Eurozone crisis: Higher inflation is part of the answer

by Simon Tilford

The biggest challenge facing the eurozone is how to generate economic growth. Whatever its leaders agree in terms of fiscal targets and surveillance will achieve little in the absence of growth. Excessively restrictive fiscal policy is clearly one obstacle to such growth, but the European Central Bank’s obsession with inflation is another. Of course the central bank must guard against excessive inflation, but it is a big problem when its fear of inflation blinds it to the much more serious threats confronting the eurozone economy. Indeed, somewhat higher inflation may be part of the solution to the crisis facing Europe. If policy continues to be directed at ensuring inflation of "below, but close to 2 per cent", countries such as Spain and Italy will struggle to regain competitiveness within the eurozone and their debt burdens will be unsustainable.

The Bundesbank's legacy is clearly visible in the ECB's official strategy. The central bank's interpretation of price stability means it has the most restrictive target or 'reference value' of price stability of any major central bank. Given that many eurozone countries have historically been prone to high inflation, the ECB’s determination to build a reputation for guaranteeing price stability is understandable. Officials from the bank never tire of saying that ensuring low inflation is the best contribution the ECB can make to economic growth. Price stability is important, of course. But a reference value of under 2 per cent and no accompanying mandate to ensure an adequate level of economic activity (such as that faced by the US Federal Reserve) is too restrictive. It is damaging in a number of ways for a currency union such as the eurozone.

First, it increases the risk that interest rates will be raised in response to temporary shocks – such as higher oil prices – that do not threaten medium-term price stability. This was illustrated by the ECB's decision to raise interest rates in July 2008, when the eurozone economy was already contracting. Perhaps more egregious was its decision to raise interest rates in July 2011, despite strong evidence of a slowing economy, against the backdrop of a deepening sovereign debt and banking sector crisis, and in the face of very restrictive fiscal policy across the currency union. The ECB’s decision to raise rates despite these headwinds raises serious concerns over its mandate. The central bank is unlikely to cut interest rates at this week’s meeting because eurozone inflation currently stands at 3 per cent. This is largely because of higher energy prices whose impact on the consumer prices index will weaken sharply from early next year.

Second, an inflation target of below, but close to 2 per cent leaves very little room for adjustment within the currency union. Since countries such as Spain and Italy cannot devalue, they can only improve their 'competitiveness' by cutting their costs relative to Germany. Such a strategy will lead to deflation and debt traps unless German inflation rises more quickly than the current projections of around 1.5 per cent per annum. The eurozone would be better off with a symmetrical eurozone inflation target of 3 per cent with the inflation rate allowed to deviate by no more than 1 percentage point in either direction. Such a target would make it much easier for a member-state to hold its inflation rate (and wage growth) below the eurozone average without risking economic stagnation and deflation.

Although a target of under 2 per cent might have been appropriate for the Bundesbank, it is ill-suited to the eurozone. Unlike Germany, the eurozone is a largely closed economy (exports account for a similar proportion of GDP as they do in US) and hence cannot rely to anywhere near the same extent as Germany on exports to close the gap between output and expenditure. The currency union as a whole cannot expect to export its way out of trouble – it needs robust growth in domestic demand.

If the ECB had to take economic activity into account, not only would eurozone interest rates be lower, but the central bank would also be pumping money directly into the eurozone economy. Much like the US Fed, the Bank of Japan and the Bank of England – all of whom like the ECB face economies struggling with the aftermath of financial crises and the associated collapse in aggregate demand – the ECB would be engaged in so-called quantitative easing (QE), the unsterilised purchasing of government debt and other assets. By bringing down public and private borrowing costs and boosting the volume of credit, QE could strengthen economic activity and guard against the risk of deflation.

Supporters of the ECB's current mandate would no doubt argue that the Fed's dual target of inflation and employment has caused it to pump up one bubble after another. The Fed is forced to sacrifice the principle of sound money on the altar of short-term pump-priming. The result is an unbalanced US economy, excessive debt, and a world awash with dollars. This, in turn, puts downward pressure on the US currency, threatening international monetary stability. But this is a largely self-serving analysis. Had the Fed not kept interest rates very low and pumped money into its economy, the world would have had an even bigger problem: the US economy would have slumped, and its trade balance swung into surplus.

The eurozone is essentially trying to ensure monetary stability in Europe at the cost of higher debt elsewhere: the crisis strategy for the currency union is for everyone to save more, and spend less – to 'live within their means'. This implies the eurozone running a huge trade surplus with the rest of the world. But this will not be possible. East Asia is pursuing a similar strategy to the eurozone. And the US economy is simply too indebted and not big enough to act as the consumer of last resort for both East Asia and Europe.

The ECB should not be responsible for setting its own mandate. One option would be to transfer responsibility for this to the Euro Group, which would agree decisions by qualified majority. Such a move would not necessarily require a new treaty; a unanimous decision in the Council could be enough. Unfortunately, there is no chance of this happening. Reforms of eurozone governance will not include reform of the ECB since several eurozone governments, not least the German one, are steadfastly opposed to such a move.

This leaves the currency bloc vulnerable to slump and on-going crisis. Fiscal policy is highly contractionary. The monetary policy stance is restrictive, given the depth of the economic weakness. The currency union as a whole cannot export its way out of trouble. Structural reforms should help to boost growth in the medium to long term. But such reforms need to be accompanied by investment if they are to deliver on their potential and with demand so weak investment will be thin on the ground. It is beholden on those governments that oppose greater monetary stimulus to explain how the eurozone economy is to grow and how the necessary adjustment in price and labour costs between the participating economies are to be made.

Simon Tilford is chief economist at the Centre for European Reform.