Domenico Lombardi is Director of the Global Economy Program at the Centre for International Governance Innovation (CIGI), where Samantha St. Amand is a Research Associate.

In 2002, Robert J. Barro identified a major policy development that would affect the next few decades, “At some point, monetary policy may have to shift from a concern with inflation to the avoidance of the kind of deflation that prevails in Japan” (Barro, 2002). After hitting the zero-lower bound on interest rates in 2008, the Federal Reserve acted quickly and aggressively to further support the financial system and to stimulate economic activity. The Fed’s expansionary monetary policy throughout the crisis and beyond is one of the reasons that the IMF is now projecting that the United States will return to its 2 percent inflation target by 2017. In the Eurozone, the European Central Bank (ECB) has responded more cautiously to the crisis: it was only this month that the Governing Council introduced further monetary stimulus after over half a year of low inflation. Despite emphasizing the symmetry of the ECB’s price stability goal (see Draghi 2014), it still appears as though the ECB has a deflationary bias, on balance, remaining more concerned with inflation rather than the avoidance of deflation. The ECB’s more hesitant monetary policy during the crisis and its previously dovish views on the persistence of low inflation are part of the reason why the IMF currently projects that inflation in the Eurozone will remain below the ECB’s target five years from now.

The Governing Council’s new policy package, which includes negative deposit rates, the extension of fixed-rate full allotment tender procedures, the introduction of targeted long-term refinancing operations (TLTROs), and a plan to conduct outright purchases of asset-backed securities, is a step in the right direction. Despite the ECB’s efforts, low inflation is likely to persist in the Eurozone over the medium term. Low inflation is harmful to the economic recovery in the Eurozone because it delays much needed intra-Eurozone sovereign debt and competitiveness adjustments. This article analyzes the impact of low inflation on debt dynamics and the adjustment of real unit labour costs (ULC) in the Eurozone countries under stress (Greece, Italy, Portugal, and Spain). It concludes with a brief discussion of the role of the ECB and EU and domestic policymakers in addressing low inflation.

Implications of low inflation on debt dynamics

The debt-to-GDP ratio is an important indicator of the sustainability of sovereign debt, and has a paramount role in credit ratings decisions and the pricing of sovereign bonds. Through these channel, the debt ratio affects domestic banks’ balance sheets and the credit flow throughout the economy. Debt dynamics are important for the recovery in the Eurozone because of their implications for the financial system and governments’ abilities to use expansionary fiscal policy. With all else being equal, a positive rate of inflation decreases the debt-to-GDP ratio by increasing nominal GDP.

The debt-to-GDP ratio in Italy and Greece is currently expected to peak in 2014 at 135 and 175 percent, respectively. It is expected to have peaked in Portugal in 2013 at 129 percent, and peak in Spain in 2017 at 104 percent. The IMF projects that by 2019 the debt ratios in Greece, Italy, Portugal and Spain will fall anywhere from 2 to 37 percent from their peaks (Figure 1, solid lines). Using the IMF’s most recent projections, we estimated the debt trajectories in the Eurozone countries under stress contingent on different inflation scenarios. If Eurozone inflation were to fall to zero percent and remain at that level over the medium-term, the debt-to-GDP ratios in Italy, Portugal, and Greece would make little progress over the medium term, resting at 134, 125, and 151 percent by 2019 (Figure 1, dashed lines). In Spain, the debt ratio would continue to rise over the medium term reaching 111 percent by 2019.

Figure 1. Debt Dynamics in the Eurozone countries under stress contingent on different inflation scenarios

Source: Authors’ elaboration on IMF (2014).

The higher the level of debt, the more sensitive the ratio is to fluctuations in the inflation rates. In fact, for every one percentage point that inflation falls below the IMF’s current projections in a given year, the debt-to-GDP ratio would rise by over one percentage point in Italy, Portugal and Greece. In Spain, it would rise by approximately 0.9 percentage points because of the current lower level of debt. If, however, inflation in the Eurozone were to remain stable at the ECB’s target of 2 percent over the medium-term, the Eurozone countries would shave an average of 4 percent off of their debt-to-GDP ratios by 2019 (Figure 1, dotted lines).

Implications of low inflation for real ULC adjustment

Real ULC is a widely used indicator of relative competitiveness that measures the cost of labour per unit of output. There are two components of ULC: labour productivity and labour compensation. If growth in real labour productivity is higher than growth in real labour compensation then real ULC will fall, increasing domestic firms’ labour cost competitiveness; and vice versa. We will use this intuition to explain the trends in real ULC growth in the Eurozone countries under stress relative to that of Germany and to reveal the adjustments necessary to catch-up to German competitiveness levels over the next five years. This will be followed by a discussion of the implications of low inflation for adjustment.

