IMF Strengthens Argument for Higher Inflation in Eurozone

By: Grzegorz Janota

The International Monetary Fund’s newly released paper by Reinhart and Rogoff evaluates measures used by the European Central Bank (ECB) to combat debt. The authors point out that, with current debt levels, growth in the Eurozone would be stunted by 1.2% over the next 23 years. In addition to austerity measures, the ECB must utilize debt restructuring, financial repression and inflation – all of which were used by developed countries in the 1930s and 1940s. This last component is worth focusing on, as it resonates with a number of economists who suggest that higher inflation in the Eurozone could be beneficial.

The argument lies in the idea that inflation leads to negative real interest rates. With a higher price level, the money used to pay off debt is worth less. Since nominal wages tend to rise with inflation, the burden of debt falls. This increases the spending of both governments and consumers, fostering economic recovery.

Germany, however, remains starkly opposed to higher inflation. Higher relative inflation is believed to be harmful to exports, a key driver of economic growth. Another deep-seated reason for Germany’s stance is the fear of another devastating hyperinflation. These fears are institutionalized in the mandate of both the Bundesbank and the ECB, which postulates that the inflation rate must remain close to but below 2%.

However, perhaps in light of Europe’s high debt levels, Reinhardt and Rogoff’s solutions may be deemed necessary despite the dangers that accompany them. Their paper undoubtedly will spark greater debate in the ECB about the benefits of inflation.

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