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Monday, April 07, 2003

On Harrod-Balassa-Samuelson and European Inflation

A post from Brad Delong of late last week has started all kinds of bells ringing in my head:

As time passes, and as the European periphery becomes richer and richer, its real exchange rates vis-a-vis the European industrial core have to rise. This is the Balassa-Samuelson effect: poor countries have low real exchange rates because international trade is concentrated among the capital- and technology-intensive goods in which rich countries' absolute advantage is greatest, and so as countries catch up to the industrial core, their real exchange rates rise. In the case of poor countries inside the euro zone, convergence and the consequent rise in real exchange rates requires faster inflation than in the industrial core.

If development on the European periphery is successful, and if growth on the European periphery is rapid, then inflation on the European periphery will be rapid too. This means that, if eurozone-wide inflation is to be low, there must be deflation--falling prices--in the German-Belgian-French industrial core of the euro zone. Deflation is, in general, a bad idea for lots of reasons, one of the chief of which is the catastrophic consequences of nominal wage cuts for worker morale.

Yet as long as the ECB takes its goal to be low inflation eurozone-wide--rather than low inflation in the eurozone's industrial core, with the developing periphery seen as a special case--it seems that the ECB has committed itself to a much more contractionary monetary policy than even the Bundesbank would have ever dared impose on the Bundesrepublik.
Source: Semi Daily Journal

The more important bell relates to the use and abuse of the Harrod-Balassa-Samuelson effect, but I will try and post something on this when I've had more time to think the topic over. Meantime another topic relates to the HICP methodology and how the country weights are determined. After a little investigation I discovered that they are in fact based on national consumption expenditure shares, chain weighted two-years-post as the data come in from national income accounts. Anyone else whi is interested in the arcane world of Eurostat statistical deliberation might find intersting this paper from the Dallas Fed.

Among the jewels that may be found there are:

"Where does this place the HICP in the classification scheme proposed by Diewert? (Diewart is one of the luminaries of index number theory: EH) Eurostat states quite explicitly that the HICP is not a cost of living index, so its conceptual framework presumably lies in either the fixed-basket, axiomatic or statistical approaches to index number construction. However, Diewert shows quite convincingly that this cannot be the case, since all three of these approaches (as well as the economic approach) would rule out the use of the Laspeyres formula for the calculation of the HICP. We will return to the issue of the conceptual framework of the HICP below. For now, it suffices to note that the HICP does not easily fit into any existing approach to the index number problem."

What should be clear is that the methodology used is far from self-evident, and the inflation composite has to be an extremely dubious number for economic policy purposes. When you consider that there's been no Europe Boskin, and that methodology varies widely from one country to another, fine tuning on this must be a bit like taking the 'big hammer' for Um Quasr. In fact the degree of uncertainty regarding the validity of the individual country figures is significant given the lack of quality adjustments in most of them. I would say there is as much possibility that the German figure is 1% too high as there is that it is 1% too low. In which case we don't really know whether or not the German economy is already experiencing deflation. My only conclusion from my investigations is one I reached long ago: deciding whether monetary conditions are too tight or too loose on the basis of the HILP is a fools errand. So it's time to throw away the cucumber sandwiches and the fine lace and go to work to try to clutch Germany from the jaws of deflation before it's too late (assuming, that is, that it already isn't). Those interested in consulting these invaluable inflation numbers can find the latest set here

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