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.