To some
it all seems very strange. The Eurozone is in recession, and no one is doing
anything about it. The ECB are keeping
interest rates at 0.75%, and there are no plans for Quantitative Easing. It is
possible to speculate on possible factors here, but there is one obvious answer.
Consumer price inflation is expected to be pretty close to 2% this year and
next in the Eurozone as a whole. So with inflation on target, what is there to
do?
Now I think there are strong grounds, familiar
to anyone who has studied economics, for saying that monetary policy is not
just about current inflation, but should be about closing the output gap
as well. The OECD in June estimated that the Euro area output gap will be between
-3.5% and -4% in 2012 and 2013. However monetary policy makers in the UK as
well as the Euro area (and, until recently, the US) appear to be just looking
at inflation. Textbooks will have to be rewritten.
Euro Area Inflation Forecasts
|
Consumer Prices
|
|
2012
|
2013
|
|
|
2.3%
|
1.6%
|
|
|
|
OECD June
|
2.4%
|
1.9%
|
|
GDP deflator
|
|
|
|
|
|
IMF October
|
1.5%
|
1.4%
|
|
|
OECD June
|
1.2%
|
1.6%
|
|
Compensation per employee
|
OECD June
|
1.7%
|
1.7%
|
But which inflation measure should they focus on? The standard
answer is consumer prices. However there is nothing in economic theory which
suggests that this should be the only inflation measure that matters. Indeed, a
convincing case
can be made that a better indicator of the costs of inflation is a measure of
output prices, such as the GDP deflator. As the Table shows, output price
inflation is expected to be well below 2% both this year and next. (The change
in the GDP deflator is not on average significantly less than CPI inflation.)
Furthermore, wage inflation, which is normally significantly greater than
either measure of price inflation, is also expected to be below 2%.
A major reason why CPI inflation is above these other
measures of inflation is commodity prices. Of course commodity price inflation
is largely outside the control of the ECB. But what the ECB is effectively
doing, by focusing on the CPI, is saying that non-commodity price inflation has
to be below 2% to compensate for rises in commodity prices. Once again, there
is no obvious theoretical reason why that is a sensible thing to try and
do. In some
Eurozone countries CPI inflation is high because of VAT increases – again it
makes little sense for monetary policy to react to this.
So the ECB is not only ignoring the output gap, but it is
also ignoring any inflation measure except the CPI. Is this just an unfortunate
consequence of the public focus on this measure of inflation? I wonder what
would happen if the reverse was the case. Imagine if CPI inflation was at 2%,
but other inflation measures were well above, and there was a large positive
output gap. Would the ECB be doing nothing in that case?
The news on fiscal policy is equally depressing, and even
more predictable (see the final section of this).
The public discussion is not about whether further austerity is appropriate. Instead
it is whether countries are undertaking enough fiscal contraction to avoid the sanctions
that are part of the Eurozone’s excessive deficit procedures (see Bruegel here).
The problem is not only the actions of politicians but also the views of those
who advise them. It is as if officials have spent the last ten years in a
losing battle to restrain public deficits, and they are not going to give up
now just when things are going their way. Spiegel
(HT MT) reports that Angela Merkel’s government has proposed some very minor
fiscal easing, but this has been met by stern disapproval from the country’s Council of Economic Experts.[1]
What we
seem to have here is a collective failure of the European governing class. It
is a governing class that is much less accountable than in, for example, the
United States. While there has been understandable discussion, and some
progress, on further economic integration (banking and fiscal union) in the Eurozone, I worry
about the wisdom of moves that give further power to a governing elite that has
failed, and continues to fail, in such a spectacular manner. (Acemoglu and
Robinson, Amartya
Sen and Niamh
Hardiman express similar concerns.) Is there a danger that economists, with the
best of intentions, are helping to dig a deeper hole for the Eurozone because
they are failing to see the bigger political picture?
Yes!
ReplyDeleteSame thing in Canada (only not as much). Before the Great Recession I used to think that if the Bank of Canada kept CPI inflation roughly on target, there wouldn't be a deficient-demand recession. We would only get a recession if the BoC failed to react quickly enough or strongly enough to shocks, so CPI inflation fell below the 2% target.
But what actually happened is that the BoC did keep inflation roughly on target (there was a small hiccup up and down, but it didn't correlate with the recession) but we still had a recession.
Time to dump CPI targeting. GDP deflator targeting would probably be better. But NGDP targeting (at basic prices) would probably be better still.
I wish we understood supply shocks/price shocks better though.
I agree, and also the nature of the non-linearity in the Phillips curve when inflation is very low.
