Investors now recognize that they did not really understand what these bonds represented – that is, the institutional construct behind the European currency. And if the global financial crisis has taught us anything, it is this: when you do not understand a financial product, you should not buy it. But if investors actually take that lesson to heart, the European crisis will be far from over.

So, should Europe embrace fiscal federalism in order to strengthen the eurozone and restore investor confidence? The problem is that fiscal federalism means different things to different people.

Americans think they know what it is: a central government with a large budget (about 20% of GDP), whose macroeconomic role is to carry out counter-cyclical spending and taxation, as most US states are constitutionally committed to some sort of balanced budget. This was clearly true in the case of the stimulus program launched in 2009, which included federal transfers to the states to sustain state-level fiscal spending. Similarly, when a state such as Michigan is hit by recession in its key economic sector (the auto industry), Washington collects less federal tax but maintains – if not increases – local spending, which partially offsets the shock to state income.

Economically, therefore, the federal budget cushions regional shocks automatically through discretionary action and stabilizing transfers to the states. Politically, it embodies solidarity and thus helps cement the union.

If this is what is meant by federalism, it is better for the European Union to forget about it. The EU budget amounts to about 1% of GDP, just one-fortieth of total public expenditure. No one, not even die-hard European integrationists, imagines that it can reach 5% of GDP (it is more likely to decrease). But even a 5%-of-GDP budget would be insufficient to play a meaningful macroeconomic role.

A second solution is what can be called “distributive federalism.” The goal is not to absorb shocks but to reduce income gaps across regions. In Germany, tax revenues are redistributed between the Länder. This is another form of solidarity, which also exists in the EU, where regional development funds are allocated to poorer regions to foster catch-up growth. These transfers are significant for poor countries: about €300 per person for Greece and Portugal every year from 2000 to 2006. Europe, in this respect, is not qualitatively different from the US.

These transfers have accelerated convergence when put to good use (for example, in several Spanish provinces), but have been ineffective when wasted (as in Greece). This feeds doubts about solidarity’s usefulness. Germans, who since reunification in 1990 know what they are talking about when it comes to such transfers, do not want to hear about a Europe where rich regions would permanently finance pockets of under-development. They are not alone in this.

What, then? Conceptually, the eurozone must include solidarity with countries facing hardship, because this is what unites and gives strength to the whole – but without the heavy machinery of a federal budget or a permanent increase in transfers. It needs some sort of mutual insurance, or what could be termed “insurance-based federalism.”

This is what inspired the decision taken in May to create the European Financial Stability Facility (EFSF), by which assistance can be provided, jointly with the International Monetary Fund, to partner countries in times of crisis. It is also what inspired the European Central Bank to launch an asset-purchase program, which has been used to buy Greek and Portuguese government bonds.

But the uproar caused by these decisions reinforces, rather than dispels, doubts. In Germany, many consider the EFSF a breach of the fundamental principle that EU governments cannot be bailed-out by their partners. And the transformation of the central bank into a quasi-fiscal agent (because if Greek debt is restructured, the ECB will record losses) is regarded with horror, as it violates the separation between money and public finances.

Instead, it is claimed, eurozone members should have been allowed to default. No matter that the public debt of the average US state is less than 0.5% of total US GDP, compared to 5% in the eurozone, which implies that the financial impact of a eurozone sovereign default would be much stronger. And no matter that there is no prohibition on the purchase of government bonds on the secondary market: the Rubicon has been crossed, and the Germans are nervous.

So there is no agreement yet to make the EFSF permanent, and it has been designed to be as un-federal as possible. When it comes to ECB purchases of government bonds, no one understands exactly for how long and for what purpose the new weapon is to be used – which reduces its effectiveness. Meanwhile, proposals for pre-adoption assessment of national budgets by the EU have attracted criticism in France and elsewhere, which serves as a reminder of the distance there is between calls for coordination and actual acceptance of its implications.

The Europeans have begun to assemble the bricks for a new building, but without having agreed on its size and design. For the time being, they rather give the impression to have thrown sandbags in disorder in an attempt to stop a wave. This may make skeptics the very people European policymakers wanted to convince. It is time to accept that those who finance EU governments through purchasing their bonds are entitled to ask inconvenient questions, and to expect clear answers.

