Tyler Cowen has a new post discussing the very low inflation rate in the eurozone:
What is the most economical model here? The ECB invested in building up a lot of credibility in some areas, such as price level stability, but that means less credibility when it comes to pushing higher inflation. So to get two percent inflation, perhaps the ECB has to genuinely and truly seek four percent inflation, because a big chunk of the market won’t believe they really want four percent. Four will get them to two.
The ECB in fact may be wishing for two percent price inflation and getting…less than that. Which in turn conditions market participants to doubt the commitment of the ECB to the rates of price inflation which it claims to be seeking. The ECB and the citizenry can get stuck in a self-fulfilling prophecies equilibrium, yet without requiring a standard liquidity trap.
I see a simple explanation, the ECB really is as stupid as they seem. Over the last 5 years everyone from market monetarists to Keynesians have been absolutely incredulous at the statements made by ECB officials, and the actions taken by the ECB. They often seem incomprehensible. ”Surely they can’t really be this stupid, there must be a dark conspiracy somewhere.” Call me naive, but I’m inclined to actually believe that they believe what they say:
1. When eurozone inflation briefly rose above 2% in 2010-11, due to obviously temporary factors like VAT and oil price increases, they sharply tightened policy, insisting that unemployment didn’t matter. They needed to focus like a laser on inflation.
2. When inflation fell far below 2%, and indeed into deflation in several countries, we were told that falling prices are actually good, as they help restore competitiveness in the PIIGS.
I don’t think there is a model, just atavistic urges. Yes, Paul Krugman and I pull our hair out when we read these comments, but I see no reason to disbelieve them. Their words are backed up with actions. For 6 years they have acted exactly like a central bank that wanted to push inflation far below 2%. Keep in mind that eurozone NGDP is up less than 5% in the last 6 years—does anyone think that will lead to 2% trend inflation?
The ECB does not need to shoot for 4% inflation to get 2% inflation, they need to shoot for 2% inflation to get 2% inflation. I might add that the ECB has NOT been at the zero bound throughout the vast majority of the past 6 years. They’ve been doing “normal” monetary policy–raising and lowering their interest rate target. So one cannot point to the zero bound issue as an excuse for the ECB’s policy failure. They can’t even do normal monetary policy correctly. Outsiders have consistently pointed out that the ECB would fail to hit their target, and we’ve been consistently right. Second guessing the ECB is like taking candy for a baby, not even a fair contest. Look, everyone from Paul Krugman to Milton Friedman knew this wasn’t going to work. Here’s a Friedman interview back in 1999 in the Hoover Digest:
EPSTEIN: Do you think the European Monetary Union will be a success?
FRIEDMAN: I hope so, but I am very dubious.
EPSTEIN: Why so?
FRIEDMAN: Because the European Union is not an appropriate area for a single currency. There are some cases where a single currency is desirable and some where it is not. It is most desirable where you have countries that speak the same language, that have movement of people among them, and that have some system of adjusting asymmetric effects on the different parts of the country. The United States is a good area for a common currency, for all those reasons.
But Europe is the opposite in all these respects. Its inhabitants speak different languages, have different customs. And there is limited mobility between countries. The exchange rate between different currencies was a mechanism by which they could adjust to shocks that hit them asymmetrically—that hit one area differently from another. The Europeans have, in effect, entered into a gamble in which they have thrown away that adjustment mechanism. It may work out all right. But on the whole, I think the odds are that it will be a source of great trouble.
EPSTEIN: What kind of trouble?
FRIEDMAN: The trouble will not be for all of them. Some among them will be affected by developments that would have called in the past for a depreciation of their currency. But given that they are locked into a single currency, the alternative will be a recession.
The only mystery is why the Europeans are confused about why the euro has failed.
PS. Rereading Tyler’s post after writing this I’m not sure I actually disagree with him. I suppose aiming for 4% to get 2% might be consistent with incompetence. I’m not quite sure if I’m arguing that they don’t have a coherent policy, or that they wouldn’t know how to achieve it if they did, or both. All I know is that there is no technical mystery—if the steering wheel is set for ENE, don’t be surprised if the ship moves in a ENE direction. Even if the announced target is ESE.
PPS. Just saw the employment report. Wages flat in July, up just 2% in 12 months. We still have slack–we are in recovery mode. Unemployment can and will decline further.