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Economy in Brief

EMU Inflation Steadies Too Bad the EU and Its Politics Won't
by Robert Brusca  March 15, 2013

The accompanying chart shows the incredible impact of the ongoing austerity programs in Europe. In high-inflation Italy the inflation rate has plunged. In low-inflation Germany inflation rate has continued to work lower. The current EMU rate of inflation is below 2%, the long-run policy objective of the European central bank. The average rate of inflation since the formation of the union is within rounding error of that pledge at 2.1%. Even so there remains the sharp differences among the harmonized consumer price inflation rates within the Community.

If we look at the statistical standard deviation of inflation among the first 12 members of the community, we find that we are back-tracking to the kind of intra-community inflation differences that were present in the early goings of the Monetary Union. In the early days of the Union the standard deviation of inflation across these members of the community started about 0.9% occasionally flaring up to 1.2 1.3% with an average of about 1.1%. Currently the deviations are back up to about 1% and the trend is rising. Those deviations had cycle down to a low of a proxy o.5% is the financial crisis. Then as the e-Zone came into recovery there was a greater divergence of inflation than we had seen previously as its divergence ran all the way up to about 1.7 percentage points. It fell back down in August 2011 to 2012 to about 0.6 percentage points and now it is back on a rapid rise. Some huge divergences have reemerged within the Community despite the fact that the chart above seems to show that, at least for those countries, inflation rates are moving in tandem.

Inflation divergence is an important metric to consider because the ECB runs one monetary policy for the whole Union. If growth is uneven and if the Union's inflation forces are uneven, it's hard to get the job done with a single monetary policy. This is especially true because the ECB does not have any regional tools whatsoever. Nor does it have any regional mandate. Essentially regional inflation differences remain unexplained. If the one were an integrated whole it is unlikely that inflation would differ by country so much. One way of reconciling what we observe is that the persisting inflation differences are evidence of a lack of European integration.

At the ongoing EU summit there is a clear recognition that things have gone wrong. A number of leaders are looking for ways to try to inject growth into their economies. There a common concern over the level of youth-unemployment. It is one common problem over which there are very concerns if not actions. However, Angela Merkel is not in favor of letting up one iota on the push to austerity. Germany has even intensified its own push, setting its sights on a balanced budget.

However, the rest of the zone is in a very different mood with Hollande in France under extreme political pressure and with the political system in Italy under extreme pressure from a public that does not want to take it anymore. Spain, Portugal and Greece continue to have their own problems but they too are focused on the ill effects of austerity.

Austerity has turned inflation tendencies on their heads. Since EMU was formed, Greece has had the largest aggregate rise in its price level, a gain of 46.4% averaging a little over 3% per year on inflation; Germany has had the lowest inflation with its price level rising just 25.2% averaging a 1.7% per year gain. However, over the past year, the second lowest growth rate for inflation in EMU in the original 11 members is Greece at 0.2%. Germany is running a 1.7% pace close to the 1.8% weighted average for all of EMU. And of course this is the way that austerity has to work. If Greece is going to regain its competitiveness and it is still some 21 percentage points short of getting its price level back to where it was when EMU was formed it will have to run a slower inflation rate than Germany. But Germany always tends to run a relatively modest pace, this means for Greece to make any progress it will have to be virtually inflation free. If Greece were to be able to maintain the inflation advantage on Germany it currently has, it would still take it 14 years to get its price level back to what it was when the European Monetary Union was formed.

It is calculations like this the cause me to wonder how austerity could ever work. It's unimaginable that Greece could hold up under this kind of pressure for another 14 years. Portugal, too, is making progress. Its inflation rate over the past year is only 0.1%. It, too, is beginning to gain back some of its lost competitiveness. Spain's inflation rate at 2.9% suggests that it's losing even more ground to Germany. Whatever else austerity is doing is not restoring price competitiveness in Spain.

The ongoing European summit has a lot of issues on its table. It is trying to deal with a common foreign-policy with Syria, it has the potential bailout in Cyprus, it is concerned about some of the political changes in Hungary. And as difficult as these political decisions are, they not as difficult as economic decisions that clearly need to be made and that, for that reason, never make any progress.

It's observations like this that cause me to still appreciate some of the economic models with their smooth and continuous functions and what we can learn from them about economic interactions and the effectiveness economic policy. But, at the same time, these observations cause me to realize that this world is not the real world. What we seem to see is something building up in a fashion that's described by catastrophe theory, where you don't get the smooth and continuous changes. Rather you get nothing. You get a logjam and then at some point the dam bursts and things change because those smooth and continuous adjustments did not take place.

Spain is not making a progress. Italy has brought its inflation rate down to 2.1% but the tension and cost of doing this seems to have burst its political system Greece is making progress but at a cost that seems far too great for it to stay the course; Portugal is that same boat..

What will happen? Look at the summit and Angela Merkel sticking in her heels in and refusing to modify her approach. She seems to be ensuring that Europe will at some point, at some date, one that is very hard to specify, find that it will come apart at the seams. If Europe refuses to change this policy that is bottling up economic and political pressures there is no doubt that at some point it will have to blow off steam. Moderation or backtracking from this severe course might work. But that is not likely. What seems most likely is that pressures will reach that point of blowing off steam before they reach the point where austerity will have achieved its objective. Despite the improvement in inflation there are clear signals that that is not enough: it's not fast enough and it's not cheap enough. But there will be no compromise.

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