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ECB, Fed supported economy as legislatures failed to act

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People who criticize world's major central banks may be doing so for the wrong reason.

To begin with, here is a simple question to ask: Is the monetary policy all there is, or is it just one of the instruments of economic management?

If economics 101 is just a vague and distant memory, or a place never visited, here is the answer.

The steering mechanism of an economy has three levers: Monetary policy (credit conditions), fiscal policy (taxes and public spending) and structural policies (roughly, the organization of product and labor markets).

But don't forget the boss: In the middle of all that is a consumer with a supremely sovereign decision to spend or save, depending on how she/he perceives the future stream of income in a given economic, social and political environment.

Absorbing these two simple paragraphs will shed a great deal of light on what is going on at the moment. It will also help to understand how balanced is the policy mix that is supposed to drive demand, output and employment while investors are trying to preserve – or hopefully increase – the real value of their savings.

Who is in charge?

The next thing to understand is the all-important housekeeping arrangement: Who is in charge of monetary, fiscal and structural policies?

That sounds easy, but it is not.

Clearly, central banks are in charge of monetary policies, with a varying degree of interference from executive and legislative branches of the government. In the best of cases, some central banks have operational independence and are subject to parliamentary oversight. But even in most of these cases, their decisions may not be totally immune to outside forces.

The European Central Bank (ECB) is a special case; being a supranational institution, it is not under the thumb of any member state government or particular interest groups.

Fiscal and structural policies are the shared domains of executive and legislative authorities.

This institutional setup implies that monetary policy decisions can be taken quickly, even though their impact on real economy is subject to long and variable lags. In a less formal language, that is also called the "outside lag."

By contrast, fiscal and structural policies are part of a complex process, depending on political forces defining the relationship between the executive and legislative branches of the government. As a result, tax and spending decisions and changes to market organization are part of an "inside lag" where they can take months, or even years, to be implemented.

Here is an example.

At the time of this writing, the French government is virtually on the verge of collapse, with street demonstrations and more than a million signatures secured to protest a draft law aimed at cutting non-wage labor costs.

Given a choice, the French government would rather tell the central bank to cut interest rates in order to revive employment growth instead of trying to accomplish that through a long process of politically flammable structural reforms. Luckily, however, the Elysée Palace lost that possibility to the ECB. And that could mean a climb-down of a president polling at 17 percent a year before the next elections.

Just say "no"

So, the ECB is out of this fight. But the ECB was pushed into massive interventions when the Germans decided a few years ago that "the euro area fiscal miscreants, unwilling structural reformers and incompetent bank supervisors had to be taught a lesson of fiscal austerity" – at the time when these economies were already collapsing.

Germany, obviously, was dumping things on the ECB, which, as a lender of last resort, had to guarantee the safety and the soundness of the financial system underlying the common currency and the economic and monetary union. For all that, Berlin kept pouring scorn on ECB's attempts to salvage the euro area amid falling governments (France, Spain, Portugal, Italy and Greece) and soaring unemployment, poverty and destitution.

The question is: Where was Germany – and the EU Commission – when the euro area countries were violating fiscal rules and running real estate bubbles? Or did this duo decide that the ECB would clean up the mess (by printing money, of course) and then be blamed for it, as is the case now?

The Congress and the White House have also dumped on the Fed the sole responsibility of running the U.S. economy. They have done that by freezing the fiscal policy in a restrictive mode for the last six years and offering no effective structural policies to address structural (not cyclical) labor market problems.

Indeed, the president and the lawmakers hold the Fed responsible for employment growth, but they have no active policy that would help 6 million of involuntary part-time workers and 3 million people who are becoming unemployable (i.e., those dropping out of the labor force and those stuck in long-term unemployment). These 9 million people are counted out of the 7.8 million officially reported job seekers.

What can the Fed do about this? Throwing cheap money at these labor market problems will do nothing, or very little in the best of cases, because structural problems require structural solutions.

By contrast, Japan's "can-do" central bank was not dumped on; it cheerfully volunteered to rev up the economy and boost inflation. But with no help from fiscal and structural policies, the Japanese monetary authorities have little to show for the huge and continuing avalanche of yen liquidity.

Over the past two years - when this ultra-easy policy was supposed to connect with the real economy and boost growth – Japan's GDP actually slowed down to an annual rate of 0.2 percent from 1.6 percent during the 2012-2013 interval.

Predictably, however, this policy generated accelerating inflation in a stagnating economy as consumer prices shot up to 1.7 percent over the last two years - a big jump from a 0.3 percent average growth over the last 20 years.

That, of course, is reassuring because it is one more confirmation of an old empirical finding that inflation is -always and everywhere - a monetary phenomenon. But the breakdown between Japan's real growth and inflation is a meager policy payoff, to put it mildly.

Looking at that, Milton Friedman, the Nobel laureate and a high priest of monetarism, would just say, with his sardonic smile, "I told you so."

Investment thoughts

Friedman's work led him to conclude that price stability was the only feasible mission of monetary policy. The Dutch school of monetarism predates Friedman, but he got all the fame and the prize money. The German Bundesbank was also a latter day convert whose hard-money tradition is still deeply ingrained into the country's culture.

Central banks, at least those with some statutory independence, should put executive and legislative authorities on the spot to face their own responsibilities for fiscal and structural policies.

Playing the handmaidens to financial markets and the chest-thumping growth promises are unwise and incompatible with what the sound monetary policy can do.

Price stability and the integrity of the financial system are the public goods that central banks can and should deliver. That should be their mission, and they should let the public know about that.

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