Central banking is a funny business. When you get down to it, it’s not really about interest rates, yield curves or hundreds of billions of euro. It’s about influence.
Central bankers are like Premier League football managers. Only by influencing others can they get what they want. Where coaches influence players, central bankers influence investors and the wider economy.
The best football teams don’t need constant input from their coach. The players understand what they’re meant to be doing and they get on with it.
Poor teams don’t know what they’re meant to be doing. They look to their coach for guidance. And their coach struggles to give it to them
The best central bank regimes don’t have to do much either. When a central bank is credible, everyone knows they’re able to keep inflation and unemployment under control. They know that, if necessary, the central bank will create or destroy as much money as is required to keep the economy where it’s meant to be.
But when a central bank is credible, it doesn’t even have to create or destroy money. Because people expect the economy to be stable, and that keeps it stable. When people don’t think there’s going to be a recession next year, they make investments this year, which stops the recession from happening next year. When people don’t think there’s going to be runaway inflation next year, they don’t spend all their money this year, which prevents inflation next year.
So there’s a circular quality to it. If people think the central bank can keep the economy stable, they act as though the economy is stable — and that keeps the economy stable. If people doubt the central bank can keep the economy stable, they act as though the economy is unstable, and that makes the economy unstable.
The Bank of Japan’s former Governor Haruhiko Kuroda gets it. He told a press conference: “I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it.”
Kuroda was speaking in 2015. At the time he was trying to get the Japanese economy out of a 25-year slump. And he was trying to convince the markets that the Bank of Japan was deadly serious — that it would keep printing money until the economy recovered.
Fourteen years before, in 2001, the Bank of Japan had tried to print money to stimulate the economy, but it hadn’t worked. At that time, the bank wasn’t committed to the policy. It didn’t try to convince the markets that it was committed. And it abandoned the policy as soon as it could. So the money printing didn’t have much of an impact.
This is where the ECB finds itself. Like a football manager who has lost the dressing room, it can’t convince the markets that it’s able to get unemployment down.
That’s the ECB’s problem. Through hard experience, investors have gotten accustomed to low growth, low returns and high unemployment in the eurozone. So it’ll take a lot to convince them that things are different this time.
For example, look at this chart of eurozone and US nominal GDP since 2019. The dotted line shows the trend of nominal GDP. That’s the economy’s long term growth rate. When nominal GDP is growing at five per cent or so, the central bank can dust its hands and say its job is done.
The eurozone and the US both responded with similar-sized QE programmes and similar sized fiscal support. But the ECB got less bang for its buck. Where the US economy is basically back on track now and fully stimulated, the eurozone is still way behind.
You can see why the markets have been slow to believe the ECB. There's a powerful constituency within the bank that wants to tighten monetary policy as soon as possible. Markets are assuming, probably correctly, the ECB won't bring the economy back to its trend growth rate if doing so means it has to endure a period of higher than normal inflation. The market is assuming the ECB will tighten prematurely, as it has done many times in the past.
Indeed, the ECB is getting its excuses in early, with models that say Italy's full employment rate is somewhere around nine per cent — which means the ECB considers its job done once it hits that target. It's absurd. In the US, it was throught for a long time that five per cent represented full employment. But in 2018, the Fed tested that theory, and learned that in fact unemployment can go as low as three per cent without generating inflation. Meanwhile, the Austrians and the Finns are insisting the ECB tighten policy with unemployment at 7.4 per cent.
One consequence of this madness is lower returns for investors. Since 2009, the Eurostoxx 50 index of European stocks has roughly doubled. In that time, the S&P 500 has multiplied seven times over.
Another is that life in Europe is meaner and bleaker than it needs to be. Youth unemployment in the eurozone has averaged about 18 per cent since 2008. People have to leave their home countries, people have to live with their parents. It's a travesty.
A final consequence, one of the few that ECB officials seem to care about, is that markets are worried about the solvency of peripheral eurozone countries again. The following chart, from economist Robin Brooks, shows government bond yields of Italy, Spain, Greece and Portugal ticking up again.
The ECB needs to face down its internal critics, or come up with a crafty new communications strategy, or something. Because its performance isn't good enough.
P.s. The ECB's incompetence works out pretty well for Ireland. Because of FDI, Ireland's economy is hotter than the rest of Europe. If the ECB ran the eurozone economy as hot as it really should, Ireland would potentially be looking at another heavy dose of inflation, like the mid-2000s.