Inflation concerns the US and Europe alike. The downward trend in energy costs is providing relief on both sides of the Atlantic. However, inflation in the old continent has now reached higher levels than in the United States. Is Europe now facing an even bigger problem?
Falling inflation and falling energy costs have caused a deep sigh of relief on both sides of the Atlantic. Price watchers’ attention has now turned to core inflation, which omits volatile food and energy prices. As a rule, it rises much more slowly – and is difficult to reverse.
Since October, core inflation in the euro zone has reached higher levels than in the US. Could Europe face an even bigger inflation problem than its transatlantic counterpart?
In economics, everyone should be familiar with Milton Friedman’s dictum: “Inflation is always and everywhere a monetary phenomenon.” However, the words of the Nobel Prize winner resonate with the current wave of inflation, which is experiencing devastating price increases due to post-pandemic supply and labor shortages, household spending and energy shocks not to be fair.
Whether and how quickly inflation can be reduced depends not only on the central banks, but also on the impact of the individual factors – supply disruptions, energy shock and wage increases – on the economy on both sides of the Atlantic.
In addition to such surprises, the economies of the richer countries also experienced massive structural changes. Covid-19 changed the living, working and consumption habits of many people in a very short time. After the restrictions were lifted, there was a rush to travel, go out and enjoy yourself.
In addition, governments in America and Europe decided to subsidize green technologies in an unprecedented way. Capital, means of production and labor must flow into the expanding sectors of the economy – not into the declining ones. Only then can the economy adequately cover the demand.
However, relocating jobs or investing in new systems and software takes time. An upswing can help. Recent studies by Rüdiger Bachmann of the University of Notre Dame and other researchers have shown that German employees are more willing to change jobs in times of increased demand than during a recession.
Another study, based on American data, finds significant pay increases for workers moving to an expanding company. It can be assumed that the current economic changes create some inflationary potential – and can sometimes be beneficial.
In a recent essay, University of Chicago’s Veronica Guerrieri and other authors argue that monetary policy should tolerate higher inflation if it gives workers more leeway to find jobs during periods of economic upheaval.
The pace of adjustment to these changes has been influenced by government policies in America and Europe. Europe’s approach during the pandemic has largely focused on maintaining the structures in place. On the continent, governments introduced generous furlough schemes to safeguard existing jobs.
Unlike in the US, there was no stimulus check-financed boom in durables to boost production. Nor did Europe’s economy overheat to encourage a redistribution of labor and capital. If US inflation is the result of economic restructuring, it should recover faster than Europe after the process.
At the same time, the European economy faced other challenges. As the Fed’s Julian di Giovanni and other authors show, supply constraints accounted for a larger share of inflation in 2020-21 than in America. After wholesale gas and electricity prices had already shown an upward trend in autumn 2021, they skyrocketed after Russia invaded Ukraine – followed by oil and coal prices. The resulting increase in inflation was much stronger in energy-importing Europe than in America.
There is a consensus in economics that central bank policy should not be too tight on a temporary supply or energy shock. Since the thumbscrews are already tight enough to handle such shocks, there is no need to tighten them any further.
As long as inflation expectations remain stable, the long-term impact is expected to diminish. As the supply gap from wood to chips slowly closes and energy prices fall, Europe should benefit more than America – assuming inflation has not become entrenched.
This is the case when employees and companies assume that prices will continue to rise. In the worst-case scenario, this creates a wage-price spiral in which employees and companies can no longer agree on how the economic cake should be divided up. In a dense, flexible labor market like America’s, which allows for almost no collective bargaining, wage growth typically follows inflation rapidly.
This is exactly what happened: wage growth accelerated as inflation began to rise. As Guido Lorenzoni from Northwestern University and Ivan Werning from the Massachusetts Institute of Technology found in a recently published study, this theoretically increases the risk of a wage-price spiral. However, it seems that America has already passed the greatest danger. According to Indeed job exchange, the country has had high wage growth, but it has been declining for some time.
In Europe, wages are often determined within the framework of collective agreements. Across the EU, this model affects around six out of ten workers. The duration of the contracts is usually at least one year, so that the adjustment of wages to economic conditions takes a certain amount of time.
In the early stages of inflation, this proved beneficial as wage pressures did not directly fuel inflation. Unions and companies could negotiate how to share the lost income and profits. After all, both sides come together around a table every year to take stock and make adjustments. Because they cover large parts of the economy, they have every reason to consider the macroeconomic implications of any deal.
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However, relations are increasingly under pressure. With inflation stubbornly persistent in Europe, unions are demanding additional pay for their members. In the most recent collective bargaining, the German unions have demanded 10.5% more wages for the public sector.
These delayed wage increases are normal in an economy where wages have been slow to settle and a supply shock has occurred. As Lorenzoni and Werning point out, real wages tend to fall first before recovering to their old levels. However, while America appears to be making increasing progress, the old continent is lagging far behind. The European race against inflation is far from over.
This text first appeared in The Economist under the title “Could Europe end up with a worse inflation problem than America?” and was translated by Cornelia Zink.
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