No eurozone mystery

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.



33 Responses to “No eurozone mystery”

  1. Gravatar of Frances Coppola Frances Coppola
    1. August 2014 at 04:54

    Goodness. A post with which I can 100% agree! The only thing I would add is that it is evident to me that the ECB is politically captive in a way that – oddly enough – other central banks are not. In trying to enshrine its independence and enforce the strict separation between fiscal and monetary policy that is essential when you only have monetary union, Eurozone policy makers have made it near-impossible for it to do its job.

  2. Gravatar of Lorenzo from Oz Lorenzo from Oz
    1. August 2014 at 04:58

    What feedback mechanisms does the ECB have? It is structurally an amalgam of various central banks while being functionally an uber-Deutschbank. The German economy is doing fine, so what feedback mechanisms exist to make them think at all differently? “Inflation bad” is a simple yardstick in a central bank where functioning at all is a success and a common bureaucratic culture has to be built out of something not too difficult.

    So, yes, I agree, we should presume they mean what they say and what they say (and do) represents the lowest common denominator thinking to give the institution internal coherence.

  3. Gravatar of Luis Pedro Coelho Luis Pedro Coelho
    1. August 2014 at 05:04

    This discussion is in terms that do not reflect how eurozoners think. It’s like you’re discussing why 19th century doctors don’t wash their hands after coming from the morgue and all the doctors look at you and ask “but should we open or close the windows?” [*]

    For example, here is a recent Eurozone (English-language) article on low inflation. The tone is that it’s a good thing that inflation is at 0.85%:

    This is from Wort, the main Luxembourgish newspaper. Small country, yes, but this is probably the newspaper that Jean-Claude Junker [EU Commission President] reads. At least his aides do (they probably reads the German/French print edition, though).

    I mean, Scott, why do you want to make life more expensive? It’s bad enough that unemployment is so high.

    *: As I’ve heard it, at the time that Semmelweis was ridiculed for stating that doctors should wash their hands after dealing with dead people the big discussion was about “austerity”. I mean, whether you should open the windows (to let out the bad humors from the sick) or close them (to keep out the bad humors).

  4. Gravatar of John Thacker John Thacker
    1. August 2014 at 05:56

    Yes, most American economists said that the Euro wouldn’t work because of, among other things, optimal currency area considerations. Why, here’s some European economists in Economics in Practice laughing at American economists for saying that the Euro would have problems from 1989-2002.

    Not sure if they’re still laughing now.

  5. Gravatar of Luis Pedro Coelho Luis Pedro Coelho
    1. August 2014 at 06:49

    Truth be told, though, the euro is not failing from not being an optimal currency zone. It’s failing from brain-dead monetary policy.

    Perhaps non-optimal currency zones need higher NGDP trend rates, but even optimal currency zones need a better central bank than the ECB.

  6. Gravatar of Sven Sven
    1. August 2014 at 06:58

    Scott, what do you think are the actual reasons for the asymmetrical shocks of – say – germany and spain?
    Is it only that spain was more leveredged than germany and so was more prone to the demand shock of the ECB tightening in 2008?
    If so, the underlying reason for the euro crisis was not a demand shock per se, but the difference in building up of leveredge in the different euro countries (and of course one can see similiar differences in the US, like texas and california).
    Which would bring us to the next question of why such stark differences in leveredge is actually possible in the first place.
    I think these are the questions that cannot be answered by refering to monetary policy failures (at least not if one rejects the austrian business cycle).

  7. Gravatar of bill bill
    1. August 2014 at 07:24

    I love the comment at 6:49 by Luis Pedro Coelho!

  8. Gravatar of John Thacker John Thacker
    1. August 2014 at 07:49

    I think that a non-optimal currency area means that the effects of monetary shocks are not uniformly distributed.

