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[Raphael A. Auer] Eurozone’s inflation divide

ZURICH ― Discussions within the European Central Bank’s Governing Council, which is poised to meet on April 7, are about to get hot. The risk that rising inflation in emerging Asia could spill over into Europe will pit the Bank’s inflation hawks against those in favor of ensuring as fast a return to full employment as possible. But what may cause even greater dissension is a renewed clash of national interests as inflation rates within the eurozone diverge.

The underlying cause of this divergence is the much larger role that imports from China and other East Asian emerging economies play in the German or Belgian economies than in southern European countries. For example, Germany’s imports from China totaled roughly $63 billion in 2009, nearly equivalent to the imports from France, Greece, Italy, Portugal, and Spain combined. And China’s trade significance, as a share of GDP, is nearly twice as great for Germany as it is for any of these countries.

In addition to this difference in the relative magnitude of imports, the benign price effect of low-cost import competition is much larger in Germany’s competitive retail landscape than in the more traditional, and uncompetitive, retail systems of Italy or Greece.

Overall, these structural economic disparities have led to vast differences in the ways that various eurozone members have benefited from the rise of cheap Asian imports over the last 15 years. Now that the era of cheap imports is waning, however, the effect on prices will be reversed, and those who benefited the most in the past may now suffer the most from Asian inflation.

The spillover of inflation from China to Europe may explain the recent upward pressure on prices in Germany. The figure relates the inflation rate during the second half of 2010 to the relative importance of imports from China. Among the depicted countries, a larger Chinese import share was clearly associated with a much higher inflation rate. It is likely that in the months to come, inflation in emerging Asia will cause pronounced divergence in inflation rates in the eurozone.

Such divergence, of course, implies ample potential for discord within the ECB in the near future. But it will also accelerate a solution to the eurozone’s main structural problem: its internal competitive imbalances, owing to wage-growth trends since the introduction of the euro that underpinned to Germany’s large trade surplus vis--vis the rest of the eurozone.

So now ― for once ― it is the German economy that is bound for higher inflation than the rest of Europe. And make no mistake about whether rising prices will feed through to wage growth. Already, barely a year into the recovery from the worst economic crisis since World War II, unemployment in Germany is at a post-unification low. With the economy likely to grow substantially as Chinese firms’ competitiveness deteriorates due to rising wages, it is hard to imagine that German trade unions will not demand hefty real-wage increases as well.

But any pickup of wage growth in Germany will bring about an unintended benefit: a much-needed convergence of unit labor costs in the eurozone. Although this might be hard to swallow for traditionalists among central bankers, it now seems likely that high inflation in Germany will be the price of achieving the eurozone’s long-term cohesion.

By Raphael A. Auer

Raphael A. Auer is deputy head of the International Trade and Capital Flows Unit of the Swiss National Bank and an LISD research associate at Princeton University. The views expressed here are those of the author and do not necessarily represent those of the Swiss National Bank. ― Ed.

(Project Syndicate)
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