Posted Wednesday, July 18, 2012, at 11:36 AM
A hot new report from the International Monetary Fund tries ever so gently to push the European Central Bank into doing its job properly, by warning that the current course will lead to prolonged recession:
Economic activity has weakened and is likely to remain subdued, particularly in the hard-hit periphery countries. After averaging 1.5 percent in 2011, euro area GDP growth is expected to be -0.3 and 0.7 percent in 2012 and 2013, respectively. In this context, headline inflation is projected to fall well below 2 percent by 2013 and to remain there through 2014. Strong headwinds to growth—including much tighter financing conditions, subdued confidence, and fiscal consolidation—are likely to be compounded by banks and households repairing balance sheets and consumers acting cautious amidst heightened uncertainty. This will add further pressure to the high level of unemployment and increase the risk of stagnation and long-term damage to potential growth as unemployed workers lose skills and new workers find it difficult to join the active labor force.
I would note further that Europe's tax structure encourages somewhat confused thinking about inflation at a time of fiscal austerity. Countries feeling bond market pressure in Europe tend to raise VAT rates, which translates into higher prices. Common sense says that trying to offset higher sales taxes with tight money is absurd, but common sense is generally in short supply in Frankfurt. The IMF rightly says that the European Central Bank needs to see the massive long-term economic risks inherent in complacency about huge short-term output gaps and calls for "supportive monetary policy ... [d]irectors generally saw scope for further monetary easing."
Unfortunately, the actual practice of the ECB seems to be to view inappropriately tight monetary policy as a good thing because it can be wielded as a weapon to induce national governments to implement labor market reforms.