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Home Publications Blogs Beat the Press Europe Asks China for Help Because of 2.0 Percent Inflation Superstition

Europe Asks China for Help Because of 2.0 Percent Inflation Superstition

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Wednesday, 02 November 2011 05:17

The Washington Post reported on the bizarre situation in which the relatively rich European Union is asking China, a relatively poor country, with assistance in its bailout package. It would have been appropriate to remind readers that the only reason that Europe needs help from anyone is that the people running the European Central Bank (ECB) are part of a bizarre cult that worships a 2.0 percent inflation target.

If the ECB was managed in the same way as central banks have been managed through time, it would simply step in as the lender of last resort and guarantee the sovereign debt of the euro zone countries and immediately put an end to the crisis. However, adherence to the 2.0 percent inflation cult prevents the ECB from functioning as a modern central banks.

The 2.0 percent inflation cult is proving to be one of the most destructive faiths in human history. The adherence to this cult prevented the ECB from taking an steps to stem the growth of housing bubbles across the continent. (This was also the case in the United States where the cult is not as widely practiced at the Fed.) Now that these bubbles have collapsed and left the economy in ruins, adherence to the cult is preventing the ECB from responding adequately.

[Addendum: Those interested in hearing more about the situation in Greece may want to tune into a conference on Thursday and Friday at the University of Texas organized by my friend Jamie Galbraith.]

Comments (15)Add Comment
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written by Blissex, November 02, 2011 6:54
«the people running the European Central Bank (ECB) are part of a bizarre cult that worships a 2.0 percent inflation target. If the ECB was managed in the same way as central banks have been managed through time, it would simply step in as the lender of last resort and guarantee the sovereign debt of the euro zone countries»

That's a vast misrepresentation of the ECB. The ECB was setup to run the Euro as a clone of the DM, and itself as a clone of the BundesBank, and Germany (and their allies) only allowed the Euro to come into existence if the founding treaties explicitly forbid the ECB to act as a lender of last resort and guarantee any sovereign debt, and that was duly forbidden.

The ECB does what it does because they know very well that their political sponsors want that. If the ECB started monetizing debt, Germany (and their allies) would disconfess the ECB and the ECB would disappear.

The people who really misbehaved in this story are the countries that borrowed in DMs/Euros thinking they could one day force the ECB to devalue it to solve their debt problems, and the banks who made liar loans to them, at rates similar to those of Germany, on the assumption that the ECB would not back the Euro but Euro bonds.

You are like BdL using a Real American (and Greek, or Spanish, or Irih, or British, or Italian) point of view where constitutions and treaties are pieces of paper, and laws are «benchmarks of opportunity». That's not the German view. The German government could authorize the ECB to violate its treaties and constitution, but the next election German voters would elect a new government that would destory the ECB no matter the cost.

On the difference between the two attitudes my usual quote from the famous sociologist New Gingrich:


«In Germany on the Autobahn there is no speed limit. If tomorrow the Bundestag adopted a 100km, or 62-mph speed limit, virtually every German would obey it. Until, that is, the next election when they would wipe out the current politicians and they would elect the "No Speed-Limit" Party.
Now this is a significant insight that American reformers have neglected for 30 years, and is the great mistake of the Great Society and everything that followed it.
And I don't want to offend anybody, but let me suggest to you that the American cultural response to the challenge of speed limits has been dramatically different than [sic] the German one. For most Americans speed limit is a benchmark of opportunity. This is not a light insight.
If you have a society where almost every middle class person routinely fudges the law, that's telling us something. We have laws that matter-murder, rape, and we have laws that don't matter. Speed limits are an example. Why would you think that a regulatory, process-oriented bureaucratic model would work?
The first thing that every good American says each morning is "What's the angle?" "How can I get around it?" "What does my lawyer think?" "There must be a loophole!" Then he proceeds to work the angle, and the bureaucracy spends its time chasing that and writing new regs to stop him. America is the most incentive-driven society on the planet.»
The ECB and Fed did not restrain the bubbles out of fear of retribution
written by Blissex, November 02, 2011 7:06
«The adherence to this cult prevented the ECB from taking an steps to stem the growth of housing bubbles across the continent. (This was also the case in the United States where the cult is not as widely practiced at the Fed.) Now that these bubbles have collapsed and left the economy in ruins»