  9. Gravatar of Frances Coppola Frances Coppola
    1. August 2014 at 08:12


    There is extensive literature on the way in which the creation of the Euro without political & fiscal union and with inadequate institutions caused what is in many ways a massive balance of payments crisis. Higher interest rates in the periphery caused capital to flow from core countries into the periphery, supported by an expectation (encouraged by the ECB) that there was no difference in risk despite the interest rate differential. The capital inflow to the periphery manifested itself in different ways in different countries – construction booms and overheated property markets in Spain and Ireland, high levels of sovereign debt in Greece and Italy. But the effect, as you say, was the buildup of leverage in periphery countries, funded by investment from core countries and mostly channelled through core country banks. When the financial crisis hit, followed by the Eurozone crisis, those capital flows abruptly reversed, causing property market collapses and banking crises in Ireland and Spain, and sovereign debt crisis in Greece and Italy. The one-size-fits-all monetary policy in an inadequate currency union of this kind cannot address such internal imbalances without causing higher inflation in the dominant core country – which means accepting a higher inflation target across the entire Eurozone. So far, the hard-money enthusiasts at the ECB (well, Buba really) have been completely unwilling to accept any softening of the inflation target. As Luis says, they LIKE falling inflation.

    This is only one of a number of readily-available papers on this subject:

  10. Gravatar of mpowell mpowell
    1. August 2014 at 08:28

    I was also a little surprised by Cowen’s comments because the explanation seems so simple.

    I will add this though: if the ECB has a change of heart about what they really want, they’ll have to work extra hard to convince people of it. Right now their target is: keep inflation under 2% at all costs. If they want to change that to: get trend inflation as close to 2% as possible, they will have to take some exceptional steps. They will hit the lower bound and I’m not sure ‘forward guidance’ will work because nobody will believe them. So they would definitely need OMO for a while. In the long run they might be able to persuade people of their new goals and get there just using rates.

  11. Gravatar of Sven Sven
    1. August 2014 at 08:54


    thank you, that sounds plausible. I will have a look at the paper.

    But still, this somehow runs contrary to market monetarists core argument, that the whole mess was caused in the first place by monetary tightening in 2008, while in reality, the mess was caused by having very uneven household leverages in different countries, that simply didn’t allow the ecb at all to constraint inflation without crushing the periphery. The same wouldn’t have happened if the leverages across countries would have been more even, because then a moderate tightening could have constrained inflation *without* causing too much trouble in some countries.

    Also, I don’t quite understand your sentence that the ecb encouraged an expectation that there was no difference in risk. Can you describe the channel how the ecb can actually achieve this? I heard this argument before, but have never actually seen a consistent explanation for this.

  12. Gravatar of Sven Sven
    1. August 2014 at 09:02

    After having a look at the paper you provided, it seem to me that it contains too many arguments that are footed on investor’s psychological factors to be consistent with market monetarists or Milton Friedman explanation. 😛

  13. Gravatar of Major.Freedom Major.Freedom
    1. August 2014 at 09:03

    Everyone who believes in monetary socialism are, quite frankly, equally stupid.

    Luckily, there are millions of people who aren’t that stupid.

  14. Gravatar of Philippe Philippe
    1. August 2014 at 09:31


    “…that have some system of adjusting asymmetric effects on the different parts of the country.”

    What did Friedman mean by this?

  15. Gravatar of Frances Coppola Frances Coppola
    1. August 2014 at 09:51


    As I said, that is only one of many papers and not necessarily the best. I will try to find some more. However, psychological factors DO matter.

    It really is not good enough for market monetarists to claim that there would have been no crisis if central banks had not tightened policy in 2008. The private and public sector leverage buildup in the Eurozone periphery was unsustainable long before then: even if there had been no American crisis, the Eurozone would still eventually have fallen apart. We need to understand why the leverage built up in the first place. Arguably the ECB’s monetary policy was too loose during the early to mid-2000s, which encouraged periphery countries to borrow – yes they paid more because of the risk premium, but rates were low generally and investors were looking for returns. But remember that the inadequacy of the Euro’s constitution means that monetary policy in effect is driven by Germany’s needs. Germany needed loose monetary policy at the time to offset the fiscal consolidation of the Hartz reforms. The price that was paid for that was the leverage buildup in the periphery. Had the periphery operated tighter fiscal and macroprudential positions at the time, resulting in lower imports, Germany would not been able to develop its export-led economy as it did: at the time of the Eurozone crisis, 40% of its exports went to other Eurozone countries. Spain is particularly tragic, because the Bank of Spain DID attempt to restrict capital inflows through macroprudential policy, and Spain’s fiscal stance prior to the crisis was by no means profligate. The problem is that the central banks in the Eurosystem are emasculated and unable to protect their economies from local shocks.

