Beyond Greece: The Inflation Debate – The IMF’s Blanchard vs. the Bundesbank


The „Greek crisis“ has become the catalyst for long overdue regulation of derivatives speculation. As Western governments will have to raise $4 trillion in 2010, speculation against sovereign debt simply cannot be tolerated any longer. But the next big issue of financial policy is already on the table: „Controlled“ inflation as an instrument of crisis management. That is what the IMF’s chief economist is recommending. Not only the Bundesbank is not amused.

by Michael Liebig

The March 4 Greek bond issue was three times oversubscribed. The 5 billion euro government loan carried an interest of 6.37%, which compares to a 3.16% yield for German bonds and 4.06% for British gilts. The next day, the Greek parliament passed a 5 billion euro austerity package. Over the next two months, Greece will have to sell another 20 billion euros in state bonds, but there is little doubt that the forthcoming issue will go smoothly as well. Those who proclaim that Greece and the euro single currency system will suffer the same fate as Britain and the then-European Monetary System in 1992 are mistaken – including George Soros himself who had said on Feb. 28th that the euro „may not survive“ the Greek crisis.

No Repeat of History

A 1992-style speculative assault won’t work this time. The paradoxical proof is the early February meeting of leading hedge funds in New York where speculative attacks against the euro and several European states were plotted. Not only did the Wall Street Journal disclose the news on the Manhattan gathering, but the paper reported that the US Department of Justice has notified the hedge funds involved that they are under investigation. And on March 6, Paul Volcker said in Berlin: „Surely the recent revelations about the use (and abuse) of complex derivatives in obscuring the extent of Greek financial obligations reinforces the need for greater transparency and less complexity.“

Opposite to the situation 1992, hedge funds and banks will not remain undisturbed. Under the headline „Hedge Funds Targeted by Supervisory Agencies,“ the Frankfurter Allgemeine Zeitung reported that the EU Commission convened a meeting of EU supervisory agencies on CDS speculation on March 5. Reuters reported that the German government has ordered an investigation to identify financial institutions engaging in speculation against the euro and European state bonds. One can safely assume that financial supervisory agencies and intelligence services of other European countries have been doing just the same.

Some Regulation At Last

On March 3rd, the German Finance Ministry announced that it has banned „naked short selling“ and that „normal“ short selling will be regulated. French Finance Minister Christine Lagarde said that credit-default swaps „need to be much more and much better regulated.“ As the head of the „Euro Group,“ Luxembourg’s Prime Minister Juncker, put it: „Torture instruments are being readied against speculators“.

In the presence of Greek Prime Minister Papandreou, Chancellor Merkel said on March 5: „Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb…We must succeed at putting a stop to the speculators‘ game with sovereign states… We can’t allow speculators to be the profiteers of Greece’s difficult situation.“ While „technically not easy, speculative instruments, including derivatives, must be curtailed,“ said Merkel.

The regulation of speculative derivatives is now a priority for the EU, said Merkel, but must also be enacted by the G20. The German government is preparing a special G20 conference on financial regulation in Berlin in May 2010. It seems that the regulation of „Over the Counter“(OTC) derivatives is high on the agenda of the Berlin gathering.

On the question of financial regulation, the Merkel government has the backing of the powerful „Federation of German Industry“ (BDI). In an March 2nd interview with the FAZ, BDI chairman Hans-Peter Keitel said: „It is unacceptable that we tolerate financial behavior that fits a casino, and may even fund it with public money. Speculation must be made unattractive and expensive. We need a new balance. We simply can’t afford a second crisis.“ Banks, said Keitel, „must lend out money [to the real economy] instead of going into proprietary trading and speculation“.

As indicated by the above mentioned WSJ report, it seems that the United States government is collaborating with the Europeans on the issue of speculation against sovereign debt. While the recent hype over Greece has certainly helped the USA selling Treasury Bonds at favorable interest levels, the Obama administration does know that financial speculators are targeting other highly indebted countries as well – including the United States: In 2010, Greece must refinance its public debt by selling some $65 billion in bonds; Germany $140 billion, Britain $350 billion, Japan $650 billion – and the United States almost $2.000 billion.

Beginning with the USA, all states of the „trilateral“ West – the USA, Japan and the EU – are enormously vulnerable to financial speculation. Therefore, effective regulation of financial speculation is not an option, but an inescapable necessity for the sustainability of the world financial/economic system as such.

I would guess that in the course of 2010 the G20 will enact an international framework for financial regulation that will suppress the most dangerous speculative excesses. But beyond financial regulation, another issue is emerging that will likely dominate the global financial and economic agenda: inflation. And the inflation issue is back precisely because of the explosion of public debt as a consequence of „crisis management“ policies. The $4 trillion in sovereign debt refinancing needs of the West in 2010 – half of it the USA – illustrate this point.

Olivier Blanchard’s „Optimal Inflation Rate“

The policy fight over „controlled“ inflation has already started in earnest. I reported already in the Letter from the Rhine about the „academic“ debate on „controlled“ inflation in the United States, for example the paper by US economists Joshua Aizenman and Nancy Marion, titled „Using Inflation to Erode the U.S. Public Debt.“ Other prominent American economists like Kenneth Rogoff and Paul Krugman have also stated that they like the idea of „controlled“ inflation.

