Unwelcome monetary conditions hold sway in the Euro Area, where the European Central Bank has allowed money supply growth to fall precipitously. This is causing unnecessary stress for European workers and businesses, generating slower than expected inflation and contributing to sluggish economic growth as well. Americans should be concerned, too, because economic weakness in Europe means less demand for our own exports.
What we are now observing is a “natural experiment,” when a major policy blunder sends the economy careening off course and, in the process, inadvertently sheds light on the validity of an economic theory. This dangerous experiment should be ended as soon as possible. But, while it continues, it provides economists with a chance to test their predictions as to which type of variable—interest rates or measures of the money supply—more accurately captures the effects that monetary policy is having on the economy.
In normal times, when a central bank wants to ease monetary policy, it does so by lowering short-term interest rates. But few if any central banks control interest rates by fiat; interest rates do not rise and fall just because central bankers say they should. Instead, those changes in interest rates need to be brought about by open market operations—purchases or sales of government bonds that add to or withdraw from the totally supply of bank reserves.
To ease monetary policy—that is, to lower short-term interest rates—for example, a central bank will typically buy government bonds, increasing the supply of bank reserves. Over time, each individual bank will hold only a fraction of the new reserves it receives, lending the rest out, setting off the circular process of multiple deposit creation that increases the money supply as a whole. Either way you look at it—as a decline in the interest rate or an increase in the money supply—monetary policy has become more expansionary. Likewise, in normal times, a rise in interest rates brought about by an open market operation that decreases bank reserves and, from there, the money supply, represents a monetary tightening.
In exceptional circumstances when monetary policy and inflationary expectations become unhinged, however, interest rates can be very misleading indicators of the stance of monetary policy. In the United States during the 1970s, for example, when inflationary pressures pushed interest rates to historic highs, those high interest rates signaled that monetary policy was excessively loose, not tight. And, as Milton Friedman and Anna Schwartz describe in their greatest and most influential book, A Monetary History of the United States, when deflationary expectations took hold during the Great Depression of the 1930s, the very low interest rates that prevailed signaled that monetary policy was far too tight, not too loose as the usual analysis might suggest.
Instead, measures of the money supply provided more accurate readings than interest rates on the stance of monetary policy, with excessive money growth reflecting expansionary policy during the 1970s and severe monetary contraction providing evidence to support Friedman and Schwartz’s argument that tight monetary policy was a key factor contributing to the length and severity of the Great Depression.
Today, in the Euro Area, we see similar evidence of a disconnect between interest rates and money growth. The European Central Bank has seemingly brought short-term interest rates down to extraordinarily low levels, leading many observers to conclude that policymakers are doing all that they can to support the still very shaky recovery of the European economies. But, as shown in the graph below, money growth in the Euro Area fell dramatically during the financial crisis and recession of 2007-09 and has never really recovered. Most troubling of all, the rate of Euro Area money growth now seems to be declining still further.
Someone who is used to associating low interest rates with expansionary monetary policy would have a difficult time explaining why Europe is suffering through a period of very low inflation and economic growth. How could this happen, when monetary policy is apparently so accommodative? But, once again, this natural experiment reveals how dangerous and misleading it can be to use interest rates as indicators of the stance of monetary policy. For as the statistics on the money supply clearly show, monetary policy in the Euro Area has been extraordinarily tight for quite some time, contributing to—not helping to solve—the dual problems of very low inflation and slow growth.
Europeans should be asking their representatives why the ECB is not taking more vigorous action to increase the money supply so as to bring the Euro Area inflation rate back towards its long-run target. Observers in the United States and elsewhere should take this opportunity to remember, too, that our own central banks are responsible, first and foremost, for making sure that the money supply expands at a slow but steady rate, so as to avoid any replay, either of the disastrously high inflation of the 1970s or the terrible deflationary stagnation of the Great Depression.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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