Let’s take a look at the ECB’s TARGET2 system. Here’s a very brief outline of the similarities between the ECB and the Federal Reserve system from the blogger ‘DP’.
Now let’s play
spot-the-difference between them. The ‘Fed’ was created to deal with the kind
of liquidity
crisis that almost brought down the financial system in America in 1907. It’s
brief wasn’t to “create a payments system”. According to the ECB (here) “TARGET2 was developed in close cooperation with its future
users. One of those users’ main requests was that the new system would offer a
harmonised, state of the art payment service.”
So the ECB wears at least two hats. It’s a central bank for the Eurosystem central banks and it operates the payment system in the EU. Now I have to digress here. One area where the “fathers” of the Euro differ markedly from the classical economists and Professor Viner is in their attitude to price indexes and statistics. Alexandre Lamfalussy, one of the “fathers of the Euro”, stated: “Nothing is more important for monetary policy than good statistics.”
The classical economists rejected the notion of indexes
being used as a proxy for the real world. Jacob Viner also lamented the
difficulty in providing conclusive evidence of the benefits of free trade using
statistical analysis. So Viner also had deep reservations about its value (back in 1937). Obviously this
was a long time before super-computers and the arrival of this highly,
digitally-integrated world we now live in. Perhaps today we can put aside these reservations and rely on prices and statistics to give us an accurate insight into the state of an economy.
Now let’s take a closer look at the Eurostat
"Harmonized Index of Consumer Prices" (HICP). The HICP only uses
final consumption prices in the index. In their words, “household final monetary
consumption expenditure" The focus of this index is not “intermediate
goods”. Goods that are in the process of being combined with other goods to
produce final consumption goods for households. Cars are in the HICP but components in the process of becoming a car
aren’t the focus of the HICP.
The HICP also excludes owner-occupied housing (OOH). That is extremely
unusual in a consumer price index (CPI). Housing costs are estimated in
different ways around the world but an estimate is usually included in a CPI. I
think it isn’t included in the HICP because the treatment of OOH in other CPIs
can’t be used in a system designed
around Hume’s mechanism. As Viner points out: "It is not purchases, or transactions, in general which are
significant for the mechanism of adjustment, but only purchases of certain
kinds." (You can search the PDF I linked in Part 1 if you want to check
the accuracy of any quotes.)
Jacob Viner actually uses houses as a specific example of
the kind of things that need to be excluded when you are trying to identify the
operation of the mechanism: “If, for
instance, a particular house has changed ownership as between dealers through
purchase and sale three times in one year, and not at all in the next year,
neither the transactions in one year nor their absence in the next year have
any direct significance for the international mechanism." (Simply replace “international mechanism” with “Eurozone mechanism”.)
In order to zero in on the adjustment
mechanism we need know three things. Firstly we need to know the size of the
portion of the overall money supply that is being used to facilitate final consumption expenditure.
Secondly we need to know the velocity of the money used for this purpose and
lastly we need to know the prices of household consumption goods. (It’s also worth noting that HICP isn’t based on a “typical
household” approach. It aims to capture the actual consumption expenditure of
all Eurozone households.)
I don’t think it is a mere coincidence that Jacob Viner’s
preferred measure of velocity is the “final purchases velocity of money”.
He describes this as “the ratio of final purchases per unit of time to the amount of specie in
the country”. We can
replace specie with Euro here. We would expect velocity to be stable most of
the time. In most households the consumption patterns are fairly consistent for long stretches of time.
As mentioned above only part of the money pool is involved in these final
consumption expenditures. There is no
need to get bogged down in discussions about how much consumption is funded
with credit. We’ll divide the money supply into two pools and then I’ll justify
that assertion about the credit component. The pools are a consumption
goods money pool and a non-consumption
goods money pool.
If we had access to the range of data that the ECB has access to, we could obtain a reasonable estimate of
the size of the consumption goods money pool
through trial and error. One indicator of the size of this pool would be the total value of all of the simultaneous consumption expenditure transactions taking
place across the Eurozone at a point in time. We could then test our estimate against observations
of consumers actual behaviour and through the huge data feed the ECB has access
to. Then over time we could refine the estimate. Now let’s assume these ‘tools’ work and examine how they might have been used in a situation
that actually occurred.
When the SHTF in Ireland a few years back the ECB was
pouring billions of Euro into the Irish banking system. Try to put yourself
into the mindset of a central banker with “good statistics”. The Irish are
pulling Euro out of their banks like there’s no tomorrow. However, final
purchase velocity is stable and so are the prices of consumption goods. TARGET2
is wired into the FX market as well so you know that most Irish people aren’t exchanging Euro for
another currency.
The statistics are telling you that this money is going
into “mattresses”. The confidence crisis is people-banks not people-Euro so you
can supply a huge amount of Euro without
worrying about prices getting out of control. The prices+>money>flow
mechanism will automatically correct the imbalances after people calm down. A
central banker would have been monumentally stupid to restrict the supply of
Euro under these circumstances.
The beauty of a system like TARGET2
is that it allows the prices+>money>flow mechanism to function smoothly. This mechanism is
usually an auto-correcting monetary policy tool that only requires intervention
infrequently. It does not resolve problems in fiscal policy, taxation
policy and other areas of government policy. If you expect it to do that your
expectations are unrealistic.
I think that by using this two-tiered
approach and disaggregating credit* (described here and here) it could help to explain a
“two-speed” economy. One where the prices of consumption goods aren’t
indicating high inflation but the prices of some asset classes are looking bubbly.
A banking union in the Eurozone is a
natural progression toward giving the ECB “good statistics” on the
non-consumption money pool and what people are doing with it.
PS - Here’s a link to an interesting discussion about “disaggregated
credit” and gold with ‘Victor The Cleaner’. A big hat tip to DP and VtC for the
feedback in the comments here that helped to crystallize this post. But don’t
blame them if you think it’s rubbish. If it is, it’s down to me alone.