Copyright Project Syndicate

How jolly, it just makes you wonder what will replace common sense once those first few decades have passed. I’d hate to think its reign would be so much shorter than that of ideology.

I’d be tempted to mock this grandiose declaration even further if it did not appear to be the harbinger of something more sinister. Yes, Orbán is of course right that some of the issues that shaped the ideological conflicts of the last century are less salient today than they used to be, while plenty of new issues have arisen that are often difficult to integrate into the traditional ideological moulds (e.g. environment and globalisation).

This has led to an increasing and ongoing flux in the democratic party systems and it partly explains why I don’t think social democracy’s current crisis is only a failure of its policies, as I noted a few weeks ago.

Some aspects of the Orbán’s remarks were particularly troubling for Hungary, but they may also offer a few cautioning glimpses into the future of – particularly Eastern – European politics in general.

Orbán picked up on his recurring theme of a national centre that crowds out traditional categories of left and right. A government that does whatever is best for its people, enacting policies that freely borrow left- and right-wing ideas alike, whatever works best if you apply “common sense.”

There is of course room for centrist politics that is not dogmatic about ideology and reaches for whatever means best serve the values it holds and the interests it represents.

In reality, however, the purported non-ideologists often pursue crass populism repackaged as “common sense”, “national interest”, “the public good”, whatever. (By populism I mean policies or communication that overly simplify complex policy matters, incite popular anger against particular groups in society (elites, minorities) with their simplistic explanations of societal problems, and build their agenda around whatever promises to resonate most vibrantly on an emotional level rather than based on their commitment to values).

Orbán is illustrative of this brand. With a strongly nationalistic rhetoric, his government – and even more its intellectual coterie – has for instance railed against the IMF and its requirements vis-à-vis Hungarian financial consolidation, leading to a breakdown in the talks between Hungary and the IMF and the European Commission.¹ In doing so, it has managed to draw some applause from the far-left in Hungary and, apparently, abroad, too.

Unless one is dogmatically dead set against fiscal consolidation or committed to tax cuts (Orbán: “the greater the crisis, the greater the necessary tax cuts”, cf.: http://simple.wikipedia.org/wiki/Voodoo_economics), the question arises: is the centrepiece of “national centre” government’s policy, a flat tax resulting in a huge tax cut for the highest income brackets, moderate cuts for middle earners, the abolition of the inheritance tax, as well as most likely massive tax hikes for the working poor, really worth more than fiscal consolidation? Common sense would suggest that it is not.

In the larger context of European policy, the issue is whether Orbán’s national centre is something that should be catching on: is a Robin Hood tax on banks (originally planned to exempt the governing party’s own finance oligarchy) and a tough anti-IMF rhetorical stance really enough to capture all that’s common sense about progressive ideology? Especially if the government’s understanding of Robin Hood is taking money from the rich and the poor and to give it to the wealthy?

In any event, Orbán’s particular brand of populism, which paints itself as above petty political ideologies and the sole representative of “national interest”, is fairly widespread in the region.

Some of the most successful Eastern European politicians, including Robert Fico, Lech Kaczynsky and Boyko Borisov have treaded similar rhetorical paths to power. And so has, of course, Vladimir Putin in Russia, albeit in very different political context.

In Orbán’s own words, his desire for Hungary is that there be “a grand ruling party, a central political force that is capable of formulating [by itself] the national issues – and to do so not in the context of permanent debates, but rather stemming from its very nature.” These words, together with similar comments (and also policies) by the PM, suggest that opposition, checks and balances, criticism, etc., are merely nuisances when one party alone has all the answers.

Apart from the damage it potentially does to democratic institutions – as it does now in Hungary, where the “central political force” has translated its vast, 52,7% voter support into a constitutional supermajority of 68% in Parliament and is in the process of bringing all independent institutions under the control of the ruling party –, this understanding is especially harmful because it negates the fundamental democratic notion that public interest is, by definition, a compromise between a multitude of interests and opinions.

