Stephen King: If we looked at the bigger picture, the eurozone's problems would disappear
Economic Outlook: If some countries have lower-than-average inflation, it must follow that others should have inflation that is higher than average
Monday 19 September 2011
I have decided that the easiest way to fix the eurozone's many problems is to stop publishing national macroeconomic data. Instead, we should only worry about the eurozone's performance as a whole. That way, many of the eurozone's current difficulties would simply disappear.
You don't believe me? Think about the UK. The numbers published on a monthly or quarterly basis refer to the UK as a whole, not to its geographical subdivisions. Admittedly, some data snapshots offer an immediate regional breakdown but, more often than not, the regional split comes out either a lot later or, in the case of balance of payments statistics, not at all.
As a result – and with the honourable exception of the housing market which, for men and women up and down the country, is something of an obsession – we don't engage too often in debates about whether macroeconomic policies are working effectively at the regional or county level. In particular, we think the Bank of England is doing its job properly if it provides price stability for the UK as a whole. For all we know, Cornish inflation may be a lot higher than inflation on Merseyside but, frankly, who cares?
In the eurozone, however, we do care. The monthly inflation data provide a snapshot of price pressures country by country. Overall, eurozone inflation currently stands at 2.5 per cent, above the European Central Bank's hallowed "less than 2 per cent" objective. This aggregate number, however, hides both "saints" and "sinners". Ireland, at 1 per cent, has the lowest inflation rate in the eurozone, followed by Slovenia (1.2 per cent) and Greece (1.4 per cent). The highest inflation rate belongs to Estonia (5.6 per cent), followed by Slovakia (4.1 per cent) and Austria (3.7 per cent).
Did the people of these countries understand that, within the euro, they'd end up with such differing inflationary experiences? Probably not. While it's not hugely surprising that inflation is so low in austerity-ridden Greece and Ireland, the average Austrian may be a little perplexed that, in downtown Vienna, prices seem to be rising at a fair old pace.
The good news is that these differences in relative inflation rates reveal that the euro is actually working. After all, adjustments in competitiveness cannot take place via exchange rates. Within the eurozone, individual currencies don't exist. Instead, competitive changes have to occur through relative movements in price and wage levels. If – as everyone in Europe now seems to accept – countries like Greece are uncompetitive, lower-than-average inflation should, in time, lead to relative economic improvement, even if it is a long, hard slog.
If, however, some countries in the eurozone have lower-than-average inflation, it must follow that other countries should have higher-than-average inflation. And, if the ECB determines that, over the long run, inflation should be a little less than 2 per cent, those countries with inflation well below 2 per cent must be counterbalanced by other countries with inflation well above 2 per cent. That's roughly the position we find ourselves in today.
Does this matter? For the good of the eurozone as a whole, it really shouldn't. But there's no doubt that policymakers are highly sensitive to inflationary discrepancies within the eurozone and, hence, the possibility that individual nations don't end up with the price stability they thought they'd enjoy as a consequence of euro membership.
Earlier this month, Jean-Claude Trichet, the outgoing president of the European Central Bank, declared: "We have delivered price stability over the first 12 years of the euro – impeccably. Impeccably! I would very much like to hear congratulations for an institution which has delivered price stability in Germany over almost 13 year at 1.55 per cent approximately... which is better than has been obtained in this country over the last 50 years."
In truth, however, the president of the ECB really shouldn't care where German inflation has been. His only concern should be where, on average, eurozone inflation has been. If, for example, German inflation had been at 1.55 per cent but the average for the eurozone as a whole had been 4 per cent, the ECB would have failed in its task even if the average German might have been happy.
The ECB cannot deliver price stability at both the eurozone level and the individual country level. It can do one or the other, but not both. If it's doing its job properly, there is no reason whatsoever why any individual nation can reasonably expect to deliver an inflation rate in line with the eurozone average. Indeed, if the likes of Italy, Spain, Portugal, Greece and Ireland have to deliver inflation rates lower than the eurozone average to improve their competitiveness, it follows that other nations will have to put up with inflation rates above average.
This conclusion offers an intriguing perspective on burden-sharing within the eurozone. Germany and its near neighbours have no desire to provide continuous bailouts to the peripheral nations, partly because they know their own taxpayers won't put up with it. They demand, instead, that Greece and others adopt reforms which, over time, will make the peripheral nations more competitive. That improvement in competitiveness, however, is precisely the process that should lead to higher inflation in Germany and other core countries.
And higher core inflation without any increase in core interest rates will leave savers in Germany, Austria and other core countries nursing losses. They will find, over time, that their savings fall in value. German 10-year bond yields are now well below 2 per cent while those in Austria are at about 2.5 per cent. Given their elevated inflation rates, real interest rates in both countries are now negative. Germany and Austria might save their taxpayers money by choosing not to bail out peripheral nations but, if the alternative is a bigger inflation differential, their savers might still lose out.
For all I know, the same mechanism may be at work in Devon, Dorset and Durham. But because no one knows – or pays attention to – inflation differentials between British counties, we don't really care. Instead, we look at the aggregate number for the UK as a whole and simply assume that appropriate adjustments take place. In the eurozone, however, national interest matters a great deal. And because it does, winners and losers are much easier to spot. No wonder, then, that the eurozone is full of frictions. In any economic system, burden-sharing has to take place. Sometimes, though, it's better not to know precisely how the burden has been shared. That way, harmony can more easily be maintained. Ignorance isn't always a bad thing.
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