The Crazy Way Europe Measures Inflation Might Doom the Euro

Matthew O'Brien May 15 2012, 5:09 PM ET

There's a long list of things that could kill the euro zone. But the most deadly might also be the most overlooked. It's the crazy way that Europe measures inflation.

Let's step back for a minute. Most central banks nowadays aim for price stability defined as 2 percent core inflation. The "core" means that they strip out volatile food and energy prices because 1) those prices mostly don't figure into long-term contracts, and 2) they're set in world markets. But Europe goes further. They strip out housing too.

Spain and Germany can't agree on how to calculate housing costs. Neither can the rest of Europe. That makes measuring euro zone inflation a problem. But Europe's solution is no solution at all. They just ignore the problem. As Kantoos Economics points out, Europe's consumer price index, the HICP, simply excludes housing costs.

Why should you care about bad inflation data? Because the ECB is nothing if not a inflation-targeting central bank. And an inflation-targeting central bank with bad inflation data is like a blind firefighter.

The below chart courtesy of Lars Christensen tries to quantify the problem. It looks at an alternative measure of inflation, the GDP deflator (blue), and sees if it has grown at a 2 percent clip (red) recently. Spoiler alert: It hasn't.

Per the GDP deflator, inflation has been dangerously low in Europe the past four years. You can thank the euro-wide housing bust for that. From Spain to Ireland to France and the Netherlands, housing bubbles have deflated. But the ECB doesn't see these price declines when it targets 2 percent HICP inflation. So it overestimates inflation, underestimates the size of the crisis, and consequently does much less than it should.

There's a long list of things that could save the euro zone, and almost all of them involve the ECB being much, much more aggressive. That's not going to happen as long as the ECB targets a metric that conveniently ignores housing, which is, for families in most developed countries, the single biggest expense.

Better data won't save the euro any more than prescription glasses can put out a house fire. But, like better glasses on a firefighter, it would be a good start.