A Macro View: Economic Divergence of the Eurozone, Bad for Investors
Mon, Jun 20, 5:55 PM ET, by Ron Rutherford, Sabrient.com
As usual, Paul Krugman is at it again with a simplistic macroeconomic view of the economy to justify his hell-bent desire to increase Fiscal and Monetary expansion at any costs. In his blog post One Size Fits One, he brings out plenty of good points about Taylor rules (rules that help the central bank maintain a stable economy based on the output gap and inflation). Let me jump right to his conclusions.
…In short, the ECB has no business raising rates.
What is true, however, is that the rule might still point to a rate rise for Germany.
So the point is that while the ECB could suffer from a one-size-fits-all problem, the fact is that it isn't even doing that; it's tightening when only Germany even arguably needs it.
He links to an economic letter from the San Francisco Fed entitled Monetary Policy When One Size Does Not Fit All (pdf). He seems to be basing his conclusion on the following graph from the letter showing the unemployment gap and core inflation.
(Click to enlarge charts)
So he is right that Germany is the one that is significantly below “full employment” or more technically the Non-Accelerating Inflation Rate of Unemployment (NAIRU), but all the “core” European countries (Austria, Belgium, France, Finland, Germany, Italy and the Netherlands) are close to NAIRU or even marginally below it. Using the NAIRU standardizes the “coefficients” across countries–Krugman has it wrong about a need for different coefficients on the two sides of the Atlantic.
More importantly, this is a static analysis of the core and peripheral countries. Since the lag time for the effects from any change in the central bank policy to the general economy takes about 18 months, the analysis clearly should be on forward looking gap rates. The next graph of standardized unemployment is from the European Central Bank as part of its Statistical Data Warehouse.
The chart above shows that for the core country, unemployment rates have been declining since late 2009 and are for the most part below their individual median rates over the periods. For example, Germany has the lowest unemployment rate since 1992 with a downward trend since 2006. From the graph it is also worth noting the significant differences in unemployment rates between countries over the long-term basis as well as short-term trends. These differences of standardized unemployment rates and NAIRU among the countries (under the same monetary union) shows that there is much structural rigidity between the countries still. The Fed letter concludes with a few reasons for these differences.
Nevertheless, the tensions over monetary policy in a union of many separate countries are likely to be greater than tensions in a single country. The United States can rely on its relatively high labor mobility and on fiscal policy to counter economic weakness, for example, options that may not be fully available to the euro area's heavily indebted peripheral countries.
Output Gaps and Taylor Rules
Krugman might have a point that the Taylor rules should use output gap as opposed to unemployment gap used in the letter. The two graphs below show the output gaps for the core and peripheral Eurozone respectively, along with the US output gap in both. The data comes from the OECD Economic Outlook in table 10. Output Gaps measures deviations of actual GDP from potential GDP as a percent of potential GDP. It includes forward looking estimates for 2011 and 2012, which is helpful when considering medium-length effects from monetary policy. There is a divergence between the core and peripheral countries with the core as a group quickly reducing the gap to zero or, in the case of Germany, surpassing the break-even point in 2012. Given the expected growth in output as compared with potential GDP, it does not seem overly early to consider raising interest rates in the core countries. On the other hand, the peripheral countries show weakness in growth and have a much longer path to eventual full employment of resources.
The graphs also show that the US has done much better than the peripheral countries, but compared with the core countries it is a lagger of the group (around the level of France), even with Finland making up the gap at a very fast rate. So while it is possible to say they are “similar” in appearance in growth, as Krugman implies, the US will be a lagger in getting to break-even output gap. This trend for the US does imply that within the next few years the output gap will be significantly reduced to zero. Unemployment still will be above NAIRU at that time, but the Fed may be required to start unwinding the extra monetary tools like quantitative easing if output gap is zero or above.
Based on the data above, Paul Krugman missed the mark on unemployment gaps with respect to the use of the Taylor Rules. The data from the output gap also confirms that soon, if not now, the European Monetary Union (EMU) will need to raise interest rates. This is at least in regards to the core countries. Structural rigidity is causing most of this divergence. If labor was completely mobile then standardized unemployment rates would converge and stay stable between regions (nations of the European Union).
The letter from the Fed provides one more graph that is important in discussions about which country benefits and which country gets hurt in any monetary policy going forward. Since the economic weights of various countries determine the amount of contributions to the central bank and thus political weight, you would not expect perfect balance between the various interests. But a reasonable compromise would represent conditions where the target rates were between the core and peripheral Taylor rules rates. The graph below shows that since the lines all crossed in 2008, the target rates used were in between the Taylor rules indicator of the core countries above and the Taylor rules indicator of the peripheral countries below. It could be argued that the rate used should have been lowered to near zero in the US and Japan, but overall it seems to be a good compromise.
Given the data we looked at regarding output gap, I think it is up to Krugman to provide a Taylor rule or some other rule to determine what the target rates should be for the EMU going forward.
The data above, and thus the implications of what the EMU may do in the future, bodes negatively for investors looking for gains in the European region. The core is basically heating up and inflation may take hold especially with a lot of power in labor unions. On the other hand, the peripheral countries could suffer economic stagnation from too high rates along with austerity measures. In an alternative universe, the problem would be easily solved by all the unemployed in Spain, Portugal and Greece packing their bags, learning German quickly and getting jobs in the hot sectors of Germany including high technology areas. Also capital would flow from the center/core to the peripheral. In other words, no structural rigidity.
SDI Glossary: "CD" Definition
SDI Glossary: "the Fed" Definition
SDI Glossary: "GDP" Definition
SDI Glossary: "Inflation" Definition
SDI Glossary: "Size" Definition
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