Eurozone Inflation Arithmetic

It would seem that my initial post on raising the inflation target has sparked a pretty fruitful debate. Here’s a quick follow-up by Max on the topic.

I think the case for raising the inflation target is very strong. But it’s especially strong in the context of the European Monetary Union.

You see, the key problem in the Eurozone crisis is “rebalancing”: The periphery countries (the GIIPS) need to reverse their current accounts. And that requires a real devaluation of the periphery vis-à-vis the core (Germany, mainly). My colleague Christoph Zwick reckons in his new working paper that the periphery-core real exchange rate needs to fall by at least 13-17 percent over the next three years. There is, of course, a lot of uncertainty about this estimate. Nevertheless let’s assume a value of 15 percent, which sounds reasonable. This implies an annual real devaluation of (approximately) 5 percent for the next three years. Within the Eurozone, real devaluation can only come through an inflation differential: inflation in the periphery (p) needs to be 5 percentage points below the inflation rate in the core (p*).

Now the ECB targets the Eurozone inflation rate, i.e. the weighted average of core and periphery inflation rates. The share of the core in total Eurozone GDP is about 2/3. Let the ECB’s inflation target be t. So we have t = (1/3)p + (2/3)p*. If you combine this with the requires inflation differential, p* – p = 5, we get p =  t – (10/3) and p* = t + (5/3). Hence the periphery inflation rate has to be 3.3 percentage points below the Eurozone target and the core inflation rate has to be 1.7 percentage points above.

An inflation target of 2 percent implies 1.3 percent deflation in the Eurozone’s periphery each year for the next three years. This would be incredibly painful. If the ECB would target 4 percent average inflation, it would allow 0.7 percent inflation in the GIIPS. That also hurts, but probably much less than hardcore deflation. Meanwhile, the new target would imply 5.7 percent inflation in the core countries, which is higher than what we had during the last decade but not at all high by historical standards.

Obviously the concrete numbers are debatable, but the general result is not: Under the ECB’s current inflation target, the necessary current account adjustment in the Eurozone seems pretty impossible. Raising that target would make it a whole lot easier.

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Senior Stupidity or Bad Punditry?

It would seem the US budget/debt ceiling crisis is on its way to getting resolved, yet an article on it that I read last week did strike me as weird.

A major puzzle for me has always been how irrational, incompetent and often plain and simply stupid many economic commentators make out large swaths of the population to be. As a self-declared liberal I find this strange at best and deeply troubling at worst. Obviously, the whole concept of fully rational economic actors is bogus, but to start from the premise that most of the population of a country is simply yet obviously dumb brings up huge problems when you believe that, in most cases and on average, individuals know fairly well what is in their interest and what is not and are therefore generally in a fairly good position to act accordingly. There are plenty of market failures, but for the most part they involve skewed incentives, not sheer stupidity. This latest episode involves a note to clients written by Greg Valiere, a researcher at the Potomac Research Group, in which he apparently states that:

“[I]t’s just a matter of time before President Obama throws a game-changer — warning senior citizens that their Social Security checks won’t be mailed because of John Boehner.”

That sentence makes no sense at all unless you assume most senior American citizens have absolutely no clue whatsoever why and from whom they get money each month. Does it really take the president to tell seniors that them receiving social security checks (as federal a program as they get) depends on the federal government actually being able to pay for stuff? Markets don’t seem all too worried about the debt ceiling either – are they also just stupid (and by that I mean far beyond the obvious failings of the strict forms of the EMH)? Or is this guy simply getting paid by quantity rather than by quality of memos he puts out?

Does your mother pay for my studies?

For something completely different, here’s a guest post by Maximilian Gödl from the Economics Department at the University of Graz. Really looking forward to more.

Does your mother pay for my studies?

Of course she does. And she would have to pay one way or the other.

“Your mother pays for my studies” was the campaign slogan of the JuLis (never mind) in this year’s student council elections in Austria. It was meant to make Austrian students aware of a simple truth – namely that university education actually costs money which comes mainly from taxes on the working population, i.e. your mother. In a country like Austria, where the government is widely known to create resources from thin air, stating simple thruths can be a sacrilege.

What the JuLis don’t seem to understand, however, is this: Since the income of the currently young is generally too small to cover the costs of their education, they have to get the money from the currently middle-aged one way or the other. The only difference between the existing tax-based system and the alternative tuition-fee system favored by the JuLis lies in the way the money is channeled from your mother to me.

The tax-based system now in place in Austria relies on a government-enforced “generational contract” whereby generation 1 is taxed to pay for the education of generation 2, who in turn will be taxed to pay for the education of generation 3, and so on. Under the alternative system practiced in most English-speaking countries, education is mostly paid for by student loans. Where do the funds for these loans come from? Well, they come from the savings of the middle-aged. So under that system, generation 1 saves to pay for the education of education of generation 2, who will save to pay for the education of generation 3, and so forth.*

In short, the distinctive feature of the tax-financed education system is not that your mother pays, but how your mother pays.

