Sophie's Choice for the EU

February 15th, 2011
in Op Ed

dirk ehnts small by Dirk Ehnts

When central banks look at their policy goals, they find the words ‘inflation’, ‘unemployment’ and ‘growth’ more often than others. Apparently, low (and stable) inflation is good for savers, while low unemployment is good for people offering their labor services and economic growth is for everybody.

Follow up:

While this is a bit simplified, nevertheless it is a consensus in macroeconomics. Of course, the recent financial crisis has then caused central banks worldwide to miss their policy goals. Inflation turned into deflation, redistributing wealth from debtors to creditors in some cases, unemployment increased and growth declined. This is bad, of course.

One question that opens up at that point is: how bad? There is a literature strand which is trying to answer this question by looking at the happiness of people and how that is influenced by economic growth, inflation and unemployment. Since central banks – like the ECB -  are in a position where they are facing both unemployment and perceived inflation threats (which I will comment on some other day) it would be nice to know how much people are bothered by inflation and unemployment exactly. Heinz Welsch provides an answer:

This paper studies the macroeconomic performance of the EU-12 member countries over 1990–2002 from the point of view of the subjective well-being (life satisfaction) of the citizens. The paper uses data for over 50,000 individuals and controls for personal characteristics (especially income and employment status). Life satisfaction is found to be negatively associated with the unemployment rate and inflation, but positively associated with the growth rate. In contrast to earlier findings, the weights placed on inflation and unemployment are of a similar magnitude.

As unemployment and inflation are both making people sad, and the weights of sadness these issues put on people is the same, what should a central bank do? Let inflation go and unemployment fall, or fight inflation and accept unemployment?

Of course, many things complicate the picture. Demographic plays a role: retired folks would see their life savings disappear with inflation and couldn’t go back to work to regain what is lost. However, young people are robbed of their chances if they stay in persistent unemployment for longer (the NY Times covered this problem in a nice article). The question of who gets what is a question of distribution.

The unemployed get no/less income, the capital owners no/less purchasing power. Therefore, a central bank nowadays is redistributing wealth among the people. This is not what it has been built for. It was supposed to use inflation-targeting to keep inflation low and stable. This was assumed to be enough to guarantee economic growth. We have found out that this is not enough.

The ECB is now between a rock and a hard place. It has to decide who will be unhappy: the unemployed or the capital owners. This decision is not made easier by the fact that the euro zone is quite segregated, with capital owners agglomerating in and around Germany, and the unemployed showing up in peripheral countries like Estonia, Ireland, Spain and Greece. Since Mr Trichet will step down in late 2011, electing a successor will be difficult.

Of course, some countries prefer a ECB president that fights inflation and keeps the euro ‘stable’, while others prefer one who focuses on the countries in distress and is more willing to put the burden of adjustment (inflation) on Germany as opposed to let already-stressed out economies go through a period of deflation.  This really is a Sophie's choice situation.

The politics of Europe are in danger to become poisoned by nationalism – the stepping down of Axel Weber might be the first event in a chain of ugly maneuvers of euro zone countries struggling for control. Of course, the president of the ECB is not a dictator – the governing council decides. However, the ECB president will be a symbol of what is to be expected. Europeans should watch carefully how Europe’s top technocrat is (not democratically) elected and what his idea for Europe’s future is. The stakes are high.

Related Article

The Dichotomy of Currency by Derryl Hermantutz

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  1. Demand Side Email says :

    Inflation, by definition, is not a rise in a particular price or category of prices. Dennis Lockhart of the Atlanta Fed made this point earlier this month. The absurdity of fighting rising commodity prices, including energy, with hikes in interest rates is virtually complete. Both reduce real demand.

    Many have argued that the Fed's easy money has leaked through into commodities, including energy. Commodities are now even talked about as an "asset class," rather than as products, and important elements of an investor's portfolio. Shades of 2008!

    As Minsky showed, there can be no real investment without a spurt of inflation, since the ratification of investment has to be carried in prices. But the world's central banks stand ready to beat that inflation, and hence investment, back into its hole if it should show its ugly head.

    Hard to see how we get recovery in real economies without investment.

    Ah well, we've wasted crisis after crisis. On to the next one!

  2. Admin (Member) Email says :

    @Demand Side from John Lounsbury

    Very good comment.

    A couple of further comments that relate:

    Karl Smith did a piece about six months ago that determined inflation of at least 4% was needed to make headway against unemployment. How Minsky of him, although he didn't mention Minsky by name.

    Note: This platform doesn't activate hyperlinks in comments. Please cut and paste the link above. Or put Karl Smith in the search window at the bottom of the Analysis Blog page. (It's a long scroll down to the bottom.)

    Why did we waste this crisis? Because the perpetrators controlled the resolution process. A number of people have lamented that we do not have free markets. I would go further to say that is only part of the complete description. The rest is that we have expensive markets.

    The burden of the oligarchy on efficiency is vast.

    Thanks for commenting. I hope you will keep adding to the conversation here at GEI.



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