German Inflation Overshoot Continues But Diminishes Euro-Area Differences Continue And Barely Diminish

The German HICP rose by 0.2% in April compared to March. It is up at a 2.2% pace Yr/Yr and that is less than the 2.3% pace of last month. At 2.2% the rate of change is closing in on the Bundesbank's desired ceiling rate of 2% and of course for the whole of the Euro-Area inflation has a ceiling of 2% as well.

What is interesting is that in Germany there have been some mutterings lately about allowing wage inflation to rise. Wolfgang Schäuble, the German finance minister, suggested it might be a good idea for Germany to experience a little wage inflation in the interest of stimulating domestic demand and helping to resolve Euro-Area imbalances. This is a huge departure for Germany albeit one that is coming at a point that is probably too late at least to save Greece. Even the Bundesbank has said it might be prepared to accept higher inflation in Germany.

Germany may finally have realized that its zeal to have the lowest inflation and greatest competiveness in the Euro-Area has helped to destroy it. I like the point made by a former science teacher of mine, that "it's a bad parasite that kills the host." Germany may not seem like a parasite, but it has conducted itself in a way that has put its own interests first in way that has displayed little enlightened self-interest. I continue to try to get people to look at the Euro-Area as a system. This is not astronomy, Germany is not the sun. It is not a competition either. Counties agreed to tie their currencies tighter that is when the internecine competition should have stopped. It's like having a car on the road: you can compete with the guy in the car next to you while your cars are separated. But then if you tie the cars together trying to go at different speeds will only lead to trouble. I don't think Germany let alone Greece ever fully comprehended the commitment to the Zone that membership entailed. It was not enough to enter the zone then do go on as before. Nor was it good to be in the Zone and out-compete your neighbor. Competition is not bad but the degree of it got out of hand and became destructive.

While Yr/Yr trends in headline inflation look good, for this month we see shorter term German inflation trends are not under control. From 12-Mo to 6-Mo to 3-Mo inflation pressures are actually building. Inflation is higher rather than lower in 54.5% of the categories over three months in 63.6% over six months and in 54.5% over 12months.

In the table below I will show some key trends that have taken hold since the Zone was formed.

As of 2011Q4 German unit labor costs had risen by only 6.9% since the start of the EMU process. No one else in EMU comes close to that. Germany in doing this held back the payments to labor making its firms hyper competitive based on labor costs… and holding back consumption. By comparison the average ULC in the Zone rose by 21.4%. The average county lost 14.5% to Germany in unit labor costs since the Zone's formation. Moreover, since Germany's numbers are included in the EMU average with a large weight it is really worse than that. At an 11.8% gain Austria was the closest country to keeping up with Germany. After that we have France at 27.5% and The Netherlands at 27.6%... and Greece at 43.8%.

So say what you want about how badly other countries behaved, but Germany with the population most willing to sacrifice for price stability entered EMU and proceeded to starve labor of higher standard of living to an extent that was way out of line with the community it had joined. In time this gave Germany a huge comparative advantage which of course means a disadvantage was thrust onto other members. This helped to set the stage for the North-South inflation imbalance which subsequently emerged.

Since EMU was formed the German HICP index has risen by 24.4% with France at the next lowest at 27.9%. On balance the EMU price index rose by 31.1% implying that Germany gained 6.9% on price competitiveness compared to other countries in EMU generally. It gained 25% on Greece sine the Zone was formed or, more correctly, 21.5% since Greece actually joined the Zone later. But German HICP prices are also 18.6% lower than in Spain since EMU began and 14.5% lower than in Portugal.

The North-South inflation split is well known. But looked at differently, there is blame all around. Since EMU was started, the German HICP average rise of 1.7% per year is lower than the ECB's ceiling rate by over a quarter of one percentage point. Meanwhile, Greece whose performance has been so poor has average 3.2% inflation over this period Spain has averaged 2.8%. Their numbers are a bit over the allowed ceiling but are trouble less for the rates of inflation they averaged than for being locked in a pressure cooker where Germany is averaging 1.7% per year. During this period the US average 2.5% per year. The median inflation rate in the Zone among members was 2.36%. Interestingly, compared to the median inflation rate Greece was the most deviant and Germany was the second most deviant.

Of course the EMU inflation rate looks more like the German rate but that is because the EMU rate is based on economic weightings of the country rates of inflation and Germany has a huge weighting in EMU. But my point is different: it's that Europe needs to decide on what its center of gravity will be and converge to that. It seems to me that the Mediterranean countries came along way toward getting their inflation rates down but did not quite make 2%. Now premature currency locking is putting them at a disadvantage despite having made significant inflation progress (not so much fiscal progress, however). And Germany's overshoot on the other side has been making things even worse.

That said the ECB has still more or less hit its inflation objective. Right now the average HICP rate since Emu was formed has been 2.1% tolerably close to the 2% ceiling. But hitting that overall target has left the Zone with persisting regional inflation, price level, and competiveness differences. If the Zone is to survive it needs to have an agreement about what those things are supposed to look like.

Countries that deviate from the agreed norm over time, even by small amounts, can find themselves in trouble. This is why a fixed currency area needs internal flexibility; it needs flexible markets it needs mobile capital. And the Zone with different countries and languages and cultures and no transfer payments simply does not fit the bill.

The question you ask about Europe is this: is it really willing to do what is necessary? Europe wants the political stability but so far it has been unwilling to pay the price. Can you have a union with soft core socialists bound together with hard-money capitalists? I don't think so. Not unless the hard core hard money capitalists are willing to support the soft socialists' agenda… and lifestyle. And I really don't see that happening. If Greece wants to be part of a currency-united Europe it will have to change…but so will Germany. And for now if Greece is going to do it, it may need a second chance because it looks like it has spoiled this one.