Stephen King: Expansion of the eurozone poses new deflation threat

Fiscal independence within a monetary union can lead to a series of beggar-thy- neighbour actions

When is an inflation target not an inflation target? When it becomes a source of income redistribution. An odd conclusion, perhaps, given that we think of unstable inflation as a key source of windfall income gains and losses. Nevertheless, the choice of inflation target can have a big impact on a country's long-term success and, in addition, its ability to compete with its main trading partners. Moreover, if inflation targets matter for income distribution, they also matter not just for economics but also for politics.

This conclusion is important for two reasons. First, it may tell us something about success and failure within the eurozone. Second, it should have some influence on Treasury thinking about euro membership. After all the Chancellor, Gordon Brown, has already hinted at a shift away from the current inflation target, based on the familiar RPIX, to a target based on the harmonised measure - known as the HICP - used within the eurozone.

An easy way to demonstrate the importance of choice over inflation targets is to use a simple numerical example. Imagine a world of just two countries, A and B. Country A has an inflation rate of 2 per cent. Country B has an inflation rate of 3.5 per cent. These two countries then decide to form a monetary union. Country A insists that it will not tolerate inflation higher than 2 per cent within the monetary union as a whole and demands that the central bank for the two countries has a target for inflation of "less than 2 per cent".

Country B agrees but has realised something that country A has failed to work out. The inflation differential exists not because country B is more "inflationary" but, rather, because it has a lower income per head and, therefore, is at a different stage of development. With productivity growing rapidly in its tradable goods sector, wages for the whole economy are rising quite quickly and, as a result, so is inflation. Country B knows that, given this "catch-up" or "development differential", it is inevitable that its inflation rate will be higher than country A's. Indeed, it expects its inflation rate within the monetary union to remain 1.5 per cent higher than country A's.

Monetary union begins and the newly formed central bank sets to work. With an inflation target of 2 per cent, it finds that the average inflation rate of 2.75 per cent - 2 per cent in country A and 3.5 per cent in country B - is too high. So, it keeps policy nice and tight, hoping to reduce inflationary expectations. After a while, the policy appears to be working: inflation in country B starts to drift downwards. But, hold on a minute, so is inflation in country A. The "development differential" demands that inflation in country B must remain higher than in country A so if the central bank aims for inflation of less than 2 per cent across the monetary union as a whole, it's inevitable that inflation will have to fall in both countries. A new "steady state" is reached when the average inflation rate comes in at 2 per cent. This is likely to mean inflation in country A of just 1.25 per cent and inflation in country B of 2.75 per cent.

In other words, country A's insistence on an inflation target for the monetary union as a whole of less than 2 per cent - in keeping with its own previous inflation experience - requires country A to have an inflation rate significantly lower than it has had in the past. But then country A discovers that its companies and unions are not very good at accepting lower wage increases and lower price increases. Unemployment starts to rise and profits come under pressure. Government revenues begin to fall back and the deficit starts to get too big - bumping into the fiscal constraints that country A itself had demanded to ensure that other, less trustworthy, countries would not misbehave.

Then things go from bad to worse. Country B looks at country A and realises that times are tough. What does country B do? Well, the obvious self-interested strategy is to tighten fiscal policy. That way, country B's inflation rate will come down even more, tightening the noose around country A's neck and ensuring a significant competitive improvement at country A's expense. Eventually, country A tips over into a grinding deflation yet can do nothing about it. Ironically, country A has been a victim of the safeguards that it demanded to ensure the success of the fledgling monetary union.

Sounds familiar? Well, of course it does. Country A is Germany and country B is the rest of Europe. The choice of inflation target matters for these countries because, first, there probably should be some kind of inflation differential across the euro area and, second, no developed country, no matter how flexible its labour markets, is particularly well-suited to deal with deflation. That deflation might arise for one country as a result of a seemingly innocuous inflation target suggests that any monetary union may suffer from the law of unintended consequences.

The point of this story is that countries can, individually, lose control of their own inflation rate within a monetary union where countries are at differing stages of development. Moreover, the fiscal independence granted to individual countries within a monetary union can lead to a series of beggar-thy-neighbour fiscal actions that might leave those countries with relatively low inflation in the first place in a spot of bother.

For the UK, this is an important conclusion. The Chancellor might choose to switch to a HICP-based inflation target rather than the RPIX target simply to demonstrate to all of us that he can be a "good European". If he does so, the target itself would have to be numerically lower - the HICP measure has, recently, been roughly 1 per cent lower than RPIX (see graph). But, with the Bank of England in charge, there would not be much difficulty in hitting either target. Within the eurozone, however, it would be a different kettle of fish: our inflation rate would depend on, first, what the ECB chooses to target and, second, our level of development relative to other countries within the eurozone.

This, in turn, raises a more general point. A key aspect of the current UK arrangements is the distinction between those that set the inflation target - the Chancellor or, more broadly, the government - and those that try to hit the target - the Bank of England. This might not seem perfect - it could smack of too much political interference - but it does mean that a democratic "choice" is exercised over the inflation target.

Should we join the eurozone, that choice would be gone in more ways than one. Yes, the inflation target for the eurozone might not differ that much from the UK at the moment but the implications for inflation in any one country could change over time. The more Central and Eastern European countries that join, the more that inflation will have to be lower in the more advanced countries if the ECB sticks to its current inflation target formulation. If this process threatens more and more deflation at the individual country level, it may be wise to take the choice of inflation target away from the ECB altogether. Otherwise, technocrats will increasingly influence income distribution and, hence, one of the key political issues of this or any other day.

Stephen King is managing director of economics at HSBC.

stephenking@hsbcib.com