Monday, October 31, 2011

Should we be more concerned about the policies being followed by the European Central Bank?

Jim was obviously agitated by my response to his question. He had just asked me whether I thought that the latest political deal in Europe would resolve the European financial crisis. Instead of saying I didn’t know I had tried to list some relevant factors, none of which I knew much about. I ended my list by mentioning that the policies being followed by the European Central Bank (ECB) were preventing the governments of southern Europe from following their pre-euro strategy of using high inflation to fund their profligacy.

‘I suppose that means you would be a strong supporter of the ECB’s anti-inflation policies’, Jim said. ‘You were an inflation hawk back in the 1980s. And I can remember a discussion in 2006 when you told me you were worried about expectations of higher inflation in America and the possibility of a re-run of the stagflation of the 1970s and 1980s. A year or so later inflation expectations started to fall. Then in 2008 we had the global financial crisis and it became obvious to everyone that there was actually more reason to be concerned about deflation than inflation’.

Jim was right about the 1980s, but I couldn’t recall our conversation in 2006. I pointed out that it wasn’t necessarily inconsistent to be concerned about rising inflation expectations in 2006 and to be concerned about the emergence of deflation a couple of years later. I suggested that central banks should be aiming to keep inflation expectations low and stable.

Jim said: ‘The fact that you keep talking about inflation expectations suggests you must have read some of the material on Scott Sumner’s ‘Money Illusion’ blog.  I started to try to explain that Scott actually recommends that central banks should target NGDP (nominal GDP i.e. aggregate demand) rather than inflation expectations, but Jim cut me off. He said: ‘I followed the link on your blog to Sumner’s blog to try to understand the European financial crisis. You obviously haven’t read whatSumner wrote a couple of weeks ago about the ECB’.

I had to admit that I haven’t been reading Scott’s blog regularly over the last couple of months. Jim said that in the post about the ECB Scott had a chart about inflation expectations in Europe that had been sent to him by Lars Christensen. At that point Jim got slightly distracted. He told me that I should read a post that Christensen had written recently on his blog, ‘The Market Monetarist’, about Calvinist economics and the gold standard mentality. ‘Christensen must have written that post with people like you in mind’, Jim said.

Jim eventually came back to the chart showing inflation expectations in Europe. He explained that the chart implies that the ECB has been driving inflation expectations sharply lower during August and September despite its mandate to produce stable inflation.

Jim ended by saying: ‘Look, why don’t you write something on your blog telling people to read Scott Sumner’s post about the ECB. And don’t forget to quote the passage where he points out how why it is so important for inflation expectations to be kept stable in Europe at present’.

I’m not sure which passage Jim wants me to quote, but this one seems to capture the main point:
‘I’m not saying a policy of steady eurozone inflation would solve the debt crisis, obviously it wouldn’t.  But the current policy is making it far worse than it needs to be.  The US made the same mistake in mid-2008.  Even at that time the subprime crisis was well understood, and estimated losses to the US banking system were quite high.  But when the Fed drove NGDP expectations much lower in late 2008 … the debt situation got far worse, and spread far outside the original subprime sector.  Now we are seeing the euro sovereign debt crisis spread to more and more countries.’

Perhaps we should be more concerned about the potential effects of the aggressive anti-inflation policies being followed by the ECB. 


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