So whether you are in favor for that system or not depends on whether you think that the government does a better job at channeling funds between generations than the market. Given the current predicament of our tax-financed pension system, we should be generally skeptical about generational contracts. The problem with such contracts is that they tend to be exploited by one side at the expense of the other, depending on whoever has the upper hand in the democratic process. On the other hand, my trust in the capital market to allocate funds efficiently is also not limitless, to say the least. Above all, one has to make sure that students from poor households can get loans to pay for tuition fees. You could do that through subsidies, for instance. One should also be concerned that the student loan market doesn’t become too volatile. So these markets have to be pretty heavily regulated.

In my opinion universities should be free to charge tuition fees, mainly because that it’s the only way they can really be independent from political influence. That doesn’t mean that you have to rely entirely on capital markets for financing education. You could give students a tax-financed voucher, for instance. Or you can have the government lend directly to students. (That’s what they do in Australia, sort of.)

But no matter which system is used, it remains true that your mother pays for my studies.

*) Note for nerds: There is a purely theoretical argument in favor of a tax-financed education system from “overlapping generation” models. It is well known that in those models the steady-state real interest rate does not coincide with the socially optimal rate which implies a sub-optimal allocation of resources among generations. A tax-and-transfer system could achieve the optimum at least in principle. I am currently working on such a model.

To Inflate or Not to Inflate

The nomination of Janet Yellen to the chair of the FED seems to be as good an occasion as any to bring this blog back from the dead. No real comment on that other than it’s awesome, so let’s get back into some general monetary economics.

Following the Great Recession there has been a lot of talk about the adequacy of the monetary policy response in its aftermath. Particularly the issue of the zero-lower-bound, well-known to Japan but often treated as something akin to an exotic decease that would never concern countries such as the United States, has been hotly debated. One of the most common calls to try and avoid the issue in the future, or at least make it’s occurrence more unlikely, has been to increase the inflation rate targeted by central banks. In the case of the United States the talk is often about raising it from 2% to 4%, whereas Japan has stopped talking and finally moved to do something about its long-lasting problem by increasing its target from 1% to 2%. And for all it’s worth, it seems to have worked fairly well. The two opposing views on this issue usually range from some weird notions of the “danger of inflation”, of “unanchoring inflation expectations” and everyone dying (or something) on the one hand to an essential no-brainer with little down-side risk on the other hand.

There is not much to say about the first notion other than there seems to be no compelling reason that central banks would have a harder time stabilizing inflation at 4% than at 2%. Even the lowest threshold value found in studies regarding the level at which things start spiraling out of control is around 8% and 4% certainly seems far enough away. Also, fear of inflation in general is essentially the view held by Niall Ferguson, which alone is a pretty safe indication that it is almost certainly wrong. The second view, however, is much more interesting. Indeed, in a perfectly nominal world (i.e. one where everyone and their dog is protected from the effects of inflation), increasing the inflation target by 2 percentage points would seem like the closest thing to a free lunch one might find.

However, and even if it is often downplayed, it would not seem to be that the issue of what a permanently higher level of inflation does to an economy over a longer period of time is as trivial or well-understood as is often portrayed. At least from my review of the somewhat limited literature on the topic it does not seem to be the case that we have all that good of a grasp of what would actually happen. My list of possible channels through which (either directly or indirectly) a higher level of inflation could affect income and wealth distribution, for instance, is solid two pages long and probably more than just incomplete. It also includes a lot of ifs and buts’, necessary assumptions regarding the distribution of creditors and debtors within the society, the nature of government institutions, the nature of different types of contracts and the bargaining power distribution between e.g. workers/unions and companies, just to name a few examples. Changing any of those assumptions flips the entire outcome.

It also does not seem entirely certain to me whether the effects this inflation would have on income distribution and wealth distribution would tend to be pointed in the same direction. And most importantly, the time frame used to make such analysis is vital. In times where the higher level of inflation boosts output back to its potential through monetary stimulus this would seem to almost certainly lower both types of inequality as measured by conventional inequality measures. What happens to the middle class is another entirely different story. It is unlikely to be the case anytime soon that we can declare that the “central problem of depression-prevention has been solved” (as Robert Lucas infamously declared back in 2003), so there will probably be another occasion where we could very much use the higher level of initial inflation. Krugman is also essentially correct in claiming thatone of the dirty little secrets of economic analysis is that even though inflation is universally regarded as a terrible scourge, efforts to measure its costs come up with embarrassingly small numbers”, yet as far as I can tell Friedman’s finding that Inflation is always and everywhere a monetary phenomenon” is about as much as we can say with real certainty.

Overall, systematic changes in inequality are generally a long-run issue, and despite price stickiness and whatnot money remains essentially neutral in the long run for the levels of inflation we’re talking about. Further, inflation most likely impacts inequality mainly through its effect on output to begin with, and from this point of view there is little reason to believe there would be any difference at all between 2% and 4% inflation during normal times. Yet maybe the fact that we would like to increase the inflation rate target says more about the nature of the target itself than about its fairly arbitrary numerical value.