European inflation targets: 'This is going to be ugly'

The quote in the title is Paul Krugman's, and I think he's right. Jean-Claude Trichet, ECB President, has put fighting inflation back on the European economic agenda. (Do click through; Goldman Sachs loves the idea). And it's not going to be good for anyone but the Bigs, Eurozone-speaking.

In a fairly brief blog post, Krugman analyzes that decision by presenting two alternative scenarios relative to strong countries (his example is Germany, for obvious reasons) and weak ones (in his example, Spain).

So let's say wages and prices are way out of line in the two countries — Spain's are way too high relative to Germany's. To fix this, you need an inflation differential that holds true over time (five years in the example), with Germany's inflation being higher than Spain's. If Germany has higher inflation relative to Spain, their wages and prices will ultimately re-align.

But an inflation differential of the proper size can work in either of two ways: (a) modest or near-zero inflation in Germany and crushing deflation in Spain, or (b) high-ish inflation in Germany and modest inflation in Spain. Either way, you can get the same differential, and the same restorative result. But one of these choices clobbers Spain, and the other gives it some breathing room.

Guess which option Mr. Trichet is strongly considering? The Professor:

In a frictionless world, it wouldn’t matter which scenario gets chosen. But in reality, scenario A, the low-inflation scenario, is vastly worse for Spain — for two reasons. First, it’s much, much harder to get actual deflation than simply to have stable prices, so scenario A means much higher unemployment. Second, because Spanish debt is in euros, scenario A implies a significantly worse debt burden.

So what we’re seeing is an ECB catering to German desires for low inflation, very much at the expense of making the problems of peripheral economies much less tractable.

This is going to be ugly.

For background, Krugman's long Europe piece is here, and our shorter summary of it is here.

Ugly in Europe has echoes that none of us want to hear. But it looks like wealthy nations (or at least their elites) have dug in their heels.

GP