[A-List] EU growth & stability pact: critique

["Michael Keaney" <michael.keaney@xxxxxx>]

Time to brave the ghost of inflation
By Paul De Grauwe
Financial Times: November 20 2002

The eurozone's macroeconomic policymakers are too heavily conditioned by
what happened in the past. Twenty years ago, inflation in Europe was a big
problem. The spectre of inflation has led the European Central Bank to set a
target for inflation of below 2 per cent. With this self-imposed limit, the
ECB has claimed for too long that Europe faces a risk of inflation when
there is instead a growing risk of deflation. And countries with low
productivity growth, such as Germany, are condemned to live with inflation
rates that come dangerously close to zero.

The ECB's case for not lowering interest rates is the existence of
supply-side rigidities, mainly in labour markets. The bank believes that any
attempt to stimulate the economy out of its lethargy by lowering interest
rates is doomed to failure. Supply would just not follow and the only
visible effect would be an acceleration of inflation.

There is a grain of truth in this. But all the talk about labour market
rigidities reveals rigidity in the minds of policymakers. For the truth is
that there is now a window of opportunity to stimulate demand without
triggering excessive inflation.

The chance arises for two reasons. The first is the new environment created
by monetary union in Europe. New research has revealed that currency unions
tend to double trade flows among member countries. This trade-creating
effect of monetary union has important supply-side effects. Trade expansion
means that companies can better exploit opportunities offered by
specialisation and economies of scale. These, in turn, increase the
productivity of labour and capital - and therefore potential output. In
theory, there is no reason why these effects will not occur in the eurozone.

To turn theory into reality, however, the eurozone needs a sufficiently
stimulatory environment on the demand side. By stimulating aggregate demand,
the ECB can trigger the conditions that will allow a permanent increase in
output. A non-inflationary demand stimulus is possible, provided central
bankers can free themselves from fears that no longer have any objective
basis.

This permanent output effect of a monetary expansion does not contradict the
classical theory that says a monetary loosening does not affect "real
things" in a permanent way. The "real thing", in this case higher
productivity, has already been made possible by the creation of the euro.

The second reason for the ECB to cut rates now without worrying about
excessive inflation is the imminent enlargement of the European Union. The
admission of 10 central and eastern European countries plus Cyprus and Malta
will offer more of the opportunities created by monetary union. It will
increase the potential for trade expansion, leading to improvements in
productivity, very much like those experienced in Europe during previous
stages of economic integration.

So, both monetary union and enlargement create an environment where a
non-inflationary demand expansion is possible. The difference between the
effects of enlargement and those of monetary integration relate to timing.
The effect of the euro can be exploited today; the effects of enlargement in
a few years' time. But the difference in timing is good news. It creates an
environment for sustaining expansionary demand policies for some time.

To paraphrase Franklin D. Roosevelt: the only thing the ECB should be afraid
of is its own fear. Fear of inflation has paralysed monetary policymakers at
a time when a policy of non-inflationary demand stimulus stands its greatest
chance of success.

The writer is professor of economics at the University of Leuven