Correcting Eurozone Imbalances

I have been thinking about the extent to which real exchange rate misalignment within the Eurozone (essentially most countries have lost competitiveness with Germany) requires austerity outside Germany. I have argued that a much tighter fiscal policy (austerity) outside Germany would have been a good idea before 2007 to prevent these imbalances occurring in the first place. However that does not necessarily imply it is required now, for two reasons. First, misalignment is eventually self-correcting, as less competitive countries sell less goods etc. Second, perceived debt risk which is driving up long term interest rates provides an additional deflationary force in many of these uncompetitive countries.

                This question is essentially a forecasting issue, so I looked at the OECD Economic Outlook forecasts. The table below comes from there. It contains a bit of a puzzle. If you look at unemployment rates, you see just the kind of pattern you would expect if correction was underway (except perhaps for Italy). German unemployment is way below the Eurozone average,  and the German average level in the decade before the recession, whereas the opposite is true for Ireland and Spain. The OECD’s calculation of the output gap tells the same relative story: everyone is below the non-inflationary level of output, but Germany by not that much, and Ireland and Spain by much more.

                If we look at inflation, however, we get a much more depressing story. Take the GDP deflator (the price of domestically produced output) for example. Inflation in Ireland is less than 1% below Germany, and that is the most favourable comparison. The signs of real exchange rate correction are weak.  

                There are two possibilities here. One possibility is that these inflation forecasts are way too conservative. In particular, low unemployment in Germany will lead to more rapid inflation than is forecast here. The alternative story is that the inflation forecasts are broadly correct, and they illustrate both the difficulty in getting inflation down outside Germany when it is so close to zero, and the difficulty in getting inflation up in Germany when its economy remains depressed. In particular, if the output gap number is right, then it is hard to see German inflation rising much above 2%. 

	Unemployment (%)				Output Gap	Ave Forecast Inflation % 2011-13
	1998-2007	2011	2012	2013	2011-13	Compensation	GDP	Consumer prices
Eurozone	8.6	10.1	10.4	10.1	-3.2%	2.1	1.3	1.8
Germany	8.8	5.7	5.7	5.4	-1.2%	2.4	1.1	1.8
Ireland	4.8	14.2	14.0	13.4	-7.1%	1.7	0.4	0.9
Spain	10.6	22.5	23.0	22.4	-5.7%	1.9	0.8	1.8
Italy	8.7	8.1	8.4	8.7	-2.3%	2.1	1.4	1.8
France	8.8	9.4	9.9	9.8	-4.2%	2.6	1.3	1.5