Does it have to be “close to, but below two percent”?

I have previously referred to the dangers of a new “impossible trinity” for the euro zone: avoiding its disintegration; avoiding a significant move towards fiscal integration; and avoiding any relaxation of the current definition of price stability.  In Wednesday’s post, I held out hope that stronger mutual insurance mechanisms could follow credible mutual assurances of disciplined policies.   Here I want to revisit the possibility of relaxing current definitions of price stability.   I realise this is taboo – but one I believe has to challenged given the nature and extent of the challenge facing the euro zone. 

The move to formal inflation targeting in the euro zone, Canada and the UK (as well as informal inflation targeting in the US) followed the traumas of the stagflation of the 1970s, not least the expensive efforts in terms of lost growth and employment to bring inflation down in the 1980s and 1990s.  However, while it is understandable that governments would not want to squander such expensively bought gains, the danger is that policymakers end up fighting the last war. 

The particular constellation of problems in the weaker euro zone economies means that it will be very difficult – maybe impossible – to pull through the crisis under current arrangements.   The boom-bust cycle in capital inflows have left a number of countries with current account deficits that cannot be financed.   There is no alternative to adjustment.   Given nominal rigidities, internal devaluation is a slow and costly process, requiring deep recessions to curb the demand for imports and induce the necessary wage/non-traded price cuts.   Slow growth further undermines the creditworthiness of States and banking systems, creating damaging negative feedback loops.   The euro zone may not survive the trauma under current policies.   A higher inflation target could lower the costs of adjustment. 

The danger is that the protection of hard-won low inflation becomes a mantra, preventing a broader reconsideration of the appropriate macroeconomic regime for the euro zone that properly reflects the full range of challenges being faced.  Good macroeconomic management could become a victim of its own past success in institutionalising a low inflation-targeting regime.   The question is whether it is possible to maintain much of the achievement of inflation targeting, while putting in place a macroeconomic regime that is consistent with a path through the crisis that avoids a disintegration of the euro zone. 

It is important not to lose sight of the strong case for inflation targeting.   The benefits are not limited to low and stable inflation.  (See, for example, this account from the Bank of Canada.)  By anchoring inflation expectations, a credible inflation targeting regime allows central banks the freedom not to have to respond to temporary supply-driven jumps in prices – due, say, to oil price or other commodity price shocks.   If inflation expectations are not well anchored, central banks may have to tighten policy because of they fear second-round inflation change effects, which would result from the temporary inflation shock becoming embedded in inflation expectations.   A credible inflation targeting regime can therefore have important benefits in terms of output and employment stability.   (The financial crisis has made it clear that central banks put too much faith in the sufficiency of inflation targeting, taking a too relaxed attitude to the build up of financial vulnerabilities due to excessive credit growth.   But this is not an argument against inflation targeting per se.   Rather it points to the need to use other instruments – including macro prudential tools – to ensure stability. )

The key question is whether the benefits of an inflation targeting regime could be obtained with a higher inflation target.   While there are risks to increasing an inflation target, the institutional structures of an independent central bank with an unambiguous mandate to achieve the inflation target over the medium run should allow the important benefits of an inflation-targeting regime to be protected.  

With the euro zone facing an existential threat, it is not enough to repeat mantras about the benefits of price stability.   Recognising the full range of objectives – including the value of a credible inflation targeting regime – it is time to reconsider the appropriate inflation-targeting regime for a euro zone in crisis.

In which Paul Krugman and Ken Rogoff agree on many things, and Krugman displays the patience of a saint

Jeremy Paxman may have been disappointed by the extent to which Krugman and Rogoff agreed in tonight’s Newsnight programme, despite his having helpfully set up their conversation by asking Rogoff if the big problem was demand or debt. But the pro-austerity (or was that small government? and did they understand the difference?) pair at the end were straight out of central casting. Well worth watching, also for a reminder of just how utterly parochial and blinkered Irish debate on the eurozone crisis, and plausible solutions to that crisis, has been.

Boone, Johnson and Wolf on the euro zone’s future

Peter Boone and Simon Johnson raise an alarm here.  

Martin Wolf reviews Germany’s options here.   From Martin’s piece:

Now turn to the second issue: how does Germany want the euro zone to be organised? This is how I understand the views of the German government and monetary authorities: no euro zone bonds; no increase in funds available to the European Stability Mechanism (currently €500 billion); no common backing for the banking system; no deviation from fiscal austerity, including in Germany itself; no monetary financing of governments; no relaxation of euro zone monetary policy; and no powerful credit boom in Germany. The creditor country, in whose hands power in a crisis lies, is saying “Nein” at least seven times.

How, I wonder, do Germany’s policymakers imagine they will halt the euro zone’s doom loop? I have two hypotheses. The first is that they believe they will not. They expect life for some of the vulnerable economies will become so miserable that they will leave voluntarily, thereby reducing the euro zone to a like-minded core, and lowering risks to Germany’s own monetary and fiscal stability from any pressure to rescue the weak economies. The second hypothesis is that the Germans really think these policies could work. One possibility is the weaker countries would have so big an “internal devaluation” that they would move into large external surpluses with the rest of the world, thereby restoring economic activity. Another is that a combination of radical structural reforms with a fire sale of assets would draw a wave of inward direct investment. That could finance the current-account deficit in the short run, and generate new economic activity in the longer run. Maybe German policymakers believe it will be either harsh adjustment or swift departure. But “moral hazard” would at least be contained and Germany’s exposure capped, whatever the outcome.

I still believe there is a third “hypothesis”.   Germany is willing to move (if hesitantly) from some of these “no” positions, but requires certain assurances and demonstrations of intent.   Will these assurances be forthcoming?   Will it be enough?

John McCartney: “Short and Long-Run Rent Adjustment in the Dublin Office Market”

below is a summary of a new paper by John McCartney (CSO)

Research just published in the Journal of Property Research provides a
number of new insights into Ireland’s commercial property market.
The  paper “Short and Long-Run Rent Adjustment in the Dublin Office Market”
reveals  that  office demand in Dublin is quite elastic –  a 1% increase in
rents  brings about a 1.13% decline in the quantity of space demanded.   In
comparison,  a  similar  rental increase would only reduce office demand in
London  by  between  0.20-0.54%.   Author  John  McCartney  said  that this
difference  was unsurprising given the relative status of Dublin and London
as  global  business locations;  “London is a major world city and a global
financial  services  centre.   As  such  many  corporations  simply have to
maintain  a  physical  presence  in  London  –  irrespective  of rents.  In
contrast,  despite the advantages of our 12.5% corporation tax rate and our
young,  English-speaking  workforce,  Dublin  is a less compelling business
location.  Therefore,  if  rents rise too sharply occupiers will find other
suitable locations.”

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