A post from Brad Delong of late last week has started all kinds of bells ringing in my head:
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.
Source: Semi Daily Journal
The more important bell relates to the use and abuse of the Harrod-Balassa-Samuelson effect, but I will try and post something on this when I've had more time to think the topic over. Meantime another topic relates to the HICP methodology and how the country weights are determined. After a little investigation I discovered that they are in fact based on national consumption expenditure shares, chain weighted two-years-post as the data come in from national income accounts. Anyone else whi is interested in the arcane world of Eurostat statistical deliberation might find intersting this paper from the Dallas Fed.
Among the jewels that may be found there are:
"Where does this place the HICP in the classification scheme proposed by Diewert? (Diewart is one of the luminaries of index number theory: EH) 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 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."
What should be clear is that the methodology used is far from self-evident, and the inflation composite has to be an extremely dubious number for economic policy purposes. 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. In fact the degree of uncertainty regarding the validity of the individual country figures is significant given the lack of quality adjustments in most of them. I would say there is as much possibility that the German figure is 1% too high as there is that it is 1% too low. In which case we don't really know whether or not the German economy is already experiencing deflation. My only conclusion from my investigations is one I reached long ago: deciding whether monetary conditions are too tight or too loose on the basis of the HILP is a fools errand. So 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). Those interested in consulting these invaluable inflation numbers can find the latest set here
On the uses and abuses of Harrod-Balassa-Samuelson I think that what's really worrying me in the way the argument is being used is this. Brad Delong (and I think in this he is only reflecting what he feels is the Brussels 'conventional view') in an earlier post (here) 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". Now 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.......?
Equally the orginal rich-getting-richer argument could now be displaced to the new 'Eastern' entrants (who remember are not in the euro). The standard use of the H-B-S effect could serve to justify the idea that price deflation should now also take place in the Southern Three as the new entrants close to converge. This argument would have a lot more logic to it as they may well be more direct FDI competitors with the Southern Three. In fact the main impact of the euro in the Mediterranean countries (where, remember, negative real interest rates exist, and the savings accounts are quietly emptying-out as everyone sinks their money - possibly irretrievably - in concrete) 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.
And if you still have lingering doubts, remember Japan is a country with high tradeable productivity, low internal productivity with high prices, and ageing population. This will soon also characterise the much poorer Mediterranean three. But look what is happening to Japan. If you still feel I haven't made my case, as I said, check back another day, I'm sure I'm going to have more to say on this one.