I am often rereading J. K. Galbraith's "The Great Crash 1929" with which I guess you too are familiar, and he gives repeatedly a very different reason and one that I agree with why the authorities don't restrain bubbles:

page 28: «Since 1929 we have enacted numerous laws designed to make securities speculation more honest and, it is hoped, more readily restrained. None of these is a perfect safeguard. The signal feature of the mass escape from reality that occurred in 1929 and before -- and which has characterized every previous speculative outburst from the South Sea Bubble to the Florida land boom -- was that it carried Authority with it. Governments were either bemused as the speculators or they deemed it unwise to be sane at a time when sanity exposed one to ridicule, condemnation for spoiling the game, or the threat of severe political retribution.»

page 51: «When prices stopped rising -- when the supply of people who were buying for an increase was exhausted -- then ownership on margin would become meaningless and everyone would want to sell. The market wouldn't level out; it would fall precipitately.

All this being so, the position of the people who had at least nominal responsibility for what was going on was a complex one. Pne of the oldest puzzles of politics is who is to regulate the regulators. But an equally baffling problem, which has never received the attention that it deserves, is who is to make wise those who are required to have wisdom.

Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. But there were also some who saw, however dimly, that a wild speculation was in progress and something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

A bubble can be easily punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. Among those who senses what was happening in early 1929, there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated. (For nearly a decade the Federal Reserve authorities had been denying their responsibility for the defaltion of 1920-1.) The eventual disaster also had the inestimable advantage of allowing a few more days, weeks, or months of life.»
The ECB and Fed did not restrain the bubbles out of fear of retribution 2
written by Blissex, November 02, 2011 7:13
Some more J. K. Galbraith quotes:

page 58: «In 1929, a robust denunciation of speculators and speculation by someone in high authority and a warning that the market was too high would almost certainly have broken the spell. It would have brought some people back from the world of make-believe. Those who were planning to stay in the market as ling as possible but still get out (or go short) in time would have gone out or gone short. Their occupational nervousness could readily have been translated into an acute desire to sell. Once the selling started, some more vigorously voiced pessimism could easily have kept it going.

The very effectiveness of such a measure was the problem. Of all the weapons in the Federal Reserve arsenal, words were the most unpredictable in their consequences. Their effect might be sudden and terrible. Moreover, these consequences could be attributed with the greatest of precision to the person or persons who uttered these words. Retribution would follow. To the more cautious of the Federal Reserve officials in the early part of 1929 silence seemed literally golden.»

page 66: «In June from Princeton Mr. Lawrence said that the [Fed] Board was still "doing its utmost to cast the proverbial monkey wrench into the machinery of prosperity". He warned the Board that it had "aroused the enmity of an honest, intelligent and public-spirited community". (This was also Wall Street.) But the Board, in fact, had decided to leave that honest, intelligent and public-spirited community strictly to its own devices. It realized, Governor Young said subsequently, that "while the hysteria might be somewhat restrained", it would have to run its course, and the Reserve Banks could only brace themselves for the "inevitable collapse". More accurately, the Federal Reserve authorities had decided not to be responsible for the collapse.»

page 68: «For now, free at last from all threat of government reaction or retribution, the market sailed off into the wild blue yonder. Especially after 1 June all hesitation disappeared.

Never before or since have so many become so wondrously, so effortlessly, and so quickly rich.

