Pierro Ghezzi is one of the smartest City-based economists – he has a new VOX article here.
In an earlier post I drew attention to the extent to which Ireland’s recent apparent competitive gains reflected the weakness of the euro relative to the dollar and sterling.
Another component of competitiveness is, of course, our rate of inflation relative to that of the Euro area as a whole.
It is therefore of interest to put on record the inflation rates in Ireland and in the Euro area since 1999.
This is facilitated by the European Central Bank’s website, from which monthly data on the rate of inflation as measured by the Harmonised Index of Consumer Prices (HICP) may be readily downloaded.
The following Chart tells the story.
It may be seen that for the first five years of the new monetary union Ireland’s inflation rate was – contrary to expectations – significantly higher than the Euro area average. This resulted in a significant loss of competitiveness relative to the rest of the Euro area.
For the years between 2004 and 2007 our inflation rate behaved as expected in a monetary union and differed little from that of the Euro area average.
During 2009 and 2010 we experienced more deflation than the rest of the Euro area. This helped restore some of the competitiveness we had lost in the early years of membership and the ‘internal devaluation’ was hailed at the time in the belief that it would play a big role in getting the economy moving again.
Since 2010, however, our inflation rate has been climbing back up towards the Euro area average.
It would seem that any further ‘restoration of competitiveness’ will require further weakness of the euro on the foreign exchange markets.
In February 2010, 20 Economists wrote to the British Chancellor to urge a speedier deficit reduction. The New Statesman followed them up for an article recently to ask if their views have changed. The responses are interesting.
Charles Wyplosz issues a stark warning here – a warning well worth heeding.
But is he too pessimistic? The fact is that the ECB has the power to cap bond yields. With bond yields capped at a reasonably low level – say 4.5 percent – the Italian government should be able to avoid default, even with a formal adjustment programme of structural reforms and fiscal adjustments. I doubt the programme would have to involve much beyond what the country is already doing. Mario Draghi has held out the promise – albeit maybe a bit too vaguely – of such support in return for conditionality. All sides have to move.
Simon has an interesting post that challenges arguments against unconditional bond-buying (QE) by the ECB. He makes a convincing case that such bond-buying for specific countries to avoid a “bad equilibrium” would not violate the ECB’s price stability mandate.
But I think his analysis misses another key (if implicit) aspect of the ECB’s mandate: in a highly incomplete political union, the ECB must minimise the risk of redistributions between members through its monetary policy (see this earlier post). Losses on bonds will be shared across the monetary union. Concerns that monetary union is a vehicle for such redistributions could doom the entire project. Of course, there is risk of such losses even on normal monetary policy operations. But this is why these operations take place within a strict risk control framework. For bond-buying, fiscal conditionality can be viewed as an effort to reduce the risk of losses, and ultimately redistributions between monetary union members.
Now it could be argued that fiscal conditionality actually increases the risk of losses. This would be the case if fiscal conditionality is self-defeating — that is, slows the economy so much that the fiscal situation actually deteriorates. Opinions differ on whether this is the case. However, if influential members believe that the ECB’s actions would unacceptably increase the risks of losses without conditionality, then the ECB would find it difficult to proceed with bond-buying, and find it particularly difficult to make the strong commitment necessary to keep yields low enough to credibly remove the danger of the bad equilibrium (see here).
The bottom line that redistributive politics within the monetary union mean that the kind of strong commitment needed to keep yields low is near impossible without conditionality. The choice may be for the ECB to act with conditionality or not to act at all.