    On the risk point: prior to the crisis, the ECB made it clear that it regarded all Eurozone sovereign debt as being of equal risk, regardless of its origins. Risk spreads on corporate debt were therefore due to corporate fundamentals: the sovereign risk element was deliberately kept small. The ECB had to do this because otherwise Euros in different parts of the union could not possibly be regarded as of equal value. However, since the crisis, it has become very clear that Eurozone debt is NOT all of equal risk. We have not yet really taken on board the damage that this does to the entire concept of a single currency, but if you recall that debt is simply a future claim on money, then it becomes obvious that if debt issued by say Greece is regarded as far more risky than debt issued by Germany, the integrity of the single currency is at risk. This is why OMT was MONETARY policy, not fiscal: the yields on government debt across the Eurozone had to be brought down or the currency itself would have fragmented.

  16. Gravatar of Benny Lava Benny Lava
    1. August 2014 at 12:18

    Yeah it is pretty clear that the ECB was was practicing regular old monetary policy. There are two graphs which demonstrate this pretty well:

    Isn’t Draghi Italian? And Trichet French? Why sabotage your own country?

  17. Gravatar of Jason Smith Jason Smith
    1. August 2014 at 13:03

    Tyler Cowen asks for the most economical model; I propose that there is a maximum level of inflation i* for a given economy. If your target is below it, inflation targeting works fine. If it is above it, then all you get is i*.

  18. Gravatar of TravisV TravisV
    1. August 2014 at 13:48

    Jason Smith,

    What is your take on Sumner’s idea of “monetary offset”?

    Imagine that the Obama fiscal stimulus hadn’t been implemented in 2009 and 2010. Would the U.S. unemployment rate be higher or lower today?

  19. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. August 2014 at 14:28

    Speaking of stupidity, what about this summer camp for financial regulators;

    It’s costing the Alfred P. Sloan Foundation $2 million. One of the instructors is quoted;

    ‘Mr. Gorton said the discussions have identified more obstacles than answers. “What surprised me is just how difficult these problems are,” he said after witnessing some of the exchanges about international cooperation. “You get kind of depressed pretty quickly.”‘

    A copy of Calomiris and Haber’s ‘Fragile By Design’ is only $25 on Amazon. And this blog is free. Both of which are probably more productive of heading off future financial crises.

  20. Gravatar of benjamin cole benjamin cole
    1. August 2014 at 16:17

    Central bankers cannot be left in charge of monetary policy. Independent central banks become cloistered, dogmatic, peevish.
    Besides, a democracy should have transparent and accountable public agencies.
    The Fed should be embedded into the Treasury Department. The ECB disbanded.

  21. Gravatar of Major.Freedom Major.Freedom
    1. August 2014 at 17:23

    Benjamin Cole:

    In a democracy, the government is legally not to be held accountable to those not in the group of majority voters. Legally, they are held accountable only to the majority.

    And by majority let that not be confused with 51% of the population. It is 51% of those who voted. If 40% vote, then 51% is about 21% of the whole population.

    Democratic institutions are actually not accountable at all in the sense of universal ethics and morality applicable to everyone. They can be evil and corrupt, genocidal even, and they would be acting perfectly within the morally legitimate bounds of democracy – as long as they garner the most “votes”. And, what is more, institutions whose purpose is to fight these injustices head on, would be necessarily anti-democratic and immoral from a democracy perspective.

    If for example a private army were hired by Palestinian or Israeli civilians to defend them from their own democratically elected governments committing war crimes, the governments would be legally not accountable to these armies, and would be within their democratic rights to annihilate them so that their bloodbaths can continue.

    What boggles my mind to no end is how religious the furvor is for democracy. Democracy is just communism with open to the public as opposed to closed to the public government. Majorities can vote to violate the rights of the minority. Nobody’s property is legally safe in democracy.

  22. Gravatar of Tommy Dorsett Tommy Dorsett
    1. August 2014 at 17:23

    Meanwhile, the euro area monetary base continues to contract. Inflation expectations are on the floor and did not respond to the most recent ECB ‘easing’ move. Full blown Japanification is setting in due to acts of commission on the part of the ECB.

