German outbreak adds to Europe's pain

Lowy Interpreter

While the headlines are focused on the unfolding debt crisis in Greece, Europe has other economic headaches as well. Economic growth is still quite tentative. Even the best performer -- Germany -- is still recording unemployment of 7 per cent. At the same time, inflation is running at 2.7 per cent and is expected to go higher, well above the 2 per cent target.

This sounds like a case of old-fashioned stagflation.

This rise in inflation is largely driven by commodity prices, particularly food. There is a good case for looking through this sort of price increase, focusing instead on the underlying or core inflation rate, while waiting for headline inflation to subside. Core inflation is running at 1.5 per cent.

But the European Central Bank (ECB) has inherited German low-inflation ideology. One of its Board members has gone public in urging the ECB to follow its mandate and respond to the excessive headline rate.

Whatever the rights and wrongs of this esoteric argument for the specifics of the German economy, tighter monetary policy will make life tougher in the peripheral countries. Portugal, Ireland, Italy, Spain and Greece all need to make drastic improvements in their external competitiveness vis--vis their Euro partners.

If German inflation is tightly constrained by ECB monetary policy, this makes it just that much harder for the crisis countries to change their relative prices: they need to have substantial falls in wages and prices, which is always painful. All this is playing out in an environment of painful fiscal austerity.

The prospect of a further €60 billion euros of assistance, on top of the €110 billion euros provided last year, holds Greek creditors at bay, but does nothing to ease the mammoth task of restoring international competitiveness.

One of the advantages of having your own exchange rate is that a devaluation administers a country-wide fall in wages, relative to foreign wages. Substantial adjustments of international competitiveness are more feasible, as sensitive domestic wage relativities are largely unchanged: people are more prepared to accept a wage cut if all their compatriots share it. Currency union precludes this possibility.

Tough policies at the ECB make it just a bit more likely that the euro will not survive in its present form. It's not clear if those members of the ECB who are advocating such policies are ignoring this possibility, or are in fact in favour of it.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.