The ECB: Inflation differentials in the Euro zone

money.jpg Why is it so difficult for the ECB and the Euro to create convergence in the Euro zone? Well, because the countries are different which again makes one type of monetary policy counter-cyclical in one country and pro-cyclical in another. However, what is it that differentiates the euro countries? A recent paper from the ECB points to differences in labour market institutions as a supply side mechanism which fosters differences in cyclical inflation and hence makes ECB policy making more difficult, at least this is what seems to be the implicit narrative.

The main point of the paper is that different schemes of labor market institutions and regulation create different dynamics in supply side drivers of inflation.  

"This paper relates the size of the cyclical inflation differentials, currently observed for euro area countries, to the differences in labor market institutions across the same set of countries. (...) We show that differences in labor market institutions account well for cyclical inflation differentials. The proposed mechanism is a supply side one in which differences in labor market institutions generate different dynamics in real wages and consequently in marginal costs and
inflations. We test this mechanism in the data and find that the model replicates well the
empirical facts."

An apparent example could be that different labour market institutions relate to differences in the degree of money illusion, but I cannot argue with authority on this one. However, the presence of income regulatory schemes would certainly affect the cyclical inflation dynamics. Wait a moment ... Did not OECD advice such policy to Portugal recently

On a general note, ECB's paper is quite mathematical as it engages in an extensive modelling of a framework from which to derive the conclusions;

"Cyclical inflation differentials should be a concern for the newly created central bank since whenever they occur on top and above the ones associated with productivity differences, they might signal differences in efficiency of labor and product market structures due to inappropriate national policies."


... asymmetric development in labor market institutions are linked to various sources of inefficiencies which might be welfare detrimental for the entire currency area as well. For this reason a micro-founded model like the one used here
could be used in the future also to answer questions on the welfare gains from different structural reforms. These issues, already relevant today, will become much more pressing in the future, when the euro-zone will include new entrants from eastern Europe."

The key point to take away here is obviously the idea of convergence in labor and product market structures as a prerequisite for containing the differentials in cyclical inflation and thus also a prerequisite for ECB monetary policy to be efficient. What are the odds?