April 03, 2003

Europe's Business Cycle and Monetary Policy

As time passes, and as the European periphery becomes richer and richer, its real exchange rates vis-a-vis the European industrial core have to rise. This is the Balassa-Samuelson effect: poor countries have low real exchange rates because international trade is concentrated among the capital- and technology-intensive goods in which rich countries' absolute advantage is greatest, and so as countries catch up to the industrial core, their real exchange rates rise. In the case of poor countries inside the euro zone, convergence and the consequent rise in real exchange rates requires faster inflation than in the industrial core.

If development on the European periphery is successful, and if growth on the European periphery is rapid, then inflation on the European periphery will be rapid too. This means that, if eurozone-wide inflation is to be low, there must be deflation--falling prices--in the German-Belgian-French industrial core of the euro zone. Deflation is, in general, a bad idea for lots of reasons, one of the chief of which is the catastrophic consequences of nominal wage cuts for worker morale.

Yet as long as the ECB takes its goal to be low inflation eurozone-wide--rather than low inflation in the eurozone's industrial core, with the developing periphery seen as a special case--it seems that the ECB has committed itself to a much more contractionary monetary policy than even the Bundesbank would have ever dared impose on the Bundesrepublik.

Economist.com | Europe's economies: ...The stream of gloomy statistics coming out of Brussels and other European capitals points, at best, to zero growth in the first quarter of this year; recession in Germany, in particular, is still a distinct possibility. There are even fears that the German economy could be heading for deflation.

In other circumstances, the case for cutting rates quickly would be overwhelming. So why the reluctance to act? Part of the explanation lies in the ECB's continuing efforts to build its international credibility. The central bankers in Frankfurt have, from the bank's inception, been determined to acquire a reputation for price stability akin to that previously enjoyed by the German Bundesbank. Unlike, say, America's Federal Reserve and the Bank of England, the ECB's only mandate is to maintain stable prices, which it defines as inflation of below 2%. Yet in spite of persistently sluggish growth in the euro area, inflation has bumped up against, or even exceeded, the 2% ceiling for a good part of the period since 1999, when the euro came into being. The ECB has, nevertheless, cut rates several times (see chart), but by nothing like as much, or as fast, as the Fed.

Posted by DeLong at April 3, 2003 07:41 PM | TrackBack


So for those of us who aren't economists (but still come here for some inexplicable reason instead of ESPN.com like a sensible person), what's the definition of the European periphery? I'm guessing it's pretty much everything that isn't as built up as Hamburg, but what's throwing me is the comment that it's becoming "richer and richer"-- which I guess, if it means Ireland or Portugal or whatever, means in the sense of catching up with countries like Germany, not in the sense that the US becomes richer and richer next to Mexico. But if so, does that stretch all the way to, say, Poland? How peripheral do you have to get to not be a richer and richer periphery (Albania?)

Posted by: Mike G on April 3, 2003 07:04 PM

It's kind of strange talking about regional inflation. IN response to a question somewhat along these lines, I heard Robert Mundell claim that that regional inflation was impossible, or something like that. He was wrong of course, as even with a single currency regional inflation can happen as long as some goods are effectively untradeable. But, hey, he has the Nobel Prize and not us.

But, I think your point should be an obvious one - they should target low inflation in the core while tolerating somewhat higher inflation in the periphery. If deflation is a bad thing for the reasons you say, then the degree of periphery inflation it allows would have to be quite "high"-substantially higher than 2% anyway.

Posted by: SnookerD on April 3, 2003 07:07 PM

Just one question. Was Argentina 'catching up' with the US, or was it pricing itself out of the game. The Balassa-Samuelson effect is a nice theory, but it either doesn't apply here, or is just plain wrong. Look for eg at the educational levels: Spain and Portugal have an average of between 8 and 9 years per working adult, whilst France and Germany have between 12 and 13. Now get the mincer equations out and do the numbers.

Or look at relative R&D activity and patenting. Or look at productivity, the ICT effect, the new economy generally, and internet uptake. It's just impossible that the Southern European economies are becoming as productive as their northern neighbours. So if you're paying yourself more, but you're not earning it, what might happen?

Posted by: Edward Hugh on April 3, 2003 10:09 PM

Inflation is a very local phenomenon in Europe, mainly because of lack of labour mobility. However, things are not as bad as prof. DeLong seems to put them.