Now the IMF’s chief economist, Olivier Blanchard, has joined the debate. On February 12, Blanchard released a paper, titled „Rethinking Macroeconomic Policy,“ which he wrote together with Giovanni dell‘ Ariccia and Paulo Mauro. The authors claim that the views expressed in the paper are their own, and not the IMF’s. But the paper is prominently displayed at the IMF’s website. ( One should know that while Blanchard is French born, he has spent almost his whole adult life in the USA – most of it at Harvard and MIT – and has US citizenship.

The Blanchard paper is written in a very abstract, academic terminology, but such language is often used for facilitating paradigmatic shifts in cognitive structures. This approach „covers“ the author, while forcing others to „translate“ the message into simple words. Blanchard writes that he is reviewing macroeconomic policy in three steps, first „what we thought we knew. The second identifies where we were wrong. The third, and the most tentative, takes a first pass at the contours of a new macroeconomic policy framework .“

The foundation of the past decades‘ macroeconomic policy was the „consensus that inflation should not only be stable, but very low (most central banks chose a target of around 2%)“. Along with the fixation on low inflation, „fiscal policy as the countercyclical tool“ was rejected, and „the focus was primarily on [public] debt sustainability and on fiscal rules designed to achieve such sustainability.“

But, argues Blanchard, this macroeconomic conceptual framework was „flawed,“ because „we have learned from the crisis“ that „stable inflation may be necessary, but is not sufficient“ and „the crisis has returned fiscal policy to center stage as a macroeconomic tool“.

On page 11 of his paper, Blanchard lets the cat out of the bag, albeit framing it in the form of a question: „Should policy makers therefore aim for a higher target inflation rate?.. To be concrete, are the net costs of inflation much higher at, say 4% than at 2%, the current target range? Is it more difficult to anchor [inflation] expectations at 4% than at 2%?“

The Bundesbank Strikes Back

What is required now, Blanchard writes, is „carefully revisiting the list of benefits and costs of inflation.“ which might lead to the desirability of „a higher optimal inflation rate“. In any case, „strict inflation targeting is not optimal,“ because „a key lesson from the crisis is the desirability of fiscal space to run larger fiscal deficits when needed.“

Blanchard does not explicitly elaborate his views on the „benefit“ of inflation in respect to public debt. But „eroding“ public debt via inflation is obviously what he has in mind.

Therefore it is not surprising that most significant reply to Blanchard came from the head of the Bundesbank, Axel Weber, and from the head the Swiss National Bank, Robert Hildebrand. They published a most unusual OpEd in the Neue Zürcher Zeitung on March 4, titled „Defending Price Stability“.

Weber and Hildebrand write that Blanchard’s arguments are „not convincing and the timing of his proposal is most unfortunate, if not reckless and damaging.“ Indeed a most unusual choice of words for central bankers. Then they continue: „Price stability is a very important public good, which is not only important for longterm economic growth and prosperity, but also for social stability. That is an important lesson of history, of which the people of our two countries are well aware. Typically, the socially weakest strata of the population suffer most through inflation, because they lack the means to protect themselves against inflation“.

And then comes Weber’s and Hildebrand’s core message in response to Blanchard’s core message: „The proposals of the IMF chief economist to the effect that the central banks should envisage higher inflation, could easily be misunderstood as the central banks‘ tilting over into collaborating with a policy of material reduction of debt via inflation.“

Tremonti’s Recommendation

Another, more indirect reply to Blanchard came from China. Addressing the National People’s Congress on March 6, Prime Minister Wen Jiabao said China is committed to price stability and will achieve an inflation rate not exceeding 3% in 2010. China’s holdings of US Treasury Bills amount to $755 billion. China will hardly consent to a policy of material reduction of debt via inflation. IMF head Strauss-Kahn just named Zhu Min, deputy head of the Chinese central bank, as his „special advisor.“ One wonders what Zhu might tell Blanchard when they get together at IMF’s headquarters in Washington.

There is no magical „trick“ in settling public debt. Certainly not inflation, because inflation is the most vicious form of austerity. Inflation hits the majority of the population which does not privately own physical wealth – real estate, economic goods or precious metals. For the recipients of social security programs, inflation means that the purchasing power of their pensions, unemployment benefits or family allowances decreases corresponding to the inflation rate – their standard of living will decline. And the same is valid for the private savings of the majority of the population whose value/purchasing power is shrinking. Austerity measures may be a transitional necessity, but they are no solution either because they atrophy overall economic activity, undermine social stability and erode the tax base. Short of state bankruptcy, the reduction of piled up public debt is only achievable through the development of the real economy: technological innovation, productive investment, and rising productivity through science and education by combining public and private resources.

In this respect a refreshing contribution was made by Italian Finance Minister Giulio Tremonti in an March 5 OpEd in the FAZ. He writes that the current crisis is the result of devouring the „poisonous fruits“ of the „golden age“ of „virtual money“. Now the „devilish bill has come due“. Tremonti recommends that the best reference for overcoming the financial crisis and its fiscal consequences is to look back to what Alexander Hamilton did after the American War of Independence and what the Europeans did after World War II in building the European Economic Community. In both cases the initial status was ruinous in economic and financial terms. In both situations the guiding principle was: As much „market“ as possible, as much „state“ as necessary for reconstructing and developing the economy and society on a continental scale. Tremonti then argues that neither private consumption nor exports are sufficient for sustainable economic development within the EU. Instead public-private investment programs for energy, environment, hard and soft infrastructures on a European scale are both necessary and doable – provided the political will is there.

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