FOLLOWING the Eurozone crisis is like watching a car crash in slow motion. European policymakers are facing down the oncoming debt crisis with entirely inappropriate protection, given the character and the magnitude of the problem rushing towards them.
The bailout of Greece, the creation of temporary and permanent bailout funds, the talk of tougher fiscal rules – all have been just feeble attempts to disguise the ugly truth that there is no one in the Eurozone able or willing to foot the bill.
But total disaster is not inevitable. The European Central Bank (ECB) could still shield members from the worst of the crash – even if a default by Greece is unavoidable.
A default by any Eurozone country would generate a massive contraction in money supply and nominal income. Some of that contraction is already on its way, especially on the Eurozone’s periphery, as a recent report of by the Bank of Italy shows. However, monetary policies are able to counteract such shocks. To do that, the ECB would have to move away from its inflation target of two per cent. Indeed, it would do well to abandon inflation targeting altogether and replace it by an explicit nominal income target, as favoured by a wide spectrum of economists, ranging from the libertarian Scott Sumner to Nobellist and New York Times columnist Paul Krugman. One way of doing this would be to target the cash level of GDP, crucially not adjusted for inflation.
Central banks currently explicitly or implicitly follow the dual mandate of maintaining low inflation and keeping the economy growing. Unfortunately, inflation targeting is a very poor way of achieving this. In situations of sudden contractions of nominal spending – resulting from a credit crunch, for instance – it does nothing to counteract such a shock and could drive consumer prices above the target rate.
A nominal income (or nominal GDP) target is not the same thing as quantitative easing. The goal is not for the ECB to monetise the public debt of Greece or Italy, nor is it to pump liquidity into banks that are threatened by the potential demise of the Eurozone.
The purpose of nominal spending targeting is to create a stable environment for economic decisions. Nominal income matters for the solvency of firms and individuals. Sudden drops have a disastrous effect on otherwise healthy businesses. Europe’s investment and business environment would become much more predictable if the ECB committed to stabilising nominal income.
A nominal income target does not necessarily mean turning the printing press on. Europeans just need banks to start lending to profitable business projects again and that can be done, for instance, by imposing a penalty rate on excess reserves. True, a nominal income target is no panacea. But the choice between targeting nominal income and targeting inflation is a choice between a bumper-to-bumper accident and, well, taking a full frontal hit at 60 miles per hour.
Dalibor Rohac is the deputy director of economic studies at the Legatum Institute.