seems likely to push for a commitment to an extended period of low interest rates.) And the Fed has been buying Treasuries at $85 billion per month since December.

And the ECB? It left interest rates unchanged at its most recent policy meeting, signaling that it might cut them later only if things get even worse. It let the monetary base, or the quantity of currency and reserves held at the central bank, shrink by some 60 billion euro last month. Yet, more than any other big economy, the euro area badly needs new monetary stimulus.

Europe's troubles are often framed as a sovereign-debt crisis. But Europe's unemployment rate of 12 percent and rising is happening not because of government debt but because of bad macroeconomic policy. Europe has suffered from a nominal shock -- that is, a drop in aggregate demand. Extraordinarily weak nominal growth now prevents the reset of prices and wages to levels that would support higher output and employment.

The pre-crisis trend of money-supply growth has been completely disrupted, despite the ECB's "reference value" goal of 4.5 percent annual growth in the monetary aggregate M3. When you subtract Germany, growth in the money supply has flat-lined for five straight years. Inflation expectations, especially in the depressed periphery, have collapsed. Greece, for instance, is entering deflation as measured by its Harmonized Index of Consumer Prices, the ECB's standard measure. Nominal income is miles below its prior growth path. The growth rate of the euro area's nominal gross domestic product averaged 4 percent before the recession. It's well below 1 percent now.

This macroeconomic mismanagement has worsened Europe's debt problems. Shrinking economies make sovereign debts less sustainable. The inability to issue sovereign debt forces European governments into austerity, worsening the recession.

The countries with the most intense debt problems -- Greece, Ireland, Italy, Portugal and Spain -- all have "NGDP gaps" of at least 10 percent, relative to the pre-recession trend line. It's not hard to see why this creates a big debt problem: If your economy was more than a tenth smaller than you had expected it to be five years ago, the debts you would have wouldn't match up either.

The ECB's inaction isn't due to any lack of authority -- or of policy options. Here's a simple one consistent with the ECB mandate: adopt a so-called Evans rule, similar to the Fed's. So long as inflation remains below 2 percent, buy assets until unemployment stops rising and set the short-term interest rate to zero until euro-area unemployment falls below 10 percent.

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