The Irish-Spanish Divergence
The first country-specific reports seem to confirm that inflation rose further. In Spain inflation rose 0.2%:points to 5.2% and in Holland, who for long have had the by far lowest rate in the euro area, it rose a full 0.7%:points to 3.0%.
However, in one country, Ireland, inflation fell from 3.9% to 3.6% (using the EU harmonized index). If the preliminary estimate for the euro area holds, this means that Irish inflation will be 0.5% below the average, while in June 2007 Irish inflation was 0.9% above the average.
The fact that Irish inflation falls relative to the rest of Europe when they experience a cyclical downturn is a good illustration of the Balassa-Samuelsson theory at work, whose conclusion is that the relative real exchange rate should correlate positively with economic growth. With fluctuating exchange rates, this would mean a falling nominal exchange rate, but for countries with fixed exchange rates and within monetary unions this would mean lower price inflation. As the relative real interest rate at the same time rises, this will provide a stimulus to increased savings in Ireland and thus help reduce its imbalances.
More puzzling then is why we haven't seen the same thing happening in Spain, at least not so far. Both Ireland and Spain had a housing bubble driven by low interest rates and large-scale immigration that have now turned into a bust, yet the Irish economy seem to cool in a more unambiguous way. One possible explanation lies in the composition of their immigrant populations. In Ireland most immigrants were (apart from returning Irish expatriates) Eastern Europeans, mostly Poles. In Spain by contrast, most immigrants were from North Africa and Latin America (although the number of Romanians in Spain rose sharply in 2007 following Romania's EU entry). High economic growth and a rapidly appreciating currency in Poland means that many Poles have found it worthwhile to return to Poland and many others yet to abstain from leaving the country in the first place, meaning that net emigration from Poland most likely (No recent actual statistics exist yet) have plummeted dramatically, or even stopped completely.
A comparable improvement in economic conditions in North Africa and Latin America haven't occurred, and the economic gap was much more dramatic to begin with, so there net emigration has probably continued. That means that population growth in Spain have probably held up far better than in Ireland, which in turn limits the decline in total economic growth. No figure for recent months exist yet, but in the year to January, population growth was 1.9% in Spain, far higher than in other parts of the EU.
As higher population growth means greater demand for housing, this will also limit the severity of the housing bust. On the other hand, the higher relative inflation this implies will make it more difficult to improve net exports in Spain.