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In my previous post I discussed the recent VAT increase in Spain, and wondered how the ECB would respond. My excellent commenters quickly provided an answer. But first a bit of background. Suppose you had a country that raised its VAT rate by 10%, and suppose it applied to all goods and services. In that case, the central bank would have two choices; allow the price level to rise 10%, or try to deflate all prices net of VAT by 10%. Of course the deflation option would be a disaster, pushing the economy not just into recession, but into depression. I think we can all agree it would be utterly mad to target the price level including the VAT.

Unfortunately it seems the ECB does exactly that. Commenter Gregor Bush quoted this passage from an ECB statement:

“Taking into account today’s decisions, risks to the outlook for price developments continue to be broadly balanced over the medium term. The main downside risks relate to the impact of weaker than expected growth in the euro area. Upside risks pertain to further increases in indirect taxes, owing to the need for fiscal consolidation, and higher than expected energy prices over the medium term.”

I thought to myself; “poor ECB, those moronic politicians gave them the wrong mandate!” A few comments later I discovered it’s even worse than I thought. This was from commenter dwb:

from a paper on the ecb website:

“The prices, which should be used in the HICP, are consumer prices (or final demand prices) rather than producer prices. Thus harmonized prices should include commodity and value added taxes in principle.”

In principle!?!?! What sort of principle calls for that sort of insanity? Commenter Mark Sadowski expressed eurozone policy perfectly:

The Euroausterity torture machine is like a head vice with the ECB on one side, and the fiscal authorities on the other, each frantically tightening as the other’s actions make it harder and harder for each of them to hit their own respective targets of inflation and fiscal responsibility.

And here’s Nick Rowe from my comment section:

Maybe there is something to this “you can’t have totally different cultures in a single currency area” idea after all. I wouldn’t want to be in a common currency area with people who were so….words fail me.

Lars Christensen has a post showing that GDP deflator inflation in the eurozone has absolutely collapsed over the past 4 years. In the US even headline CPI inflation is running about 1.1% over the past 4 years, and is expected to show the same increase over the next two. It’s an epic failure.

I don’t even think we should be targeting inflation, but for God’s sake if we do then at least choose a metric that makes some sense in terms of the basic economic theory we teach on EC101. Deflating the price level to offset a VAT shock? That’s foolish. Doing so when you also are suffering a severe recession because of single currency problems, that really foolish. And doing so when you also have the greatest debt crisis in world history. Like Nick Rowe, words fail me.

I recall a lot of people saying “well, you can’t expect the Fed to do more, after all inflation is unpopular with the public.” Don’t they know that inflation is actually much lower than under President Clinton? Does anyone recall consumers complaining of high inflation when Clinton was President? I recall one newspaper article after another praising Greenspan for bringing us low inflation. If America had simply replicated Greenspan’s “low inflation” over the fast 4 years, instead of the actual 1.1% rate, this recession would have been much milder.

People need to get off the sidelines and start screaming. What’s wrong with our profession? Roughly 75% of academic economists in America vote Democratic. Why aren’t all of them outraged by Fed and ECB policy? Why aren’t they out there demanding action? Are they stupid?

Update: Scott N says the following in the comment section:

It’s easy to say they are stupid, but I don’t think that is it. They are just like everyone else. They won’t change their opinions until they are presented with overwhelming and undisputed contrary evidence. These people have spend their lives advancing New Keynesianism and they aren’t about to change on a dime and admit their life’s work might have been wrong.

I certainly don’t think they are stupid, I’m throwing that inflammatory term out there to try to provoke an answer. (‘Ignorant’ would have been more appropriate.) Scott implies that new Keynesianism is about fiscal stimulus. That’s wrong. The new Keynesian model calls for monetary policy to steer the economy. So I’ll ask the question again; why aren’t economists demanding the ECB cut rates? Why don’t they demand the Fed do level targeting, and try to make up for the ultra low inflation over the last 4 years? Why the silence?

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This entry was posted on July 12th, 2012 and is filed under Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



