Repost: European Inflation Targets
One problem with blogging is that at any given time many of your readers don’t know about ground you’ve already covered. I’ve tried to remedy that in part with my list of macroeconomics posts over to the right — before commenting on my macro analysis, you might want to read them. Still, it sometimes helps to repost an earlier argument.
So, about why the euro needs inflation to work, here’s what I wrote some time ago:
Jean-Claude Trichet is sounding hawkish about inflation again — and this is very bad news for the European periphery. Let me offer a stylized example to explain why.
So, imagine a eurozone that contains only two countries, Germany and Spain. And let’s make two assumptions: first, Germany’s economy is three times the size of Spain’s, so that German inflation is 3/4 of the overall index, Spain’s inflation 1/4; second, past events have left Spanish wages and prices 20 percent logarithmic too high relative to Germany. (Why logarithmic? So I can just add percentage changes, without having to worry about compounding.)
Now suppose that you want to get relative prices and wages back in line over the course of 5 years. How can this happen? Well, one way or another we need to have German inflation 4 points higher than Spanish inflation over that period.
So consider two scenarios: in scenario A, we have 2 percent German inflation and 2 percent Spanish deflation. This implies an overall eurozone inflation rate of 1 percent. In scenario B, we have 4 percent German inflation and zero Spanish inflation, implying eurozone inflation of 3 percent.
In a frictionless world, it wouldn’t matter which scenario gets chosen. But in reality, scenario A, the low-inflation scenario, is vastly worse for Spain — for two reasons. First, it’s much, much harder to get actual deflation than simply to have stable prices, so scenario A means much higher unemployment. Second, because Spanish debt is in euros, scenario A implies a significantly worse debt burden.
So what we’re seeing is an ECB catering to German desires for low inflation, very much at the expense of making the problems of peripheral economies much less tractable.
This is going to be ugly.
I’d add that the ECB and European leaders have been in complete denial on this point, willing neither to acknowledge the deflation their policies require nor to accept the need for higher overall inflation if deflation is to be avoided.
