To someit all seems very strange. The Eurozone is in recession, and no one is doing anything about it. The ECB are keepinginterest 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, familiarto 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 casecan 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 someEurozone 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?
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