Perhaps Messrs Hoover and Mellon and the Federal Reserve were right in keeping their hands off. Perhaps it was worth being poor for a long time to be so rich for just a little while.»

page 206: «Yet, in some respects, the chances for a recurrence of a speculative orgy are rather good. No one can doubt that the American people remain susceptible to the speculative mood -- to the conviction that enterprise can be attended by unlimited rewards, which they, individually, were meant to share. A rising market can still bring the reality of riches. This, in turn, can draw more and more people to participate. The government preventatives and controls are ready. In the hands of a determined government their efficacy cannot be doubted. There are, however, a hundred reasons why a government will determine not to use them. In our democracy an election is in the offing even on the day after an election. The avoidance of depression and prevention of unemployment have become for politicians the most critical of all questions of public policy. Action to break up a boom must always be weighted against the chance that it will cause unemployment at a politically inopportune moment. Booms, it must be noted, are not stopped, until after they have started. And after they have started the action will always look, as it did to the frightened men in the Federal Reserve Board in February 1929, like a decision in favour of immediate as against ultimate death. As we have seen, the immediate death not only had the the disadvantage of being immediate but of identifying the executioner.»
...
written by skeptonomist, November 02, 2011 9:45
"the ECB ...would simply step in as the lender of last resort and guarantee the sovereign debt of the euro zone countries and immediately put an end to the crisis."
As the Fed did in 2008? Dean has argued that the Fed should not have simply bailed out the banks and insurance companies by pledging the credit of taxpayers, but now he wants the ECB to pledge Europe's credit. But whose? This is really the heart of the problem, even if you accept that the ECB should play the role of lender of last resort. This is not its official responsibility - its official role is to provide price stability. You can decry the 2% inflation limit (I personally question whether there needs to be a limit at all - the U.S. and the world did fine after WW II while interest rates were held low), but this is not the problem which Europe is facing because of possible sovereign default.
A crisis is the time to force reform. This opportunity was missed in the US in 2008-2009 and the banks are worse than ever. I doubt if the solution to Europe's problems is to empower the central bank even more. Has the Fed justified the reliance that has been placed on it in the last 50 years or so?

...
written by freebird, November 02, 2011 10:29
Perhaps the notion of "asking for assistance in its bailout package" is the wrong spin on this move. Germans voters don't want to pay this tab, and the Chinese authorities have been looking for a way to diversify out of dollar denominated debt, so it could be win/win.
...
written by Blissex, November 02, 2011 10:38
«but now he wants the ECB to pledge Europe's credit. But whose? This is really the heart of the problem, even if you accept that the ECB should play the role of lender of last resort.»

The whole point of DB's argument is that since nobody (that means Germany) wants to pledge their donations (not quite their credit) to make good the losses on the Eurozone debt, the ECB should just absorb those losses, as the ECB has an infinite supply of zero-cost Euros.

Therefore DB is not advocating that the ECB be lender of last resot, but donor of last resort, that is that instead of lending money the ECB should monetize the losses on the Eurozone sovereign debt, and that's why the inflation rate matters. Because if the ECB monetizes those losses, the Euro inflation rate presumably will go up.

It is the usual story: since fiscal policy is politically impossible because nobody is volunteering to pay higher taxes, monetary policy provides the spending power by monetization of losses, resulting in a widespread and inescapable inflation "tax" on the purchasing power of the same people who refused to pay more taxes to the same effect.

Put another way again, it is technocratic mandarins knowing what's best for German voters, and overriding the German voters's very strong determination to let Greece sink, via indirect monetary policy means.

I think that the technocratic mandarins may be right as to the lesser evil, but democracy is supposed to be a mechanism by which voters suffer the consequences of their choices.

Besides, there is still the moral hazard angle when central banks monetize the losses of kleptocracies like Greece (or the French and German financial systems).
Lender of Last Resort
written by sherparick, November 02, 2011 3:25
Troll Blissex is one of those for whome economics is a morality play, a play best exemplified by Aesop's fable of the Ants and the Grasshopper. The good, industrious, ants (Germany in Europe, the 1% here in the U.S.) are being asked to bailout the lazy, hardpartying, grasshoppers (Greece, Ireland, Spain, Italy, and Portugal in Europe) and folks who bought houses during the bubble years here in the U.S. It is funny how the "moral" people in this story are always the bankers/creditors. You would think creditors could use a little "moral" hazard so the next time they will think before handing out loans "is this prudent?"

