December 01, 2011
The NYT Magazine had a useful piece outlining some of the key issues on the future of the euro. It would been helpful to mention the issue of euro zone inflation as one of the key factors affecting the ability of euro zone countries to get through the crisis. The southern euro zone economies are currently uncompetitive with Germany and other northern euro zone economies. They can regain competitiveness either by having their nominal wages fall (the path suggested in the piece) or by having their wages and prices rise less rapidly than in the northern European economies.
The former path is extremely painful. It would require many years of high unemployment. Even then, success is far from assured. One effect of falling prices is that the debt burdens of these countries would increase in real terms. (If wages and prices fall by 10 percent, then Italy’s 2 trillion euro debt is 10 percent larger relative to the size of its economy.) Falling wages and prices are also likely to discourage investment, since businesses will know that the products that they will be selling in 5 or 10 years will get lower prices than they would today.
The alternative route to regaining competitiveness would have a somewhat higher euro zone rate of inflation, which would allow the southern euro zone countries to regain competitiveness by having a lower, but still positive rate of inflation. However, going this route would require the European Central Bank to loosen its commitment to maintaining a 2 percent rate of inflation.
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