2007 December 09 Sunday
Inflation To Force Recession In Europe?

Germany's inflation rate is in a danger zone.

Oil prices have risen 83 percent since mid-January, reaching a record $99.29 a barrel on Nov. 21. In Germany, inflation accelerated to 3.3 percent in November, the fastest pace since records began in January 1996.

Adding to inflation concerns, M3 money-supply growth, which the ECB uses as a gauge of future price pressures, accelerated to the fastest pace in more than 28 years in October.

The European Central Bank (ECB) wants to lower interest rates in order to cushion the effects of the credit crisis and in order to prevent any further rise in the Euro against the US dollar. But the ECB might be forced to raise interest rates instead in order to lower inflation. Such a move would likely force Europe into a recession.

Food and energy prices are going up most dramatically.

Consumer price increases are clearly evident in stores. In the western state of Hesse, the cost of butter has jumped by 48 percent over the past year and fuel prices have shot up by 26 percent.

Lettuce, meanwhile, costs 74 percent more in eastern Saxony than it did in November 2006.

Inflation is a problem for the entire Euro currency zone.

A figure for the entire 13-nation zone is due for release on Friday, with Broyer forecasting it could now hit 2.9 percent, up from 2.6 percent in October.

The ECB is worried about inflation.

European Central Bank President Jean-Claude Trichet threatened to raise interest rates if an oil-driven jump in inflation spurs pay increases.

There is ``strong short-term upward pressure on inflation,'' Trichet said at a press conference in Frankfurt after the ECB left its benchmark interest rate at 4 percent. The ECB ``will not tolerate second-round effects'' on wages and some policy makers wanted to raise rates as early as today, Trichet said.

But the southern European countries are voting against higher interest rates. The conflict between southern and northern Europe on inflation and interest rates could eventually lead some European countries to exit the Euro. Megan McArdle places only 50:50 odds on the survival of the Euro.

Overall, I'd place the odds on the survival of the euro at about 50%, which makes me definitely a euro-skeptic. Europe is not an optimal currency zone. America isn't either, but we have a lot of things that make it tenable: high labor mobility (so depressed regions depopulate rather than stagnating), high capital mobility, and automatic fiscal stabilizers that transfer federal money, in the form of things like unemployment benefits, to depressed areas. These are no panacea, but they make the dislocations of central monetary policy bearable. Europe, on the other hand, is full of people who stay where they are no matter what the economy does, and the EU government does not, broadly speaking, transfer money by local need. At some point, I find it easy to imagine that the costs of exit could be outweighed by the costs of staying, particularly as euro-enthusiasm wanes.

Since Trichet and the ECB face such conflicting pressures from different European countries one has to take what the ECB members say with a grain of salt. They can't speak as confidently as US Fed members can. Their institution is walking a tightrope of sorts. So observers tend to see the ECB has more restrained in terms of what it might do.

"Trichet's remarks can't be taken seriously," said Jörg Krämer, an economist at Commerzbank. The reality is that the ECB has cut its growth forecast for next year from 2.3pc to 2pc and expects inflation to fall back to 1.8pc by 2009.

Dario Perkins, an economist at ABN Amro, said the tough tone was intended to cool wage demands in Germany, now reaching the highest in a decade. "He was threatening the unions directly," he said.

Can the ECB get away with forcing the Euro zone into a recession?

Some European economic analysts hoped that Europe has become decoupled from the US economy since so little European exports go to the United States (we use East Asian producers in order to live beyond our means). But Nouriel Roubini is having none of that. He argues that Europe's economic fortunes are still closely linked to that of the United States in his post Global Recoupling Rather than Decoupling as the US Heads towards a Recession.

Recoupling or contagion is also evident in financial markets. Certainly European financial markets did not decouple from the summer and fall financial turmoil in US financial markets; rather there was massive contagion: the ECB was forced to inject liquidity faster and more than the Fed. And the lingering liquidity and credit crunch has been as severe – if not more severe – in Europe than in the US. Thus, based on recent European loan officer surveys, the credit crunch – especially towards corporate lending – is now more severe in Europe than in the US. This is no surprise as the relatively more bank-based financial system of continental Europe – relative to the capital markets-based financial system of the US and UK – is more vulnerable to credit crunches when there is a seizure of liquidity and credit that flows to the corporate sector.

The ECB faces a big problem: Europe is hard hit by a credit crunch. But high inflation is preventing the ECB from following in the footsteps of the US Federal Reserve to lower interest rates. Europe's higher inflation combined with the credit crunch might force Europe into a recession before the United States. Since salaries haven't been keeping up with inflation in Germany for years that's going to be a pretty bitter pill to swallow.

Share |      By Randall Parker at 2007 December 09 11:00 AM  Economics Business Cycle


Comments
daveg said at December 9, 2007 12:44 PM:

It is strange that food prices are rising here, but seems to be because of the demand created by bio-fuel.

I don't see it on gas, however. Gas prices have been great here. They have changed very little as oil has climbed very little vs the dollar.

I am in southern europe, however, do perhaps it is different in Northern Europe.

One would think that the strong euro would drive prices down, however.

Stephen said at December 9, 2007 6:43 PM:

Surely a "credit crunch" would lower inflation? ie less credit = less spending = less demand = less inflation

Maybe the good bergers of Saxony could pop across the border and sell their butter to Hesse, and the bergers of Hesse could sell their lettice to Saxony?

Randall Parker said at December 9, 2007 8:02 PM:

Stephen,

Sure, a credit crunch will, if it goes far enough, cut back demand. The ECB doesn't want the credit crunch to go that far. Think of it this way: The credit crunch is like a set of dominoes. It starts falling and many more dominoes fall than are necessary to cut back on inflation.

Butter: The problem for the Germans is that the Eastern Europeans are buying their dairy products and bidding up the prices. This is happening on a global level with dairy products. It is not just a problem with Hesse or even just Europe. I could present you with URLs on articles I've read about this but I'm feeling lazy at the moment. ;>

Stephen said at December 9, 2007 10:37 PM:

Apropos of nothing in particular, I've just returned home from work to discover the house has been burgled - forced window, doors opened and stuff moved.

But nothing appears to have been taken, so I guess I (or something) interrupted them.

...or they hated our taste is cd's and left in disgust!

Its just what I don't need at the moment - combined music critics and burglars.

Typical though, I unplugged my video security system last week to do some renovations - what are the odds of something happening I thought!!

Ned said at December 10, 2007 7:42 AM:

The Germans will regard any inflation as pure poison, even in the range that many Americans would find only annoying, say, 5-6%. During the 1920's, runaway inflation, coupled with the political instability that followed WW I, pretty much wiped out the German middle class and fatally undermined the Weimar Republic by driving many into the arms of the extreme Left (the Communists) or the extreme Right (the Nazis). So you can count on the ECB to stomp on the inflation brakes hard by ramping up interest rates. This, however, will cause many European economies to tank, as they are already being hurt by the strength of the euro vs. the dollar. I agree that the euro's long-term prospects are shaky. As the article correctly points out, what may save it is the difficulty of disentanglement to restart national currencies.


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