ECB is targeting the Eurozone inflation, the HICP, which is defined as the consumption weighted national inflation rates. This means that core country inflation in France and Germany is responsible for half of the HICP. Truly peripheral countries like Greece and Portugal have only a marginal impact on the HICP.

Posted by: Mats Lind on April 4, 2003 12:47 AM

I don't really understand what different it would make if the ECB concentrated on 'core' eurozone inflation rather than all eurozone inflation.

Greece, Portugal and Spain, the countries that are clearly poorer than the rest of the eurozone, have a share of about 15% of eurozone GDP. Hence even if the ECB let them have double the inflation rate of the core, so 4% not 2%, it would only require the 'core' to have inflation of 1.7%, not 2% to make the eurozone total 2%. Surely this isn't that deflationary?

Ireland, which does have higher inflation, is much richer than the EU average, so isn't really a non-core country. But anyway, it's gdp is 1.6% of the total, so even an Irish inflation rate of 10% hardly impacts on eurozone wide inflation rate.

Posted by: Matthew on April 4, 2003 12:54 AM

I wrote the above post before Mats' post had come up -- but basically we're saying the same thing.

Posted by: Matthew on April 4, 2003 12:57 AM

I think in years to come, the UK is going to look smarter and smarter for staying out of the Euro. For the leading European economies, the reduction in transaction costs from a common currency are clearly outweighed by the loss of monetary flexibility in my opinion. And due it's less flexible economy (labor market, entitlements structure etc.), Germany needs monetary flexibility more than the UK does. Watching Germany's fate in the Euro zone is like watching a slow motion train wreck.

Posted by: Joe Blog on April 4, 2003 06:34 AM

First, if the peripheral countries do succeed in growing, their contribution to the overall inflation measure won't be marginal anymore, so there is a potential (though long run) problem. Second, this all boils down to the old question of whether all of the euro zone really is an optimal currency area. It is useful to make a comparison with the US case. Wouldnt, eg., West Virginia or North Dakota benefit in some ways from devaluing vis a vis the rest of us? Would those benefits outweigh the benefits of fixing their exchange rate at 1:1 as they have in effect done? The response in those places is to get on a bus and go to Chicago or NY when growth at home is limited. Given the much lesser labor mobility in Europe this isnt an option. So what happens? Labor stays there, is in excess supply, is unhappy, supports political parties that seem to cater to their problems and sooner or later some politician will say gee, dont crucify me on a cross of euros. How that plays out could go any of a number of different ways.

Posted by: steve k on April 4, 2003 07:06 AM


The first part doesn't quite follow. The peripheral countries (Greece, Portugal and Spain) (at present) have a gdp per head of about 67%, 70% and 82%. Given their share of EU gdp is 15%, if their GDP per capita reached 100% of the EU average their share would only be 20%, and of course by then their excess growth and hence inflation should have disappeared.

It's a little bit more important in the case of the countries that wish to join the EU, although most of them are very small and will remain so even if they reach the EU average income. Poland is of course the exception.

Posted by: Matthew on April 4, 2003 07:36 AM

Ah, the Balassa-Samuelson effect. IMHO two important papers with different conclucions:

Sinn/M. Reutter, The Minimum Inflation Rate for Euroland, NBER Working Paper No. 8085, 2001, CESifo Working Paper No. 377, 2000.


German Council of Economic Experts, 267-278 (Sorry, in German)

Posted by: Old European on April 4, 2003 08:11 AM

Apart from the above discussed problems with Balassa-Samuelson and ECB's inflation targeting, there is a growth-theoretic problem as well. With EU and EMU succeeding in making captial flow freely, labour and capital go separate ways. Above-linear returns from capital makes it accumulate in some locations, most significantly in Ireland, and deteriorate in others, like Germany.

Some growth models might even predict the Europeans to be worse off from the increasing capital mobility. OK, we might eventually reverse those economic losses by moving like the West Virginians. But that would be a huge cost for us, culturally and psychologically, being the descendants of those who refused to leave for better prospects and freedom in America, of those who stayed to fight against other Europeans in several wars.

