The ECB’s Original Sin and Franco Modigliani’s Long View

Yves here. This post gives some new wrinkles on the flaws in Eurozone architecture and policies. What intrigues me about Modigliani’s critique is that he flagged one issue that we’ve called out regularly, that of persistent private sector underinvestment. Modigliani warned in 1998 of the dangers of falling into a “low inflation trap” and of the ECB fighting the last war.

By Biagio Bossone, Chairman, Group of Lecce; Member of the Surveillance Committee, Centre d’Études pour le Financement de Développement Local and Stefano Sylos Labini, Researcher, ENEA. Originally published at VoxEU

The ECB’s response to the Crisis – not providing stimulus to the Eurozone economy when it needed it, and allowing it to slip into a low inflation trap – is a reflection of the monetary union’s faulty architecture. This column recalls a 1998 manifesto from several distinguished scholars that warned EZ policymakers of the potential consequences of a misguided policy framework. Two sets of issues need to be critically addressed by current EZ policymakers: its objectives and instruments.

The ECB has not only failed to provide stimulus to the Eurozone economy when needed, it has allowed it to slip into a low inflation trap (Kang et el. 2016). This is in sharp contrast to the US Fed, which has served its country well by taking an aggressive stance against the Crisis. The depth of the Eurozone recession is not the making of the ECB only, and the responsibility for it must primarily be ascribed to the destructive policy orientation of the EZ member governments. Moreover, the ECB response to the Crisis is a reflection of the original sin of the Eurozone, its faulty architecture.

A Pernicious Orthodoxy

Yet someone had foretold all this, warning EZ policymakers of the consequences that a misguided policy framework would produce. In 1998, Franco Modigliani and other distinguished scholars issued a ‘manifesto’ that was aimed to challenge the “pernicious orthodoxy that has gripped Europe’s policy makers” whereby only a limited number of supply policies are to be devoted to fighting unemployment, while demand policies (in particular monetary policy) must be exclusively assigned to controlling inflation (Modigliani et al. 1998).1

The manifesto outlined a set of demand-side and supply-side policy proposals that, together, were intended to right the unemployment bias inherent in the policy approach of the then nascent Eurozone. There is no space here to recall the proposed measures put forward, which would sound innovative and appropriate still to date, especially in so far as they would have inspired a truly European vision of economic policy. We only focus on what the manifesto had to say on the role of the ECB, and the implications that can be drawn from the experience since then.

A Salutary Heterodoxy

The manifesto called for a significant, sustained, and lasting reversal of stagnation in private investment. The reversal was to derive partly from the proposed supply policies, but mostly from the traditional instrument for controlling investment, monetary policy. Accordingly, it was necessary to give a broader and more constructive interpretation of the statutes of the ECB, which would set low unemployment as the other key goal of monetary policy, on an equal footing than preventing inflation.2

Modigliani and colleagues argued three basic points in this regard.

  • First, making price stability the overriding ECB target was much like using all the military mighty to fight an enemy that was no longer there.

Since 1991, inflation had been falling steadily from high to very low levels in the whole industrialised world. The perils of inflation from investment revival were negligible, and could be further reduced through supply-side policies. Attributing to the ECB the only task of fighting inflation was unacceptable, since this would leave it too much leeway; with sticky wages, the ECB could achieve the inflation target by prudentially raising the interest rate ad libitum, reducing investment and raising unemployment further.

  • Second, monetary policy has very limited control over the level of prices, at least in the short run.

Indeed, monetary policy instruments – money supply and the interest rate – do not directly affect prices when there is slack in the labour market. Given large-scale unemployment, they can affect prices only indirectly by affecting the rate of economic activity and hence of unemployment (and of capacity utilisation) and thereby the growth of wages and finally prices. However, unemployment is not a potent instrument to control inflation when there is plenty of slack, while it has a considerable impact on social welfare.

  • The third reason for giving the ECB a central role in promoting investment was that with the shift to the single monetary policy, the ECB was to become the only institution within the monetary union with substantial power to influence investment.

The alternative was to adopt national fiscal measures (subsidies, tax rebates, tax credits), but these were not possible due to the fiscal squeeze that was engineered under the Maastricht parameters.

As the manifesto itself recognised, the proposed reinterpretation of the ECB role would meet with serious objections. One was that central banks are unable to stimulate investment. The reply was that if central banks can control prices, they can do so only because they influence demand by influencing investment. Another objection was that since the euro had to gain credibility as a new currency in the eyes of the markets, the new single monetary policy had to be seen as a continuation of the Bundesbank’s policy, with interest rates kept at levels high enough to attract foreign capitals and to strengthen the exchange rate of the euro, especially vis-à-vis the dollar. The manifesto counter-argued that such a policy would be a major mistake, which would hurt the economy; as in the case of the dollar, a strong currency could only be the product of a robust economy attaining full employment.