The problem with the single currency, which Germany and the European elite wanted, is that you are linking economies with very different levels of productivity. If you have a common Fiscal union, like the U.S., money can flow from one region to the other and you don't run into sovereign debt crisis. The ECB said not a word as banks in capital flowed out to the periphery creating internal current account deficits and capital surpluses. Everyone was making money, so the party roared on. Until it stopped, and then it became the little people's fault in Greece, Spain, Italy, Portugal, and Ireland, and not their bankers.

And if the ECB announced that it would begin buying an unlimited number of bonds of the perpheral countries to put their interst rates at a sustainable level (say 4%, 2% above the 2% inflation target), probably at very little cost the crisis would pass as the markets would stop fearing default.

Instead, we will see default and recession and political turmoil and probably deaths across Europe. Now that is a morality tale.


...
written by Blissex, November 02, 2011 5:56
«And if the ECB announced that it would begin buying an unlimited number of bonds of the perpheral countries to put their interst rates at a sustainable level (say 4%, 2% above the 2% inflation target), probably at very little cost the crisis would pass as the markets would stop fearing default.»

This finessing of the interest burden might work for Italy, but it is completely unrealistic for Greece. Greece is not having an interest burden problem, but a solvency problem.

Greece simply cannot repay the principal they have borrowed and quite happily consumed or hidden in fiscal paradises, under any realistic scenario (one that takes less than 50-100 years).

So someone has got to lose a lot of money.

The German and French voters really believe their morality tale, and don't want to pay taxes to save the Greeks mostly because they haven't been told that a large chunk of their savings and pensions have been invested in Greek bonds or would disappear if there were several sovereign defaults.

The Greeks, who have 280 billion euros of capital flight hidden away in Switzerland, don't want to pay any taxes to return the liar loan money to the suckers in France and Germany who gave it to them.

So DB and many other advocate taxing everybody in the EU (both Germany and allies and Greece and similar) indirectly by increasing the inflation rate.

But this is not the role of a lender of last resort as in smoothing a temporary liquidity crisis; it is a role donor of last resort, as in monetizing a permanent insolvency crisis.

At least BdL in his similar blog entry recognized that legally the ECB cannot monetize member state debts, even if he then argues that they should ignore the legalities and do it regardless, while by omitting mention of the legalities DB seems to misrepresent the ECB as unwilling to act as donor of last resort, when it is explicitly forbidden by treaty and political reality to do so.
...
written by skeptonomist, November 02, 2011 7:33
Blissex, I agree with a lot of what you say, including the benefits of reading Galbraith's little book on the Crash of 1929 - if everybody who speculates read and understood the material in that book (or in some other longer books on the same subject) we might not have crashes.

I also agree with Dean and many others that inflation would be good idea in some respects, but my point is that this is not as easy as looks. The Fed has been doing absolutely everything it can to expand the money supply, and this has not caused much inflation (Krugman periodically emits dire warnings of deflation). The Fed did not bail out the U.S. banks by inflating or promising to inflate. I see no reason to believe that the ECB can cause inflation on demand any more than the Fed can. If and when inflation persistently rises above 2% then the cult may come into play, but I don't see that this is preventing the ECB from bailing out Greece - many other things are involved. The situation in Europe, as in the U.S., is beyond the powers of a central bank, even if it acted like the B of E in 1827 or J.P. Morgan in 1907. Economists should be thinking about institutions and mechanisms which could replace central banks. As Dean himself has often said, the FDIC has considerable powers of this sort, and they could have been extended to take over the failed investment banks instead of last-resort lending (= throwing money at them). The European situation is much more complex, but asking for a central bank to be the savior is asking for trouble in the future, even it actually works now.
Being a Lender of Last Resort IS the Responsibilty of the Central Bank
written by Dean, November 03, 2011 6:26
It is absurd for the ECB to say "not my job." That is what a central bank does. This is like setting up a Navy that is intended to defend the East Coast of the United States and when an enemy emerges on the West Coast, it ignore it and says "not my job."

