The German minotaur

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.

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4 Responses to The German minotaur

  1. Nick Rowe says:

    Tony: keep this up, and you will convince yourself that NGDP targeting really would be much better than inflation targeting, especially if it is hard to observe the need for those relative price changes, and hard to adjust the inflation target to accommodate them because it is hard to specify a transparent rule. 😉

    • Yes – but alternatively you could keep inflation targeting, but with a sensible target for a highly diverse monetary area subject to large asymmetric shocks and no automatic mechanism for large internal fiscal transfers.

      1-2% was ALWAYS stupidly and dangerously low, as more than one economist pointed out at the time of Maastricht, and should anyway have been thrown overboard as the first casualty of the Eurozone crisis. Such a low target implies chronic difficulty in changing relative wages and prices (given downward inflexibility) as well as the risk of monetary policy losing all traction so you can’t achieve even that low target (as we see). That the Bundesbank – er sorry, ECB – still declares a higher target (say 4%) verboten says more about the hidebound arrogance of that institution than it does their economic nous.

      As Benoit says, its a human catastrophe of epic proportions – the welfare costs of higher Eurozone inflation are absolutely trivial compared to the cost of something like the Greek tragedy, no matter what any RBC-flavoured DSGE model with some dodgily-calibrated Euler equation implies.

  2. Sorry about the profanity but this is a self inflicted human catastrophe of epic proportions. The western world needs to carefully but _urgently_ start raising the targets!

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