Posted by: Mats Lind on April 4, 2003 08:56 AM

I think I've got hold of what's worrying me in all this. Brad says: "As time passes, and as the European periphery becomes richer and richer, its real exchange rates vis-a-vis the European industrial core have to rise".

This idea of the periphery becoming richer and richer (relative to the core) is based on some growth theoretical assumptions which might well be extremely suspect. Rather than the model of all countries converging to a common homogeneous type, what we may have is a centre/periphery dependence based on an inter-relation of economies with different structural characteristics. The Southern Three (Spain, Portugal and Greece) have economies which are driven by construction and tourism, Germany and France have large machinery, equipment and technology components in the traded sector. These economies are not 'converging' in any meaningful sense of the word. A look at the 'Asian' model Japan, the four 'tigers' and now China is instructive in this sense. This model exports manufactured products to acquire strategic capacity which is then put to good use. This is not happening with the Southern Three whose structural dependence is inbuilt.

If you look at the tradeable and non-tradeable sectors you will see that, as theory predicts, productivity is higher and inflation lower in the tradable sectors. But it is what is happening in the non-tradeable sectors - low productivity growth and high inflation - that is preoccupying, since these form an important part of the cost structure of the tradeables, and their impact must be felt eventually, as non-tradeable sectors gradually get traded by importing from cheaper sources (look at Spain's ballooning current account deficit for one). Normally this problem would be resolved by a devaluation of the currency, but with EMU.......?

The main impact of the euro in these countries (where, remember, negative real interest rates exist) is that the central core economies serve as guarantors for debt liabilities on the perifery. If Europe was one state this might work, but in a Europe of rising political tensions and lacklustre economic performance it is hard to see the centre being held fortune to the moral hazard presented by the perifery. One day the markets will wake up to this fact, and the willingness of the core to sacrifice for the periphery will really be put to the test.

Posted by: Edward Hugh on April 4, 2003 09:50 AM

America is obviously slowing in growth and a return to recession seems more possible with every macro report. Europe is also slowing, and Germany may well be in recession. The European Central Bank has pursued a policy opting for defense of the Euro and needless concern with inflation, while allowing growth to dwindle. What is needed is a more flexible Central Bank mandate, and a loosening of fiscal policy strictures to limit business cycle swings.

We may well now be in a world recession: growth below 2.5%. America is not likely to be as much of an engine of world growth as it was from 1998 to 2001. Time for more expansion of domestic demand in Europe and Asia, especially Japan but also South Korea and China.

Posted by: anne on April 4, 2003 12:05 PM

Why grumble about Europe -

On the Bush administration watch the projected 10-year budget of the American government morphed from a surplus of $5.6 trillion into a deficit of $4 trillion....

Alan Krueger [Economics - Princeton University]

Posted by: lise on April 4, 2003 12:46 PM

Anne - Not to worry. Now we have another reason for a stock dividend tax cut. Remember, when we are all told that 350,000 jobs were lost in February because of snow? Blizzards in Los Angeles and San Francisco. Guess it must be snowing somewhere since another 100,000 jobs were lost in March.

Posted by: jd on April 4, 2003 01:04 PM

"I think in years to come, the UK is going to look smarter and smarter for staying out of the Euro. For the leading European economies, the reduction in transaction costs from a common currency are clearly outweighed by the loss of monetary flexibility in my opinion. And due it's less flexible economy (labor market, entitlements structure etc.), Germany needs monetary flexibility more than the UK does. Watching Germany's fate in the Euro zone is like watching a slow motion train wreck."

Eeeps. I think you're right, but for the wrong reasons. The reduction in transactions costs (and exchange rate risk, no trivial matter) _would_ be worth it if the European Central Bank were willing and able to pursue a more expansionary foreign policy. Like so many, however, it is chasing the horizon of absolute price stability which always, always, leads to prolonged recession. It's time for the ECB to substantially change its charter, or else to obtain a temporary dispensation from the EU leaders from fulfilling the terms thereof.

Posted by: andres on April 4, 2003 06:26 PM

I think expansionary monetary policy is more useful than expansionary foreign policy, in this case.

Of course, in the U.S., we have both expansionary monetary policy AND expansionary foreign policy!

(I know, I'm being a nitpicky bastard, and I know you just made a typo and meant monetary anyway, but I just couldn't miss that one!)

