Thursday, June 14, 2012

Gustav Cassel and the Euro Inflation Divergence

Recently, I've been reading End This Depression Now! by Paul Krugman. On page 166, Professor Krugman begins to talk about the problems of Europe. He points out that currently, there is a situation where much of the "troubled" periphery (GIPSI, Greece, Ireland, Portugal, Spain, Italy) could do with devaluations, but they are locked into a single currency. This reminds me very much of the Gold Standard, where countries currencies are essentially pegged to one another because they are all pegged to Gold (okay, that's not exactly how it worked, but it's close enough for my purposes here). As I summarized in A different perspective on the Great Depression, Dr. David Glasner of the blog Uneasy Money takes the position that the Great Depression was caused by the Gold Standard and, specifically, with the rising monetary demand for gold, which was warned of both by Ralph Hawtrey and Gustav Cassel.

Among other contributions to economic science, Gustav Cassel developed the idea of Purchasing Power Parity, which basically says that in the international macroeconomy, the Law of One Price would result in a specific relationship between the price level of different countries and their exchange rates. Basically, the idea is that a country with a high price level will have weak currency, which compensates for this fact. The domestic or monetary union version of this would indicate that the price level should ultimately equilibrate to a common level throughout the area where there is a common currency (except where there are frictions of one type or another which intervene), which is the simple "Law of One Price" but for price level, rather than individual prices.  What does one see in the data for the European Union?

Source: alexanderarnon, Probably Matters blog

The price level has been growing considerably faster in all of the GIPSI countries than Germany, France, and Austria at least through later 2008, although their rates have slowed down since then, except in Greece.  If these countries had their own currencies, one could expect that over the long run, these countries would be undergoing gradual (hopefully) devaluations of their currencies, which would make their prices equilibrate in the European market.  The point is, that in the current monetary union, this means that their price levels should gradually converge with the countries like Germany, France and Austria.  The direction of this convergence could mean a lot for the levels of unemployment in the periphery.  With the low and slowing inflation rates in the Core, the Periphery will have to undergo deep deflation to affect the convergence quickly or maybe a frozen price level for several years to allow the Core to catch up.  Better still?  The Core could try pushing up inflation!

I have a few thoughts on this. It might be helpful if the ECB adopted price level targeting, instead of trying to target the level of inflation. This would help to provide credibility that convergence could realistically occur and it would not lead to an indefinite period of  higher inflation, once convergence takes place, the growth path of the price level target could be brought down.  Another would be for the ECB to directly buy the government bonds of the Core.  Core countries could develop stimulus packages that would include investments in their own power, communications, and transportation infrastructure.  Maybe Germany could even start a limited World War III (it can happen again, can't it?) with the United States.  In fact, scratch the rest of it... the European Union should start an arms race with the United States (just joking).  If it weren't an awful idea...

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