DeleteYes. Either there's a non-linearity at very low rates of inflation (but why wasn't it there in the 1930's??) or else, maybe, inflation targeting was (in a weird sense) *too* successful, in making inflation inertial, like some sort of Schelling focal point at 2%. Or both. I don't know.
DeleteYes !
ReplyDeleteGreat post. I like it as much as Nick Rowe does, but I focused more on the "failure of European governance" part.
There is a problem with policy dominated by non partisan civil servant technocrats. Technicians can develop an orthodoxy and stick to it, sheltered from reality by our safe public sector jobs. I think the usual historical analogy is useful. One name for Austerian ideology is the Treasury view, that being his majesties treasury. On the other side of the pond, the Treasury staff were over ruled by elected officials trying to guess what policy would work unaided by experience or training. That worked rather better (here I stress high unemployment in the UK started much sooner).
Now effective control of policy by elected officials can lead to sub-optimal policy such as, say, invading Iraq (the generals were against it but obeyed).
Still Democracy has its advantages as a policy development process. Europe might consider trying it some day.
I have in other contexts advocated more delegation to technocrats. I think the key here is accountability. The best national central banks and fiscal councils are subject to effective public scrutiny - being questioned by MPs in public hearings, written about in the national press, analysed by private sector and academic economists etc. This is what is missing at the European/Eurozone level. The same actors at the national level are too small to have a significant impact on European technocrats, so they are much less accountable.
Delete"Is there a danger that economists, with the best of intentions, are helping to dig a deeper hole for the Eurozone because they are failing to see the bigger political picture?"
ReplyDeleteOf course economists are digging a hole for the eurozone : it is what maximizes their own power, and thus their utility. Between two policies, economists will invariably favor the most technocratic because it maximizes their influence.
Taking policy advice from an economist is a democratic suicide, so says economic theory.
I disagree. In UK inflation targeting has been long forgotten (5% last year) and we have witnessed the effects of this the last 4-5 years with no growth and stagflation.
ReplyDeleteThe fact that BoE has ignored inflation and its impact on the economy, is obvious in the fact that zombie companies are still operating which is causing inefficient application of capital and lack of growth.
If anything, deflation would be very welcomed in the UK since it would allow for some of the asset bubbles to deflate.
The EU situation is not a problem which is directly linked to inflation but with a creation of monetary union which does not have a fiscal union.
Economists should stop playing gods and should stick to their remits. Otherwise they really have an impact on democracy which they should not do so since they are not elected.
I agree completely that the ECB's obsession with its inflation mandate is a huge catastrophe. But I do wonder about this:
ReplyDelete"What we seem to have here is a collective failure of the European governing class."
I'm somewhat sympathetic to Josh Mason's alternative theory: maybe this is exactly what the "governing class" in Europe wants.
http://slackwire.blogspot.com/2012/06/pain-is-agenda-method-in-ecbs-madness.html
This is similar to Kalecki's famous analysis of the political problems that would make full employment difficult to sustain, though here we're not talking full or not full, we're talking 50 percent of people in their twenties unable to find work in the worst-hit countries.
I doubt this is what the EU elites really want especailly at this moment and stage of development of the EU.
DeleteThey might even have had the idea before that if there are problems because of the framework they would likely be solved by strengthening that framework (and more integration).
Those times are gone they look scared as hell of the thing falling apart.
By getting into the daily affairs of people you simply need a management structure with that, that can cope with eventualities. And as it now is on the daily agenda of ordinary people (aka as voters) you need a platform there to get measures accepted and approved. If you donot have that you likely will end up, like now, with huge problems, no effective management structure to deal with it and no platform to get it adopted. Which will hardly do good to further EU integration.
The EU is effectively still a treaty (which is a legal document). And so is the Euro Zone.
ReplyDeleteIn that treaty as far as the ECB goes it is about pricestability. Which is not necessarily equal to inflation.
It simply does what it legally is supposed to do. If you want that to change you basically have to change the rules of the game (change the treaty).
It cannot change the rules simply becuse the rules donot really work. The sytem is change the rules first and after that you can do other things. It tries to bend the rules but it is only so nuch it can do. And basically already looked to have gone way too far. Simply a huge litigation-risk has come up.
You are right about the political part (this is mainly/largely a political issue that goes via other rules than pure economic ones.
However you miss the fact that the political situation is laid down in legal provisions. And these have their limitations.
You cannot change them when you want or when they donot work. bend them a little is the max.
Plus you have to change them via the rules for changing it. Which makes changing it under the present conditions from very difficult to simply impossible.