It has been almost a year since inflation peaked in Europe as a whole. After reaching 11.1 percent in November last year in the EU as a whole, inflation has fallen steadily; the July and August numbers were 6.1 and 5.9 percent, respectively.
Before inflation started coming down, there were real worries that Europe would end up in stagflation, i.e., both high inflation and high unemployment at the same time.
Normally, the macroeconomic relationship between inflation and unemployment is defined by the so-called Phillips curve: when unemployment is low, inflation is high, and vice versa. Since the 2020 pandemic, however, that relationship has been difficult to detect in the European economy. In particular, the recent spike in price hikes threw off any attempts to track the Phillips-curve-style movements in inflation and unemployment.
Hence the worries that inflation may stay high and combine with high unemployment.
So far, that has not happened. The EU has been dancing on the edge of that economic volcano but has yet to fall into it. A welcome decline in inflation appears to have pushed stagflation out of the picture:
- Netherlands topped out at 17.1 percent inflation in September last year; in August this year the rate is only 3.4 percent;
- Germany has seen its inflation rate fall from 11.6 percent in October 2022 to 6.4 percent in August;
- Hungarian inflation has come down from 26.2 percent in January to 14.2 percent in August.
Even if Hungary still has a rate of 14.2 percent, the trend is steadily and predictably downward. All other things equal, the Hungarian economy will be at price stability well before next summer.
Other countries have been even more successful at bringing down inflation. Like Hungary, the three Baltic states have also left 20+ percent inflation behind them. Their current numbers are lower than the Hungarian one: as of August, Estonia’s inflation rate was 4.3 percent, Latvia stood at 5.6 percent, and Lithuania at 6.4 percent.
That may make it look like the Baltic countries have been more successful economically than Hungary has. They have not: while the Hungarians maintain an unemployment rate well below 4 percent, all three Baltic states are stuck around 6.5-7 percent.
These numbers exemplify two scenarios, one where stagflation is a risk and one where it is not. With its very low unemployment, Hungary is safe from stagflation; by contrast, if inflation gets stuck in the three Baltic states, they could soon find themselves dealing with a stagflation-like scenario.
Is there a risk that inflation will stop falling in Europe? Yes, there is. Some countries have not had the same luck as others in bringing inflation down. Belgium saw a small uptick in August, though from a very low 1.7 percent to 2.4 percent. This is nothing to be concerned about, but a country with unemployment stuck around 5.5 percent should have virtually no inflation to worry about.
Greece has seen a similar rebound, with a 3.5 inflation rate in July and August topping the 2.8 percent from June. Spanish inflation is slowly on the uptick, from 1.6 percent in June to 2.1 in July and 2.4 in August.
Bulgaria has gotten stuck around 7.5 percent inflation. After having seen the rate of price increases fall from 15.6 percent last September to 7.5 percent in June, there has been no more downward movement in Bulgarian inflation. Czechia is having a similar problem: its inflation rate topped 19 percent back in January, but after a nice decline to 11.2 percent in June, it seems reluctant to fall below 10 percent.
Croatia is in a similar situation, with inflation stuck in the 8-8.5 percent range since May. Austria is just a hair lower, with annual price hikes stubbornly stuck at 7-8 percent.
Irish inflation has remained in the 5-percent vicinity since May. France has a similar problem: although the French economy never experienced the troubling levels of double-digit inflation that plagued some EU member states over the past year, the August inflation rate of 5.7 percent is higher than the numbers for both June and July. It is also problematically close to the top rate of 7.3 percent from February.
Overall, 12 EU countries have made no progress on inflation since May. All it takes now is for unemployment to start rising, and stagflation will become a real problem.
To date, Eurostat has not released the full set of unemployment data for August for the 27 EU member states; the latest complete set of data is from July, when
- A total of 15 EU member states had a higher unemployment rate than in June;
- Four of them recorded rising unemployment for the second month in a row;
- At 11.2 percent, Spain had the highest unemployment rate in the EU.
The Greeks had the second-highest unemployment rate (9.9 percent), followed by Estonia (7.3), France and Italy (7.2), and Cyprus (7.0).
At the other end, Germany had the lowest unemployment rate (3.0). Four more countries had a rate below 5 percent: the Netherlands (3.5), Slovenia (3.6), Bulgaria (4.3), and Ireland (4.5).
Several countries have a problem with unemployment being stuck at levels way above traditional full employment. Spain is stuck above 11 percent and France does not seem to be able to get below 7 percent. A whole crop of smaller EU countries is trapped in the 5.5-6.5 percent range: Latvia, Lithuania, Portugal, Romania, and Slovakia.