Posted by: Julian Elson on April 4, 2003 06:31 PM

No Julian, I think the typo was 'fiscal', so you just made it two 'typos' (Murphy's Law?).

But why does nobody take the debt liabilities seriously, and anyway 3% deficit is already fiscal expansionary. I feel sorry for poor Pedro Solbes, since in all the mess he is one of the few people trying to push in the right direcetion.

Of course, this is only walking on one foot. What Europe needs is job creation and labour force expansion, and what this means, apart from a changed attitude to risk, is immigration (in ever larger numbers), and a changed sense of identity. My vote is to begin negotions for EU enlargement with India tomorrow. That would solve the population problems dramatically in the short term, bring-in a lot of talented people on an equal footing (not like the silly German proposal of giving them a 5 year green card after learning German - which really smacks of 'old European' colonialism) and would change, at a stroke, our geographical and ethnic identity. We would move from being an 'imperial' society to being a genuinely multi-cultural one, and at the same time attach our fortunes to one of the real planetary rising stars.

While this may seem dramatic to some, our problems are very serious indeed, and if we are not to give way to the cynicism of laughing at our own misfortunes we need some sort of plan which is credible and will bring back hope.

In this I am emboldened by the precedent that both Marshall and Keynes spent agood deal of their time thinking about India. Not for nothing was it considered to be the 'jewel' in the imperial crown.

Posted by: Edward Hugh on April 4, 2003 10:44 PM

Brad is asking about the HICP methodology and how country weights are determined. They are based on national consumption expenditure shares, chain weighted two-years-post as the data come from national income accounts. Anyone interested in the arcane world of Eurostat statistical deliberation might find the following paper from the Dallas Fed interesting:


Among the jewels you will find there are:

"Where does this place the HICP in the classification scheme proposed by Diewert? Eurostat states quite explicitly that the HICP is not a cost of living index, so its conceptual framework presumably lies in either the fixed-basket, axiomatic or statistical approaches to index number construction. However, Diewert (2002) shows quite convincingly that this cannot be the case, since all three of these approaches (as well as the economic approach) would rule out the use of the Laspeyres formula for the
calculation of the HICP. We will return to the issue of the conceptual framework of the HICP below. For now, it suffices to note that the HICP does not easily fit into any existing approach to the index number problem."

When you consider that there's been no Europe Boskin, and that methodology varies widely from one country to another, fine tuning on this must be a bit like taking the 'big hammer' for Um Quasr. My only conclusion is one I reached long ago, it's time to throw away the cucumber sandwiches and the fine lace and go to work to try to clutch Germany from the jaws of deflation before it's too late (assuming, that is, that it already isn't). Have a nice weekend everyone.

Posted by: Edward Hugh on April 5, 2003 03:20 AM

While I love your blog, I must admit that this post of yours really elevates the notion of risk-taking by several levels at once. I guess you might combine EU expansion to India with Berlusconi´s less far-fetched idea of integrating Russia and Israel. After all, you would then encircle both the 53rd state of the U.S. and China at the same time! Certainly a bold vision...

Turkey would be next, would it not? Do not underestimate both the positive effects of migration from Turkey and the difficulty of achieving consent for a Turkish accession. It will, e.g., not be possible with a conservative German government.

Posted by: Joerg Wenck on April 5, 2003 06:12 AM

Edward -

Does your analysis extend to Japan. I expect so. Then, the lack of population growth is critical to making sense of the slow growth of Germany and Japan and such growth lag is likely to persist. France, Italy, Netherlands, England? What then of America in light of the aging of the baby boomers and slowing of immigration? Please go on with this line of analysis.


Posted by: anne on April 6, 2003 09:30 AM

Why is population growth such an essential dymanic for economic growth? What can be made of the recent experience of Australia and Canada? Is the key to growth in these countries Asian immigration? Certainly, Canada has been enriched with Asian immigration. My sense is the same for Australia. Interesting.

