the crisis has borne out our broad - based approach and exposed the incompleteness of the transmission mechanism in the reference model. the second shortcoming of this paradigm is its undue focus on small economic fluctuations around benign states of the economy. this left economists unprepared in terms of being able to predict the crisis and its impact. third, the paradigm rests on the built - in assumption that the announcement of an inflation target automatically yields credibility. the canonised version of the model does not allow for an understanding of how institutional strength and a track record affect credibility. institutional strength requires central bank independence, for which, in turn, legal independence is a necessary, but by no means sufficient prerequisite. inflation targeting the reference model has been at the heart of inflation targeting approaches. in brief, inflation targeting can be summed up as follows : first, take inflation and output gap forecasts as summary statistics of the state of the economy. second, ignore a host of variables, particularly money and credit. assume that these adjust to the state of the economy, but do not influence it independently. third, fine - tune the policy instrument so that inflation forecasts – whatever the nature of the shocks that might have caused them – are stabilised, and output volatility is minimised, at a pre - set horizon. it has long been known that it is misleading to limit the information set to output gap and inflation forecasts. output gaps are ill - defined and cannot be accurately measured. furthermore, inflation forecasts are not summary statistics of the state of the economy. different underlying shocks – even though they might lead to the same inflation forecast – can have vastly different implications for policy. risk management it has frequently been argued that central banks should act as risk managers by organising their framework around events with a high deflationary impact. to minimise the likelihood of deflation, central banks should err on the lax side and aim at significantly higher inflation rates. with this in mind, the imf asks whether a permanent inflation target of 4 % is appropriate. the proposal is nothing less than asking whether in the pursuit of price stability central banks put macroeconomic stability at risk. i do see the temptation for governments to ask for higher inflation in order to monetise the dramatic build - up of public debt in nearly all advanced economies. this is why calling on central banks to raise inflation rates permanently is most unhelpful. it deflects from the most pressing problem that, currently

for failing twice to submit a sufficient corrective action plan. bis central bankers ’ speeches it would be naive, however, to believe that with better governance crises could always be prevented. the second pillar to compensate for the euro area ’ s “ missing institutions ”, therefore, is to strengthen the way in which the euro area as a whole manages crises. having witnessed how imbalances in one euro area country – no matter how small – can become systemic and create financial obligations for other taxpayers, the eu institutions, national governments and national parliaments are now playing a much stronger role in demanding and monitoring economic reforms. this shift is visible in much more active role of the euro area heads of state or government in the economic management of the euro area – now institutionalised in the form of the euro summit. it is also visible in the greater scrutiny applied by national parliaments to the economic policies of other member states : for example, to approve financial assistance programmes a number of national parliaments now require eu - imf compliance reports and debt sustainability analyses. this changing role of national parliaments underscores the recent observation by herman van rompuy that national parliaments are increasingly eu institutions. the commission is also gaining a much stronger crisis management through the new “ two pack ” legislation. the current proposals would allow the commission to put any member state under enhanced surveillance if it is experiencing or threatened with financial difficulties – regardless of whether it has requested financial assistance. this would imply stress tests of the banking sector by the eba, monitoring of macro imbalances and regular review missions by the commission in liaison with the ecb. moreover, the commission would be able to send back budgets that did not comply with the sgp before they had been adopted by national authorities. in other words, the euro area is responding to the crisis by creating a new and more comprehensive model of economic governance. this is aimed at preventing imbalances in all policy areas before they can trigger crises – and managing crises more effectively when they do arise. in many ways, this response is sui generis and departs from the template we associate with political federations. for example, the “ two pack ” gives the commission the power to demand the kind of reforms that the u. s. federal government could not demand of a u. s. state. moreover, the federal government would not be able to sanction a state if, for example, its tax code was leading to a local housing bubble. this is now not excluded