ECB’s Continued Rapacity: A Lesson From The 1970s
Despite the increases in recent months, the Eurotower remains one of the central banks with the lowest nominal and real interest rates in the world. This testifies to the prudence with which it has moved so far. The risk of past decades is that inflationary expectations become ingrained in the behavior of economic agents and that more drastic anti-inflationary actions will eventually be needed. Statements by members of the government must be particularly careful to preserve their independence.
Current Nominal And Real Interest Rates Around The World
Despite the increases in recent months (up 2.5 percent since July 2022), the ECB remains one of the central banks with the lowest nominal interest rates in the world. The rate on the main refinancing operations rose from 0 to 2.5 per cent, while the most important policy rate, that on banks’ deposits with the ECB, increased in the same period from a negative value of -0.5 per percent to 2 percent.
Only Japan, Switzerland and Denmark rank below the ECB with Japan the only country to still have a negative policy rate, unchanged since 2016 (Table 1). Almost all advanced countries (Norway, Australia, South Korea, the United Kingdom, Israel, Canada and the United States) have inflation similar to or lower than that of the Eurozone and higher policy rates. The case is different for countries such as Poland and Hungary, which have much higher nominal rates (6.75 and 13 per cent respectively) against, however, a considerably higher inflation rate (16.6 and 24 per cent respectively). 5 percent).
Of the 27 central banks considered in Table 1, 22 increased their interest rates during 2022 (a sign that inflation is a global phenomenon), 2 left them unchanged and only 3 central banks (China, Turkey and Russia) have reduced them.
These comparisons do not consider the different inflation rates across countries. Taking this into account, various measures of the real interest rate can be calculated; in the last column of Table 1 we consider the real interest rate calculated as the difference between the nominal interest rate and the inflation rate recorded in the last 12 months.
Considering this metric, the ECB’s real rate is equal to -6.7 per cent, one of the lowest values among all the advanced countries. Indeed, in these countries, real interest rates are higher, in many cases by several percentage points, than in the Eurozone.[1] Only in Denmark, Sweden and the United Kingdom are real rates slightly more negative than in the Eurozone; in Italy, on the other hand, considering the inflation rate reached last December at around 12 per cent, real rates equal to -9.1 per cent are obtained. Even lower values are recorded in countries with anomalous inflation rates from 17 percent in Poland to 95 percent in Argentina.
Particularly instructive is the case of Turkey in which the government has repeatedly fired the heads of the Central Bank in order to impose a line of low interest rates; the consequence was a depreciation of the Turkish lira of 27 per cent (in one year, against the dollar) and an inflation rate that was close to 100 per cent. High inflation has aggravated social tensions in the country, so much so that at the beginning of the year President Erdogan had to announce that in 2023 “the inflationary bubble will be eradicated”, an announcement that few believed given that it is not clear how he intends to pursue the goal.[2]
Given the size of the European economy, the most significant comparison for the ECB is with the American FED. This shows that the ECB’s rates are quite low and 200 basis points lower than those of the FED, despite the fact that the inflation recorded in December 2022 is lower in the United States than in the Eurozone by almost 3 percentage points (6.5 per cent in the United States and 9.2 in the Eurozone). In addition, the FED increased interest rates 7 times during 2022, including 4 times by 75 basis points. In the same period, however, the ECB raised its rates only 4 times, of which only 2 times by 75 basis points and the remaining times by 50.
The Lessons of The 70s
In almost all the countries considered, inflation has not reached such high levels since the 1980s. As can be seen from Table 2, in 1980, following the second oil shock following the Iranian revolution, in almost all advanced countries inflation exceeded 10 per cent, reaching 21 per cent in Italy, 18 per cent in United Kingdom, 15th in Spain, 13th in France and the United States. Even then, however, very few countries (South Africa, Turkey and Brazil) recorded real interest rates lower than the current ones of the ECB; and those few were going through epochal political events and recorded unenviable inflation rates: 94 percent for Turkey, 46 for Brazil and 14 for South Africa.
While there are parallels between today’s events and those of the 1970s and 1980s, there are also notable differences. A recent article by Ben Bernanke, referring to the case of the United States, is very useful for understanding the similarities and differences.[3] The similarities can be summarized as follows: in both cases, a long period of price stability was followed by high inflation both driven by demand (spending on the Vietnam War and the Great Society programs eventually of the 1960s, the expenses for Covid today) and from the offer (the shocks to the prices of energy and food goods).