  23. Gravatar of Nick Nick
    2. August 2014 at 04:24

    That’s a lovely thought, and I can see why it’s appealing to think it would work. But, honestly, in the US both the executive and legislature have many ways of trying to influence the central bank already (statutory independence or no) and there has been no evidence of either leaning on the Fed in a productive fashion. And instead of passing ARRA, they could just have easily passed a law loosening monetary conditions even though its is not ‘their job’. Almost no one inside the political process has shown much of a clue about the source of our problems is or how to turn things around.

  24. Gravatar of TravisV TravisV
    2. August 2014 at 04:46

    Great stuff by James Caton:

    “A Critique of Phillips, McManus, and Nelson on Central Bank Demand for Gold and the Initiation of the Great Depression”

  25. Gravatar of Morgan Warstler Morgan Warstler
    2. August 2014 at 04:53

    This is perhaps TC best sentence ever.

    When “selfish” and “law-abiding” point in the same direction, that is very often what you will get.

    I recently did a post on “Do Progressives Fake Naïveté?”

    Given that states and their founding laws / structures are formed by hegemons holding power before the state is formed, a lot of progressive “logic” is really solely the provenance of revolution, reverting to SoN and making a new State.

    This doesn’t mean progressives can’t have “goals” – but logically you are either going to be asking compromising with the current state OR be going for a toppling.

    Note the hegemons the top 1/3) are far more comfortable talk about secession, new C conventions, armed standoffs and having 300M guns. They whip that revolution card out ALL THE TIME.

    Progressives meanwhile use logic that assumes a ton of make-believe things, and then sit around and talk about it in academia, but none of this conversations is REAL.

    MM can PASS. Why? Because we can, if we actually try, get the top 1/3 to demand it.

    MMT is junk. Why? Because the top 1/3 will never even discuss it.

    GI as a wage subsidy can PASS.

    Free money will never get into the debate.

    But progressive talkers routinely drop their ideology masks, and get realpolitik, with their readers, but never want to do explainers like this:

    TEN HARD COMPROMISES Vox staff would make to fix Obamacare.

    Obama will be sending immigrant kids home, here’s why.

    Frances would write:

    “If to get a GI done, we have to accept a work requirement (GICYB), thats much, much better than status quo.

    Eventually to be serious person, you have to horse trade, so you can stop being a media brand, and get some changes made now.

  26. Gravatar of TravisV TravisV
    2. August 2014 at 07:51

    Brad DeLong on Nick Rowe vs. Simon Wren-Lewis:

    “I am on Simon Wren-Lewis’s side, and am in fact even more on his side than he is.”

  27. Gravatar of Daniel Daniel
    2. August 2014 at 09:17

    DeLong’s answer is such a fine exercise in circular logic.

    Is that the outcome of an economics education ? Assuming A to prove A ?

  28. Gravatar of ssumner ssumner
    2. August 2014 at 15:36

    Luis, You said;

    “Truth be told, though, the euro is not failing from not being an optimal currency zone. It’s failing from brain-dead monetary policy.”


    Sven, You said:

    Scott, what do you think are the actual reasons for the asymmetrical shocks of – say – germany and spain?
    Is it only that spain was more leveredged than germany and so was more prone to the demand shock of the ECB tightening in 2008?
    If so, the underlying reason for the euro crisis was not a demand shock per se, but the difference in building up of leveredge in the different euro countries (and of course one can see similiar differences in the US, like texas and california).”

    This is the same mistake the euro-elites are making. When you look at the difference between one country and another, within a single currency, you look at real factors. When you look at the poor performance of the overall currency zone, you focus on nominal shocks.

  29. Gravatar of Lorenzo from Oz Lorenzo from Oz
    2. August 2014 at 20:03

    TravisV: I would have a simple answer to Brad DeLong: income expectations.

  30. Gravatar of Vaidas Urba Vaidas Urba
    3. August 2014 at 03:22

    Scott: “I see a simple explanation, the ECB really is as stupid as they seem. … I don’t think there is a model, just atavistic urges”.

