I was interested to read Simon Wren Lewis‘ post on the dysfunction in the Eurozone caused by German improved ‘competitiveness’.
Is this right? Well, one thing I learned from those in my team at the Bank of England who were experts at international macro [main tutors were De Paoli and Lipinska, now of the Fed], is that with relatively little effort, you can get pretty much whatever result you like.
So the answer is: who knows? One cannot speak definitively about German dysfunction.
Nonetheless, here is another Wren-Lewis like story, told in the language of Balassa-Samuelson, plus downward nominal rigidities.
Germany gets better at making tradable goods. This increase in German wealth drives up the price of German non-tradeables. The relative price of tradeables does not change much, as, in this sector, the law of one price holds more nearly. For a given inflation rate in the Eurozone as a whole, this Balassa-Samuelson runaway effect [runaway being the opposite of the ‘catch up’ we thought was happening before the crisis started] should mean above average inflation in Germany, and below average inflation in Greece.
If the runaway effect is large enough, or, put differently, if ECB monetary policy fails to generate enough inflation to accommodate the runaway, this may mean negative inflation in Greece. If there are downward nominal rigidities, the force that would otherwise generate negative inflation [in particular negative nominal wage inflation] generates high unemployment.
In this story, the solution is to set the inflation target such that it is higher, the greater is the relative price change that technology runaways requires. I doubt very much that, even if this were possible, it would have been allowed by the ECB.
But there was the additional problem that the collapse in demand caused by debt-deleveraging, coupled with the zero lower bound, meant that the ECB could not even meet the 2 per cent inflation target, let alone generate enough to accommodate the problems described here.