For the ECB to be more effective it needs to follow the lead of the Federal Reserve
Opinion: US body has duty to regard level of unemployment, not just inflation
President Barack Obama with Janet Yellen at the White House in Washington last week. Photograph: The New York Times
In her speech accepting the chairmanship of the US Federal Reserve, Janet Yellen stated that her main priority would be implementing monetary policy in a way that minimised unemployment. She also said she was aware of the economic and social strains caused by unemployment, something we have not heard from the current president of the European Central Bank, Mario Draghi.
Her concern is not surprising in view of the fact that much of her highly respected research has been on unemployment and its effects. Because she is known to give priority to reducing unemployment over maintaining a very low rate of inflation, she is known as a “dove” to the Wall Street vultures who respect only “hawks”, such as the former chairman Alan Greenspan, who consistently favoured reducing inflation over reducing unemployment.
If Janet Yellen had been made president of the ECB, she would not have mentioned unemployment in her speech, because the sole objective of the ECB is the control of inflation, while the Federal Reserve has as its mandate not only the control of inflation but ensuring that unemployment is minimised. If inflation rises above 3 per cent in the euro zone, the ECB must immediately take steps to reduce it.
When the euro was introduced and the ECB established, Germany’s Bundesbank insisted that maintaining low inflation be the overriding objective. It is significant that the ECB is located in Frankfurt, down the street from the Bundesbank.
The Bundesbank’s prioritising of inflation control was an understandable result of Germany’s experience of hyper-
inflation in the late 1920s and again at the end of the second World War. While some historians argue that hyperinflation in the late 1920s contributed to the rise of Hitler, it could also be argued that it was the mass unemployment that resulted from Chancellor Brüning’s drastically deflationary policies in 1930 that led to the surge in support for the Nazis.
Another factor that determined the anti-inflationary stance of the ECB was
the collapse of the “Keynesian consensus” that governments could ensure full employment by managing aggregate demand through state spending and taxation. The combination of low growth and high inflation of the 1980s, which Keynesian policies could not solve, led to the rise of new classical macroeconomics, which argued that people were capable of anticipating changes in macroeconomic policy and reacting to them.
If this is true, were a central bank to increase money supply in order to stimulate the economy, people would anticipate inflation and seek pay increases to compensate for that inflation, which in turn would reduce employment. The increase in the money supply would be self-defeating.
According to the tenets of new classical macroeconomics, rational expectations and efficient markets would render stabilisation policy ineffective. From the late 1980s until the economic crisis of 2008, inflation did indeed fall and the period was referred to as “the Great Moderation”. But while inflation was low, growth was lower in most rich countries than it had been in the 1970s and though unemployment fell, job security decreased and work intensified in many occupations. The number of banking crises was also higher in the 1990s than in the inflation-ridden 1970s and early 1980s.
While new classical macroeconomics originated in the US, its policy prescriptions were not taken on board by the Federal Reserve because the Fed’s mandate dates from 1978, before the rise of new classical economics. The 1978 Humphrey-Hawkins Act gave it the goal of minimising inflation while also seeking to promote full employment and lower interest rates. This means that the Federal Reserve does not have to always prioritise controlling inflation but may tolerate mild inflation, if doing so results in lower unemployment. In contrast to the president of the ECB, who must state his inflation target, Janet Yellen is not under any such obligation.
Dr Yellen will also have the advantage of presiding over a central bank that operates in a monetary union that is also a fiscal union, unlike the ECB, which must implement a “one size fits all” monetary policy in a euro zone with divergent economies. Soon after Ireland adopted the euro, Germany experienced an economic slowdown and the ECB lowered interest rates to stimulate economic growth there.
The lower interest rates at which Irish banks could borrow from European banks, without exchange-rate risk, led to the lending frenzy that ultimately led to the collapse of the Irish banking system. The Central Bank of Ireand could not raise interest rates to dampen the lending spree. (It could at least have shouted “stop”, and why it did not may be revealed by the long-awaited banking inquiry).
Fears for the survival of the euro have diminished over the past year as tentative moves to establish an EU system of bank supervision and an EU mechanism for rescuing failing banks have been made. But Mario Draghi has argued these measures may not be enough to guarantee the future of the currency and he believes a fiscal and, ultimately, a political union will be required if it is to survive.
In his speech on accepting the Nobel Prize in Economics in 2011, Thomas Sargeant urged the EU to emulate the US, which on its formation took on the debts of the states. This action, argued Alexander Hamilton, one of the founding fathers, would be the “cement of the union”.
Sargeant’s proposal no doubt gave Angel Merkel nightmares, but unless a real banking and fiscal union are achieved in Europe, the ECB will not have the capacity to stimulate employment and growth that the Federal Reserve has used so effectively to counteract the Great Recession.
Seán Byrne lectures in economics at
the Dublin Institute of Technology