A European disease? Non-tradable inflation and real interest rate divergence

When the euro was introduced, conditions for economic convergence –the process of narrowing income gaps between lower and higher income countries– seemed to be present. Nominal interest rates between higher and lower income countries had converged rapidly and capital was flowing from the richer (the "core") to the poorer (the "periphery") countries of the area. This convergence process was supposed to be the main reason behind the strong macroeconomic divergence between the core and the periphery, and the imbalances were supposed to be reduced as countries would converge. No need to worry about these imbalances then argued Olivier Blanchard and Francesco Giavazzi [1].

The 2010 euro crisis cast doubt on the reality of the convergence process. In 2015, Benoît Coeuré noted that “in the worst affected countries, convergence in GDP per capita has been reversed, casting doubt on one of the fundamental objectives of the single currency” [2]. And J. Stiglitz recently claimed that "the euro has failed to achieve either of its two principal goals of prosperity and political integration: these goals are now more distant than they were before the creation of the eurozone. Instead of peace and harmony, European countries now view each other with distrust and anger.”

How did monetary integration accentuate the divergence between its member countries? A recent article quantifies the effect of monetary integration on price divergence in the Eurozone. Before the 2008 global financial crisis, this divergence took the form of strong inflation differentials. These diverging inflation rates in the area could have reflected a convergence of price levels between countries. Nevertheless, several studies have already shown that, while prices in tradable sectors (such as manufacturing activities, transportation or tourism) have converged [3], prices in the non-tradable sectors did not (the real estate sector, wholesale and retail trade, etc.). As a result, the divergence in inflation rates between countries reflected mainly the substantial price differentials between tradable and non-tradable goods in some countries.

This article further investigates the mechanisms behind the divergence of relative (non-tradable to tradable) prices across Europe. The starting point is Figure 1 which shows the evolution of relative prices and real interest rates in the periphery compared to core countries over 1995-2013. The periphery faced a steep increase in relative prices (+27%) relatively to core countries (+12%). Housing bubbles did play role in explaining these developments [4], but cannot explain a bulk of it. In Portugal for example, prices in the real estate and construction sectors even fell (-8%) between 1999 and 2008. And when excluding the housing sector from the sample, the periphery faced a steep increase in relative prices (+24%) over 1999-2008. It reflected strong price increases in sectors such as public administration, health and education (+51%), financial and insurance (+ 45%), infrastructures (water supply, electricity, gas, +40%) and wholesale and retail trade (+ 26%).

This study suggests that these developments are not only the result of a relative loss of productivity in the non-tradable sectors (the traditional Balassa-Samuelson effect), but are also the result of the sharp drop in interest rates in peripheral countries. Monetary integration allowed a convergence of nominal interest rates in the zone around 4.3% in the mid-2000s. This convergence resulted in sharp declines in interest rates between 1999 and 2008 in the peripheral countries relative to core countries: the nominal interest rate declined by an average of 7.6 points between 1995 and 2008, compared to an average of 3.16 points for core countries. This decline in the interest rate had an asymmetric effect on the non-tradable and tradable sectors. This asymmetry results from the well-known real estate bubbles but also from a strong growth in domestic demand, which translated in large imports of tradable goods whereas non-tradables cannot be imported. But this is also due differences in capital intensities between these two sectors. It is this latter mechanism that is quantified in the article (the effect of the interest rate arising from differences in capital intensity).
As a result, both the Balassa-Samuelson effect and the interest rate have a significant impact on the relative price (non-tradable to tradable price).

In Greece, the fall in the real interest rate between 1995 and 2008 relative to the euro area average (-2.3%) could account for slightly less than half of the increase in relative prices. This interest rate effect, together with the Balassa Samuelson effect, account for more than 78% of the relative price increase in Greece. In Italy, these two effects explain more than 65% of the relative price increase (+14.1%), but the Balassa-Samuelson effect contributes more to this increase than the effect of the interest rate for this country. In Germany, the small increase in the real interest rate relative to the euro area average (+1.4%) explains only 7% of the decline in the relative price. This effect, together with the Balassa Samuelson effect, account for only 26% of the decline in the relative price in this country. Interest rates therefore appear to have played a much larger role in relative price developments in Greece than in Germany.

Monetary integration –permitting the convergence of nominal interest rates among member States– has fostered sectoral imbalances in the "periphery" of the area. Since the 2008 financial crisis, in the periphery, increased interest rates may have contributed to internal rebalancing but labor reallocation happens at a high social cost as the non-tradable sector is more labor-intensive than the tradable sector. The divergence thus now takes the form of strong heterogeneities in how economies reacted to the financial crisis, and through high differentials in unemployment rates across countries. Reducing these differences is such a challenge that many economists, including Joseph Stiglitz, doubt the European capacity to do so.

[1] O. Blanchard & F. Giavazzi (2002), Current account deficits in the euro area: the Feldstein-Horioka puzzle?, Brookings Papers on Economic Activity, 33 (2): 147-210.

[2] Speech by Benoît Cœuré, member of the Executive Board of the ECB, at the Ambassadors' Week, Paris, 27 August 2015.

[3] Á. Estrada, J. Galí and D. López-Salido (2013), Patterns of convergence and divergence in the euro area, IMF Economic Review, 61 (4): 601-630.

[4] Thomas Grjebine, in the April 2014 Lettre du CEPII, shows that a majority of OECD countries experienced spectacular increases in housing prices between 1997 and 2007.