Euro-Area Inflation Signals Are True

The table below shows the rise in various national HICP indices since the Euro was launched in January of 1999. We show the average inflation rate by country and also present the aggregate rise in each headline HICP. Interestingly, the more a country's HICP has risen the more likely, that country is to be on an EMU watch today list for debt problems.

We can show the same effect using core HICP indices. Note that in Greece prices have risen some 27.8% more than in Germany since the Euro was formed. How can Greece compete in the Zone with Germany owning a nearly 30% price advantage?

Greece has seen its price level rise 19.8% more than the EMU average since 1999. For Luxembourg, a small financial center not on the debt hit list, its core index has risen by 13% more than average; after that it is Spain (11.7%), Portugal (9.7%), Ireland (7.1%), and Italy (6.3%).

Differences in fiscal policies have Fed the local price levels (all in expressed in euros, of course).

EMU has no clear or binding fiscal corset; that remains the Achilles Heel (more like, the cancerous tumor) of the Euro-Area. The Maastricht criterion that was meant to contain spending has not worked. It has turned out to be the Mass-Trick that some of us expected that it was. Cheating and fiddling the rules was part of the problem, too. But mass tricks come in many shapes and sizes. Compliance remains part of the issue.

While the ECB has a done a good job in containing inflation overall the diversity of inflation within the Euro-Area remains a problem Greece cannot devalue the drachma to get its competitiveness. The Drachma is gone so is Drachma drama. Greece will have to run a domestic inflation rate below the euro average to gain back its competitiveness lost and that will (would) be a slow painful process. More to the point to gain on Germany Greece will have to run an inflation rate below that of Germany and Germany's overall rate has averaged 1.64%. To be clear Greece will have to run an inflation rate persistently below 1.64% (or something like it as the future for German inflation is unknown). Assuming Germany's inflation metrics repeat, if Greece were to hold its inflation below Germany's by 1% per year (and run a headline rate of 0.64% per year) after 28-years it would have restored price competitiveness with the Euro-Areas most competitive country. Not that I think Greece would do such a thing; but that sort of calculation brings the numbers, and the task at hand, to life.

Compare that to dropping out of the Zone, defaulting on your debt so you only had to pay a 'fraction of it', bringing back the drachma and reestablishing price competitiveness 'overnight.' Which would you choose? All hands up for 30-year of pain! Any takers?

These statistics are depressing. And they are reminiscent of the problem that the UK had in the interwar period as it went back on the gold standard either too soon or at the wrong parity. The UK went back on the old pre-war parity. It was convinced that going back on gold was the right thing to do, but to make it work the domestic price level was too high and it would have to fall. The sorts of policies that make domestic prices fall are well known and are very unpopular and in fact all that pressure was in train in the interwar period and that is one of the reasons why it became the interwar period instead of the post-war period.

Quite part from getting Greece, Portugal' Ireland, etc back on stable sustainable cash flows hovers the question of how much deflation they may need to restore their intra-zonal price stability.

Robert Mundell the intellectual father of the Euro-Area points out that in any region there are going to be 'inflation divergences. We certainly have a quite a few in the US. But in Europe they persist not just in 'regions' but in 'countries.' They seem to be the result of fiscal excesses. If so, stopping the fiscal excess will stop or slow the inflation differentials from growing. But are some of these differentials too big to shrink back to a size that the countries can deal with? That is a question that hangs heavy in the air.

When I look at the situation in Europe I am reminded that the act that tied the Thirteen US Colonies together was the Federal government acquiring each of the colonies' debt and putting it instead in the name of the United States. It was Alexander Hamilton's masterstroke of policy. But like all political deals that one had a side-clause that had nothing to do with the main notion to absorb the colonies' debts. That side deal wound up setting the seat of Government in what is now Washington DC.

It is not clear what lessons of history apply to Europe. It is a financial mess and several countries have debt burdens that are too large to bear. We already witnessed Germany shouldering a great burden to unite East and West Germany and doing so at a too-strong rate for the ostmark. Germany's successful consolidation was more painful that it had anticipated but it was total monetary and fiscal; it was nation-building. And it was a success. In the US case of the assumption of 'state level' debt by the Federal government there were many arguments on the table that would be similar to those we would hear today were the Euro-Area to put this idea on the table. It is not clear if Europe can muster the will to yoke itself to such a harness. The existing, persisting, price level differences are another issue for Europe to deal with. Is Greece in the same position as the interwar UK? Or is the Greek economy so different from the others in terms of its structure and industry that these differences are not so lethal?

These are some of the broader questions that underlie what has become a process of political sniping in Europe. It is all made a bit worse buy have a banking sector in much worse shape than the new European stress tests reveal. But then when you make someone pass a battery of easy tests and give them a diploma for doing so, you would not expect it to be worth much.

I had hoped that this far from the center of the economic, and financial crisis we would be able to see and deal with our issues more fairly. But Europe feels that it is being pulled back into the abyss. Unfortunately when this happens clarity of thought and transparency of action are the last things we get from policymakers who think pretty lies serve the public purpose much better. But some of the public is too sophisticated to be sucked in and the lies just serve to help paint a picture for the uninformed public of a scene that does not exist with tradeoffs that are not realistic. This enables politicians to look at markets and to ask, 'Why are speculators doing things like that?' when they themselves know the answer to that question quite well. At some point Europe will have to deal with its real problems. It will involve the use of word like 'loss,' 'restructuring,' 'mistakes,' and maybe even 'consolidation.'

It’s one thing to be on a roll. And it may be true that a rolling loan carries no loss. But at some point its kinetic energy dissipates and as it stops rolling it becomes a new game of hot potato. Even now some can see that even with a lot of momentum left in the roll, that the end game will not be pretty. Those with foresight are reluctant to continue to play.