Price Level Adjustment Failure in Euro Zone

by Dirk Ehnts

Today, Eurofound (don’t ask) has published pay developments for the European Union, which includes euro zone members. Let’s start with the results:

Figure 1: Average nominal collectively agreed pay based on collective agreements databases, 2009 and 2010 (%)

What is new, of course, are the numbers for 2010. According to neo-classical theory (the market works, prices adjust towards equilibrium) we should see higher wage growth in (current account) surplus countries than in (current account) deficit countries. Why? Capital flows have reversed and now go from deficit to surplus countries as those restrict lending in the periphery. Also, austerity programs should press prices and wages down, so that the deficit countries can start exporting again. The proceeds they can use – via the banking system – to reduce their pile of foreign debt.

What we see is the reverse. Countries like Germany, the Netherlands, Belgium and Austria are at the bottom, joined by the UK, which has its own currency and really doesn’t need falling wages at this moment. These statistics provide another argument for those that price levels in the euro zone have been wrong all along, and that the market won’t fix the disequilibrium. Even worse, the way wages are moving now makes it more difficult for the deficit countries to turn into surplus countries.

If the euro is to survive, two policies must be found to remedy the two issues that are most urgent:

1. Unemployment in deficit countries. Long-term youth unemployment at around 50% and general unemployment rates of 15-20% for many years are not acceptable from the social point of view.
2. The price levels are wrong and must be corrected. Prices in deficit countries must come down, those in surplus countries must come up. The latter solution is easier from a policy perspective (expansionary fiscal policy at very low yields for bunds – 1.77% for 10 year bunds today), but politics stands in the way. Otherwise, growth will not return to deficit countries for years to come.

Some might say that fiscal policy in deficit countries will push inflation rates up, but I doubt it. The economies are probably below potential output, and an increase in employment would not translate into inflation because supply increases. The question whether fiscal policy will push inflation up in an economy where unemployment is low and the output gap small is not so much up for debate, I would think. However, politicians that force austerity programs on other countries cannot possibly get away with fiscal expansion at home, can they?

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