“So what?”, you might say, especially in Western Europe, where such populism may have made headway but is rarely as successful as it is in this region. For starters, this means that the gap in the quality of democracy within the EU is far greater still than the economic development gap, and unlike the latter, which tends towards convergence, there are some alarming signs that the democracy gap is widening.

Second, if you do not find this particularly disturbing in and of itself, consider what it means for European politics: a substantial portion of the people shaping the Union will have no fixed political commitments but rather unpredictable, self-serving stances. Coordination and compromise – already an immense burden with 27 members – will be a nightmare with such idiosyncratic and autocratically inclined leaders.

Furthermore, building a coherent and strong progressive political force in Europe will be difficult if social democratic parties in the region will be sidelined to the degree they are now, or worse, morph into populist political organisations themselves. The spread and sustained success of such populist politics will require the rethinking of integration strategies and of progressive politics, too.

Americans of course have always looked at the world from the view of a great power and the relationship to Europe has never been exclusive. But during the Cold War the European allies were at the center of America’s political and military strategy to contain Soviet Communism. These days are over and there hasn’t been a President in the Oval Office as eager as Barack Obama to transform the security structures he inherited from the Cold War. Defense projects have been reevaluated, the State Department for the first time is undergoing a profound policy review process and the G20 has already substituted the G8 as the relevant format for decision-making among the big players.

For more than sixty years the common enemy in the east bound the US and its European allies together. And leaders from both sides of the Atlantic took this relationship pretty much for granted. Today there is criticism that President Obama shows no enthusiasm for the transatlantic relationship and lacks emotional ties with European leaders. Despite the fact that Obama has been to Europe eight times since he took the oath of office, which is hardley a sign of disinterest, it needs to be realized, that on both sides of the Atlantic a new generation of politicians is now in charge.

It is a generation that did not experience the Second World War, like Helmut Schmidt or George H.W. Bush, or was politically formed by the Cold War like Helmut Kohl and Ronald Reagan. Thus the decades of close personal and emotional relations between the Atlantic partners are over. But what sounds disappointing in the first place is nothing more than the consequence of NATO’s successes. Europe’s security is no longer threatened by an external enemy. So instead of being nostalgic about the Cold War solidarity the new situation should be seen as a chance. It provides the opportunity for the necessary evaluation of structures and readjustment of political priorities. The transatlantic relationship will not lose its importance, but it certainly needs a new foundation.

From global warming, international terrorism to the rising economies of the south, the new global agenda is demanding a common approach. Above all, the western model of democracy is under pressure in many parts of the world. But unlike in the Cold War days it will not be sufficient to point out human rights violations and the lack of individual freedom while relying on the attractiveness of one’s own way of live. In the last decade countries such as China succeeded in fighting poverty and lifting millions of people up to modest wealth, and as a result created political legitimacy for the authoritarian rulers. Instead of lecturing the world about democracy the west needs a new emphasis on poverty reduction and wealth creation. And it should seek closer cooperation with countries like Brazil who have chosen a democratic way to achieve those goals.

The Bush-years demonstrated bluntly that military might without legitimacy is not sufficient to defend the US position in the world and that the US needs allies and friends. Europe on the other hand, will in the years to come dedicate the biggest share of its energy to the EU-integration process and therefore should have a natural interest in maintaining a US security commitment. Given the experiences from American history this commitment is far from assured. After World War I the isolationist camp dominated US foreign policy until the Japanese attack on Pearl Harbor reestablished the American presence on the continent.

In today’s polarized American politics isolationist themes are resurrected for instance when congresswoman Michele Bachmann from Minnesota stated that she doesn’t want the US to be “part of the world economy” because “this is a very bad direction because when you join the economic policy of different nations, it is one short step to joining political unity and then you would have literally, a one world government.” Of course, this is not the view of a majority, but after the mid-term-elections in November Mrs. Bachmann and her supporters within the Republican Party might become even more influential.

Unless it modernizes its economy and society, Russia can forget its claim to status as a world power in the twenty-first century and will continue to fall behind both old and newly emerging powers. Moreover, Russia needs partners for its modernization, because its population and economic potential are too small for it to play an important role by itself in the emerging new world order. Russia’s strategic nuclear weapons will be insufficient to ensure it a place among first-rank powers.

