What Are They Thinking?

The common European currency seems well on its way toward annihilation, and the demise is more likely to happen with a bang than a whimper. One might have thought that the looming catastrophe would elicit a sense of urgency in the statements and actions of European officials. “Depend upon it, sir,” Samuel Johnson once told Boswell, “when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.” So far, however, there is little evidence that minds are being concentrated, least of all the minds of those who really count, Chancellor Merkel and the European Central Bank (ECB).

As I pointed out in a previous post in August, the main cause of the debt crisis is that incomes are not growing fast enough to generate enough free cash flow to pay off the fixed nominal obligations incurred by the insolvent, nearly insolvent, or potentially insolvent Eurozone countries. Even worse, stagnating incomes impose added borrowing requirements on governments to cover expanding fiscal deficits. When a private borrower, having borrowed in expectation of increased future income, becomes insolvent, regaining solvency just by reducing expenditures is rarely possible. So if the borrower’s income doesn’t increase, the options are usually default and bankruptcy or a negotiated write down of the borrower’s indebtedness to creditors. A community or a country is even less likely than an individual to regain solvency through austerity, because the reduced spending of one person diminishes the incomes earned by others (the paradox of thrift), meaning that austerity may impair the income-earning, and, hence, the debt-repaying, capacity of the community as a whole.

I reproduce below a new version of the table that I included in my August post. It shows that from the third quarter of 2009 to the first quarter of 2011, NGDP for the Eurozone as a whole increased at the anemic rate of 2.95%. Eight countries (Luxembourg, Malta, Austria, Finland, Belgium, Slovakia, Germany, and the Netherlands) grew faster than the Eurozone as a whole, and eight countries (France, Italy, Portugal, Cyprus, Spain, Slovenia, Greece, and Ireland) grew less rapidly than the Eurozone as a whole. Guess which of the two groups the countries with debt problems are in. I have now added NGDP growth rates for the first, second and (where available) third quarters.

Comparing NGDP growth rates in Q1 with growth rates in Q2 and Q3 is instructive inasmuch as the ECB raised its benchmark interest rates by 25 basis points at the start of Q2 (April 13). In Q1, Eurozone NGDP rose by 5.01%, but in Q2, Eurozone NGDP growth fell to just 2.17%, with Q2 NDGP growth less than Q1 growth in every Eurozone country except Slovakia and Cyprus (Greece not yet reporting NGDP for Q2). On July 13, the ECB raised its benchmark interest rates by another 25 basis points. For the five countries (Austria, France, Germany, Netherlands, and Spain) already reporting NGDP growth for Q3, four had slower NGDP growth in Q3 than in Q1, with three reporting slower NGDP growth in Q3 than the average between Q3 2009 and Q1 2011. Rebecca Wilder has an important recent post with graph showing that the spreads between bonds issued by Belgium, Italy and Spain and bonds issued by Germany began increasing almost immediately after the ECB announced the increase in its benchmark interest rates on April 13, with the spreads continuing to increase in Q3. The connection between monetary policy, NGDP growth and the debt crisis could not be any more plain.

Nevertheless, there are those (and not just the Wall Street Journal) that seem to find merit in the unyielding stance of the Mrs. Merkel and the ECB. In his column last week in the Financial Times, John Kay, usually an insightful and sensible commentator, compares bailing out the insolvent Eurozone countries with a martingale strategy in which a bettor increases his bet each time he loses, in the expectation that he will eventually win enough to pay off his losses. Such a strategy only works if one has deep enough pockets to sustain the losses while waiting for a lucky strike. The problem in John Kay’s view is that the other side (the rest of the world) has deeper and can raise the ante to an intolerable level. Here is how Kay sums up the current situation:

Now the players look to the only remaining credible supporter. Surely the European Central Bank can enable them to see the night through. The ECB really does have infinite resources: if it runs out of money, it can print more.

Up to a point. Money created by a central bank is not free – if it were, we could all be as rich as Croesus. The resources of a monetary agency come either directly from taxpayers or indirectly from everyone through general inflation. To fund the bet the ECB would have to stand ready to buy, not just every Eurozone government bond issued so far, but any that might be issued. And more. . . .

Of course, say the advocates of this course, if only the banker would promise to underwrite our losses he would not actually have to pay. If you will only lend me a bit more money, says the gambler, you will get it all back, and more. That is the seductive song of the martingale.

The difference, of course, is that gambling is a zero-sum game. When the ECB is asked to print more money, the point is not to lend money with which insolvent governments can place a bet in the hope of winning enough to repay what they owe; the point is to create an economic environment conducive to growth. The inflation that John Kay finds so scary is actually the last best hope for all those creditors holding the sovereign debt of five or more Eurozone countries, debt increasingly unlikely, thanks to Mrs. Merkel and the ECB, ever to be repaid.