If the people involved in designing the ECB did not understand the role of a central bank in the economy this is not an excuse for the people holding the job of running the bank from failing to carry through the responsibilities of a central bank. If they felt that the ECB mandate somehow prevented this, then they should have both looked to stretch the mandate (as did Bernanke) and also raised the issue with the EC and larger public.
...
written by Blissex, November 03, 2011 6:48
«the ECB mandate somehow prevented this, then they should have both looked to stretch the mandate (as did Bernanke)»

The ECB mandate specifically forbids any monetization of any member state debt, and that was one of the key points to get it approved by Germany. It was well understood.

If the ECB were to ignore its founding charter then Germany would simply destroy it, and probably a large chunk of the EU would collapse because Germany would feel totally betrayed.

Both politically and culturally before than economically.

The model of the EU is that on many critical issues even the smallest state has a veto, and they have been using it, and if the rest of the EU ignored Germany and screwed them too (because the "donor of last resort" can only be Germany) they might very well betrayed by the EU.

«and also raised the issue with the EC and larger public.»

The German public is well aware of the issue and is still totally against any monetization of the debt.

Especially for Greece, that is a kleptocracy and whose citizens very well have the money to pay the debt back, but they hid that money away in Switzerland.
...
written by Blissex, November 03, 2011 7:19
æThe Fed has been doing absolutely everything it can to expand the money supply, and this has not caused much inflation (Krugman periodically emits dire warnings of deflation).»

This is only because Serious Economists define "inflation" narrowly as low income wages growing significantly above zero.

The Fed has successfully engineered with their recent policies:

* A significant resumption of asset price inflation (stocks, commodities). Except that it isn't "inflation" because it is not low income wages.

* A significant reversal of deflation (including unemployment) of low end wages in the USA. Except that it is not "inflation" because the result it is not significantly above zero.

* Still, even "inflation" as related to the CPI is now above 2% (because of commodities cost push more than the feeble recovery in labor market conditions).
The will of the peoples
written by Blissex, November 03, 2011 7:37
Put another way, the fundamental mistake that DB is making in his argument is that the ECB is not worshipping the 2% inflation target out of ignorance of the role of a central bank.

The ECB are respecting the will of the peoples of the EU who very explicitly mandated the ECB to never act as the *donor* of last resort, and have very clearly not changed their mind.

Also because if the ECB ignores the will of the peoples who founded it, those peoples will end up "ignoring" the ECB.

While the Germans, the Dutch, ... may well be wrong in their insistence that the ECB must not monetize Greek debt, and technocratic mandarins who want the opposite may well be right, that's a different issue.
The EU exists in large part because of Germany
written by Blissex, November 03, 2011 7:57
Just as a reminder: the EU was designed as a way for Germany to have a stake (and influence) in the rest of the continent without rolling tanks all over the same continent (the French instead intended it as a way to have influence over Germany without having to call the Americans to beat it up).

It is really very important that Germany feel respected within the EU. Ideally even a bit loved, but at least not taken for suckers.

Agreeing in 1992 that the ECB should never monetize a member state debts, and then going Bush "it is just a piece of paper" is not the right way to show that the rest of the EU respect Germany.
Default but with unemployment insurance
written by Blissex, November 03, 2011 11:16
If Germans were a bit less maniacal they would propose the following:

* Default on debt for Greece.

* German unemployment insurance extended to unemployed Greeks.

Basically, a Ford style "Drop Dead" to the kleptocratic Greek government and the groups it has enriched with the proceeds of liar loans, and generosity to the fellow citizens of Greece who haven't benefited that much from the liar loans.

But I doubt that the Germans have the courage to do it.

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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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