Fighting Inflation: Are Small Eurozone Countries Left Behind?

Pierre Lesuisse, University of Strasbourg and Jean-Louis Combes, University of Clermont Auvergne (UCA)

In 2023, Croatia will complete its course under the exchange rate mechanism (ERM-II) and become an integral part of the euro zone. Bulgaria is also there from the summer of 2020. ERM-II is the last step for the country before entering the euro zone. The countries there have been participating in the process of monetary convergence for at least two years to ensure their stability against their future partners in the euro zone.

Because sharing its currency with other countries means giving up the ability of its central bank to respond to shocks affecting its economy by, among other things, influencing the exchange rate. Under a fixed exchange rate regime, Bulgaria could, for example, choose to devalue its currency, in other words, reduce its value relative to others, to encourage exports and curb imports in order to increase national output. This is even more true when faced with a relatively tight European labor market, both in terms of wages and mobility.

For two years, the country has been in a kind of testing phase. It’s a matter of seeing if it’s stable enough to give up on this tool. After entering the euro zone, the European Central Bank (ECB) will take control of monetary policy. It needs to be accommodated by ensuring that its policies are consistent with the policies adopted by the country individually.

However, our recent work concludes that Frankfurt’s monetary policy is largely influenced by relatively strong economies. In turn, the smallest economies suffer. In case of desynchronization of the economic cycle, they must rely on other instruments such as budgetary policies or strong institutions regulating the labor market.

This result does not seem insignificant at a time when key interest rates are regularly raised to fight inflation: on July 27, September 14 and November 2 they were raised to 0.00%, 0.75% and 1.50% respectively. Measurements and heterogeneities that raise questions when we know the relationship between inflation and unemployment.

Dangerous exercise

The discovery of this relationship dates back at least to the statistical work of New Zealand economist Alban Phillips in 1958. The author gives his name to the curve showing the constant and inverse relationship between the unemployment rate and the evolution of prices.

High inflation is the price of low unemployment, it is beginning to be understood. From a purely empirical relationship first observed in the United Kingdom between 1861 and 1957, certain currents of economic thought have in fact concluded a causal relationship and trade-off between these two variables.

Thus, fiscal stimulus policies should stimulate aggregate demand: companies can produce more and demand additional workers, reducing unemployment. Faced with this drop in unemployment, companies are also forced to raise wages to attract fewer and fewer unemployed workers. Firms will then pass these additional costs on to prices, all of which feed inflation.

It is an asset for the policymaker to understand this relationship and to know the extent to which monetary authorities can be trusted, especially when the latter intervenes to curb inflation within the monetary union.

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Indeed, monetary policy within a monetary union is always a dangerous exercise. It is modeled based on what happens on average for all members. The further a member is from this average, the more likely they are to be managed by measures that are poorly calibrated for their particular situation. In other words, it requires different economies to have relatively synchronized business cycles to some extent to prevent monetary policy from running counter to their particular needs.

For all these reasons, it is then interesting to draw a Phillips curve for the euro area as well as for each of the 19 Member States.

Counterproductive effects

We initially focus on seven relatively small economies that have gone through all stages of membership in recent years, from joining the European Union (EU) to joining the euro area: Cyprus, Estonia, Latvia, Lithuania, Malta, Slovenia and Slovakia.

Using quarterly data, our first results show that gradual entry into the euro area is accompanied by a diluting inflation–unemployment relationship. This means that the arbitrage between the two has something more significant than between the other twelve members of the eurozone. Entry into the Eurozone leads to the loss of the observed empirical relationship with the Phillips curve in the smallest economies.

Therefore, monetary policies can have heterogeneous effects depending on the size of the economy concerned. This observation suggests that the smallest economies must balance price volatility with employment through other channels, particularly through labor market institutions, at the risk of being exposed to ineffective monetary policy.

Under the assumption that relatively stronger economies can tip the scales (for example, if France and Germany experience a simultaneous economic slowdown), the effect of monetary policy can be reversed. A productive yet upward growth trajectory for small economies. It may even exacerbate the imbalance between the evolution of prices and the labor market.

Why the European minimum wage?

This empirical relationship, the Phillips curve, represents a contribution to the evolution of the euro zone anyway. This justifies the current interest of the European Commission in the internal institutions of the labor market, and we better understand the interest of the proposal for a directive for the European minimum wage. The idea: the monetary union also develops together with the real sphere and cannot be separated from it.

These questions also point to a great deal of research needed to understand and support policy debates within monetary union and the EU as a whole.

It should be noted that we took a sample of small open economies. It will be interesting to analyze the evolution of the balance of power when relatively strong economies such as Poland, Hungary or the Czech Republic join the eurozone. Joining the single currency has become mandatory for virtually every EU country. Only Sweden and Denmark, which came earlier, will be able to make an exception.

Pierre Lesuisse, Doctor of Economics – Researcher at BETA (Strasbourg) – Science Teacher (Strasbourg), University of Strasbourg and Jean-Louis Combes, Professor of Economics, University of Clermont Auvergne (UCA)

This article is republished from The Conversation under a Creative Commons license. Read the original article.