Does this open the door for stagflation? For most of Europe, the answer today is negative, but I emphasize “today”. Things can change quickly, especially since there is a general trend of inflation getting stuck at uncomfortably high rates.
Nevertheless, here are some encouraging examples of how the macroeconomic machinery works as it should:
- From April to July, Estonian inflation fell from 13.2 percent to 6.2 percent; meanwhile, unemployment increased from 6.2 percent to 7.3 percent;
- Cyprus went from 5.8 percent unemployment in April to 7 percent in July, while inflation fell from 3.9 percent to 2.4 percent;
- From April to July, Latvian unemployment increased marginally from 6.3 percent to 6.5 percent; inflation, on the other hand, declined from 15 percent to 6.6 percent.
It is never good news when unemployment rises, but it is encouraging when that rise is coupled with declining inflation rates. That way, their economy still operates on sound macroeconomic premises, which means that governments with their heart in the right place can take economic policy measures to bring unemployment down.
The big threat to this frail European economic stability is the fact that inflation and unemployment do not always behave as the good old Phillips curve prescribes.
There are two reasons for this. The first reason has to do with the capacity ceiling in European economies. Just as there are different kinds of inflation, unemployment comes in different flavors. The one we see most of is typically referred to as cyclical unemployment: it rises in recessions and falls in recovery periods, i.e., when economic activity picks up speed again.
The other type of unemployment is structural in nature. It means that there are workers who are involuntarily without a job, but who cannot find a job regardless of how well the economy is doing. This type of unemployment can have many causes; a commonly mentioned one is that their skill sets are obsolete or otherwise mismatched with the current labor market (such as a machine typist who never learned word processing).
Another reason for structural unemployment is that the economy for a variety of reasons is unable to produce enough jobs for the whole workforce. Without going into the causes of this inability, from a strict statistical viewpoint, it seems as though Europe has a fairly widespread problem with this type of unemployment. As a result, unemployment gets stuck at higher levels than for economies with low structural unemployment (such as the U.S. economy).
One of the problems with structural unemployment is that it creates a lower inflation threshold in the economy than would otherwise be the case. An economy coming out of a recession will see inflation return at a relatively low rate of employment, i.e., a high rate of un-employment; the capacity ceiling in the economy is comparatively low.
This means that with inflation rising without a corresponding full decline in the jobless rate, the two variables no longer move as the Phillips curve predicts they will.
The other reason why inflation and unemployment can become decoupled is that the type of inflation included in the Phillips curve is no longer the dominant type of inflation in our economy. For inflation to rise and fall when unemployment falls and rises, inflation has to be the result of high levels of spending—a.k.a., aggregate demand—throughout the economy. Households and businesses have to be consuming and investing, respectively, at very high levels given the capacity of the economy.
Under normal macroeconomic conditions, i.e., when the central bank is not monetizing budget deficits, the inflation we experience is almost entirely of this demand-pull kind. However, when the central bank starts buying government debt and otherwise pumps cash out in the economy, soon enough we begin to see monetary inflation. This type of inflation is both statistically and causally independent of the unemployment levels in the economy.
When monetary inflation dominates the price increases we see in the economy, we can get any level of inflation at any level of unemployment. Modern economies do not often experience monetary inflation—the historical example we know best was the protracted stagflation episode 40-45 years ago—but when they do, it is not a pleasant ride.
We just had another episode with monetary inflation, and we have teetered on the edge of a real stagflation experience. Inflation came down just in the nick of time to avoid a much more serious experience than the post-pandemic economy put us in, but we are still not out of the danger zone. To see why, consider Figure 1, which schematically explains the type of inflation that dominated the European and American economies over the past five years. Prior to the point in late 2020 when we started seeing the first signs of accelerating price hikes, inflation was predominantly demand-driven; the gray areas show this type of inflation, while purple indicates a mix of the two.
The massive monetary expansion during the pandemic resulted in a sharp rise in monetary inflation. It first became the dominant type of inflation, then—as governments forced economic shutdowns—it completely took over the economy (green). As the closed-down economies opened up again, the two inflation types reversed the process, so to speak:
The problem for some countries in Europe, where the capacity ceiling of the economy is associated with a high rate of unemployment, is that they will have serious problems avoiding a rebound to higher inflation rates. When price increases are driven by high demand, and when the economy runs out of supply-side capacity relatively early, a stagflation situation with both high unemployment and elevated inflation is no longer just a theoretical problem. It can become an acute real-world problem.