Liberty Street Economics

« | Main | »

July 14, 2014

High Unemployment and Disinflation in the Euro Area Periphery Countries

Thomas Klitgaard and Richard Peck

Economists often model inflation as dependent on inflation expectations and the level of economic slack, with changes in expectations or slack leading to changes in the inflation rate. The global slowdown and the subsequent sovereign debt crisis caused the greatest divergence in unemployment rates among euro area member countries since the monetary union was founded in 1999. The pronounced differences in economic performances of euro area countries since 2008 should have led to significant differences in price behavior. That turned out to be the case, with a strong correlation evident between disinflation and labor market deterioration in euro area countries.

The unemployment rate in the euro area stands at around 11.5 percent, roughly 2.5 percentage points above the average over the euro area’s existence and 4.0 percentage points above the 2007 level. The chart below shows that the labor market deterioration inside the euro area since 2007 has been particularly harsh for the four periphery countries—Greece, Ireland, Portugal, and Spain. Unemployment in Ireland and Spain shot up with the global recession as housing bubbles in those countries burst, while the rates for Greece, Portugal, and Spain, jumped during their sovereign debt crises. Today, unemployment rates in Spain and Greece exceed 25 percent. At the other end of the spectrum, Germany’s unemployment rate barely rose during the global recession and has been trending downward since 2010.


The chart below shows core inflation (which excludes energy, food, alcohol, and tobacco) for the periphery countries and Germany. From 2000 to 2008, the core inflation rates in these countries averaged near 3.0 percent, about 1 percentage point above the average for the euro area as a whole. Inflation rates then declined during the 2008 recession, to near zero for Spain and Portugal, and to deflation in Ireland. Inflation then moved back up in 2010, with the exception of Greece, before finally retreating to near zero or below at the end of 2013.


The bump up in inflation would seem surprising given that the euro area experienced a recession from late 2011 to early 2013. The explanation is that the price indexes in the four countries were all pushed higher by increases in value-added tax (VAT) rates as part of their fiscal consolidation efforts during the sovereign debt crisis. The next chart shows the difference between the overall inflation rate (not the core measure) and an official inflation calculation that excludes changes in VAT rates. (Data for Ireland are not available, but the country raised its VAT rate in January 2012.) The impact of taxes on inflation is substantial, distorting any empirical study of inflation dynamics that failed to take taxes into account. Note that the VAT increases stopped boosting inflation rates by the end of 2013, making it more straightforward to measure the degree of disinflation by comparing inflation rates in 2013 with rates in 2007. (Note that the values turn negative for Greece in 2013 as the country cut some VAT rates to support the tourism industry.)


An examination of all euro area member countries shows that changes in core inflation and unemployment rates were indeed correlated over this period. The chart below plots the change in the inflation rate with the increase in the unemployment rate. Specifically, the vertical axis shows the change in the inflation rate between Q4:2007 and Q4:2013. For example, Portugal’s inflation rate fell from 2 percent to no inflation over this period, so it is listed as -2 percentage points. Greece is the extreme case. Core prices in Greece shifted from rising at a 3 percent rate in Q4:2007 to falling 3 percent in Q4:2013, so it has a -6 percentage point reading. The horizontal axis displays the change in the unemployment rate over the same period, with Greece and Spain at the far right. A regression line fitted through the origin has a 10 percentage points increase in unemployment rate correlated with a 2.5 percentage points drop in inflation, with Ireland and Portugal near this ratio. The same is true for the euro area as a whole. Spain and Greece are outliers. Spain had less disinflation relative to the change in its unemployment rate than suggested by the euro area experience during this period, and Greece had more of a response.


A similar relationship exists for wages. The next chart replaces core inflation with wage inflation in the business sector, with wages measured by average wages and salary per hour. Spain again sticks out with less of a wage inflation response to the jump in the unemployment rate than suggested by the euro area pattern (from +4 to 0 percent), while Greece had a much stronger response (from +4 to -10 percent) to its downturn.


One explanation for the more restrained response of price and wage setting in Spain is that while its unemployment rate spiked along with that of Greece, the Spanish economy was by other measures doing much better. In particular, output in Spain was 6 percent lower in 2013 than it was in 2007 while Greek GDP was down almost 25 percent. An earlier
blog noted that Spain’s unusually steep drop in employment relative to output can be attributed to a flexible labor market that relied heavily on temporary contracts at the onset of the downturn.

Overall, these data show the large drop in periphery inflation from 2007 to 2013 was correlated with increases in economic slack over that period. The core price index is now falling in Greece and the other three periphery countries have core inflation rates near zero. Still, there are signs that a recovery is taking hold in the periphery countries, which will put some upward pressure on inflation rates. How much rates rise, however, will also be dictated by inflation expectations. It is very likely these expectations have been revised down significantly from pre-2008 levels for these four countries, suggesting that the risk of deflation will remain even as labor markets start to improve.

Klitgaard_thomasThomas Klitgaard is a vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Richard Peck is a former senior research analyst in the Group.

About the Blog

Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Asani Sarkar, all economists in the Bank’s Research Group.

Liberty Street Economics does not publish new posts during the blackout periods surrounding Federal Open Market Committee meetings.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Image of NYFED Economic Research Tracker Icon Liberty Street Economics is available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Economic Inequality

image of inequality icons for the Economic Inequality: A Research Series

This ongoing Liberty Street Economics series analyzes disparities in economic and policy outcomes by race, gender, age, region, income, and other factors.

Most Read this Year

Comment Guidelines


We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:

Please be brief: Comments are limited to 1,500 characters.

Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.

Please be relevant: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post.

Please be respectful: We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will
not be posted.‎

Comments with links: Please do not include any links in your comment, even if you feel the links will contribute to the discussion. Comments with links will not be posted.

Send Us Feedback

Disclosure Policy

The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.