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Economics & Finance - BLOG

ECB Rate Cut Justified

Antonio Fatas, INSEAD Professor of Economics |

Hans-Werner Sinn, the president of the Ifo Institute for Economic Research says the ECB was wrong to cut rates. I disagree.

When I teach these days about the negative performance of the Euro economies over the last six years I always get asked about how policy makers could get it so wrong. The answer can be found in the article that Hans-Werner Sinn published today in the Financial Times (Why Draghi was wrong to cut interest rates). It is hard to know where to start commenting on the article. It is not only inconsistent but also full of arguments that go against any economic logic supported by misleading use of partial data.

Interestingly, the article starts with the argument that given that inflation in the Euro area is below its target and falling (down to 0.7% in October), it seems that "last week's interest rate cut is understandable". Correct. That's the only reasonable paragraph of the article as the next one opens with the sentence:

"However, deflation in parts of a currency union is not the same as deflation of a union as a whole, because its internal effects on competitiveness cannot be compensated for by exchange rate adjustment.".

Let me start with the first part of the sentence. It is an interesting proposition to argue that the ECB should not manage just average inflation (and growth?) but also try to manage these variables at the regional level. This is not the mandate of the ECB. And that is exactly what Hans-Werner Sinn proposes, that the ECB tries to keep inflation in any region (country?) of the Euro area below 2%.This will imply overall deflation in the Euro area.

The second part of the sentence is even worse. If it is true that we need a realignment of relative prices within the Euro area, you will NOT get it by keeping inflation low. The article argues that the "printing presses" from Southern Europe have slowed down the realignment of the relative prices of goods needed for improving competitiveness. Wrong. There is plenty of evidence that prices and wages exhibit downward nominal rigidity and that it is much easier to allow changes in relative prices when inflation is positive. It is the low inflation level of the Euro area that is limiting the adjustment in relative prices (Krugman makes this point today in his blog).

The article also argues that the ECB policies have kept the value of the Euro down and this is one of the reasons why the German economy is running a current account surplus (not sure which chart he is looking at to argue that the value of the Euro is low...).

 

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Comments
HWS,

Antonio Fatas distorts my argument. Nowhere did I say the ECB should keep the Eurozone inflation rate low, and indeed this is not my opinion. I have always advocated more inflation to allow the relative price changes to happen . Even in this article I argue that Germany needs to give up its resistance against more inflation.

In fact, the article does not even make an argument against the ECB’s interest rate cut. I could have made an argument against it on the grounds that it expropriates savers, but I didn’t. Antonio Fatas should know that the headlines of newspaper articles are never made by the author. The article was not meant to argue against the interest rate cut, but against the ECB policies of providing replacement credit for missing private credit and of providing free-of-charge investment insurance. The reason for the headline title is probably that a day earlier Martin Wolf had written an article in favor of the interest rate cut, with the exact opposite headline.

The article moreover does not argue the ECB should actively try to influence relative price changes. To the contrary, it argues it should stop its interventions aiming at reducing such relative price changes. This, indeed, is the main point the article tries to make. Not the interest rate policy, but the collateral and SMP/OMT policies, which turn monetary policy into fiscal policy, that is the issue.

Hans-Werner Sinn

Antonio Fatas,

Prof Sinn, I understand that the Financial Times might have chosen the wrong title for your article and this is clearly unfortunate because in policy questions as important as this one, clarity matters. So I understand that you might be more favorable than what the title indicates to the reduction in interest rates that Draghi implemented, which means that our views are not that far from each other when it comes to the aggregate policy stance of the ECB. I personally wished that the ECB had moved earlier and not wait until this month.

On the other issues, I think we still hold different views. On relative price adjustments we all agree that they are necessary but we disagree on whether the ECB can facilitate them by ensuring an inflation rate which at a minimum is at its target and possibly slightly above.

On the issue of capital flows among Euro countries, this is a complex issue. The ECB has played a strong role providing liquidity to countries/banks that had no access to funding from private markets replacing the traditional role that the IMF has played in similar crises where there was a sudden stop. There is always risk involved in liquidity provision and we will need to analyse the data ex post, once we know the outcome of these risky position to see if they did the right thing (in fact, it will be more difficult than that as what we would need to do as researchers is to think about a counterfactual - what would have happened if those actions had not taken place?).

I am sympathetic to your views that without putting pressure on some Euro countries, reform will never happen. So allowing them to have more time might in some cases postpone what cannot be avoided. But I also see the damage that can be done if the ECB did not act as a lender of last resort for these countries or financial systems.

Antonio Fatas

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