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Higher inflation could hurt Germany Samuel Brittan: Financial Times 18/07/03 According to the old saying, "There's none so blind as those who will not see and none so deaf as those who will not hear". When I wrote in this column a fortnight ago about the danger of using "deflation" as a label for all the risks affecting the world economy, the response of some financial analysts was as though I had said that there were no dangers of any kind. It is as if a doctor were to doubt that a patient was suffering from tuberculosis and were immediately accused of pronouncing him free of all disease. Critics have kindly reminded me that the German "core" inflation rate, excluding energy and food, is 0.8 per cent. According to HSBC analysts, it may be slightly negative at times next year. What critics overlook is that the last thing Germany needs is a more clearly positive rate of inflation. In the years leading up to monetary union in 1999, the fear was expressed that France would be at a competitive disadvantage. Some sympathetic Americans asked me why the French were accepting a self-inflicted wound. But history contrives to spite economic forecasters; and it is now Germany that is believed to have the overvalued real exchange rate. This is probable but not certain. The Bank for International Settlements, for one, doubts it. Germany's current balance of payments showed a surplus in 2002 equivalent to $50bn (£31bn) - higher than anything achieved since 1989 - a figure the Organisation for Economic Co-operation and Development expects to increase further this year and next. But there is evidence to suggest that this surplus has been achieved at the cost of real output and employment. In the decade since that, eurozone currencies have been more or less locked together, eurozone domestic product has risen by less than the average of the Group of Seven richest countries in all but two years and German gross domestic product has consistently risen by less than that of the eurozone as a whole. German unemployment started off well below the eurozone average but exceeded it for the first time in 2002 and is now higher still. There is an illuminating graph in the last OECD economic survey of Germany showing the real effective exchange rate on three different bases (see charts). All show a large post-unification rise in the first half of the 1990s. Since then, the real exchange rate based on consumer prices has fallen back to where it was at the beginning of the 1990s. But, as the second chart shows, in terms of unit labour costs in manufacturing it is still about 15 per cent higher. This is a crucial indicator that it is in manufacturing that labour costs tend to be most rigid against market pressures. The third chart shows an index based on "unit labour costs in the business sector". It would be reassuring to suppose that this means Germany has regained its external competitiveness. But it is just as likely that business costs have been held down by job cuts and by switching activities to places where labour is cheaper, in central and eastern Europe and the Far East. The best assumption is that Germany does need further real devaluation if it is to be externally competitive. This is all the more likely following the rise of the euro against the dollar, which Gerhard Schröder, the German chancellor, has bewailed - echoing King Canute's supposed complaints a millennium earlier. The only way that Germany can have a real devaluation against its partners in the single currency area is by establishing a rate of inflation below that of the eurozone average. When that is barely 2 per cent, Germany must aim for 1 per cent or less. And since the course of economic life never has run smoothly, this could mean the odd quarter when, as the banking analysts warn us, inflation may dip below the zero mark. Professor Jürgen von Hagen of Bonn University has pointed out that Germany experienced such episodes in the 1960s and again the mid-1980s, with no harm done. He would regard true deflation as a period of negative growth in the price level lasting two, three or more years. But the argument is not over words. The scapegoat in the debate is the European Central Bank, as John Snow, the US Treasury secretary, has hinted. If only, it is said, the ECB would aim for an inflation target of, say, 3 per cent, Germany could continue to regain competitiveness, with inflation well above the zero mark nearly all the time. This is questionable. If the eurozone rate of inflation were higher, the forces pressing down on German costs and prices would be weaker and competitiveness might not improve much faster than it is doing already. It is worth remembering that the harmonised European inflation index misses out housing costs and would register between 0.5 per cent and 1 per cent higher if it were more like a normal consumer price index. So the critics are, in effect, talking about a eurozone inflation target rate of nearly 4 per cent, which some would like to raise still higher in view of the special needs of new members from eastern Europe. We are coming perilously near to the old argument that inflation does not really matter. I have made a rough guess about the reasons for the sluggishness of the eurozone economy in general and the German economy in particular. I attribute some 5 per cent of the responsibility to over-caution or tardiness on the part of the ECB; 15 per cent to mistakes of national fiscal policy; 25 per cent to the difficulties of a "one interest rate fits all" monetary approach; and some 50 per cent to the deficiencies of the "European Social Model", which is antisocial, ought not to be European and is certainly not a model. This leaves 5 per cent to be allocated according to taste. Germany needs both a real devaluation and labour market reform. Combine these in any way you like. But I suspect that if the ECB had heeded the cry of the deflation mongers Mr Schröder would not be bringing in even his limited structural reforms. In that case, the outlook for jobs and output in Germany would be little better in the short term and a good deal worse in the longer run.
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