Today’s post by Marcus Nunes about the case against the ECB’s OMT plan being heard in the German courts planted a thought-seed about some of the things Jens Weidmann has had to say about the state of EZ monetary policy lately. So I dug up a recent speech that is posted in the BIS archives to get some idea about what this guy is peddling; and it isn’t pretty.
Apparently, he believes that any perceived compromise on the price stability mandate is a slippery slope to becoming like Venezuela. Here he is explaining how his phobia of “fiscal dominance” dominates his thoughts (emphasis is mine; notations and references are omitted).
Public debt and inflation are related on account of monetary policy’s power to accommodate high levels of public debt. Thus, the higher public debt becomes, the greater the pressure that can be put upon monetary policy to respond accordingly. Suddenly it might be fiscal policy that calls the shots – monetary policy no longer follows the objective of price stability but rather the concerns of fiscal policy. A state of fiscal dominance has been reached.
Technically, fiscal dominance refers to a regime where monetary policy ensures the solvency of the government. The traditional roles are reversed: monetary policy stabilises real government debt while inflation is determined by the needs of fiscal policy.
Intuitively, the logic of the fiscal theory can be described as follows: Let us assume additional expenditure, for instance higher transfers, which are not financed by additional taxes but by issuing additional bonds. Consequently the value of real debt is now higher than the present value of future tax payments. Households feel richer and thus consume more, causing output and inflation to increase. Monetary policy has to stabilise real debt to avoid an inflation spiral, with the result that it responds at a rate of less than 1 to 1 to inflation, thereby violating the Taylor principle. Thus, higher inflation reduces debt in real terms and lower real interest rates reduce the real debt service burden of existing government debt.
In each of the two cases, a regime of fiscal dominance is characterised by higher inflation and probably also more volatile inflation. Monetary policy is no longer able to control the inflation rate, and therefore welfare losses will occur.
The first problem is the appearance of the words “suddenly” and “might.” Suddenly and might are not the basis of rational theory or sound policy.
And there is something wrong with this too:
Let us assume additional expenditure, for instance higher transfers, which are not financed by additional taxes but by issuing additional bonds…
I think some rationalization that the current state of debt in the EZ did not come from discretionary spending, a sudden urge toward extreme largess, but rather a need to keep banks from failing and destroying money as the EZ financial system collapses into a pile of smoldering ruins is required. Some actually learned a lesson from the Great Depression, as Weidmann is apparently is behind the curve. And when the euro participants’ OMOs push the limits of the Laffer curve, there will be trouble if faced unexpected expenses arising from a financial crisis. They can’t tax more than can be taxed.
Even more importantly, however, Weidmann is leaving out the effects on the real value of debt, specifically government debt for purposes of this discussion, from the disinflation that occurs when the central bank has failed its price stability mandate in the downward direction, excess demand for money and “safe assets” is not accommodated, downward price adjustments are forced on the broad economy while wage stickiness and other supply side rigidities cause massive losses in income, both in real time and expected future income. Less national income = less tax collections against a backdrop of amplified existing nominal debt burden. I think that here I am describing welfare loss that is much worse than a deviation of a couple of percentage points on the CPI in the upward direct from the point of view of average Joe. But Weidmann conveniently ignores that it is a consequential tradeoff in order to preserve central bank independence – including the power to destroy instead of foster.
Monetary policy cannot exist in a vacuum; we do not have monetary policy for the sake of monetary policy. And while the central bank should have some perceived level of independence, it should also have rules and consequences for violating the rules that are enforced by the political system. Such violations as pretending that the stability clause in the price stability mandate does not exist, and the lower prices are, the better it is for everyone involved, are among them. Monetary policy can never achieve a zero inflation environment because the supply side exists with all of its imperfections and vulnerabilities toward both acts of God and government. Monetary policymakers should recognize that reality and fit that into the central bank’s operations, because it does have a moral obligation to provide a stable atmosphere for markets and people to prosper. Anything short of that is undemocratic and results in a tyranny that no democracy should tolerate.
In a democracy, the elected leaders should “call the shots,” not some unelected, self-important, power-hungry appointed bureaucrats. If Jens Weidmann gets away with calling the shots in his own country, that is Germany’s problem. It should not continue to be the problem of the rest of the EZ; and I certainly hope that the German courts move to slam the final nail in the coffin of the euro zone so that Weidmann and others of his ilk will be exclusively a German problem without the benefit of being the recipient of capital flight from the rest of the EZ victims of his disastrous policy prescriptions.