Keep Monetary Policy and Structural Reform Separate

European QE alleviates the need for structural reform. Or so Merkel and Weidmann say. The argument here is that if the ECB eases monetary policy in an effort to improve economic conditions in Southern Europe, that enables Southern European countries to kick the can down the road and delay on enacting structural reforms.

This is hogwash.

Now, I do not mean to say structural reforms are not necessary. Jay Shambaugh, an economics professor at Georgetown, descries the current European malaise was the result of three interconnected crises: a banking crisis, a sovereign debt crisis, and a growth crisis. Given the crisis in growth, structural reforms such as “deregulating product or retail markets, streamlining rules for investment or starting businesses, implementing policies that foster innovation, or removing barriers to entry in various services professions” must play a role.

But central bankers should not try to be “enforcers”. The Bank of Japan tried this in the 1990’s. In his article titled “The Political Economy of Deflationary Monetary Policy“, Adam Posen argued that there was a broadly held belief at the Bank of Japan belief that tight money was necessary to encourage economic dynamism. As an example, Posen draws on remarks by BOJ Governer Hayami in 2000:

“Mr. Hayami also repeated his view that the zero interest rate policy was undermining structural reform in Japan and preventing the rise of promising high-tech industries. “If we retain zero interest rates indefinitely, these places will lose vitality…and it will end up being a minus for Japan’s economic recovery.”

Given the lack of evidence that tight money can encourage structural reforms, Posen concludes “that ‘creative destruction,’ invoked and praised repeatedly in Hayami’s speeches, [was] the motivating ideology”.

The fact that the German leadership is committing the same errors as the Japanese leadership in the 1990’s shows that this obsession with structural reform is deep seated in the minds of “very serious people”.

Syriza’s victory also shows that democracies do not walk willingly into structural reform when growth is moribund. Instead, they are likely to elect radical parties that promise to overthrow these reforms. And so instead of slightly higher inflation which would help Greece more easily accomplish an adjustment in real wages, we instead get a party whose platform includes higher minimum wages and public sector pensions. As Scott Sumner has complained, “conservatives seem so opposed to slightly higher inflation that they’ll often end up tacitly or explicitly supporting much more statist policies instead.” Unfortunately, we see exactly this playing out in Greece today.

Fortunately, Draghi seems to have a clear head on the issue of structural reform.

“What monetary policy can do is create the basis for growth,” he said. “But for growth to pick up, you need investment; for investment, you need confidence; and for confidence, you need structural reform.”

One would hope that German leadership would also adopt this attitude. Insist on structural reform, but recognize that the only way to get there is through a monetary policy that takes the needs of all Euro nations into account.

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