Thursday, May 13, 2010

You'll never beat the Irish

Estonia has qualified to join the Eurozone in 2011. Lucky Estonia. It worked out so well for Greece.

Anyway, the European Central Bank has published the calculation of the various tests which ended up determining that Estonia could join. One of the tests requires that aspiring countries have inflation within a close distance of the 3 lowest rates in the European Union in the year preceding the evaluation. For the year to March 2010, the three lowest inflation rates are Ireland (-2.7%), Portugal (0.8%) and Estonia (-0.7%). The average of these three is -1.3% and the 1.5% distance that a country is allowed to be within that average means a test value of 0.2%.

But it would have been a tad embarrassing to have as a criterion for Eurozone membership that inflation essentially be zero, since this would very much accord with the critique from the likes of Paul Krugman that the Eurozone is excessively inflation-phobic.

Without knowing the chain of logic that led them to this decision, it should be noted that the ECB ended up not following the above reasoning. Instead they tossed Ireland out of the sample (page 9) --

These factors are mainly related to the exceptionally strong downturn in economic activity and the associated significant decline in wages in Ireland. The Irish inflation rate has therefore been excluded from the calculation of the reference value as its inclusion would have given rise to a distortion in the reference value.

In other words, Ireland had done such a good job of slashing wages that it was making the Eurozone look too much like the deflationary zone that critics think it is. On the other hand, Estonia also had negative inflation and had the privilege of being included in the average that it was being compared against. Instead one could have argued that a Eurozone tendency to deflation is just as damaging as inflation, and so the preference should have been to countries that could keep inflation in the middle. In that sense, Sweden with its 2.1% inflation looks like the ideal member. Except they don't want to join. Doesn't that tell us something?

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