Debt Targets Would be Much Easier to Hit if the ECB Had Expansionary Policy

The Washington Post reported on the new agreement among euro zone countries on fiscal policy and noted the difficulty that many countries would face in reaching their debt targets. It would have been worth mentioning that the polices of the European Central Bank (ECB) are making it more difficult for these countries to reach debt targets.

The ECB has remained committed to keeping a very low inflation rate even in a context where the euro zone countries have a huge amount of excess capacity and unemployed workers. If the ECB adopted more expansionary policies it would both allow more growth and help to reduce the burden of the debt through inflation.

If a country can sustain 3.0 percent real growth for 5 years and there is 4.0 percent inflation, then a debt burden that is equal to 100 percent of GDP can be reduced to 84 percent of GDP even if the country runs annual deficits equal to 3 percent of GDP ($450 billion in the United States). After 10 years the debt to GDP would be down to 73 percent of GDP. More rapid growth will also make it easier to run lower deficits since it will increase tax revenues and reduce payments for unemployment benefits and other transfers.

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written by skeptonomist, December 09, 2011 9:05 AM

The Fed has maintained federal funds rate at zero for almost three years now, promising to keep doing this indefinitely, and has stuffed incredible amounts of money into bank reserves - has this led to inflation? Why should anyone think that the ECB could produce inflation when the Fed has not? Krugman argues that the US is in a liquidity trap, in which monetary expansion (or contraction) has little or no effect - why should this not be true of Europe as well? There is no good reason for the ECB to be fighting nonexistent inflation, but on the other hand there is no evidence that additional expansion would accomplish much.

Many economists seem to think that policy should be based on belief in the idea that if central banks say they will allow high inflation, there will automatically be high inflation. It would simplify things if central banks could thus set inflation rate by decree, but there is no empirical evidence that this is how things work in the real world.

Thanks for laying out how inflation could actually reduce the debt burden
written by Brett, December 09, 2011 5:34 PM

Wonder why we don't see news articles point that out? Oh yeah, because the media blows.

Debt Targets Would be Much Easier to Hit if the ECB Had Expansionary Policy

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