Before leaving the subject of inflation, I will make one further comment on German inflation-phobia. It is certainly true that the German hyperinflation of 1923-24 was a traumatic event in German history, undoubtedly leaving a deep imprint on the German national memory. Although a deep aversion to inflation has been a constant feature of German economic policy since World War II, it is also true that inflation in Germany for the past three years has been at or near its lowest level since the end of World War II. Nor is there much doubt that German inflation hawkishness has increased since the creation of the ECB, Germans becoming more sensitive about the danger of inflation created by a non-German institution than they were about inflation produced by the good old German Bundesbank. Conversely, the ECB has been all too eager to show that it can be even more hawkish on inflation than even a German central bank.

But have a look at German inflation in historical context. Here are two charts presenting German CPI. The first shows the annual change in the CPI in Germany from 1951 to 2009.

The second shows the year-on-year change in the CPI by month from January 1961 to October 2011.

The charts are instructive in showing that even in the heyday of the German Wirtschaftswunder from 1950 to 1966 under conservative governments headed by Konrad Adenauer and then by Ludwig Erhard (friend and disciple of Hayek, member of the Mont Pelerin Society, and the acknowledged architect of the Wirtschaftswunder) the rate of inflation was often above 3%. For long stretches of time since 1950, Germany has had inflation above 3%, sometimes over 5%, nevertheless managing to avoid the political and economic disasters that, we are now told, supposedly follow inexorably whenever inflation exceeds 2%.

A similar story is told by the third chart showing the German GDP price deflator measured quarterly since 1971. The price deflator is now running at the lowest rates in 40 years.

Is the risk to the German economy from a rate of inflation closer to the mean rate of the last 40 years, say 3-4%, really so intolerable? What are they thinking?

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15 Responses to “What Are They Thinking?”


  1. 1 Lorenzo from Oz November 28, 2011 at 12:08 am

    The answer to the question of how stupid can a central bank be seems to be, pretty stupid: even disastrously so.

  2. 2 Lars Christensen November 28, 2011 at 1:19 am

    David, once again you are so very right – as usual that is rather depressing. I am equally frustrated that it seems so hard for people differentiate between increasing NGDP level and growth expectations and “bailing out” certain nations. Would there really be a euro crisis if the ECB would just focus on NGDP level target? If it did so then individual countries’ problems would be exactly that – the problem of individual countries rather than a systemic problem.

  3. 3 Luis H Arroyo November 28, 2011 at 2:45 am

    You don´t have an idea of what minuscule and erroneous is the sense of break up risks between european professionals. Generaly they think that if each country reduces its debt, the problems would be solved. So, it is not a question for the ECB, is a question for each peripherical countries.
    Yes there is a lot of people concient de la gravedad, but they omit the ECB as main responsable.
    The euro is a very profound sentiment of been the cuase of stability, which is curious because it has not prevent inflation nor financial instability; quite the opposite, euro has amplified the problem of the banks and bond markets.

  4. 4 MG November 28, 2011 at 12:03 pm

    Since my name was invoked in this post, I must make a comment.

    “What are they thinking?”

    They are thinking that, if the euro goes down, THEY (Germany) will make out fine, whereas if they take action, THEY (the politicians) will get tossed out by the voters, even if what they do succeeds (succeeds for Europe, mind you, not for Germany — no matter what else happens, Germany is going to come through this better than the rest of the Eurozone). The same is true for the rest of the politicians in the countries likely to muddle through this in OK shape. Even if they do what you and I think of as the right thing, and it works, they’ll be pilloried in their home countries as profligates.

    I confess I was for the Euro way back when, thinking it represented some kind of progress towards a more cohesive, unified world. My one concern, and it was slight, was that Germany would wreck the thing by being irrationally tightfisted when it counted, but I thought they were too smart for that, and that the combined weight of the rest of the EU would force their hand, anyway. Boy, was I ever wrong.

    Their tightfistedness isn’t even irrational, when you look at it from a purely political angle. How many austerity-pushing politicians in a still-healthy country have lost their jobs? The only ones to go so far are in Greece and Spain, countries whose economies are falling apart — and they were both replaced by politicians even more austerity-minded than the ones kicked out. Austerity is a short run political winner, it seems, even if it’s stupid, destructive policymaking. It makes perfect sense, if you assume politicians are less interested in the public good than they are in their electoral prospects.

  5. 5 David Pearson November 28, 2011 at 3:58 pm

    “The inflation that John Kay finds so scary is actually the last best hope for all those creditors ”

    Default or inflate: these are, indeed, the only two options on the table. The trouble is, MM’s are not really proposing either. Instead, they are proposing a modest increase in inflation for a couple of years, all done while leaving the l.t. trend (2%) intact. Is this really enough real debt reduction to get Europe out of its debt problems? If so, then clearly they were not so large to begin with. If they were not so large to begin with, then markets must be wrong. If markets are wrong, market monetarism does not work.

