Unemployment and inflation in the European Monetary Union: A new approach?

• Author: Acocella, Nicola

1. Unemployment: types, indicators and trends

   There are various types of unemployment. We do not deal with either the voluntary or the frictional unemployment.

   After the Second World War, market economies experienced very different situations of employment and unemployment in the two phases that can roughly be identified: before 1973 (date of the first oil crisis) and after that date. In the pre-1973 phase, unemployment was generally in continuous decline in most countries; in the subsequent phase, on the contrary, it underwent a substantial increase until the mid-1990s. Since then it has always reduced, until 2007, when the substantial real negative effects of a significant financial crisis, the Great Recession, began, which was relatively light and short for the United States, but much heavier for the European Union, due to its fragile and unsuitable institutions (Fig. 1).

   In the last two years, when the effects of this recession had practically diminished and many countries had returned to their pre-crisis, or even higher, income levels, the negative effects induced by the pandemic have occurred, which have been wearing off in the last year, so much so that by the middle of 2021 growth rates have returned to the levels of the last quarter of 2019, as forecast (see Fig. 2).

   The unemployment rate is often not an appropriate measure of the phenomenon of unemployment for various reasons. In addition to situations of hidden unemployment and discouraged workers there is also a category of unemployed, called NEETs (from the acronym of Not (engaged) in education, employment or training; or the youth of the three 'no', which in Spanish is indicated as Nini or Ni-ni, from Ni trabaja, ni estudia, ni recibe formation). In the EU Italy showed the highest percentage of NEETs with respect to the population aged 25-30, after Bulgaria and Latvia, while The Netherlands (5.7%), Sweden (7.2%) and Germany (8.6%) had the lowest percentages (Fig. 3).

2. Types, trends, causes and effects of inflation

   It is well known that the term 'inflation' usually indicates a sustained increase in the general price level and, therefore, the loss in value of the currency. The types of inflation are numerous, ranging from creeping inflation to hyperinflation. It can derive from excess demand, lack of supply--on the one side--and pressure of costs (especially, wages), on the other.

   Post-war inflation underwent very different trends in developed and underdeveloped countries. In some of the latter--for example, in the Latin American countries--there are normal situations of galloping inflation or even hyperinflation, which, moreover, do not necessarily generate a collapse of the currency and the need to replace it, that is to find another instrument capable of performing monetary functions. Within the developed countries, apart from the immediate postwar period, inflation normally had a creeping character until the oil crises (1973 and 1979). In the following years, and also as a consequence of them, the phenomenon showed an almost generalized tendency to accentuate up to the 1980s, without ever assuming, however, the characteristics of hyperinflation (Fig. 4).

   After the Second World War, not only was the reduction in prices not accompanied by the onset of the recession (which happens rarely), but there were even situations in which stagnation of demand and inflation were present together (hence the term stagflation). The reader can usefully combine the data reported in Figures 1 and 4 and will note that after 1973 in many countries there has been a simultaneous increase in unemployment and inflation. Even in the first decade of the new century--and in particular in 2007-2008--there has been a notable increase in the price of oil, but this has not produced stagflation effects.

   Reducing inflation can become an economic policy objective for two essential reasons:

   1. the fear that an uncontrollable phenomenon of hyperinflation could be triggered;

   2. the weakening of the social conflicts related to it.

   The economic and social costs of galloping inflation and hyperinflation are certainly more relevant. In such situations, first the transparency in the functioning of the relative price mechanism that underlies the allocation of resources is reduced and distortions and inefficiencies are created. In extreme cases of hyperinflation, there is even the risk that the economic system will have to do without the advantages deriving from the use of money, which could no longer perform its proper functions as a unit of account, an intermediary for exchanges and a store of value. In fact, the continuous and significant changes in the absolute level of prices associated with galloping inflation cause relative prices to vary continuously, thus making the calculations of convenience necessary for the efficient use of resources difficult. In addition, the social and political costs of inflation should be noted. In fact, we can remember, first of all, that Hitler's rise to power was due to various factors, to which inflation and unemployment that had hit Germany hard in the 1920s and early 1930s are by no means unrelated. The memory, then, of German hyperinflation is at the basis of the desire--in some cases, the obsession--of the Germans for monetary stability.

