Can Inflation Cure the Eurozone?

Does the eurozone need a dose of higher (but still generally low) inflation to help solve its economic and financial quandary? The word coming out of the International Monetary Fund’s (IMF) Global Financial Stability Report released Wednesday suggests the answer is a qualified “yes.”

The Financial Times notes that the IMF has again called for interest rate cuts by the European Central Bank (ECB), while further recommending additional liquidity injections through the newly created Long- Term Refinancing Operation (LTRO) and more sovereign bond purchases.

That is not necessarily a prescription for inflation, of course. But the IMF has flagged the risk of a deflation-debt spiral in Greece, Ireland and Spain — three countries receiving IMF support — and the article reported that the IMF has forecast that “inflation was likely to fall below the ECB’s target — below but close to” 2% to 1.5% in 2013.

Germany’s historically based fear of inflation aside for the moment, wouldn’t a modest uptick in European inflation make it easier for indebted countries, companies and individuals (and the banks they owe money to) to retire debt? And even if toggling the inflation switch up a notch is politically a non-starter, shouldn’t eurozone officials at least be very afraid of falling below the target, given the risks of deflation?

“This is precisely what I, and many others, have been saying,” says Wharton management professor Mauro Guillen. “Growth must come first, and debt reduction and fiscal balance later. The problem is that the politicians have no credibility. So the markets think that they will get growth now and forget about fiscal discipline later. It’s essential that Germany and the ECB help change that perception so that European countries in the periphery can start growing again.”

But despite a ringing deflation warning from the IMF — known for advocating relatively mainstream economic remedies — on the importance of maintaining adequate liquidity, the ECB seems squarely focused on an inflation threat, based on one of its first public statements following the IMF report.

Peter Praet, of the ECB’s executive board, made it clear in a speech to Germany’s finance ministry on Thursday, the day after the release of the IMF report, that containing inflation will continue to be a key policy at the multilateral bank. While acknowledging that the current crisis in Europe is “exceptional” and a real threat to the prosperity of the region and the world requiring a “forceful response,” he said many factors limit the range of official response regarding any increase in liquidity.

For one thing, the weak budget positions of many countries place “severe constraints on the capacity of governments to – somehow – spend their way out of the crisis.” Even in the face of calls for more action from monetary authorities, and presumably from organizations such as the IMF, Praet said, “we cannot afford to take measures that entail the risk of adverse economic consequences, such as moral hazard in fiscal policies or an unanchoring of inflation expectations.”

Wharton finance professor Franklin Allen points out that many observers believe that a dose of mild inflation, particularly in Germany, would be an effective adjustment policy. “It would also be much less painful than having prices fall in the periphery countries.” But this “assumes that the ECB can easily control the inflation level. This is quite difficult in the current environment. They may well end up increasing asset price inflation rather than consumer price inflation,” creating another bubble. The ECB  could also overshoot. “Even if they are successful, there is likely to be an adverse political reaction in Germany. So my guess is that the ECB will not try to do this.”

This all comes against a background of a huge bank deleveraging in Europe, according to the IMF report, that could drastically reduce the amount of credit banks can offer to businesses — an additional reduction in liquidity that could tamp down economic growth. Sovereign risks, weak euro-area growth, high rollover requirements and the need to strengthen capital cushions are forcing banks to shrink their balance sheets “by as much as $2.6 trillion (2 trillion euros) through [the end of] 2013, or almost 7% of total assets,” the report notes. “[Our] estimate is that about one-fourth of this deleveraging could occur through a reduction in lending.”

The IMF projects global economic growth at 3.5% in 2012, up 0.2 percentage points from its forecast at the beginning of the year. It projects a 0.3% contraction for the eurozone economy, a bit improved over the 0.5% contraction forecast in January.

Christine Lagarde, managing director of the IMF, recently discussed the merits of austerity measures in an exclusive interview with Knowledge@Wharton.

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