  6. 6 Lorenzo from Oz November 28, 2011 at 9:07 pm

    David Pearson: surely the MMs are proposing an increase in income. Some of this will be a rise in the price level beyond any increase in output, but they are not proposing inflation as “the solution”.

    This seems to be a case of, as Bill Woolsey points out, Market Monetarists treat nominal GDP as something that really exists–the flow of money expenditures on current output. Critics treat nominal GDP as the product of real output and the price level. This notion of money as some epiphenomenon is unfortunate at the best of times, but is particularly unfortunate when considering debt.

  7. 7 David Pearson November 28, 2011 at 10:16 pm

    Lorenzo,
    I cited David’s quote, “…inflation…is the last best hope.” Beyond David, I believe other MM’s have consistently argued that the Fed should boost inflation expectations.

    BTW, the same argument applies: would a modest, temporary acceleration in European NGDP eliminate the markets’ concerns over the banking system and fiscal deficits?

  8. 8 Will November 28, 2011 at 11:45 pm

    I have a film script. A group of renegade economists labors to resurrect the eminently competent German central banker Hjalmar Horace Greeley Schacht as a last-ditch effort to save the euro. The reanimated Schacht is fully weaponized, and unleashed on the ECB. Audiences gasp at Schacht’s persistent efforts to infiltrate the dysfunctional institution, which is ultimately successful. Having bested Mario Draghi, Schacht saves the euro by introducing a fictional second currency. And then he gets the girl!

    Sadly, I don’t see anything short of such magical thinking saving the euro.

  9. 9 Lorenzo from Oz November 29, 2011 at 12:35 am

    David Pearson: yes, but the focus is still on raising nominal income. As for evidence about what it might do to reassure markets, David Beckworth has that covered.

  10. 10 Benjamin Cole November 29, 2011 at 5:19 pm

    The increasing fixation and hysteria about any rate of inflation is a puzzling trait of our time.

    Forget that even accurately measuring inflation is the subject of valid debate. Forget that the USA prospered mightily from 1982 to 2008 with mild and varying inflation. Forget that Japan has beaten inflation since 1990, and has been a pitiful backslider nearly the whole time.

    To a large portion of economists and policymakers, nothing matters except that we hold the line on inflation.

    When did this obsession—this unhealthy fetish—with inflation become the central characteristic of our macroeconomic authorities? Is it because we lack other, real foes, such as the USSR? The need for a “enemy” has transferred itself to inflation and the imagined wrongdoing of weak-kneed central bankers and their liberal enablers?

    Jeez, I prefer prosperity, and I will endure some inflation. That is the way of the real world. Utopia is the next stop—unless you are a central banker in Japan. You are in utopia now.

  11. 11 David Glasner November 30, 2011 at 9:31 am

    Lorenzo, Yep, that does seem to be the answer.

    Lars, Have a look at today’s editorial in our favorite publication the Wall Street Journal, and weep.

    Luis, People can’t seem to grasp the obvious fact that there is more to the debt crisis than irresponsibility by the borrowers. Taking any step that will ease the pain of the borrowers is thus viewed as a form of moral hazard.

    MG, All this time and I didn’t know who you really are. To introduce a new distinction, there’s a difference between real economics and folk economics. The great unwashed, believers in folk economics, believe that austerity is the solution, and the politicians are giving them what they want.

    David, The current rate of NGDP growth in the eurozone is in the 2-3% range. So I don’t think it’s correct that market monetarists are advocating only a temporary increase in NGDP growth for the eurozone. Thanks to the wonders of compound interest even a 2% increase in the growth rate of NGDP could do a lot to reduce the debt problem.

    Will, I say go for it.

    Benjamin, To adopt a Hayekian perspective for a second, the question is when does monetary policy have a neutral affect on the operation of the economy. There are circumstances where easier monetary policy (faster increase in NGDP) results in faster growth in RGDP. The “discovery” that there is a long-run vertical Phillips Curve was really a discovery that above some (undetermined) rate of inflation, the Phillips Curve becomes vertical. You can’t observe the whole Phillips Curve, so the logic that says that Phillips Curve is vertical above that minimum (unobservable) rate of inflation does not show that the Phillips Curve is not upward sloping at very low or negative rates of inflation (at least under some circumstances). The trick is to find that sweet spot on the Phillips Curve at the minimum inflation rate on the vertical segment.


  1. 1 Sumner and Glasner on the euro crisis « The Market Monetarist Trackback on November 28, 2011 at 12:05 pm
  2. 2 BullseyeMicrocaps.com » Euro Explanations Trackback on November 29, 2011 at 12:44 am
  3. 3 What Are They Thinking? | poleconomix.gr Trackback on November 29, 2011 at 6:40 am
  4. 4 Japan’s 2-Decade Experiment with Fiscal Austerity and 0.7% NGDP Growth « Uneasy Money Trackback on February 13, 2012 at 7:37 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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