But where can Russia turn? Towards East Asia? To the south and the Islamic world? Neither of these is a serious option. As it is, Russia can turn only towards the West, and to Europe in particular.

For Europe, however, Russia’s role is of critical strategic importance. Even a partial revision of the post-Soviet order in the direction of an increased Russian grip on ex-Soviet states or satellites would drastically change EU strategy and security policy.

Both sides claim to want improved bilateral relations, but there is room for doubt about whether Russians and Europeans actually think about their relations in the same terms. A look beyond the cordial rhetoric reveals profound differences.

When Russia’s former president and current prime minister, Vladimir Putin, declared several years ago that the greatest disaster of the twentieth century was the demise of the Soviet Union, he didn’t just speak for himself but arguably for the majority of Russia’s political elite. The overwhelming majority of Europeans, however, probably view the USSR’s breakup as a cause for celebration.

Indeed, today’s Russia avowedly seeks to reverse the post-Soviet order in Europe that emerged after 1989/1990, at least in parts of its neighborhood, while the Europeans and the West want to maintain it at all costs. So long as Moscow doesn’t understand these fundamental differences and draw the right conclusions from them, Europeans won’t view Russia’s opening towards the West as an opportunity, and Russia will always encounter deep mistrust in Europe. But this doesn’t preclude practical and pragmatic co-operation in numerous areas.

Russia today has retained its strength only as a supplier of energy and other natural resources. It is therefore no surprise that Putin has sought to use this lever to rebuild Russia’s power and to revise the post-Soviet order.

Russia’s natural gas supplies to Europe play a vital role in this regard, because here, unlike in the case of oil, Russia’s bargaining position is very strong. Even more importantly, its direct neighbors are either completely dependent on Russian gas supplies – Ukraine and Belarus – or, like Azerbaijan and Turkmenistan, are dependent on Russia’s pipeline system to sell their gas output.

Russia certainly pursues economic interests with its gas-export policy – all the more so when gas prices are trending down – and it wants to expand its role on the European gas market to intensify the dependencies that now exist. But this is unlikely: Russia’s disruption of gas supplies in January 2009 made clear to the EU in no uncertain terms what price might have to be paid.

That is why “diversification of gas-supplier countries” has since been EU policy – including, first and foremost, the Nabucco pipeline project, which would open a southern corridor between the Caspian Sea, Central Asia, northern Iraq, and Europe. Nabucco would reach Europe via Turkey and would drastically reduce Caspian supplier countries’ dependence on Russia’s pipelines, and the new southeastern EU members’ dependence on Russian gas supplies. So it comes as no surprise that the Kremlin is trying to scupper Nabucco.

Two other developments promise to prevent increased European dependence on Russia: massive expansion of liquefied gas imports into the EU and – linked to this and to deregulation of the European gas market – the transition from long-term supply agreements and the oil-price peg to market-dependent spot prices.

Nonetheless, the primary goal of Russian gas policy isn’t economic, but political, namely to further the aim of revising the post-Soviet order in Europe – a quest that is not about the EU as much as it is about Ukraine.

Ukraine’s new prime minister, Mykola Azarov, was stunned when Putin unexpectedly confronted him during a joint press conference with a suggestion to merge the Ukrainian and Russian gas companies. Unlike the Ukraine government’s assent to extending the Russian Black Sea fleet’s deployment in Crimea – a decision that led to physical violence in Ukraine’s parliament – this was not a prolongation of the status quo, but a public demand for its revision.

With the Nordstream pipeline in the Baltic and the exorbitantly expensive South Stream pipeline in the Black Sea, Russia is not just trying to create direct gas connections between Russia and the EU that bypass Ukraine and undermine Nabucco. The main goal is to put pressure on Ukraine, as well as on Azerbaijan and Turkmenistan, which want to supply Europe with gas independently of Russia. Once those aims are achieved and/or Nabucco goes ahead, South Stream will be shelved because it doesn’t make economic sense.