The crucial difference is that in the 1970s any attempt by the Fed to raise interest rates to fight inflation was met with strong political resistance due to negative side effects on the growth rate of the economy and employment. In particular, President Lyndon Johnson exerted strong pressure on the FED to keep interest rates low and at the same time passed a tax increase that was supposed to curb inflation, but it had no effect. Richard Nixon also made it clear to the new FED chairman that he would not tolerate an economic slowdown, especially near the 1972 election. He also announced a temporary freeze on all prices and wages in the United States on August 13, 1971, the same day in which the convertibility of the dollar into gold was suspended (de facto marking the end of the Bretton Woods regime). Nixon’s move was very well received by Wall Street and was considered a political success. However, it gave way to a phase of great instability in the international financial system and did not have the desired effect of calming, if not temporarily, inflation which exceeded 10 percent in 1974.
In the following years, in the absence of a monetary policy to counteract it, inflation took root in the expectations and behaviors of businesses and workers, reaching a maximum of 13 percent in 1980. Only then was inflation held back from what was a real regime change by the Fed led by Paul Volcker. Policy rates thus went from 10 to 21 per cent in less than two years.
The consequence of acting late was a deep recession in the United States that spread rapidly to the rest of the world. Furthermore, real interest rates reached very high values which led to a sharp increase in public and private debts in many countries, including Italy.
Unlike then, and perhaps due to the experience gained, today the FED (but the same can be said of the ECB) enjoys a high degree of independence and has the necessary consensus to fight inflation from the outset. This means that inflationary expectations for households and businesses remain substantially anchored at the level desired by central banks (close to 2 per cent). This emerges both from the differences in yield between nominal and inflation-indexed securities and from surveys of operators.
Another important difference between the 1970s and today concerns the debate over the causes of inflation. In the 1970s, the widespread belief was that, since inflation is mainly generated by the supply side, it cannot be combated by restrictive monetary policy. Of course it is true that monetary policy can do nothing to reduce the cost of energy or to solve slowdowns and disruptions in supply chains. However, over time, the conviction has prevailed that monetary policy must act promptly by reducing demand to the level compatible with the lower supply and to avoid destabilizing inflationary expectations.
What Italy Has Learned Since The 1970s
Many of these considerations, relating to the role of the central bank, also apply to Italy. It will be recalled that in the 1970s, in Italy as in the United States, the prevailing idea was that the central bank should comply with government policies. The best known expression of this approach is due to Guido Carli, then governor of the Bank of Italy, who said in his Final Considerations on 1971: “We ask ourselves the question whether the Bank of Italy could refuse to finance the deficit of public sector by refraining from exercising the faculty attributed by law to purchase government bonds. Refusal would make it impossible for the state to pay salaries to public employees and pensions. It would have the appearance of an act of monetary policy; in substance it would be an act seditious, which would be followed by the paralysis of the institutions”. Therefore, for Guido Carli, as for much of the economic culture of the time, the independence of the central bank could even lead to acts that could be defined as “seditious”.
As is well known, things changed radically starting from the 1980s: Italy no longer wanted to be the country of inflation and continuous devaluations of the exchange rate because this was considered harmful to economic growth and social cohesion. This explains many crucial economic policy choices: joining the European Monetary System in 1979, the divorce between the Bank of Italy and the Treasury in 1981, and subsequently, between 1983 and 1984, the Scotti award and the so-called San Valentino decree, with which the government and social partners undertook to rapidly reduce inflation. In this context, the Bank of Italy was able to operate with greater independence than that allowed by the divorce.
In conclusion, today it is more than legitimate to discuss the speed with which the various central banks move, as well as the ways in which they communicate their actions and their intentions. But it is difficult to doubt the need to implement monetary policies to combat inflation. In the light of the data presented in this note, it is also very difficult to say that the ECB has been particularly aggressive up to now; on the contrary, policy rates in the Eurozone, valued both in nominal terms and net of inflation, are among the lowest in the world.
A final consideration concerns the relationship between the ECB and governments. Central bank independence, an achievement of recent decades, does not prevent economists, commentators and even politicians from discussing the appropriateness of central bank choices. In fact, the hearings of the ECB in the European Parliament are designed precisely to ensure that it is accountable for its choices. However, it is clear that the utterances of the members of the government must be particularly cautious and must not give rise to the suspicion that they want to submit the ECB to the wishes of this or that government.
This article is originally published on repubblica.it