A large gap between ULC in Germany and the Eurozone countries under stress developed from the creation of the euro in 1999 to the start of the Great Recession in 2008 (Figure 2). Throughout the crisis most of these countries have been working towards closing this gap, with the notable exception of Italy. Spain and Portugal have decreased their real ULC throughout the crisis by sustaining higher growth in real labour productivity than in real labour compensation. Greece has also decreased its real ULC; however, it has done so by decreasing real labour compensation while its real labour productivity has been falling. Germany has accommodated the relative adjustment by maintaining relatively high growth in real labour compensation coupled with low growth in real labour productivity. Italy is a real outlier: its relatively high growth in real labour compensation coupled with near zero growth in real labour productivity has prevented any improvement in its relative competitiveness. These trends explain why Italy’s labour cost competitiveness has deviated from the other Eurozone countries under stress during the crisis.

If current trends in the two components of real ULC continued over the medium term, Greece and Portugal would catch-up to German competitiveness levels by 2018 and 2017, respectively (Figure 2). Spain would maintain relatively flat ULC levels, but would continue to approach German competitiveness because of the dynamics in Germany. At the same time, Italy would continue to diverge from the competitiveness levels of the other Eurozone countries under stress while maintaining the gap between Germany.

Figure 2. Real ULC Trend Projections and Convergence Scenario

Source: Authors’ elaboration on OECD (2014).

Given current trends in real labour productivity, we estimated the adjustments in real labour compensation necessary to catch-up to German competitiveness levels by 2019 (Figure 2, dotted lines). Greece, Portugal and Spain would be able to maintain positive growth in real labour compensation over the next five years as long as Germany continues to maintain relatively high growth in real labour compensation. Italy, however, would need to decrease real labour compensation to catch-up with Germany by 2019. Even worse, it would have to decrease nominal labour compensation because the required reduction in real compensation is higher than the projected inflation rate.

Low inflation makes adjustment to real labour compensation more difficult or practically infeasible. Workers may unwittingly accept cuts to real wages as long as their nominal wages continue to rise, or at the very least remain the same. Decreasing nominal wages, however, could create social unrest and potentially prolong the recovery. There may also be legal barriers that restrict the flexibility of labour compensation; particularly in countries with a higher trade union density – the percentage of workers that are union members. Italy, the country that requires the largest adjustment, has a higher trade union density than any other country in our sample at 36 percent. The union densities of Germany, Greece, Portugal and Spain are significantly lower at around 18, 19, 25 and 16 percent, respectively.[1]

Adjusting real ULC is important for the recovery because it facilitates price adjustment and internal rebalancing within the Eurozone. Adjusting ULC by cutting compensation, however, may prolong the recovery by increasing unemployment, poverty and inequality. A more satisfactory and effective way to adjust relative competitiveness is to improve productivity by implementing growth-enhancing structural reforms.

The role of the ECB and other policymakers

Mario Draghi (2014), the President of the ECB, has acknowledged the importance of inflation for debt dynamics and competiveness adjustment but indicates that it is not the correct tool for the Eurozone because “monetary policy is geared to the euro area as a whole… there will always be some jurisdictions where inflation falls substantially below the euro area-wide objective, while inflation rates will naturally have to exceed the objective elsewhere.” But no Eurozone country currently has a 12 month rate of inflation above or even equal to the ECB’s target, while four countries are experiencing deflation.[2] We don’t need to inflate away the debt, but sustaining stable inflation around the ECB’s target would aid internal adjustments and decrease uncertainty within the Eurozone.

If the crisis has taught us anything, it is that Barro’s prophecy was correct: concerns over high rates of inflation have, for most central banks in the major advanced economies, been overshadowed by concerns over persistently low rates of inflation. Only recently has the Governing Council’s concern over persistently low inflation overshadowed its nightmares about unanchoring medium-term inflation expectations. Monetary policy is by no means a panacea and cannot solve the underlying structural problems within the Eurozone. The additional monetary stimulus introduced by the governing council, however, is a step in the right direction. It will support price stability and facilitate intra-Eurozone adjustments while the EU and domestic policy makers continue the ongoing efforts to strengthen the financial sector and implement structural reforms.


Barro, Robert J. (2002). “Bush’s Economic Policies: The Bull’s-Eyes and Busts.” BloombergBusinessweek, November 3, 2002. Retrieved on May 12, 2014

Draghi, Mario (2014). “Monetary policy communication in turbulent times.” Speech at the Conference De Nederlandsche Bank 200 years: Central banking in the next two decades on April 24, 2014. Retrieved on May 12, 2014

IMF (2014). World Economic Outlook Database April 2014. Washington: International Monetary Fund.

OECD (2014). OECD.StatExtracts: Productivity and ULC by main economic activity (Total Economy). Paris: Organization for Economic Co-Operation and Development.

[1] OECD, “Trade Union Density” OECD.StatExtracts. Most recent reported values for each country are 2011 for Germany, Greece and Italy, and 2010 for Portugal and Spain.

[2] April 2014 Harmonised Indices of Consumer Prices (HICP) data retrieved from Eurostat on June 5, 2014.

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