The Track Record

Interestingly, four years into the existence of the new single currency, the ECB’s first self-evaluation of its own monetary policy strategy (ECB 2003) did not even consider hypothetically the need for a broader mandate, confidently affirming that maintaining price stability is the best contribution that monetary policy can make to economic welfare. The clarity of this objective – the evaluation concluded – helps avoid excessive policy activism and overly ambitious attempts to fine-tune economic developments.3

Seven years after the publication of the manifesto, one of its authors, Beniamino Moro (2005) assessed how things had since progressed by looking at facts and data. On the ECB role, Moro observed that the ECB behaviour did bear out the impression of an ‘anti-growth bias’, with the inflation rate target of 2% being too small for the whole EU currency area, in view of its internal heterogeneity and the markedly different inflation and economic growth rates across member countries; there was a big risk for Europe that the sum of tight monetary and fiscal policies might trigger a perverse spiral.

Past 2005, Eurozone monetary policy was largely calibrated on the core economies of the area, in the absence of tools to address idiosyncratic shocks and with an inappropriate indicator – the deficit-to-GDP ratio – used as the key metric to evaluate fiscal policy at the country level (Wren-Lewis 2015).4 As a result, the single monetary policy could well turn out (and did in fact turn out) to be sub-optimal relative to individual non-core countries, while no framework was envisaged to induce consistent and sustainable output growth rates country-wise and across the area.

The inefficiency of ECB policy became evident following the eruption of the crisis in Europe in 2010, as recounted by Kang et al. (2016). In the circumstances, ECB chairman Mario Draghi did all he could, given the institutional and political constraints. His courage and skills were high, the results too little and too late.

ECB Reform

What should be done? At a minimum, a wide debate should be opened on the adequacy of the EZ architecture. Without any attempt to identify a complete agenda, at least three sets of critical issues should be raised on the ECB policy framework.


  • Dual mandate

The Crisis has shown that considering Modigliani’s proposal to broaden the interpretation of the ECB statute is a largely overdue issue (Saraceno 2013). Establishing price stability and low unemployment as equal-status macroeconomic policy objectives would crystallise one of the major lessons from the Crisis: demand-side policies do affect employment and wages. Introducing a dual mandate would thrust upon the ECB the responsibility to mediate between these two overarching social objectives in normal times, while it would steer monetary policy to address unemployment problems in times of crisis.

  • Nominal GDP targeting

An alternative option to consider is for the ECB to targeting nominal GDP (Sumner 2014). Hitting the target avoids recessions in nominal terms by definition, and dampens recessions in real terms by supporting aggregate demand. More generally, nominal GDP targeting reduces positive and negative GDP fluctuations; in recessions, it focuses on returning the economy to a normal path; in an inflationary environment, it provides a gradual path to stability.

  • Symmetric inflation target

As an inferior alternative, the ECB inflation mandate could be set to be strictly symmetrical. Like in the Bank of England’s case, inflation below 2% would be judged to be just as bad as inflation above 2%, and if the target is missed by more than 1 percentage point on either side, the ECB chairman would be required to write an open letter to the European parliament explaining the reasons of the deviation and identifying corrective measures.


  • Monetary finance

In extreme economic circumstances, monetary finance of increased fiscal deficit always succeeds in stimulating aggregate nominal demand, and provides a more certain and less risky way to achieve stimulation than any alternative policy lever, while the scale of stimulus can be appropriately calibrated and controlled (Turner 2015, Bossone 2016). The ECB should be enabled to use such instrument if circumstances so require.5 This would obviously raise delicate coordination issues between the ECB and national governments (Bossone 2015).

The ECB has proven unable to raise inflation through its QE programme. Higher price dynamics cannot be achieved if the monetary stimulus fails to reach the real economy. When the latter is in deep recession or deflation, and fiscal space is limited, only monetary finance can be effective as it allows newly created money to be transformed into additional (public or private sector) spending without raising public debt. One way to apply money finance at the whole EZ level would be through an initiative whereby the European Investment Bank would issue bonds to finance a large investment plan for the area, and the ECB would purchase the EIB bonds with newly created money. Through such initiative, money finance would pursue the inflation target by stimulating demand and reducing unemployment. The new investment financed would strengthen the output potential of the Eurozone.

Policy Review

  • Framework re-evaluation

The ECB should periodically re-evaluate its policy framework, soliciting views from experts, elected officials and private citizens, and releasing a public report describing the chosen framework. This process would provide more public understanding of, and political support for, ECB policies, and reduce its risks of confirmation bias, tunnel vision, and group think (Kocherlakota 2016).


The manifesto recalled above shows the enlightened view that Franco Modigliani and colleagues were able to express at a time when a rigid orthodoxy was getting hold of Europe’s economic and financial institutions, in particular, those that would since underpin the new currency. Orthodoxy did win, and a monetary union came into being grounded on an economic philosophy that denies a role for demand management, supports mercantilistic policies, and faithfully believes in fiscal consolidation and ‘structural reforms’ (basically, greater labour market flexibility) as ways to force the economy into internal devaluation. The victory of orthodoxy has meant the defeat of the euro dream. It is time to learn from past mistakes.

