What should the European Central Bank actually do?
As parts of the eurozone seem to be creeping into deflation, a number of you have written and asked me what I think the ECB should be doing. Here are my views on three options:
1. Quantitative easing. People mean different things by this, but I am not sure that a complicated answer would be much better than a simpler one. I view it as better than nothing, but there is a risk it amounts to little more than a short- vs. long-term asset swap, which is hardly a solution.
2. Nominal gdp targeting. In general I like this idea, but which ngdp gets targeted? Eurozone ngdp, presumably. But when you have multiple countries, individual countries can end up with insufficient nominal gdp even if the eurozone meets a well-specified target overall. (Given independent bank regulators, debt structures, fiscal authorities and the like, I view this as more serious than say the 50 U.S. states, which have a higher level of integration, most of all at the policy level.) How much of a guarantee is there that Portugal would reap expansionary benefits, given the private credit contraction in that country? The potential clustering of ngdp growth in some parts of the eurozone is another way of stating why the currency union wasn’t a good idea in the first place. This is still much better than doing nothing, but as a monetary policy rule ngdp seems better designed for the single-country case.
There is another issue with ngdp targeting for the ECB, and that is markets simply might not believe it. If that were the case, what then should the ECB actually do to see through the promise? That brings us to #3:
3. A new and different inflation target. My current wish would be a new ECB mandate specifying a minimum core inflation rate of three percent for each of the largest countries in the eurozone, say France, Germany, Italy, and Spain. If any of these four countries seemed to be coming in under three percent inflation, the ECB would have to do more. And if need be, you could extend this rule through to more countries, with Malta and Cyprus probably at the end of that list.
Sumnerians should note this also might be the best way to actually meet an operational ngdp target for a fair number of eurozone countries. Note that I accept many of Scott’s critiques of inflation rate targeting, at least on a theoretical level. The (only?) advantage of this policy is that citizens would know what it means. They would know they hate it, in the same way that say Americans hate higher gas prices. They would know this is a higher inflation policy and the ECB would know it could not spin it any other way. A fair amount of inflation and thus monetary stimulus would in fact result.
Of course that is also why this is unlikely to happen. We’ll probably get some form of ineffective QE as a cop-out but better-than-nothing attempt.
“Needing a policy that you hate” — maybe there should be a phrase in Nahuatl for that?
Addendum: Scott Sumner comments.