Sunday, April 10, 2011

When Inflation Could Be Good

Paul Krugman has written recently on the large divergence in labor costs in Europe. Notably, many of the struggling southern European countries have experienced surges in labor costs above the 2% inflation target of the European Central Bank, whereas countries like Germany have experienced the opposite. The ECB is now encouraging the southern countries to "get with the program" and start a deflationary cycle.

Well, that seems a tad unfair, so to speak. As Krugman points out, "During the eurobubble years, there were huge capital flows to peripheral economies, leading to a sharp rise in their costs relative to Germany." Why was there a surge? In the simplest explanation, it can be attributed to the adoption of the euro. A common currency significantly reduces transaction costs. Also, investment abroad (in a non-common currency) requires converting to the local country's currency. If the investors have fears about the volatility of the exchange rate (which is likely in a developing or emerging economy), they might shy away from putting their money down. Naturally, it follows that the adoption of the euro alleviated many of these worries.

So while the rise in labor costs can be attributed to foreign inflows, what's wrong with asking the countries to deflate? Well, why not ask, say Germany, to inflate (although that's easier said than done, I realize)? This a two-birds-with-one-stone solution. Incredibly low headline inflation has been a post-crisis worry, and for once, inducing inflation will not only help the country in question, but also many of its neighbors struggling with different problems.

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