The Return of Inflation Politics

Oliver Blanchard, chief economist of the IMF, has made the suggestion to raise the central bank’s target rate of inflation to 4 % arguing this would give central banks more flexibility. He claims the current crisis shows that this has become necessary and points out deflation plagued Japan as a negative example. The IMF has started rethinking some of its long held stances in the wake of the crisis. It went that far as to release a report promoting capital controls to prevent the influx of speculative capital. This time, Mr. Blanchard is either quite on the wrong track or hiding his true motives.

I started studying with Blanchard’s introductory macroeconomics textbook and one topic covered is called the liquidity trap. It describes a situation where the central bank cannot stimulate the economy further by lowering the interest rate, that is to say a situation that exactly describes current economic reality. Saying times have changed and we need to raise the “normal” level of inflation to avoid getting into that trap again is quite shortsighted and is certainly not a lesson of this crisis. Say we hit the inflation target every year we have accumulated inflation of well above 100 % over the course of the next twenty years. That is hardly price stability. The reasons why we are in this crisis are much too complex and a repetition can be prevented in other ways such as by reforming financial systems and public spending policies. Quite likely a target inflation of 4 % would have left us in the same situation and being caught in the liquidity trap would have been, if anything, merely delayed. Somehow it seems people always start forgetting the effects of one economic evil if it hasn’t occurred in a long time. Inflation has enough negative effects to justify a goal of stricter price stability than 4 %.

If, however, the IMF is barely hiding an uneasy truth, it might do a good job convincing citizens of giving up price stability. The truth is that we have little other choice than getting prepared for much higher inflation. In the very short run overcapacities are still putting pressure on prices and create deflationary tendencies. Famously coined by Milton Freedman, inflation is always and everywhere a monetary phenomenon and in the middle run the excessive liquidity pumped into crisis-ridden economies will push inflation. A bit longer down the road is a much worse problem: governments will need inflation. It is impossible to repay national debts that are, as it is becoming increasingly evident, much higher than previously claimed. Inflating away some of the obligations will be inevitable to prevent total fiscal collapse. Inflation of 2 % will not do the trick. It is questionable whether 4 % will do.

More on the euro

Just an additional note on the ongoing discussion about the euro and potential bail outs. Paul Krugman writes in his New York Times op-ed on the same topic. He is as always somewhat more critical and deems the whole common currency project as being built on "hubris" and "arrogance".

Bailing out or not? Greece and other Disasters

I do not want to claim that the whole world is about economics, but sometimes economic theory provides important insights. There are many controversial topics in economics, but I have not yet heard of a theory telling us that it is a good idea to give a single currency to a group of totally inhomogeneous countries. And so a lot of economists were warning of a situation like this. It is still surprising how fast and to what extent events are unfolding now. Greece is teetering on the brink of fiscal collapse and Spain and Portugal are not following far behind.

There are many advantages of the euro such as providing stability, avoiding costly cash exchanges, and not least creating a sense of unity among its participants. None of the critics has doubted this. Seeing Greece, Spain, Portugal now struggle with the very consequences of the common currency gives rise to the question whether those positive effects outweigh the negative ones. It has become evident that the eurozone (countries that have introduced the euro) is just too heterogeneous and in a sense to big. Size as such is not the problem, but the decomposition of economically strong countries and weak ones builds a dangerous mix. Certain countries might be better off without the euro while the remaining members might be do better without them. While from an economic point of view this statement seems quite obvious, political considerations do not allow Europe’s wealthy economies to merely drop poorer ones and force them out of the common currency.

So bailing out or not? Of course, Greece and other countries tumbling towards default cannot be left to themselves. The question is rather how to shape a bail out in order to avoid moral-hazard issues as effectively as possible. German and French government officials had maintained a low profile as long as possible in order to force Greece to make painful budget cuts and introduce essential reforms. Anyone knowing the least bit about the Greek political landscape can probably tell you that fiscal tightening is a Hercules task there. If Greece, Spain, and Portugal cannot solve their problems by means of their own efforts and only rely on external help, the difficulties for the eurozone are both delayed and in the long run severed. Bringing the IMF into the picture and letting it provide the funds for a bailout and supervise the reform process might be a good solution. However, taking IMF money would severely damage the euro’s reputation and is thus probably not a viable option.

The most likely solution at this point, a Franco-German led bail out, should be conditioned on as strict obligations and requirements as politically feasible. I do acknowledge the argument often brought forward against an IMF-style strait jacket. However, for countries that are member of the eurozone this is additionally a question of solidarity and mutual respect. If a non-eurozone country does not manage its budget properly and gets into fiscal troubles it affects other nations to a limited extent. If a eurozone country does not act fiscally responsible, other members have to foot the bill. This cannot be a permanent condition at least as long as the European Union is not politically united (even then it should not). Solidarity is certainly due in a severe crisis like this, but benefiting economies should not be given the possibility to maneuver themselves directly into the next fiscal disaster.

Europe – Quo Vadis?

I am not a particular fan of the Wall Street Journal, although I must admit they are sometimes quite inventive when coming up with arguments why Mr. Obama’s politics are a complete disaster and will completely ruin the United States. Nevertheless, I enjoy reading their view on international politics and in particular Europe (I do not often agree with them there, either). So is Europe’s dream of power waning with the rise of the so called “G2” (that is China and the U.S.)? To give a quick answer: probably yes. There are two main reasons why I think this is the case. On the one hand, Europe is not able to unite fast enough and speak with one voice. On the other hand, I believe Europe does neither really want nor need to aim for increased political influence.

First, those who were dreaming of a united Europe as a political counterpart to the U.S. have always been somewhat naive. While Europe’s economic weight is undoubtedly still considerably heavy, although in relative decline as well, its political power has always been based on individual member states. Without a fully integrated political union it is not going to be taken seriously on the world stage. And such a union, if possible at all, will take probably another half century or more. Moreover, economic and cultural nationalism is again on the rise in many European countries. Take France’s or Germany’s industrial policies (particularly in the automobile sector) or the view towards Europe of the likely new government in the U.K, just to mention some examples. The Lisbon treaty made evident what many in Brussels did not want to see: Europe needs to rest and digest. Deepening political ties and expanding its geographical borders have taken their toll. This is only natural considering where Europe has came from after the catastrophe of World War II. It has come a long way and it should be proud of it. We should not forget that Europe started as a peace project and has more than fulfilled its promises in that respect.

Second is the question whether it is necessary to be a global heavyweight in the political sphere. That depends largely on people’s priorities and an imminent threat of any kind of military hostility towards Europe seems more than unlikely (at least for European countries already member of the bloc). Political influence always comes at a cost and I am not sure whether Europeans are willing to shoulder such expenses. I believe Europeans, in particular the young generations, do not care much for political importance of Europe and have other priorities. They believe in the unique process of different cultures and values growing together. Europe has learnt its lessons. Just look at e.g. the attitude of Germans towards war in general and the one Afghanistan in particular; it is completely unpopular there.

Europe will be occupied with managing itself for some time to come. I feel quite comfortable with that thought. Of course, our politicians who strive for ever more power and influence will keep trying to convince us otherwise.