Eurozone Inflation Arithmetic

It would seem that my initial post on raising the inflation target has sparked a pretty fruitful debate. Here’s a quick follow-up by Max on the topic.

I think the case for raising the inflation target is very strong. But it’s especially strong in the context of the European Monetary Union.

You see, the key problem in the Eurozone crisis is “rebalancing”: The periphery countries (the GIIPS) need to reverse their current accounts. And that requires a real devaluation of the periphery vis-à-vis the core (Germany, mainly). My colleague Christoph Zwick reckons in his new working paper that the periphery-core real exchange rate needs to fall by at least 13-17 percent over the next three years. There is, of course, a lot of uncertainty about this estimate. Nevertheless let’s assume a value of 15 percent, which sounds reasonable. This implies an annual real devaluation of (approximately) 5 percent for the next three years. Within the Eurozone, real devaluation can only come through an inflation differential: inflation in the periphery (p) needs to be 5 percentage points below the inflation rate in the core (p*).

Now the ECB targets the Eurozone inflation rate, i.e. the weighted average of core and periphery inflation rates. The share of the core in total Eurozone GDP is about 2/3. Let the ECB’s inflation target be t. So we have t = (1/3)p + (2/3)p*. If you combine this with the requires inflation differential, p* – p = 5, we get p =  t – (10/3) and p* = t + (5/3). Hence the periphery inflation rate has to be 3.3 percentage points below the Eurozone target and the core inflation rate has to be 1.7 percentage points above.

An inflation target of 2 percent implies 1.3 percent deflation in the Eurozone’s periphery each year for the next three years. This would be incredibly painful. If the ECB would target 4 percent average inflation, it would allow 0.7 percent inflation in the GIIPS. That also hurts, but probably much less than hardcore deflation. Meanwhile, the new target would imply 5.7 percent inflation in the core countries, which is higher than what we had during the last decade but not at all high by historical standards.

Obviously the concrete numbers are debatable, but the general result is not: Under the ECB’s current inflation target, the necessary current account adjustment in the Eurozone seems pretty impossible. Raising that target would make it a whole lot easier.

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3 thoughts on “Eurozone Inflation Arithmetic

  1. I am very sympathetic to your contribution. However, I would also like to augment your discussion by a few related issues. Probably, not all of them are non-starters. I’d be happy to foster some more discussion.

    A major idea of the design of EU institutions was the notion that a common currency – that is, the replacement of flexible- by fixed exchange rates – significantly lowers transaction costs (in terms of uncertainty, but also in terms of administration costs). No question, this is a good idea – given that the participating countries are similar (enough). The Maastricht criteria were considered to represent a benchmark for similarity. However, these benefits come with a cost (this is the point at which I like economics). Flexible exchange rates, as a policy instrument, are not available anymore even if it turns out that participating countries are not similar enough anymore. If, for example, labor productivity in Greece is lower than in Germany, then the lack of flexible exchange rates may lead to unemployment in Greece – to say the least.

    In this blog, inflation targeting was raised. The role of inflation targeting clearly was to substitute for flexible exchange rates. The role flexible exchange rates played in the past should now be the role of the ECB’s inflation targets. To my modest opinion, I do not agree with this view of the situation. I am rather convinced that some countries are members of the EU that are not similar enough (by any standards). And as a very strong conclusion, given that they are not similar enough, they probably should possibly not be members of the EU.

    Having hypothetically excluded non-core EU-countries (and this is a pure ECONOMIC consideration – NOT a consideration regarding the EU), the inflation targeting question looses importance, to my point of view.

    I am also having a general question regarding inflation targeting. How does it work? To my point of view, it is really a question of how productive a firm is allowed to be. And after all, if EU allows for a high inflation target, how do the associated trade deficits contribute to solving EU economic problems?

  2. First of all, thanks for dropping by the Blog, and also for linking to it on your website – I very much appreciate it. While the post was obviously written by Max, I would like to offer some of my thoughts on the issues you raised, of which I am not quite sure I understand all.

    The point with Eurozone countries not being similar enough is, of course, vital. As a quick comparison, the richest Eurozone country in 2009 in terms of GDP per capita (if we exclude Luxembourg) was Ireland, which was over 3 times “richer” than the poorest country, Estonia. Compared to the United States, a monetary union of similar size, the richest state (excluding D.C.) is Delaware, which is only around twice as rich as the poorest one, Mississippi. GDP/Capita seems like a somewhat decent proxy to measure heterogeneity, and given even the Eurozone lacks many of the stabilizing institutions the US has, this is indeed a huge problem.

    You mention that inflation targeting was a substitute for flexible exchange rates, which confuses me a bit. As far as I understand it, inflation targeting in general only became possible because, following the collapse of Breton Woods and later the European Monetary System, most countries moved to flexible exchange rates. As such it would seem that flexible exchange rates are essentially a prerequisite for inflation targeting (or any kind of activist monetary policy in general). Countries in the Eurozone no longer being able to target inflation individually is what is causing the problems. One of the costs of pegging ones currency to a fixed exchange rate is that one looses the ability to use inflation targeting (on an individual country level). In a sense, under Bretton Woods, it was the FED who “set the inflation target” (by which I mean was basically the only one able to conduct independent monetary policy) given that everyone else was pegged to the Dollar. Once the periphery no longer has the need for a higher overall inflation target since they can again target their own inflation rate, the discussion indeed becomes obsolete on those grounds (even though not in general, as the zero lower bound, for instance, remains relevant).

    If you find the time, I would also be interested in what exactly you mean by saying that inflation targeting “is really a question of how productive a firm is allowed to be”. I would assume you approach the issue from a microeconomics perspectives, while I feel more at home in macroeconomics. Maybe that is part of the reason why, although I might agree, at the moment I am as unable to understand your point as the Parisians here are unable to understand me most of the time. In essence Inflation is nothing more than the amount of money that is issued above and beyond the amount of real activity generated in any given period of time. If a firm becomes more productive, i.e. produces more with the same input (a.k.a. produces more added value, as an example), RGDP would rise. In order to achieve the same level of inflation, more money would need to be printed, which is exactly the idea since otherwise we would at some point run into deflation. Unless I am making a terrible logical mistake, a non-negative level of inflation, rather than limiting how productive a firm can be, allows a firm to be able to increase its productivity and actually make use of that increased productivity in the first place. Inflation targeting only makes sure this happens.

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