In my last post
I wrote: “Mapping macroeconomics into a morality play is almost always a
mistake.” I can think
of lots of examples. For example: The private sector has to tighten its belt,
so the public sector should too. Or: Recessions are a punishment for previous excess.
Within a currency union, when the central bank is willing and
able to do its job, these morality stories are often about what happens when one part
of the union deviates from the inflation target. (Any deviation of inflation
from target is accompanied by unwarranted movements in output: I’ll take these
as read in what follows.) Let’s imagine dividing the Eurozone in half, and
call each half G and R. So the standard story is that ‘excess’ in R raises
inflation in R: to 3% say. The ECB does its job, keeping average inflation at
2%, which means inflation is forced down to 1% in G. This makes G too
competitive, so if the ECB was willing or able to keep average inflation at 2%
we would have to have a period of 3% inflation in G and 1% in R to put things
right.
The morality often drawn here is straightforward: irresponsible excess in R
has led to uncomfortable deviations from the ideal of 2% inflation in G. The
morality play normally skates over the fact that this excess in at least parts
of R was financed by lending from G: morality always seems
to reside with the borrower. But we could tell the story a different way. The
problem started because G tried to undercut prices in R, by allowing inflation
in G to be 1%. As the ECB had to keep average inflation at 2%, this 'forced' inflation in R to 3%. G is now enjoying the benefits of undercutting R, and is
very reluctant to undo the process.
So which story is right? We all know there
was excess in some parts of R, either by governments (Greece) or banks
(Ireland), but both countries are small. One way of discriminating between the two stories would be to look at real interest rates. If the ECB was having to react to excess demand in R, we would expect to see high real interest rates. If instead the ECB was having to offset deflation in G, we would see low real interest rates. Here is what actually happened.
From 2000 to 2007 the ECB kept inflation pretty close to 2%.
But it did not achieve this by raising real interest rates. Instead interest
rates fell in 2003, so that real short rates were close to zero from 2003 to
2005. This seems much more consistent with the story where G tries to undercut
R, and the ECB has to cut rates to keep average inflation at 2%, forcing
inflation in R to 3%. Sure enough, 2003-5 were years when the output gap in Germany
was significantly negative (OECD estimates -1.4% 2003, -1.7% 2004, -1.9% 2005).
Both the ‘undercutting by G’ story and the more traditional ‘excess in R’ story still contain much too much pseudo morality for my taste. The German government did
not deliberately engineer zero growth in domestic demand from 2003-5, any more
than governments outside Germany (Greece excepted) tried to stoke up excess
demand. In an ideal world both could have used fiscal policy more effectively,
but the system hardly
encouraged that. But this evidence does suggest that seeing the competitiveness imbalances in the Eurozone as simply the result of excess outside Germany is at best only half the story, and at worst not a very realistic story at all.
