Otmar Issing Is Still Living in His Monetary Fantasy World

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Jörg Bibow
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Otmar Issing can look back on a long and consequential central banking career. Even in his retirement he is still living the part, evaluating whether his successors at the European Central Bank are pursuing stability-oriented monetary policies to his liking. His most recent critique (“‘Living in a fantasy’: euro’s founding father rebukes ECB over inflation response” https://www.ft.com/content/145b6795-2d21-48c6-984b-4b05d121ba16) shows him on the wrong side of events and debates about sound monetary policy, again.

Mr. Issing spent an eight-year stint at the Bundesbank as chief economist of Germany’s legendary central bank and retired guardian of European monetary affairs. Misled by M3 overshots that were the result of the Buba’s own rate hikes inverting the yield curve, Buba kept on hiking until it crashed newly unified Germany, and the ERM too. Recession-caused fiscal troubles then saw Mr. Issing’s Buba cheerleading pressures for fiscal austerity. These involved hikes in indirect taxes and administered prices that were distorting headline inflation upwards and delaying Buba easing (see https://www.levyinstitute.org/publications/on-the-burdenr-of-german-unification). The ensuing malaise in Europe was so pronounced that it almost prevented Mr. Issing from becoming a founding father of the euro.

But the euro got lucky, courtesy of a last-minute push from America’s dot-com boom. And so Mr. Issing got his chance as the ECB’s influential first chief economist. Unfortunately, lessons from Germany’s debacle ten years earlier were not learned. The newly formed euro monetary union repeated the blunder of pairing fiscal austerity with growth-unfriendly monetary policy, resulting in stagnation and inflation stubbornly above two percent due to austerity-inspired hikes in indirect taxes and administered prices distorting headline inflation (https://www.levyinstitute.org/publications/assessing-the-ecbs-performance-since-the-global-slowdown and https://ideas.repec.org/p/imk/studie/01-2006.html).  Germany itself was supercharging austerity and wage repression and turned into “the sick man of the euro”. (see Bibow 2005 “Germany in crisis – The unification challenge, macroeconomic policy shocks and traditions, and EMU”, International Review of Applied Economics, 19(1): 29-50. And https://www.levyinstitute.org/publications/bad-for-euroland-worse-for-germany)

Not all members were stuck in stagdeflation though as financial liberalization fired up bubbles elsewhere in the euro area. (see https://www.levyinstitute.org/publications/how-the-maastricht-regime-fosters-divergence-as-well-as-fragility) Nonetheless, Mr. Issing’s previously held doubts about the optimality of Europe’s monetary union were dissolving. So convinced of the optimality of the ECB’s guardianship, he declared in 2005 that: “Today, in light of the evidence gathered so far in the euro area, I am more confident in saying: ‘One size does fit all!’” (see https://www.ecb.europa.eu/press/key/date/2005/html/sp050520.en.html). He retired from the ECB just in time to be no longer in charge when the euro’s apparent success story unraveled. But his immediate successors made sure to stick with the stability-oriented wisdom they had been taught by Mr. Issing, so that the euro area got stuck in the doldrums for years (https://www.levyinstitute.org/publications/germany-and-the-euroland-crisis).

It was only with the arrival of the Draghi team that enlightenment finally reached the ECB. Today, the ECB, still trying to steer a flawed monetary union that is lacking fiscal union, is confronted with unprecedented challenges in the form of a pandemic and the Ukraine war. Given Mr. Issing’s track record, they should take encouragement from his latest critique – they may actually be doing something right. A monetary policy mindset that always and everywhere sees provoking recession as a matter of precaution is unlikely to yield optimal monetary policies outside of Mr. Issing’s fantasy world.

It is telling that Mr. Issing uses his recent interview with the FT as an opportunity to invent yet another fantasy. Attacking the ECB for failing to start normalizing monetary policy a long time ago, Issing is reported to have asserted that: “The prospect for a ‘stagflationary’ situation of rising inflation and slowing growth is ‘the worst combination’ for a central bank, said Issing, who contrasted monetary policymakers’ responses to the two oil shocks of the 1970s. ‘The Bundesbank tried to control inflation and the consequence was moderate inflation and a mild recession,’ said Issing, who joined the German central bank in 1990. But ‘the Fed waited too long’ and the US had ‘double-digit inflation and a deep, deep recession.’”

It is of course true that inflation in the U.S. reached double digits in the 1970s and the U.S. suffered a double-dip recession in the early 1980s. Employment reached its trough at the end of 1982, 2.4 percent below the previous peak in early 1980. It was only in September 1983 that employment exceeded its pre-recession peak. Where Mr. Issing takes a deep dive into his “stability-oriented” dreamland is in asserting that (West) Germany only experienced a “mild recession” in the early 1980s. For in 1983 employment in (West) Germany was still 2.7 precent below its previous peak in 1980. It took until 1987 for (West) Germany’s employment to finally exceed its pre-recession peak. Of course, Mr. Issing would blame (West) Germany’s poor employment record despite allegedly only suffering a “mild recession” on “structural problems” and a lack of fiscal austerity. Because in Mr. Issing’s fantasy world – courtesy of the money neutrality postulate – “stability-oriented” monetary policy cannot possibly be responsible for anything else but price stability.

I am reminded here of the late Milton Friedman, the arch-monetarist, who refuted Mr. Issing for his comfort-seeking fancies about the relevance of monetary neutrality propositions for central bankers (see https://onlinelibrary.wiley.com/doi/abs/10.1111/1467-8454.00169), stating: “Neutrality propositions give little if any guide to effective central bank behaviour under such circumstances. Perhaps they offer comfort to central bankers by implying that all mistakes will average out in that mythical long run in which Keynes assured us ‘we are all dead’.” (see https://digitalcollections.hoover.org/objects/57393)

Central bankers, too, even the worst ones, deserve retirement before they are dead.