    The real scandal is that there was a model in 2011. The ECB did what Taylor Rule was recommending at that time ( ), they did what their forecasts recommended. The vote to increase the interest rates was unanimous. Surprisingly, until the summer of 2011 markets did not react negatively to the rate hikes.

    Good news is that the ECB has changed the model it uses. Here are some excellent recent statements by Sabine Lautenschläger, German member of ECB’s executive council: “For me, keeping the downward gap to the benchmark within limits is therefore part of the price stability mandate in order to firmly anchor inflation expectations and reduce the risks of deflation.

    Despite this more quantitative definition of price stability, monetary policy is not a mechanistic process. The decisions as to what monetary policy measure to take and whether it is the right one depend on the causes of the very weak price developments. For example, is sluggish lending weakening demand? Do the weak price developments reflect necessary adjustment processes in the crisis countries? Or are fluctuating oil and food prices driving the sharp fall in the rate of inflation?

    Oil and particularly food prices more recently have indeed played a key role in inflation developments in recent months. And the increases in prices of services are also tending to decline, all in all, even if it is likely that this can mainly be attributed to developments in the crisis countries.

    Such price changes are normally only reflected in the inflation rate temporarily. Monetary policy therefore does not normally react to temporary oil or food price developments. The fact that our mandate is geared towards the medium term allows us to look beyond such short-term developments.

    So why did we deem it necessary to act? In the current situation, keeping a steady hand on the tiller would have endangered our mandate of maintaining price stability.

    After all, the interplay between falling oil prices, an appreciating currency and a very faltering recovery in demand in many parts of the euro area masks the risk of a phase of very low inflation lasting too long. This can lead to market participants adjusting their inflation expectations. They would then no longer be geared to our target of below, but close to, 2%, but perhaps to the prospect of very low rates of inflation. The example of Japan shows that such a decoupling can directly endanger price stability. Falling inflation expectations may become firmly established in lower wage settlements, triggering a spiral of falling prices and expectations that would be difficult to escape. The risk is then that prices fall so sharply that, for example, consumers postpone their purchasing decisions because they expect prices to fall even further, and companies put off investment. This does not just harbour considerable risks for price stability in the euro area; deflation also increases real debt, thereby impeding debt reduction, including the reduction of private debt.

    Now many critics of the low interest rate policy point out that low prices are the consequence of the necessary adjustment processes in the crisis countries. And these critics rightly argue that, in a similar way to short-term fluctuations in oil and food prices, such adjustment processes within the euro area seldom require a monetary policy reaction. They are not normally reflected in the average rate of inflation for the euro area in the medium term. Rather, the issue here is relative price changes.

    Germany, too, went through this kind of reform process a number of years ago. As a result, wage and prices in Germany were below the euro area average for a long time. Back then, however, Germany was already able to improve its competitiveness thanks to low inflation, while rates of inflation in many other Member States were higher than that specified in our definition of price stability. Overall, though, inflation in the euro area was close to our benchmark.

    However, the situation today is different. Even in Germany, inflation is and remains very low – it stood at 0.6% in May and 1% in June. Prices and wages in the crisis countries therefore need to fall even more sharply in order to make up competitive disadvantages. This in turn makes economic recovery in these countries more difficult and may therefore exert further downward pressure on prices. Then we soon find ourselves in a vicious circle in the euro area.”.

  31. Gravatar of ssumner ssumner
    3. August 2014 at 11:56

    Vaidas, Another reason to discard the Taylor rule.

    I see both good things and bad things in that statement:

    “For example, is sluggish lending weakening demand? Do the weak price developments reflect necessary adjustment processes in the crisis countries?”

    This is not good.

  32. Gravatar of Jason Smith Jason Smith
    3. August 2014 at 12:50


    In my analysis, the ARRA took 2.5% off the peak unemployment rate (roughly consistent with other analyses, also presented):

  33. Gravatar of Jason Smith Jason Smith
    3. August 2014 at 12:56


    Pressed submit too quickly … In my view monetary offset can happen when inflation is high relative to monetary base growth, but not when it is low relative to monetary base growth (another way of saying that in my model is that the information transfer index is low and high, respectively). This shows the different policy regimes:

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