Eurozone rebalancing depends on German inflation
The Federal Statistics Office reported that German consumer prices increased 0.2% on a seasonally-adjusted basis in October, translating into a 1.3% annual gain on a harmonized basis. German prices are very sticky, since the domestic economy doesn’t see the boom and bust cyclical behavior like that in other developed economies. However, inflation may headed north, especially if the trend in industrial prices (PPI), a +3.8% annual clip, is any leading indicator. (Click on chart to enlarge.)
Will German policymakers see the inflation for what it is? It’s a shift in relative prices to drive real German appreciation in order to rebalance current accounts across the region amid a fixed currency regime.
The Eurozone region is now characterized by current account imbalances, imbalances that are now being addressed through fiscal austerity measures. According to the IMF October 2010 World Economic Outlook, Germany will run the second largest current account surplus in the Eurozone as a percentage of GDP this year (second to Luxembourg), 6.1%, while Greece and Portugal will run the largest deficits, -10.8% and -10%, respectively. Among the bigger economies, Spain’s 2010 current account deficit sticks out at -5.2% of GDP. In fact, just 6 of the 16 Eurozone economies are expected to run current account surpluses in 2010.
If these fiscal austerity measures are to succeed in Europe, the hardest hit economies – Spain, Portugal, Ireland, Greece – must generate income externally via export growth. In order to gain export growth, competitiveness must be drawn upon in one of three ways (or a combination): (1) the nominal exchange rate depreciates in the debtor countries (CA deficit countries); (2) final goods prices fall in the debtor countries relative to the creditor countries; or (3) unit labor costs fall in the debtor countries relative to the creditor countries. Any combination of the three will shift the real exchange rate in favor of the debtor countries and drive export growth.
Since (1), depreciation of the nominal exchange rate, is clearly not an option in the single-currency Eurozone, it’s up to (2) and (3). I’ve talked about wage-cutting; and most of the fiscal austerity packages include some degree of public sector wage cuts, so I won’t address that here. And point (2) has been addressed mostly via fiscal austerity dragging price pressures domestically, and leading to increased competitiveness. But point (2) can be seen from another light…
…it’s all about relative prices, and inflation in Germany realtive to the debtor countries can establish competitiveness in debtor countries.
German inflation is important for two reasons.
First, it’s all about relative prices (point 2 above), so competitiveness in Spain, for example, could similarly be generated if German inflation rises relative to that in Spain, holding Spanish inflation constant – even more so if Spain’s inflation rate is falling . In fact, a rather stark increase in German inflation is likely needed to generate a rebalancing effect when nominal depreciation is out of the question (as is the case for the Eurozone).
On to the second reason why German inflation is important: the ECB average inflation target.
The table to the left illustrates the compounded annual rate of inflation (CAGR) for each of the current member Eurozone economies since 2000. Germany has, on average, seen prices rise at a 1.7% annual rate, while Spain has seen prices rise at a 2.9% annual rate.
Amid fiscal austerity, German inflation is needed is to keep the ECB’s target average inflation rate– the average inflation rate is the weighted HICP across all of the Eurozone economies – around 2% while the much of the Eurozone experiences disinflation (or deflation).
Spanning 2000-2009, the Spanish economy contributed roughly 0.4% to the Euro area’s average 2.1% annual inflation (based on the HICP country weight, which is 12.6% – see the Eurostat publication for links to the data). Greece contributed roughly 0.1%, on average, to overall inflation. Going forward, there will be a lot of inflation slack to be picked up as these economies contract further.
It’s gotta be Germany!
But will German policymakers and its massive export sector tolerate higher average annual inflation? Let’s say at roughly 3%, and for some time? I’m skeptical – so the outlook for the Eurozone, in my view, has just worsened.
Rebecca Wilder
By the way, I just told my German husband, Herr Wilder, about this article. You know what his response was? “Oh…Germans don’t like inflation.” Enough said.
Another great post, Rebecca. I’ll pass this to my French wife, Madame Farrar, so she won’t be influenced by German ranting.
“In fact, just 6 of the 16 Eurozone economies are expected to run current account surpluses in 2010.”
Well, that’s almost half, so that should be within the normal range, no? 🙂
“If these fiscal austerity measures are to succeed in Europe, the hardest hit economies – Spain, Portugal, Ireland, Greece – must generate income externally via export growth.”
And how is that working out?
“And how is that working out?”
Not well – and we’re not even into 2011, when the bulk of the fiscal austerity starts to kick in!
