Heiner Flassbeck — The Heart of the Euro Problem: A Response to INET's Rob Johnson

A currency union at its core is about harmonization of inflation rates as all countries give up national monetary policies and explicitly agree on a common inflation target (close to under two percent in the EMU). From here the argument is absolutely straightforward.

First, we have very strong evidence that inflation rates are highly correlated with unit labour costs (ULC, for the overall economy, of course, not for industry). Second, we know in general that the development of ULC is much more the result of exogenous factors than the development of price changes, which leads to the conclusion that ULC growth determines inflation to a very large extent. Third, we know specifically (or should know) that the biggest country in Europe, Germany, even before the official start of EMU, had decided to dramatically change the course of its wage policy.

In a tripartite agreement in 1999 government and negotiating partners on the labour market agreednot to allow growth of nominal wages along the lines of productivity growth and the inflation target of two percent (hitherto the traditional German approach) for the future but to remain clearly below that line. This has being applied and has been enforced by the “flexibilization of the labour market” in the first years of the Red-Green government. This implied that German ULC growth and its inflation rate would systematically remain below the commonly agreed inflation target in EMU.

As no other country had a similar arrangement it implied also that over time huge discrepancies in inflation rates and huge real appreciations of other countries (against those like Southern Europe that would slightly overshoot the inflation target but even against those like France that would strictly stick to the target) and huge unsustainable imbalances would be the result. One big country permanently gaining international market shares and increasing its surpluses and the others permanently losing and going deeper into deficit is a scenario for collapse if corrective forces do not come into play sooner or later.

INET
The Heart of the Euro Problem: A Response to INET's Rob Johnson
Heiner Flassbeck, August 8, 2012