Inflation: The Secret Answer to the Eurozone Crisis (see addendum)

April 13, 2012

Robert Samuelson is the type of guy who stands there holding a fire extinguisher trying to figure out what to do as the house burns down. In his column today he ponders the euro zone crisis. He relies extensively on Jay Shambaugh, an economist at Georgetown, telling us that Shambaugh identifies three distinct crises:

“First, there’s a banking crisis. Banks have too little capital (a buffer against losses) and have a hard time raising funds. Next is the sovereign debt crisis. The high debts of many countries raise fears that, like Greece, they may default. And, finally, there’s an economic growth crisis. Low growth or slumps afflict most of the 17 countries using the euro.”

He continues:

“Each crisis aggravates the others. Because banks hold huge portfolios of government bonds, fears about the bonds’ values weaken the banks and threaten their failure. Weak banks in turn don’t provide ample business and consumer loans to increase economic growth. And feeble or nonexistent growth shrinks tax revenues and makes it harder for governments to service their debts. “

Wow, it sounds so hard. Now let’s imagine that the religious zealots running the European Central Bank (ECB) learned some economics and turned away from their low inflation cult. They could do something like what was recommended by Olivier Blanchard, the chief economist at the IMF. The ECB could target a higher rate of inflation, say 4.0 percent.

If it could convince the markets it was serious about this target — throwing out as many reserves as necessary to push inflation higher — it would address all three of these inter-related crises. Higher inflation would directly reduce the burden of sovereign debt.

If inflation averages 4.0 percent over the next five years instead of 2.0 percent (the current target), then GDP will be roughly 10 percent higher, reducing debt burdens proportionately. This means, for example, if Greece is looking at a debt to GDP ratio of 120 percent in five years with the current inflation target, its debt to GDP ratio would be 108 percent in the higher inflation scenario.

Higher inflation will also have the effect of lowering real interest rates and thereby boosting growth. If businesses know that they will be able to sell everything they produce for 20 percent more five years from now, it will give them more incentive to invest. Higher growth will also help to alleviate government deficits and debt burdens.

Finally, the loans on banks’ books are likely to look much better in a context where house prices have risen by 20 percent (this is moving in step with inflation — that is not a housing bubble) and economies are stronger. Stronger growth will also reduce corporate bankruptcies.

The problem really is not that difficult if the people holding the fire extinguishers would use them. Unfortunately, the ECB crew, like Samuelson, seems determined to focus on its inflation fighting even as the house burns down around them.



I am well aware of the ECB charter. This is not an excuse. I recently wrote a column comparing the ECB’s pursuit of 2.0 percent inflation with the Maginot Line that the French military constructed prior to World War II to defend against a German invasion.

The correct course for French generals assigned to construct the Maginot Line would be to tell their superiors that it would not be an adequate defense against a German invasion. (The Germans just walked around the Maginot Line and went through Belgium.) If their superiors refused to listen, then the appropriate response is to resign, not to commit more resources to building a barrier that was absolutely useless for its intended purpose.

Similarly, competent economists at the ECB should be saying that adhering to a 2.0 percent inflation target as the sole purpose of a central bank is grossly irresponsible economic policy. If the governments insist on acting like fools then they should be forced to find certified fools to do their job. No serious economist has any business working for the ECB at a time when its policies are leading to so much devastation across Europe.


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