“And how is that working out?”
Not well – and we’re not even into 2011, when the bulk of the fiscal austerity starts to kick in!
Actually, the Irish current account is near-balanced compared to the rest of the headline Periphery countries. It got to the austerity early, deflation…the works, which has helped exports. However, that is unlikely to last as Spain, Portugal, the UK, initiate their austerity measures.
Ha ha – LOL! The Germans are totally crazy (clearly, I speak with some authority, albeit anecdotal, on the subject).
My husband always says something like, “we’re just good at making things”
So does Merkel:
“Germany’s trade balance is a product of market forces and evidence of superior German products, Merkel told Die Welt newspaper in an interview to be published in tomorrow’s edition, the day she leaves for the G-20 summit in Seoul.”
Too bad the German banks own near 1/4 of all Irish debt on their books (see page 16 of the BIS quarterly Review).
Rebecca
Sorry, but count me as one of those who have little to no problem with Robert Mundell and his optimum currency areas theory. Moreover, Europe itself is naturally operating its economy according to these principles.
In practice this means that Europe does NOT have massive current account imbalances, since the means by which a current account should be measured is to look at the entire currency area. And what is the current account of the Eurozone? -0.4% of GDP. Very low.
Eurozone economists will also be quick to point out that complaints over, say, the budget deficit of Ireland or the current account deficit of Spain can easily be answered by pointing at the United States: What of the budget deficit of California? Or the current account deficit of Texas? If you’re arguing against “one size fits all” then, in theory, you should allow individual states in the US to have their own currencies so that they can devalue them to gain trade advantages with other states.
Of course the answer that many will give to that is that “The United States is more culturally homogenous and has greater labor mobility than the Eurozone, not to mention a common language”. Well just forget the fact that over 50% of people in the Eurozone speak English, or the fact that the unemployed in Mississippi won’t shift to Vermont to find work.
Greece and Ireland are certainly in a bad situation, but no worse than California or other US states. And just as US states will benefit from overall growth in the single currency US economy, so will Eurozone countries benefit from overall growth in the single currency Eurozone economy. Greece and Ireland, therefore, have to wait for the rest of the EU to recover. And as far as I remember, latest Eurozone growth was stellar compared to the US.
“Greece and Ireland are certainly in a bad situation, but no worse than California or other US states.”
That may be true, per se – but if Greece or Ireland or Spain or Italy bring down the overall Eurozone economy, then there’s no automatic stabilizer to support the regional decline. In the US, the Federal government underpins any business cycle decline by running deficits as tax receipts fall and transfers rise,
Another point: if the Spanish economy goes into recession, then people don’t leave Spain to find work – they stay in Spain. This is not the case in the US (usually, that is, when people are not stuck, underwater, in their homes). If a California crisis causes massive jobloss and resource underutilization, then people move to another state that has greater prospects.
It’s highly debatable whether or not the Eurozone is an optimum currency area. It’s not, in my opinion. The increased saving in some countries must be financed by reduced saving in others – the interdependence of trade requires that.
”And as far as I remember, latest Eurozone growth was stellar compared to the US“
I’d hardly call it stellar, when the largest economy, Germany, posts a 2.2% gain on exports and inventories. Surprising, yes.
Rebecca
Germany, with lower unemployment than in the weaker European countries, is prone to generate more inflation under the same monetary policy regime. Remaining elements to consider are fiscal policy and structural differences. As regards fiscal policy, Germany has done a bit of inappropriate twiddling, but relative to what has been done in the European peripherals and the UK, Germany’s adjustment is small. Thus on fiscal policy, Germany is also running in the right direction for higher inflation than in the periphery. Structural differences are less helpful in supporting adjustment. “Germans don’t like inflation” may, on that point, be enough said.
There is no linkage between fiscal austerity measures and export growth. These are two separated things. Export growth would ease fiscal austerity measures, but you can get your household deficies clean without it. You must cut your expenditures and increase your revenues, speak raise your taxes. Something the US will have to learn also. It is politicaly always easier to have low taxes and high expenditures, because it doesn´t hurt so much than otherwise. But in the long term it will create a huge debt problem.
In my opinion you should study more the German Schuldenbremse (debt brake):
http://translate.google.com/translate?js=n&prev=_t&hl=de&ie=UTF-8&layout=2&eotf=1&sl=de&tl=en&u=http%3A%2F%2Fde.wikipedia.org%2Fwiki%2FSchuldenbremse_%2528Deutschland%2529&act=url