Monday, January 29, 2007

The Economist And The Euro Zone Economy

The Economistis usually relatively sound on monetary matters, but no so in their latest issue. The Economist Finance and Economics section seems to be made up of a mix of semi-Austrians and Keynesians. This week, it seems, the Keynesians were in charge (as articles aren't signed, we don't know the exact identity of the writer)..

In the article, they argue for a rather crude and naive "unit cost of labor"-theory of growth in which unit labor costs are everything that matters. The recent relative strength of the German economy is supposedly evidence of this. Had they bothered to check their own chart more carefully, they would have noticed that relative German unit labor costs have been as low or nearly as low this for more than five years, yet it is only now that it recovers. And even now, growth is only a tenth of a percentage point above euro zone average. And they failed to noticed how Italy had low growth even in the mid 1990s when unit labor costs were low. Not to mention how fast growers like Ireland and Greece have seen rapid increases in unit labor costs. They did however notice that fast grower Spain have seen such rapid increases, yet they fail to notice how this contradict their growth theory.

The truth is that growth differentials have virtually nothing to with unit labor costs, particularly not in a monetary union for reasons explained below. Instead it depends on demographics and differences in regulatory-, tax- and fiscal policy. Spain, Ireland and Greece is doing well because of favorable demographics and unsound policies while Italy is doing badly because of unfavorable demographics and unsound policies. Germany is a mixed bag, with unfavorable demographics combined with modest liberalizations, which not suprisingly means that it achieves average growth.

Interestingly, The Economist in the past have tried to argue the opposite theory. That lower than average inflation in a monetary union is bad for growth, because it means real interest rates is higher. In June 2003, they predicted (in a article unavailable to non-subscribers) that Germany would forever roast and live unhappily ever after. Now they are arguing that the same conditions means that they will live happily ever after.

The truth is that in a monetary union, above average inflation contains both advantages or disadvantages, likely to cancel each other out. On the one hand, higher unit labor costs will slow growth, on the other hand it will also imply lower real interest rates and lower relative cost of capital goods. The Economist in its bias against monetay unions manages to first make the error of assuming that below average inflation is necessarily bad and the error that above average inflation is necessarily bad. The only thing consistent about its arguments is that they are false and biased against monetary unions.


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