EMU exposes the great price divide
Monday 10 May 1999
Since EMU removes the option of maintaining price competitiveness through exchange rate changes, domestic price levels will feel the force of the more open competition unleashed by EMU. This is likely to lead to a levelling down of price levels across Europe, which will reduce the average inflation rate and sustain inflation differentials. Contrary to the critics of EMU's "one size fits all" monetary policy, these differentials are not necessarily unsustainable or harmful.
The Maastricht-inspired obsession with inflation differentials has obscured the fact that price levels across the EU are still widely divergent. For example, Germany's price level is some 46 per cent higher than Portugal's (see chart). These differences largely reflect differing income levels. Prices, like wages, tend to be lower in poorer countries.
Higher inflation in low price economies can be sustained if it does not undermine their price competitiveness. Consider the following "dual inflation" process. Portuguese workers are paid much less than German workers because they are much less productive. As productivity in Portugal's internationally tradeable sectors (eg manufacturing) catches up with that in Germany, so wage levels tend to catch up.
However, because productivity growth in the non-tradeable sectors (eg public services) is lower, any spill-over of these rapid wage gains into these sectors will lead them to experience relatively high inflation. Since by definition non-tradeables are not subject to international competition, this does not present a competitiveness problem.
It will, however, push up the average inflation rate in the economy as a whole, resulting in a positive inflation differential in relation to high income countries.
This process is not directly connected with EMU. Indeed, it has been at work in Europe for many years. However, EMU is giving it extra impetus as the poorer parts of Euroland are enjoying the benefits of a lower, common interest rate and heavy foreign investment.
While this catch-up process points towards a levelling up in prices, there are three other forces which suggest that EMU will, by stimulating competition, lead to an accelerated levelling down. First, it will make price comparisons more transparent. Consumers will no longer have to use fluctuating exchange rates to compare prices. Aside from fuelling the already lucrative trade in cross-border shopping, this should also stimulate home shopping via mail-order and e-commerce. That said, much of the pressure for narrower price differentials will come less from individual consumers, than from distributors, wholesalers, and major retailers.
Secondly, EMU will cut transactions costs and remove foreign exchange uncertainty. In the past, while buyers were perhaps aware of cheaper foreign supplies, they may have been reluctant to switch from long-established local suppliers for the sake of savings which might be wiped out by subsequent currency movements. The fact that exchange rates between the so-called "legacy" currencies are now fixed permanently removes this deterrent.
Thirdly, EMU is accelerating the restructuring of European industry, courtesy of a surge in cross-border mergers and acquisitions, portfolio flows and direct investment. The pursuit of profit is also encouraging the rationalisation of distribution and consolidation of supplies across Europe. Moreover, as producers find their margins being squeezed they will become even more resistant to relatively high taxes or public service charges.
This is not to suggest that there will be complete price convergence. Indeed, some prices may not converge at all. Transport costs, tax differences and government regulation will all continue to sustain national price differences. Few Austrians are likely to jump on a plane to Portugal because haircuts there cost less than third of the price in Austria.
Nevertheless, the sheer scale of the price differences leaves plenty of scope for accelerated convergence. For example, surveys have found that differentials in pre-tax prices of consumer durables range up to 50 per cent, and those on certain food items such as cooking oil are up to 400 per cent. Some indication of the limits to the process can be gleaned from studies that show that price level differences between the Euroland economies are around seven times greater than those within them. Moreover, national aggregates perhaps underplay the convergence potential since they conceal even bigger differences in the prices of particular products.
Another way of looking at this is to consider how long it would take for price levels to converge at current inflation rates.
In the case of Spain, with inflation at 2.2 per cent, it would take until 2023 for its price level to reach the euroland average.
The implications of this for Europe's economy and markets are profound. First, there is likely to be a bias towards the levelling down in price levels. A survey by KPMG Consulting of 307 large European companies, found that of the 64 per cent of companies with variable pricing across Europe, 86 per cent expected the price range to narrow and of those 64 per cent expected prices to go down and only 11 per cent expected prices to go up.
An ING Barings study estimated that the average Euroland inflation rate could be reduced by around 0.25 per cent per annum over the next five years. This is broadly the equivalent of a 1 per cent pa fall in the price of tradeables in the "high price" economies. Meanwhile, it also implies that the widening in Euroland inflation differentials which has occurred since 1997 is not an aberration. Rather, it is a sign of things to come.
To the extent that higher inflation in the lower price economies reflects higher productivity growth it should have no impact on either the European Central Bank's monetary stance or to bond investors' credit assessments. The ECB argues that national inflation rates are a matter for national governments to address through fiscal policy or structural reforms. The structural price convergence trend bolsters this position, since it suggests that persistent inflation differentials may not only be sustainable, but even desirable.
Second, economic growth, like inflation, likely to be higher in the "low price" economies. By contrast, in a generally low inflation environment, the levelling down in price levels may require prices of tradeables in the "high price" economies to fall persistently. Given the resistance to pay-cuts, this in turn means that producers will need to maintain rapid productivity growth. So in the absence of robust growth and increased labour market flexibility, unemployment will remain high.
Third, the combination of the euro and more uniform pricing across Euroland will sharpen the competition facing the UK and Euroland's other neighbours. Any discrepancies between their prices and those in Euroland will become more visible. UK businesses may be forced not just to quote in euros but also to fall into line with prices prevailing in Euroland.
This points to a rosy outlook for Europe's financial markets. In addition to low inflation and low interest rates, larger, quoted companies may be able to improve their margins if they succeed in securing lower prices from their suppliers while not passing on the full benefit to their customers. Indeed, the accelerating pace of corporate restructuring suggests they may be ahead of policy-makers in rising to the challenge of price convergence.
Mark Cliffe is chief European economist at ING Barings.
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