How to fix the Eurozone


It's rare that an economic question is clear cut. Nearly all issues are two sided, with substantial costs and benefits to all approaches. But the reason the Eurozone crisis has resumed is pretty obvious—'bad' disinflation and deflation almost universally across the bloc, and a failure of the European Central Bank to provide even the most basic monetary stability. The solution is equally obvious: meet the inflation target and commit to a level target to prevent future cock-ups. Household, firms and sovereigns take out (nearly all of) their debts in nominal terms, i.e. not adjusted for inflation. They are likely to build in expected inflation. However, if inflation is higher than expected, debtors incomes should rise faster than they expected, while their debt is still fixed, making the burden lighter. Of course, this means creditors receive less than they expected. It's the same on the other side.

If the central bank promises 2% inflation per year over the next ten years, and the markets believe it, then the yield of a gilt that matures in 10 years will take this into account. This goes (approximately) for all other assets in the economy, like mortgages, consumer credit, business loans and so on. If inflation departs from target it enriches one side at the expense of the other, contrary to what they all could have reasonably expected when they signed these contracts.

There is a complication: there is a difference between the inflation and deflation caused by supply shocks and that caused by demand shocks. When prices rise because everything really has become more costly to produce (a supply shock like an OPEC oil price hike) then this makes debts harder to pay, but worth no more. When prices fall because everything has become cheaper to produce (a supply shock like Chinese labour coming onto the world market) this makes debts easier to pay, but worth no less. But central bank expansions and contractions are demand shocks, not supply shocks.

This means that the national debt will be harder to pay if inflation comes in lower than target for monetary reasons. Inflation has been below the European Central Bank's target for nearly two years, and is falling further below it. Twelve countries have either zero inflation or deflation. Unless there were massive supply-side improvements across the Eurozone—which we would see in the form of impressive real GDP growth or productivity improvements—this would usually mean that firms will find it hard to make good on their investments, and governments will find their national debts increasingly hard to manage. This is exactly what we are seeing.

As I said above the weird thing about this situation is we actually have an easy-ish solution. Commit to meeting the inflation target, making up the deficit of the past few years and targeting a level path of inflation (or total income) in the future. That means that if the ECB makes a mistake and 'undershoots' its target, it doesn't allow this to distort the economy but does a little extra inflation in the next few months; if the ECB 'overshoots' it does a little less. This is not baleful central bank 'intervention' or 'disortion'—the distortion was letting the rules of the game depart so far from those they signed all of their contracts expecting.

The alternative is a 'lost quarter century' of stagnation while everyone slowly adjusts to the new monetary arrangements they have been hit with.