[OPE] Europe's ECB on inflationary pressures

From: Jurriaan Bendien (adsl675281@tiscali.nl)
Date: Fri Jun 20 2008 - 17:12:21 EDT

In the long recession beginning in the 1970s, price inflation was blamed especially on unsustainable wage rises, which had the effect that firms raised their output prices to compensate. There was at that time a brief primary commodities boom, and then two oil shocks. But since real wages these days are basically fairly stagnant (except at the top end) this cannot be the main source of inflationary pressures now. Resurgent price inflation is therefore attributed to rising energy and commodity prices, where demand outstrips supply, and thus, inflation is explained essentially now in terms of resource scarcity. The trouble with that is, that a large chunk of energy and commodities requirements are imported into the EU, and therefore, short of multinationals investing more in increasing output abroad for export to the EU, there is nothing much you can do about that domestically. Euro area average annual inflation was 3.7% in May 2008, up from 3.3% in April. A year earlier the rate was 1.9%. Now what to do?

Lorenzo Bini Smaghi, a member of the executive board of the European Central Bank, has quite an interesting comment on this here:


He writes among other things that:

Over the past 10 years, commodity prices [in the EU] have increased on average by 18 per cent a year (24 per cent energy, 4 per cent food, 10 per cent industrial raw materials). Unless technological innovations lead to substantial savings or to an increase in supply, the world economy will have to learn to live with continuously increasing commodity prices. For central banks, continuing to assume that these price increases are one-offs could put their credibility at risk. (...) Over the past decade [EU] manufacturing has recorded an average inflation rate of 0.8 per cent in the euro area (..) In services, however, inflation was on average 2.3 per cent and has accelerated in recent months."

What is Smaghi's solution?

"To reduce internal inflation, profit margins and domestic costs should be contained, in particular labour costs. This can hardly be achieved by squeezing nominal wages, which would be socially unacceptable in our advanced societies and would further subdue aggregate demand. The only way forward is to increase productivity, in order to contain costs and prices, especially in the services sector."

That sounds fairly post-Keynesian, but in fact his solution is more neo-liberal. In the core EU countries, he is aware, GDP per person employed has actually declined somewhat.  How do you increase productivity? To increase productivity in services, he argues, more competition is necessary, and to generate that competition, the non-financial services sector (about twice as large as the goods-producing sector, qua value added) should be liberalised, especially - he says - in retail distribution where the EU clearly lags behind the US. 

Essentially, we have to work harder for the same wage, and create more output with given inputs, to beat inflation, that's the story. Well actually the wholesale & retail sector in the EU27 generates only 16.6% of the value added of the non-financial business sector, though employing 21.2% of the sector's workforce of 125 million. http://epp.eurostat.ec.europa.eu/portal/page?_pageid=2293,59872848,2293_68195486&_dad=portal&_schema=PORTAL ¶)
Whereas liberalising the retail sector sounds good, more competition there would mean essentially closing down a lot of small outlets employing relatively lowpaid staff and with a relatively low profitability, and substituting fewer large outlets, plus rationalising the product-chains more, sort of like the Walmart model Mr Sarkozy admires so much. I doubt however whether that is going to make much difference to the overall price inflation rate. The question there is, how you could unleash more competition, without at the same time raising unemployment longterm. And what of the results of competition? Businesses outcompete other businesses, pushing them out of business, resulting in less competition, since then a few firms dominate the market. Presumably what you need in that case is a better environment for new entrepreneurs.

I think we need here both a better theory of the empirical causes of price inflation in an historically new environment, and a better economic strategy to respond to it. (In this respect, it is interesting to note that R&D contributes only 18.4 billion euro in value-added to the non-financial business sector total of 5.1 trillion euro! (ibid.)). If for example the average inflation rate in EU services is 2.3%, you have to isolate the main sources of that inflation. 

This whole discussion is a bit weird obviously, if we leave out of consideration the financial sector and capital finance. Smaghi argues "If domestic inflation does not come down through these measures [i.e. more productivity and competition in the services sector], there is only one option left: monetary policy. [In other words, you have to raise interest rates]. But monetary policy acts indiscriminately across sectors, by containing aggregate demand." But what if financial speculation itself is actually an important contributor to price inflation, driving up costs? Just as an indication of importance, the EU27 financial sector (output defined) now contributes a whopping 28.2% to total gross value added (33.7% in the UK, 29.3% in Germany, and 49% in Luxemburg). http://epp.eurostat.ec.europa.eu/portal/page?_pageid=1996,39140985&_dad=portal&_schema=PORTAL&screen=detailref&language=en&product=Yearlies_new_economy&root=Yearlies_new_economy/B/B1/B11/daa17168šĆ)
Of course there are not just these options but many more - hypothetically you could for example reduce energy taxes for business operators, and so on.

Another problem is with the very notion of "aggregate demand". If GDP is taken as an indicator of aggregate demand, it not only leaves out intermediate consumption (precisely where commodities and energy are important), property income and transfers, but also it does not reveal the structure of aggregate demand. If (say) 10% of adults account for 30% of the personal income/demand, and 30% of adults account for 10% of the personal income (a strongly skewed personal income distribution) then this has major policy implications if you want to talk about price inflation. The tragedy of the policy makers is that they are now saddled with a categorisation of EU economic activity which does not even clearly quantify the distribution of who generates what kind of income, and who receives income from what source. That is more or less the secret of a few experts. How good anti-inflationary policies can emerge from this, is a moot question. We do not get very far, if the problems are not tackled at their source.


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