Home > Uncategorized > There is no Eurozone Phillips-curve… (1 graph)

There is no Eurozone Phillips-curve… (1 graph)

In a recent blogpost  Paul Krugman wonders about the methods to calculate potential output and states:

I’ve noted on a number of occasions that the standard methods for estimating economic potential are working very badly in this slump; they are, all too often, causing officials to interpret the slump as “structural”, something that can be fixed only through painful reforms (which, when unemployment fails to fall, will be dismissed as just not enough) rather than as a shortfall in demand. Spain is an especially striking case.

And he’s right. One of the standard methods for estimating structural unemployment is calculating the NAIRU, the ‘Non-Accelerating Inflation Rate of Unemployment’, with a ‘Phillips-curve’ which shows a relation between inflation and unemployment. An increase in non-structural unemployment will, according to this line of thinking, lead to a decrease in inflation as it will drive down wage increases and might be cured by additional demand while an increase in structural unemployment will not affect inflation and can’t be cured by additional demand. A rise in unemployment absent a decline in inflation will therefore be understood as ‘structural’. As inflation in the Eurozone was, between 1999 and 2012 and except for 2009, basically flat (it hovered between 1,6 and 2,7%) this means that using this method will yield that every increase in Eurozone unemployment in this period was structural – as inflation did not change.  And it is exactly this conclusion which is shown in chart 8 in this ECB Monthly Bulletin article, which plots NAIRU-estimates for the Eurozone from the IMF, the OECD and the European Commission. According to these institutions almost all Eurozone unemployment, including the present 27% rates in Spain and Greece, is structural.

But the question is: “how wise is it to calculate an Eurozone wide average NAIRU?”. As we all know it is possible to drown in a river which is, on average, only thirty centimeters deep. And Krugman shows that the Spanish economy does exhibit a kind of Phillips curve relationship – this despite the absence of such a relation on the Eurozone level, as shown in the ECB article. How come? What happens can be shown by comparing Phillips curves for Spain and Germany.

Phillips

The average curve for Spain and Germany (Germany with a weight of 2 and Spain with a weight of 1) is not only much flatter but also much shorter. This means that unemployment as well as inflation in Germany and Spain to an extent show opposing and offsetting tendencies (which of course matches well with large capital flows from Germany to Spain). Which means that an average Phillips curve for these two countries (let alone the Eurozone) is an arithmetical figment of the economists’ mind – two countries with cyclical unemployment do not add up to one country without it.

Caveat: I do not think that ‘structural unemployment’ is a useful concept anyway as all these ‘rigidities’ always suddenly turn out to be rather unimportant once an economy recovers – whenever there are plenty of jobs the participation rate always increases by leaps and bounds.

Technicalities: I did not use consumer price inflation but domestic demand inflation and compared unemployment with inflation one year later, all data Eurostat.

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