3. The policies against unemployment and against inflation in particular in the EMU

   3.1. Policies against unemployment in general

   First of all, it is necessary to distinguish policies that tend to reduce unemployment from those aimed at mitigating its effects, while not affecting its level, or doing it little. Of the first kind are the maneuvers of aggregate demand through fiscal or monetary policy or even the devaluation or depreciation of the exchange rate, which increase the foreign component of aggregate demand. On the other hand, unemployment benefits tend to a large extent to reduce the negative effects of unemployment, although they can act to some extent to reduce their level, because they automatically lead to an increase in public spending, other items being equal, when a falling demand and rising unemployment take place (acting as automatic stabilizers). A negative effect of the unemployment benefit can derive from the possibility that the unemployed person is satisfied with the subsidy, giving up an active job search. This would be absolutely harmful and would run counter to the purpose of the subsidy. To avoid this effect, it is necessary that the subsidy is limited in time or linked to the job search. One possibility is that it will cease after a certain period of time or if the worker turns down a series of jobs. Obviously, the appropriateness of the positions offered to him with respect to the characteristics of the worker should be carefully evaluated, before depriving him of the allowance.

   Another important distinction alludes to the different policies that tend to attack the different causes of unemployment. Thus, if the indicated policies are recommended for cyclical unemployment, resulting from the scarcity of aggregate demand, structural unemployment requires other policies, which rather affect the structure of the economy: retraining policies, policies tending to accentuate geographical mobility (such as availability of affordable housing), policies that improve the circulation of information.

   3.2. Policies against inflation in general

   Also policies against inflation must be calibrated according to the types and causes of inflation. Thus, if this arises from excess demand or is cost-push, restrictive fiscal and monetary policies are indicated. To better understand how inflation is affected by acting on aggregate demand we can say that, according to the Phillips curve, as the unemployment rate increases (due to the reduction in demand), lower employment pushes down the prices of factors of production and wages, thus reducing prices and inflation. Conversely, a low unemployment situation pushes wages upwards by indirectly reducing the final price of products and services and the rate of inflation. From a macroeconomic point of view, the curve suggests that it is always possible to make an economy work at low unemployment rates, as long as one accepts price growth (i.e., inflation) and, conversely, that one has to accept higher unemployment rates, if inflation is to be curbed. In fact, it is possible to avoid this dilemma (high inflation or high unemployment) if one has two instruments at the same time, such as fiscal policy and incomes policy.

   Monetary policy and macro-prudential regulation can be used in particular against credit inflation. Restrictive monetary policy reduces the quantity of money in circulation, raises the interest rate and thereby reduces the demand for credit. Macro-prudential policy establishes criteria of prudent administration of an anti-cyclical nature (for example, an increase in liquid reserves during phases of expansion and their reduction in crisis phases), aimed at avoiding excessive credit concessions and, with this, a systemic crisis.

   For supply-side inflation, both incentives to increase supply and contractions in demand are indicated, but the former require time to produce their effects. Cost inflation can be avoided through incomes policies, which establish rules relating to the increase in wages and profits, such as, for example, that wages can vary only to the same extent as labour productivity and that the prices of finished goods must not rise (that is, that firms' profit margins do not vary), as happened in Italy in the early Nineties.

   Finally, imported inflation can hardly be regulated by import containment policies (duties, physical restrictions, devaluation of the national currency), which would increase the price of imported goods. It can be blocked or indirectly reduced through policies of contraction of aggregate demand (as was the case with inflation deriving from the 1973 and 1979 oil crises) or the incomes policy.

   3.3. The...