In Europe and the United States, this challenge has been understood. Now it is necessary to stand by those in Ukraine who see a European future for their country, to open the southern corridor via Nabucco, and to accelerate development of a common European energy market. A decisive European policy will improve, rather than strain, relations with Russia, because it will result in more clarity and predictability.

Copyright Project Syndicate

First, the Copenhagen Climate Conference has provided the European Union with a first glance of what the future of multilateralism will be like. Unless European states speak out loud together, with one unified voice, nobody will listen. Even more important is a closely related factor: Everybody is expecting Europe to be ambitious on climate protection. Europe has a responsibility for ecological transformation and a leading role to play in developing a new economic model. If Europe doesn’t change quickly and with strong transformative powers, then nobody will care. It is all about the performance of the first mover. Whoever wins the race will have the chance to lead world markets in the future.

Second, the climate narrative in Europe has changed. When the heads of states and governments decided on the integrated energy and climate strategy in 2007, everybody had the Copenhagen Conference in the back of their minds. The European Union had to take the lead to get the United States and others moving. Copenhagen was a large part of the legitimacy of Europe’s climate strategy. Following Copenhagen, however, this legitimacy has been fading away. The United States finds itself far away from getting climate legislation passed. And Europe has been in need of a new story about why climate protection makes sense. The new story has to be the economic success green markets will provide in the future.

The interaction of these aspects has led to a change in the reasoning behind Europe’s climate policy. The international process remains important, of course, but it is not the only reason for Europe’s ambitious climate targets anymore. It is the European self-interest that should force EU member states to adopt stricter reduction commitments.

Looking at the low price for certificates in the EU emissions trading scheme, taking into account the temptation of currently low oil prices and bearing in mind that political regulation is one of the most important factors for private investments, climate policy is not solely a debt to other parts of the world, or our own dirty history, but it is a vital economic policy for today’s and for tomorrow’s generations.

It seems like the ministers understand what the future challenges look like. It is time to discuss the design of such an appropriate political framework. The race is on.

The new journal includes contributions by Norman Birnbaum, Klaus Busch, Milos Pick, Vera Glassner, Andrew Watt, Uwe Fink, Nick Crook, Karolina Stegemann, Udo Rehfeldt, Mia De Vits and Stephen Barber.

We hope you enjoy your reading.

Member States would be expected to enact national laws that formalise the public finance recovery path and set budget targets that are consistent with the medium-term objectives in the Stability and Growth Pact.

Oh dear, is there no learning at all? The Stability and Growth Pact (SGP) has been revealed as an inadequate fiscal straitjacket that nobody cared about when the economy needed support in the wake of the credit crunch. The economy still needs support! And setting the SGP in stone by passing it as national law, similar to what Germany has already done, will not help but destroy growth potential in Europe.

This is not the flexible and responsive governance mechanism needed but the extension of an old mistake.

The golden rule in mountain climbing is that your hands always need to have a good hold. If you have a good grip, you can take some license with your feet — for example, make an attempt to reach a ledge that’s still covered with the dew, or scale a crossing that might be a little too wide for your legs. But if your hold is uncertain, you can take no risks: a single error could be fatal.

A mountain climbing analogy seems apt given that the upcoming Kansas City Fed’s Jackson Hole conference is focusing on fiscal policy. It also helps us understand what the stance of fiscal policy should be at this point in the crisis. It suggests that governments should commit to future spending cuts large enough to stabilize debt levels over the medium term. But, once future sustainability is locked in, they could afford to take some risks with current deficits. They could delay removal of the fiscal stimulus, or even add some additional stimulus if private demand is slow to recover.

Putting the fiscal cost of the crisis in perspective

The IMF has computed the fiscal cost of the crisis and compared it with the fiscal cost of aging (IMF 2010). In almost all advanced economies the fiscal cost of the crisis is an order of magnitude smaller than the fiscal cost of aging (health, pensions and old age care). In the average advanced G-20 country the present value of the fiscal cost of the crisis amounts to about 30% of GDP; the present value of the fiscal cost of aging is estimated at close to 400%. In Holland, to make just one example, the estimated increase in age-related spending over the next 15 years amounts to 7% of GDP per year.

