If I understand the news coming out of Europe correctly, the new head of the European Central Bank is offering a simple deal: If fiscal policy becomes hawkish, monetary policy will be dovish. In other words, as government spending is cut to put European governments on a sounder financial footing, monetary policy will do its best to ensure that any adverse impact on aggregate demand is kept to a minimum.
He wonders why we cannot get this sort of deal in the U.S. He makes the point that I made at dinner with Tim Congdon. The would-be monetary doves on the left believe we are in a liquidity trap, and the would-be monetary doves on the right are frightened of inflation.
I think what this is getting us is the worst possible combination--expansionary fiscal policy and non-stimulative monetary policy. The hawkish monetary policy may limit inflation in the near term (when lower inflation is not necessarily a good thing), but meanwhile the long-term inflationary pressures are building due to the fiscal deficits.
On the prospects for Europe actually implementing tighter fiscal policy, color me skeptical. Show me some significant cuts in European agriculture subsidies and I'll change my mind.