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  1. Jesper

    Private sector tend to invest for two reasons:
    1. Need to increase capacity due to increased demand
    2. Cutting costs (usually about cutting number of employees)
    The private sector is unlikely to make use of the ultra-low interest rates until demand picks up or there is a significant upward pressure on wages. Therefore I think it is unlikely that the ultra-low rates in the current environment is not a significant benefit to private investment (productive at least, if including asset bubbles then….)

    For the public sector.
    Either it gets enough resources through taxation or it borrows to meet current and future needs. There are (still) powerful groups arguing for lower taxation now and in the future. It seems likely, at least to me, that for the economy to pick up then the current income distribution has to change. Companies and high-earners has to reduce their share of the economic gains. If they don’t then papering over the growing inequality by pumping out loans through what has been shown to be rather incompetent bankers and central bankers is likely to lead to another burst credit-bubble.
    The monetarist dream of improving living conditions for the majority through printing money is only that, a dream and for many it is a night-mare. Printing money is in the current environment the equivalent of changing the map to match the preferred world instead of letting the map reflect reality.
    & a closing remark: Has the Fed improved the life for main street or has the all/most of the gains gone to banks? If it has gone to the banks, why would the result be different in Europe?

    1. digi_owl

      Or MMT is right, and the public sector can spend first and worry about the taxes later.

      But that would largely nullify the role of the central bank, and to a large extent neuter the role of banks in the economy.

  2. washunate

    This is in sharp contrast to the US Fed, which has served its country well by taking an aggressive stance against the Crisis.

    Thanks for the laugh. Yes, thank God for how the USFG has acted over the past couple decades.

    I continue to find it interesting when people in positions of influence conveniently leave out fraud and NATO when discussing Europe.

  3. nostromo

    One way to apply money finance at the whole EZ level would be through an initiative whereby the European Investment Bank would issue bonds to finance a large investment plan for the area, and the ECB would purchase the EIB bonds with newly created money.

    Interesting how they take the central element of the Holland-Varoufakis-Galbraigh “Modest Proposal for Overcoming the Euro Crisis” without, of course, acknowledging it… But why should them? The proposal was just published in 2011, almost 5 years ago.

    1. Yves Smith Post author

      FWIW. it wasn’t the central, it was a central. It was the third of four proposal.

      And I’ve had very left leaning economists say that that still runs afoul of Germany’s interpretation of EZ rules. They’ve repeated nixed Eurobonds, for reasons I must confess I haven’t been on top of, and this appears to be to close. I agree it’s a fine idea, but Germany has ruled out all sorts of things that need to be done to move to more Euro-wide spending and governmental/legal authority, like a Eurozone-wide deposit guarantee scheme, something that is essential for the Eurozone to work.

      1. washunate

        Isn’t the basic question what would the bonds pay for?

        Germany has a far more equal society than the US and they have better passenger rail and they have better healthcare and they invest in wind and solar power and they’ve been rebuilding the former east Germany and they’ve been letting in more non-German immigrants than most other homogenous European nations in the post Cold War era and so forth. The euro doesn’t prevent national governments from investing in the public commons. Those are policy choices made by national (and sub national) governments themselves.

        The euro wasn’t even Germany’s idea. It was our French friends who thought it better to peg the French and Italian currencies to the west German mark rather than have free floating currencies within the ECSC/EU.

        I agree I don’t fully get what the Germans are thinking. But I am pretty confident that we Anglo-Americans have no business questioning their budgetary preferences. Quite the contrary, there are many things we could learn from our German friends.

  4. Steven Greenberg

    When people wonder why their is no private investment in more production capacity, I like to frame it as “What part of no freakin’ customers do you not understand?”

    1. digi_owl

      Work > wage > consumption > production > work.

      The cycle of economic life, and should be so obvious that any kid that can do basic math should see it.

      But somehow big name economists dismiss it fervently.

  5. Lune

    The goal of the ECB (i.e. BundesBank by another name) was to cement German dominance over Europe, both in raw GDP and financial philosophy (hence the single-minded focus on inflation). The ‘flaws’ the authors bring up are not bugs, they’re features. After all, it’s not a coincidence that while most of the EU machinery is in Belgium, the ECB is in Frankfurt.

    To this extent, the ECB has accomplished the goals its politicians had. It has been a stunning success, bringing all of Europe under a teutonic heel, with stunningly low inflation to boot. If you wish to now change the goals of the ECB, you must first change the politics of the EU. The structure of the ECB is secondary, and indeed, I’d argue is a result of the politics, not the other way around.

    That isn’t happening. For example, if Mario Draghi resigned tomorrow and somehow, by some miracle, you got a central banker who believed in a dual mandate, what pray tell could he do to increase demand in the face of an EU-wide abhorrence of fiscal stimulus, wage growth, and increased social welfare spending? Keep buying bonds?

    1. washunate

      That actually isn’t the history, though. Quite the opposite, fixing the currencies of Bonn, Paris, Rome and the smaller nations was a French idea. They preferred the certainty of tying then West Germany into their system over the uncertainty of what would happen if the West German currency came to dominate the field.

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