This suggests that policymakers should forget about the crisis and get on with reforming entitlements. A good reform of entitlements would allow them to postpone the date of fiscal exit, if needed, for a long time.

The point is not new. It was made for the US by Ben Bernanke in Dallas last spring in a speech dedicated to fiscal exit strategies (Bernanke 2010). And it was reiterated by Larry Summers this week (Summers 2010).

The difficulty with commitments is that they need to be credible, and this requires two conditions.

• Legislation needs to be passed, and;
• Projections need to be reliable.

Larry Summers obviously understands the point about the importance of entitlements reform, but unfortunately he fails on both conditions (Summers 2010). He ‘forgets’ to mention Social Security reform, which is by far the largest item in the growth of entitlements in the US. And on health he notes that the legislation adopted last spring “offers the potential to contain health costs”: Offering a potential is not exactly the reassurance markets are looking for. With such an uncertain handhold, governments like mountain climbers can take no risks — a single error could be fatal. That’s why markets are concerned with the current stance of US fiscal policy.

Europe’s Situation

Europe in this respect seems to be ahead of the US. Reforms of age-related spending are being discussed in almost all capitals, ranging from Rome to Paris and Berlin.

An interesting characteristic of the European reforms is that they focus on the age of retirement. Unlike a reduction in benefits or an increase in contributions, raising the retirement age probably won’t affect current consumption and it has a positive effect on supply. If workers anticipate that they are going to work longer, and hence have higher lifetime incomes, consumption will increase now. This will help offset the recessionary impact of the crisis. Raising the retirement age has a powerful scissors effect on the fiscal challenge of aging. It boosts the future stream of tax revenues while reducing the future stream of pension spending. The National Institute for Economic Research has estimated that an across the board two-year increase in the retirement age would reduce long run debt levels in the UK by as much as 40% of GDP.

Avoiding Ricardian offsets

Committing to future spending cuts by reforming entitlements today may also be the condition for making sure that the increases in government spending still in the pipeline (not all stimulus money has been already spent) continue being expansionary.

Empirical research on spending multipliers suggests that the response of private consumption to an increase in government spending depends on households’ expectations about offsetting fiscal measures in the future. To induce a positive response of private consumption to a spending increase you need to accompany it with a commitment to cut spending in the future. If a current increase in public spending appears to be permanent, and households expect that the budget will be balanced via increases in taxes, private consumption falls and the increase in public spending is self-defeating.

References

Bernanke, Ben (2010)

IMF (2010)

Summers, Larry (2010)

This column was first published by voxeu.org

The outcome of the battle is well-known: victory for the inflation hawks. Germany was only willing to accept monetary union, and the demise of the D-mark, if the ECB was a European replica of the Bundesbank. So it happened: the ECB was given a primary mandate to ensure price stability, subject to which it was to contribute to the other Treaty-defined goals of the European Union: among a long list of other things this includes employment.

While the treaty wording closely paralleled that of the Bundesbank law, the ECB was left to define ‘price stability’ as it saw fit. Initially its definition was annual price increases (as measured by the so-called Harmonised Index of Consumer Prices – HICP) ‘below 2%’, a target achievable over an unspecified ‘medium term’. In 2003 this was tweaked to ‘below but close to 2%’, to avoid giving the impression that the lower inflation was the better, and possibly even that deflation – persistently falling prices – was welcome.

The crisis has seen a renewal of calls for a change in the mandate. A higher inflation target has been suggested (here). Calls for including employment and growth objectives have re-emerged (here) and there is widespread agreement that central banks need to pay more attention to asset-price bubbles and financial stability. These are important debates but they must not obscure an important fact: the ECB is currently failing to fulfill its mandate – even on its own narrow definition.

Let’s look at the numbers. Start with the annual inflation rate for the euro area which comes out every month and is the figure usually reported in the media. In June it was (provisionally) 1.4%. That’s below 2%. But is it ‘close’? Well reasonable people might disagree on that. The thing to do is look behind the headline number and at the context.

