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What Europe Needs Now Is Moderate Inflation

Paul Krugman: Europe’s inflation problem: It’s too low. Moderate inflation is actually a good thing for modern economies.

(Image: AMMER; Austria / CartoonArts International / The New York Times Syndicate)

Europe’s inflation problem: It’s too low. Moderate inflation is actually a good thing for modern economies, for two reasons — one involving demand, one involving supply. On the demand side, inflation reduces the problem of the zero lower bound: Nominal interest rates can’t go negative but real rates can, to the extent that modest inflation is embedded in expectations. On the supply side, inflation reduces the problem of downward nominal wage rigidity: People are very reluctant to demand or accept actual wage cuts, and this becomes a serious constraint if the relative wages of large groups of workers “need” to fall.

Both problems are very much present in the United States, but they’re even worse in the euro area, where fiscal policy has been highly contractionary — thanks to savage forced austerity measures in the peripheral euro zone countries and precautionary austerity measures in the core nations, so that monetary policy is the only game in town — and where peripheral economies also need large internal devaluation.

Given this, Europe’s latest inflation numbers are just disastrous: core inflation over the past year of just 0.8 percent. Alas, European officials think that because the European Central Bank has calmed financial markets and some countries are showing slight growth, the crisis is over.

More Notes on Germany

I had a few more things to say about Germany’s trade surplus and the report from the United States Treasury explaining, correctly, that this surplus is harmful to the world economy. If you ask me, the worst thing in an article published recently in Der Spiegel about the controversy is a statement from Germany’s Economics Ministry, which said that “Germany’s surplus is a sign of the competitiveness of the German economy and global demand for quality products from Germany.” Economists everywhere should read this and weep. It is a basic truth in accounting that: Current account = Savings – Investment. Any story about the determination of the current account balance must take this into account.

Suppose you have wonderful products that the world loves; even so, if you have low savings and high investment, you must run deficits. How can this happen? Simple: You end up with a high value currency and/or high wages relative to competitors. So while it’s impressive that Germany can run a surplus despite quite high labor costs, and that’s a testimony to the quality of its stuff, ultimately the surplus reflects high savings relative to investment. And we are, as I wrote in a different context just the other day, in a world awash in savings – a world in which someone who decides to spend less and save more makes everyone else poorer.

That’s not the normal situation, but it’s where we are now, and where we have been for five years. Does the German Economics Ministry not understand any of this? My guess is that it doesn’t — that Germany really does see itself as a role model, believes that all would be well if everyone behaved the same, and doesn’t see the notion of a world in which everyone runs big trade surpluses as being problematic in the least.