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Economy in Brief

EMU Inflation is Headed Lower
by Robert Brusca  April 11, 2013

With most of the European monetary union's first 12 members having reported we can assess inflation in the zone. Of the 10 reporting countries in the table only three have inflation at or above the ECB's ceiling rate of 2%. That would be Luxembourg at 2%, Spain at 2.6%, and the Netherlands at 3.2%. The figures of the table are interesting because they help us understand how the ECB has held Inflation to its promise during its lifetime. The third column in the table shows the difference in the individual country price level increases from the EMU central rate. Notice that only two countries have had a rise in their respective aggregate price levels during the period. Only two nations' inflation rates have experienced a smaller price level rise than the rise of the average for EMU. Note that the weighted average EMU rate during this period since the EMU was formed is at 2.1%, quite close to the ECB's pledge to hold inflation no higher than 2%.

This table makes it perfectly clear (although it is never been a secret) at the inflation rate that the ECB has pursued as a weighted average inflation rather than an average rate among countries. In fact, the average rate among these countries unweighted would be an inflation rate of nearly 2.4% over this whole period. Apart from France and Germany that have run inflation rates below the 2% threshold the next lowest is Belgium at 2.16%. The ECB has hit its inflation targets by having its two largest economies run inflation lower than the rest of the zone.

This been done persistently over the life of the zone and clearly has contributed to the problems the zone has now and the emergent price differentials which represent competitiveness differentials across the zone. The column to the far right in the table recasts the differentials as price level rise differentials between each member in the lowest inflation member which is Germany. On that basis you see that Greece, Luxembourg, and Spain have seen their price levels rise more than 20% beyond the amount the price levels have risen in Germany since the formation of the European monetary union. Since Luxembourg is a financial center that rise hasn't really harmed its economy. But if you look at the countries whose price levels have risen substantially faster than Germany's you have a clear hit list of countries that have debt problems and are being faced with the constraint of austerity. You see Greece on the list, you see Spain, you see Portugal, with Italy right behind followed by Ireland.

Another interesting aspect of this divergence is that the ECB makes one policy for the entire region but the region faces very different inflation circumstances depending on which member country is being considered. Since the financial crisis, the dispersion of inflation across the zone has risen and then for a brief while it fell; and now, even with inflation falling, the dispersion of inflation across the zone is rising.

Rising inflation dispersion causes great problems for the ECB and impedes its ability to make good monetary policy it also creates problems for exchange rate policy. We have drawn in above the purchasing power parity estimate of Europe's exchange rate. Note that we extended this period beyond the formation of the Eurozone itself by simply using national economic weights and national inflation and exchange rate data prior to the formation of the European Union. This extended period should serve to give us a better estimate of what the true parity rate is for the countries of the monetary union against the rest of the world. We are looking at not simply the euro arrayed against the dollar, but against its broad basket of currencies. The chart puts parity somewhere around 105 (an index number of real value) while the current level of the euro is somewhere just North of 120 on that same index.

What this tells us is if we use the euro average price level to assess where the euro belongs, the euro needs to be at a lower level in general. It is too high by about 15% - against all currencies on a AVERAGE. And this is something that some of the peripheral countries have been clamoring about. In this regard if we turn to the table and look at the data that show us the position of the price levels across countries, the deviations from the EMU weighted average show us what countries are in better shape and what countries are in worse shape.

Clearly France and Germany that had the smallest price level increases in Europe as a whole, have a greater competitive advantage Germany's competitiveness measure is actually about seven percentage points lower than that of the Zone and France's is about four percentage points lower. These differences mean that French and German trades are coming closer to being conducted at true parity values when they trade outside of the Zone. With the zone already some 15% overvalued, a country like Greece is stepped back another 16 to 17% because of its relative lack of competitiveness within the zone Spain steps back another 14% and so on. These combined figure show the peripheral Europe is at a huge competitive disadvantage when it trades outside the union.

If European policy were to restore competitiveness by letting the euro drop the question would be restore competitiveness for whom? Restoring competitiveness to neutral for the euro as a whole would leave France and Germany with absolute advantages with the rest of the world outside the community while all other EMU nations with still have competitiveness disadvantage is ranging from a thin 1% in Belgium to a sizable 16% nearly 17% in Greece and better than 14% in Spain and so on.

This table is just another way of thinking about how policy slippage within the zone creates more policy problems for the zones policymakers. Both monetary policy and exchange rate policy become difficult in an environment where an economic unit with a singular policy has such internal divergence.

Despite ongoing tensions in the Zone, evidence from the behavior of markets suggests that the Europeans are comfortable with their dislocations and discomfort. Italy, despite having no government and despite having surging political parties whose policy objectives would seem to threaten the viability of Italy within the Eurozone, is having no difficulty hawking its bonds or in funding its government. There seems to be little stir about the reports that one of the indignities that has befallen Cyprus is that it will be forced to sell a good chunk of its gold reserves.

Austerity may be the means for Europe to put the toothpaste back in the tube. But we continue to think that the demands of austerity to restore price level competitiveness are too great; its political disruptions will be too great and that eventually it will not work. And it may not mean that the European monetary union comes apart but it's not clear what kind of European monetary union would be able to stay together with such tensions that would continue in such a Zone. For now we look at Italy as seemingly resilient; its investors are more clearly in denial, as its risks remain high. But for the moment Europe seems to have no taste for seeing the risk summer is approaching, it is spring, the blossoms will be out, Paris is going to be beautiful and the Europeans are happy.

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