Depressed eurozone countries are left with few policy options. With monetary and fiscal policy options off the table, and no independent currency, the eurozone is relying on low inflation to slowly recover.
One of the biggest challenges facing eurozone economies during the global financial crisis and sovereign debt crisis is the lack of policy options. In a currency union, each country does not run its own monetary policy and does not have its own currency.
Monetary policy is a blunt instrument, which is based on what is best for the region rather than any specific country. Policy is too loose for Germany but not loose enough for countries like Greece, Spain and Italy. Domestically we can appreciate this problem; during the mining boom the cash rate was too low for Western Australia and too high for states that relied on manufacturing. That is simply a limitation of monetary policy.
As a result, fiscal policy was the primary tool for these countries but it wasn’t long before this was also off the table.
Without any conventional policy options, countries such as Spain were left with a painful rebalancing of their economy. Their issue is that they are largely uncompetitive due to wages that are relatively too high. Unfortunately it is not enough that the Euro depreciates because a high share of eurozone trade is with other countries in the eurozone. A depreciating currency did nothing to boost Spain’s competitiveness against Germany, which helps to explain why Germany can run a high trade surplus while other countries in the region struggle.
So how can these depressed economies improve their competitiveness? There are a few possibilities.
First, lower nominal wages. For countries such as Spain or Italy, this directly improves their competitiveness against Germany. But wages are notoriously sticky due to employee contracts, with employees rarely willing to take a pay cut.
Second, labour mobility. If labour can move free throughout the eurozone then it would alleviate imbalances across the region. Despite the close economic ties between eurozone countries, labour mobility is quite low. This is likely because each country has a different national language and can be culturally dissimilar. By comparison, if there are labour imbalances in Australia it is quite easy for someone from Melbourne to move to Perth.
Third, aggressive ECB monetary policy. This would support growth in depressed economies and generate more inflation in the better performing ones. This would change the relative wages between countries such as Spain and Germany. However, the ECB has an explicit aim of keeping inflation close to, but below 2 per cent, which provides little scope for this approach.
Finally, deflation (or very low inflation). This is basically a reversal of the aggressive monetary policy approach. Relative prices between countries in the eurozone change by having different rates of inflation. For example, if Spain runs low inflation while Germany has higher inflation, then eventually Germany goods become more expensive compared to Spanish goods. Spanish goods are then more competitive both within the eurozone and internationally.
Data released overnight suggests that the deflation or low inflation approach is being used (intentionally or otherwise) to remove labour market imbalances within the region. Inflation, in the eurozone, continued its downward trend falling to 0.7 per cent in the year to October, to be at its lowest level in almost four years. At the beginning of the year Euro inflation was running at around 2 per cent.
In Spain, prices have deflated by 0.1 per cent over the year to October, reflecting a sharp decline in price growth over the past year. By comparison, inflation in Germany is running at higher than the eurozone average, though it has slowed recently.
But while deflation allows for this internal devaluation to take place it obviously comes at a cost. Deflation and low inflation does not happen by accident, it is a reflection of broader economic conditions and highlights the depressed nature of countries such as Spain, Italy and Greece. There must also be concerns that low inflation expectations could become entrenched, providing headwinds for the eventual recovery. Finally, inflation can be a beneficial tool for reducing debt levels; whereas deflation makes debt a greater burden and it must be questionable whether this would be politically palatable over a long period.