Closing the competitiveness gap through German inflation or periphery deflation

Mr Gloomy European Economist again has a very good post. As he states, it is a ‘completely unscientific simulation’ but I think it is useful in the same way Paul Krugman’s ‘quick and dirty’ charts help sort out some basic intuitions.

The core thing Mr. Saraceno does is to simulate how long it would take for the so-called periphery countries (in the Eurocrisis) to converge their price levels with that of Germany, which would mean they are at a level field again in terms of price competitiveness. First he calculates these terms with the assumption these countries have zero inflation from now on, and next he calculates what the average rate of deflation would need to be to reach the same price level as Germany by 2020.

Obviously the assumptions are not realistic, and the mechanism through which the German inflation would be achieved is left out for the moment – it would be easier to achieve the higher level of German inflation if Germany would aim to improve domestic demand rather than exports.

But assumptions aside, the conclusion from this ‘sketch’ is clear: price convergence MUST happen and it is not going to happen anytime soon.  One can wonder about the resilience of the eurosystem, like Paul Krugman does:

This need not lead to a breakup of the euro: Pessimists on that front, me very much included, misjudged the strength of European elites’ commitment to the project. But the euro might yet survive — and be a continuing disaster.

But even given this, 6-11 years of continuous deflation (not to mention the risk that Germany itself would slip into deflation) just is VERY long, especially in politics. And the more need for deflation, the more unemployment. Which is simply not politically tenable.

Finland at the moment does not have very low inflation, but it does have a large problem with unemployment – there is a huge gap between those seeking work and the number of vacancies: the number of those seeking work was (curve (1) in the document in the link, in January 2014) still rising and the number of open vacancies ( curve (2))has been fairly stable since 2008. Regardless of these numbers, the current Finnish government (of 6 parties, led by the National Coalition Party and the Social Democratic Party) still intends to do everything to increase the labour supply. It is no surprise that the (only two!) opposition parties in parliament, the ‘agrarian conservative’ Center Party and the True Finn party have been rising in polls (even though these concern the EP elections, not domestic elections; there the picture is slightly different).

But regardless of the polls, the political field in Finland is extremely in consensus about the need to ‘break’ the increasing public debt (not even 60% of GDP) and implement measures to increase the labour supply. The goverment has even asked for a ‘national consensus’ on this issue – the ‘need’ for reforms and budget cuts will one way or another lead to increases in the labour supply, which is not necessarily (sic) a good thing at the moment.

The interesting thing is that seen from the macro-economic imbalances picture (current account surpluses etc) Finland has reduced its surplus, which is ‘good’ in terms of convergence. But politics in Finland are absolutely hyper about this fact and want to restore the surplus. This is perhaps one very clear example that Finnish politicians don’t really understand the nature of the eurocrisis. Which thus also means they won’t find the proper solutions.

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