A Monetary Phenomenon or Not?
What the eurozone is telling us about inflation.


Even though inflation is undeniably a monetary phenomenon, a shocking number of policymakers at the Federal Reserve and other institutions ’round the globe still cling to the view that “too much” economic activity is the culprit. For them, inflation’s akin to steam issuing from the radiator of an overheated engine. Thankfully, a test of the thesis is now readily available in the form of Nobel laureate economist Robert Mundell’s invention — the euro.

In sharing a common currency, the dozen member states of Europe’s Economic & Monetary Union (EMU) are governed by the same monetary policy (much like the 50 states of the U.S.), but this uniformity doesn’t stretch to all policy matters. The economic, regulatory, and fiscal regimes of EMU countries, while reflecting certain unifying directives from Brussels, don’t necessarily align, and the differences, particularly as regards taxation, often bear directly on economic growth. The eurozone thus can serve as a sort of proving ground of economic and monetary theory.

So what do the numbers reveal? The monetary-phenomenon naysayers are clearly wrong. The firm conclusion to be drawn from the euro’s record is that price inflation is, in truth, the result of too much money pursuing too few goods and isn’t controlled by the pace of economic growth.

In a two-step process, the euro started out in 1999 as merely a unit of account for settling various non-cash transactions such as stock purchases. It wasn’t until three years later that it became full-fledged legal tender, serving as both a unit of account and a means of exchange following the introduction of euro notes and coins into circulation on Jan 1, 2002 in a dozen countries — namely Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.

Monetary policymaking at the same time officially shifted from these nations’ respective central banks to the newly created European Central Bank (ECB).

As one would expect were inflation a monetary phenomenon, rates of consumer and producer price increases in the EMU are converging. Differences in inflation rates among euro countries actually started disappearing in the run-up to the single currency’s inception in 1999, when the euro exchange rates of the participating currencies were irrevocably set and EMU member states began implementing a common monetary policy.

Convergence can be gauged in a variety of ways. One of the simplest methods is to compare the difference between average and median rates of inflation. The greater variance in rates of inflation among EMU member states, the bigger the difference between the average and the median rates of inflation. Conversely, the less variance in inflation rates, the narrower the gap between the average and median inflation trendlines. This is because statistical or numerical extremes (i.e., outliers) have a disproportionately greater effect on data-set averages than on medians, or midpoints.

In the pre-euro period of 1991-96, the difference between average and median (year-on-year) consumer price inflation rates averaged 1.3 percentage points among the 12 countries that would eventually comprise the EMU. Then, as member states started unifying their monetary policies, the gap between average and median consumer price inflation closed substantially, averaging just 0.2 percentage points in the 1997-2001 period. Since the euro’s entrance into circulation in 2002, moreover, the EMU’s average-median inflation gap has been a remarkably small 0.1 percentage points.

EMU producer price inflation has converged as well. In the 1991-95 period, average PPI inflation exceeded the median rate by nearly 0.8 percentage points. In the 40 or so months since the euro entered into circulation, however, the EMU’s median rate of producer price inflation has surpassed its mean rate by an average of 0.2 percentage points, once more confirming that inflation is a monetary phenomenon.

Another means of gauging convergence is to measure the difference between the highest and lowest rates of inflation at any given time. Once again, the results show a distinct shift toward greater harmony in both consumer and producer price inflation.

The high-low range in consumer price inflation (as measured year-on-year) contracted from 10.2 percentage points in the pre-euro period of 1991-96 among the 12 participating EMU countries to 3.7 percentage points in the euro transition period of 1997-2001, and then to 3.3 percentage points in the post-euro period of 2002-05. The PPI’s high-low inflation range similarly narrowed, with the year-on-year percentage gap contracting from 12.7 points in pre-euro 1991-96 to 5.4 points in 1997-2001 and later to 4.1 points in post-euro 2002-05.

As for the influence of GDP on price inflation, the EMU data find no correlation. Economic growth in the eurozone has ebbed and flowed over the course of the past 15 years, alternatively converging and diverging without any determinable effect on inflation. In fact, during the period of the EMU’s boom of 1997-2000, when real GDP grew at an average rate of 4.4 percent year-on-year, consumer prices increased by a mere 2 percent year-on-year.

Robert Mundell was not only right about the euro’s ultimate success. He was also right in predicting that a prudently run ECB monetary policy would result in low eurozone-wide inflation. EMU consumer price inflation has, in fact, averaged just 2 percent since 1999 (on a 12-month basis). The EMU’s record in managing inflation indeed has been marginally better than that of either OECD countries as a whole, whose inflation rate was 3.1 percent over the same period, or the U.S., where consumer price inflation averaged 2.5 percent.

Where the U.S. still beats Europe (Old Europe, that is) is in tax policy. Old Europe, as largely represented by the EMU, has yet to see the pro-growth wisdom of low marginal tax rates on personal income, even though the emerging markets of New Europe are making low flat taxes the cornerstone of their economic revival.

Old Europe is paying a price for its recalcitrance. In the 1999-2005 period, GDP growth averaged a paltry 1.9 percent in the EMU (year-on-year) and 2.1 percent in the European Union as a whole, whereas U.S. GDP grew by 3 percent on average over the same period (which included the 2000-01 economic contraction and the post-9/11 jitters).

– William P. Kucewicz is editor of and a former editorial board member of the Wall Street Journal.