The annual inflation rate measures the change in prices between, in this case, June this year and June last. As long as inflation is fluctuating gradually, it’s a pretty good guide, as it has the advantage of smoothing out short-run blips in the month-on-month data, enabling us to focus on the bigger picture. This is not true of the US, where inflation has been falling steadily, so the annual-change figure clearly becomes a ‘lagging indicator’ and can be misleading. But in the euro area headline inflation picked up during the winter, having been negative before that (see chart). More on the EU-US difference in a minute.

Next, the price index (HICP) contains elements that fluctuate wildly and should not be targeted by a sensible central bank. If you compare HICP with an index excluding energy prices and seasonal food (‘core inflation’, the preferred measure in the US, but not, alas, in Europe) you get the picture in the chart.

While the big swings in HICP since the start of 2008 are impressive, the key point is that core inflation has been falling almost monotonically month for month since the crisis broke in the late summer of 2008. Core inflation has been at or below 1% – i.e. only half the target rate – since October 2009, that is eight consecutive months. Thus the underlying rate of inflation is substantially and lastingly below ‘below but close to’ 2%. On this basis the ECB is missing its target ‘from below’ and policy should be more expansionary.

Now, monetary policy operates with time lags and it is right and proper for central banks to look at inflation prospects when setting policy. A possible defence against criticism of policy inaction at the present juncture is that, as the economy recovers, inflation is expected to rise. But how plausible is this argument?

The recovery is extremely sluggish and highly uncertain. Consumption is constrained by stagnant employment and sluggish wage growth, as firms seek to rebuild profit margins and unemployment remains high. An investment pick-up is highly unlikely given capacity utilisation rates some ten percentage points below long-term averages – there is just too much existing spare capacity. The very limited growth of achieved in the first two quarters of the year was on the back of government stimulus measures and net exports. The stimulus packages have been wound down and already reversed in a number of euro area countries.

From 2011 all the European countries will be engaging in budget consolidation, throttling demand. Continuation of rising net exports is questionable. The depreciation of the euro has come to an end – indeed the euro has appreciated by almost 10% against the US-dollar since the start of June: this will tend to reverse the pattern, mentioned earlier, that inflation has been falling more rapidly in the US than Europe, which was contingent on a sharp depreciation of the euro against the dollar. On top of this, there are worrying sign that growth in the USA and some Asian emerging markets, i.e. Europe’s export markets, is running out of steam.  Unsurprisingly in the light of all this, all the main leading indicators of economic activity have now already topped out – with growth sickly and unemployment at 10%!

In such an environment it is hard to see where any growth is to come from, much less a recovery strong enough (of the order of 0.5% a quarter) to close the output gap: yet this is a condition for the argument to hold that rising economic activity will push inflation upward.

The facts are inescapable. The ECB is not fulfilling its mandate, even on its own narrow definition. Inflation is too low. It is very likely to fall further, raising real interest rates and damaging the prospects of recovery. Very low inflation also makes it much harder to correct competitive imbalances within the euro area, because more countries have to go through actual deflation. And there is a significant risk of area-wide deflation resulting from even a small negative shock, which would be poison to attempts to reduce both government and private debt levels. In such conditions the ECB is obliged by the Treaty in its own restrictive interpretation to engage in expansionary policies.

There are a number of options. The official base rate could be cut, which would above all else send an important signal to the markets. There must be an immediate cessation of all measures to tighten liquidity provision – the recent ending of one-year liquidity helped push up the value of the euro – and renewed liquidity provision for six or even 12 months should be re-introduced. Given the fiscal crisis facing many euro area economies, a substantial program of long-term government bond purchases on the secondary market (quantitative easing) is an obvious way forward.

Source: Pewglobal.org

The Pew Global Attitudes Project has recently published a very interesting piece of research investigating attitudes towards the full Islamic veil. The results show a remarkable difference between Europeans and US citizens.

Even though Damian Green, the UK immigration minister, says a ban of the Burka would be “un-British” the vast majority of Brits seem to be in favour.

No matter where you stand in this debate, it is an interesting case exposing how easily religious freedom, personal freedom and cultural identity can clash.