Internal Devaluation, Inflation, and the Euro (Wonkish), by Paul Krugman, in NY Times: I’ve been writing for a long time about how the euro area needs more inflation. But I suspect that many readers don’t quite see how this ties into the macro story. So here’s something that may or may not clear things up — a stylized little model linking euro inflation and the adjustment problem to overall monetary policy. It’s very stylized, making some obviously untrue but I think still useful assumptions, and I have been finding that it clarifies my own thinking, at any rate.
So, imagine a currency area with just two countries, Spain and Germany, which I’m going to represent in an aggregate supply-aggregate demand framework.
On demand, I’ll make two assumptions I don’t believe. The first is that the ECB can determine nominal GDP for the euro area. Under liquidity-trap conditions, this is a very problematic assumption, and I don’t mean to drop my skepticism for other purposes. For right now, however, it’s useful, I think, to use nominal GDP as a proxy for the whole range of possible expansionary policies the ECB might follow.
By assuming that the ECB chooses nominal GDP, we get an aggregate demand curve for the euro area as a whole: Py = Y, where P is the price level, y is real GDP, and Y is the target nominal GDP. Now for my second assumption: Cobb-Douglas preferences, so that a fixed share of total spending falls on Spanish and German output respectively. This doesn’t have to be true, and surely makes no difference to the final conclusion — but it means, given the overall target, individual-country AD curves reflecting that fixed division of the total.
Meanwhile, on the supply side, I’ll assume that prices can rise but not fall (because of downward nominal wage rigidity), so that the AS curve in each country is a backwards L.
Given all that, the current situation looks like this:
Spain is deeply depressed, while Germany is close to full employment.
How can Spain restore normal employment? The current European strategy is “internal devaluation”, which means expecting Spain to cut wages and thereby restore competitiveness; this can be represented as a downward shift in Spain’s AS curve (with the new curve in red):
The trouble with this strategy is twofold: it’s really, really hard to get wage cuts, and deflation in Spain makes the problem of debt overhang worse.
What’s the alternative? Aggressively expansionary monetary policy, which shifts the AD curves of both countries to the right. This raises output and employment in Spain, but leads to inflation in Germany:
I’d argue that this is a much better outcome. But it does mean a rise in the overall euro price level, because of the asymmetry between the effects of higher demand and lower demand in the face of wage stickiness. In practice, because these developments would play out over time, following the path of higher demand would mean that the ECB would have to accept temporarily higher inflation.
And of course the difference between these two strategies demonstrates what a really bad idea it is for the ECB to have a mandate that only takes account of price stability, with no consideration for the real economy.
Just in case you’re wondering, this little model does not in any way contradict what I’ve been saying in other euro analyses — it’s just a different angle of approach. But it may be helpful. And trivial as the model is, I think it suggests just how important it is that the ECB find some way to escape its stable-price shackles.