Posted by: anne on April 6, 2003 11:00 AM

"Why is population growth such an essential dymanic for economic growth?"
It surely is not. However, shrinking populations and "deteriorating" age cohort mixes do, of course, have a very adverse effect on growth. I remember reading how Michael Milken remarked in a panel discussion for which he had assembled four or five nobelists at his Milken Institute that the US trade/growth deficit could be cured by inviting roughly five million new immigrants to the US.
Basically, I am with Edward on this subject. But it cannot be really understood without reference to cultural dynamics, mathematical ecology and institutional economics. That is a tall order.
And then there is the problem of meaningful quantification. Edward puzzlingly also has a page with graphs done by Ray Kurzweil which show how fast things get faster, i.e., the degree of acceleration inherent in technological progress. This points to accelerating growth and thus an offsetting effect in terms of overall future growth. In my view, combining an increase in the retirement age with pro-immigration policy and an innovation-friendly incentive structure should do the trick. However, obviously there is no way to ever remove the growth advantage a "younger" society has during the brief period that it stays younger. Why should there be?
But maybe Edward´s thesis is more pessimistic and refers to increasing resistance against technological change in "older" societies.

Posted by: Joerg Wenck on April 6, 2003 02:21 PM

"maybe Edward´s thesis is more pessimistic and refers to increasing resistance against technological change in "older" societies"

Thanks a lot Joerg, I couldn't have put it better myself. It's not just being older, but being older in an accelerating environment. Actually I owe the inspiration for this argument to Luigi Cavalli Sforza who showed up in this blog recently (although Darwin's 'Descent of Man' is probably another important point of departure). The argument runs like this. Humans differ from most other mammals in that the period of parentally protected learning is extended. This 'apprenticeship' has one value when the parents 'acquired learning' is an important source of information about what the world is going to be like tomorrow. It takes another value when the balance tilts from this source to on-the-fly adaptation to new and unanticipated environments. If we could develop a metric to compare societies along these evolutionary lines (which would, as you note, also involve 'cultural' as well as age parameters) then we might be able to address some of the Schumpeterian-type problems lying out there in front of us.

We might also be able to begin putting some attributed values to the locked-in workforce experience of some of the older and larger corporations. Really most of the proposed 'labour market reforms' in the European context have this in mind: a writing-off of the book value of these workers. At the firm level everyone sems aware of this, but few seem to focus on the macro and growth implications.

"This points to accelerating growth and thus an offsetting effect in terms of overall future growth."

I'm afraid I'm not so convinced of this connection. But this involves a more technical discussion about growth theory, cross-elasticities, sector shares and productivity which is probably better left for another debate about another weblog item.

On the 'India' question. Of course, I agree. I'm being outrageous. But I'm being outrageous for a reason: to try and provoke some critical thinking on the topic. Europe's big drawback is its geographical and ethnic sense of identity. If Europe wants to move forward it has to address this problem. My 'provocation' was only because I think if people disagree with it, it is interesting for them to ask themselves why.

On Turkey, I thoroughly agree. And about the difficulties facing multi-culturalism in Germany. This is why I think looking to the CDU for the important 'structural reform' is absurd.

Posted by: Edward Hugh on April 7, 2003 08:22 AM

You're right that I think this applies to Japan. In fact I think it is an important part of the explanation for the Japan 'deflation' phenomenon. However I would emphasise that all this really has the status of a strong hypothesis. It's an idea, but it's an idea that still needs a lot of work. There are far too many loose ends at present. But that's why I'm here, tailing on to Brad's blog, because I think scientific development is a collective endeavour, and that sharing and discussing ideas forms part of the endeavour.

I think it's still early days. We don't understand all this yet - not by a long stretch. There have to be things we can do to, but maybe, as Brad recently reminded me, the first thing we have to do is recognise what we don't know.

As far as the US goes, would that I could see the future, but I can't. But perhaps, as Aeschylus recognised, it's better that way.

Posted by: Edward Hugh on April 7, 2003 08:46 AM

I am commenting on a comment above where it has been stated that Britain will prove to be all the better for staying out of the single currency.

This is non-sense. The key word is EMU is credibility. This is why it is based on a hard-nosed monetary stance..... and why ECB is so much slower than the FED at changing rates.

When this current phase of EMU was in its infancy major European Economists could not of made more of the importance of 'credibility' and GB enthusiastically agreed. What now? Britain will join when it suits them but they will join. Why? Because of the long term advantages of higher GDP growth, free trade, Euro as the major currency and all of the advantages that comes with it.

Posted by: R Murphy on April 29, 2003 08:19 AM
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