How to devalue without devaluing

WHEN people talk about the problem of debt around the European periphery, they generally frame the issue something like the following. Peripheral nations have huge debt loads. Solving this problem will require domestic austerity and a move toward trade surpluses. But it is very difficult for European nations to accomplish this transition without the option of devaluation. Typically, a country busily crushing domestic demand through austerity can count on foreign demand to pick up some of the slack thanks to the trade advantage of a weakening currency. Rising exports facilitate the shift to net national saving. But euro zone countries are shackled to the euro. To improve their cost competitiveness, these countries must either leave the euro area and re-adopt their own currency, or slowly and painfully force down real costs through deflation. As both options are nasty, pundits are generally quite down on the prospects for the economies of the periphery.But there is another option! When we talk about China we point out that the Chinese economy is undergoing a real appreciation despite its dollar peg. Why? Because Chinese inflation is higher than American inflation, which means that the real exchange rate is shifting. China's efforts to control the yuan-dollar rate are offset, to some extent, by increases in the price of Chinese goods.Something similar could happen in Europe. Spain needs to become more competitive relative to Germany, but it can't shift its nominal exchange rate with Germany, because they share the same currency. But if inflation rates in the two countries diverge—if German inflation rises faster than Spanish inflation—then the real effective exchange rate will move in Spain's favour despite the shared currency. Why might we expect German inflation to rise faster than that elsewhere? The main reason is the divergence in economic conditions between the two areas. Germany's economy has been booming in recent quarters, and unemployment there has fallen. In debt-stricken Europe, however, growth has been weak (or non-existent). Unemployment is high, real estate costs are falling, and so we'd expect inflation in such places to be subdued while prices in Germany face upward pressure. Voila; revaluation without abandoning the euro.There's just one problem. Inflation rates are behaving the wrong way. Over the past twelve months, German prices have risen 1.3%. But Spanish prices are up 2.3% and Greek prices rose a striking 5.2%. Only Ireland, where prices have fallen 0.8% over the past twelve months, is moving in the right direction.European Central Bank estimates of cost competitiveness tell a similar story. From the first quarter to the second quarter of this year, Germany's competitiveness improved faster than in any of the peripheral countries. Over the year to the second quarter, only Ireland improved its competitiveness relative to Germany.How to explain these counterintuitive trends? One thing to point out is that governments reaching into the austerity toolbox often grab first at hikes in the VAT rate, which feed through to consumer prices and inflation measures. The other thing to note is that it's early yet. Germany faced a deep recession, and its strong recovery only began in earnest in the second quarter of this year. As German growth continues, the economy will tighten up and workers may begin demanding and receiving wage increases. Meanwhile, austerity packages across much of the periphery are in their early stages. In Ireland, where austerity came earlier and labour markets are more flexible, competitiveness is improving. As Portugal, Spain, and Greece grind down public sector wages and move into the thick of tough austerity programmes, economic slack will restrain price increases.But the key to a relatively painless internal revaluation is inflation in tighter markets. And it's here that the European Central Bank could play a particularly useful role. Were the ECB to adopt a looser monetary policy, we would expect inflation to pick up first in the markets with the least excess capacity, and that would obviously mean rising prices for Germany.The situation is kind of bitterly amusing. The Germans hate the idea of paying for bail-outs across Europe. They want peripheral countries to buckle down, slash their deficits, and accept as much of the pain of adjustment as they can. But the best thing Germany can do to facilitate this process is to allow the ECB to pursue a monetary policy that makes internal adjustment easier—by increasing inflation in Germany. And that's maybe the one thing Germans hate more than writing cheques to the Irish government.