EUROPE
The riddle of eurozone inflation
Spring 2007
Right across the eurozone many consumers complain about rising prices. Some say the euro has brought modest inflation, others believe that it has been much more serious. Giancarlo Corsetti investigates the puzzling differences between perception and reality
Commentary:
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European consumers have been grumbling about the euro’s impact on prices ever since it was launched in 2002. Many Germans call the currency the “teuro”, adding the “t” from “teuer”, meaning expensive. In fact, average inflation in the last few years has hovered just above 2%, quite close to the level defined by the European Central Bank as the benchmark of price stability in the monetary union. So have eurozone citizens simply got it wrong?
Plenty of anecdotal and survey evidence shows that people blame the euro for a net loss of purchasing power. Opinion polls conducted across Europe around the launch date of the new notes and coins in January 2002 found a significant rise in the number of people who thought prices had increased either moderately or a lot.
Economists are able to translate such qualitative opinions into quantitative estimates of “perceived inflation”. Usually, perceived inflation is very close to actual price rises, as measured by national and European statistical institutions. Perceived and actual inflation broadly coincided in all European countries until the end of 2001, but once the euro was introduced perceived inflation took off in the eurozone, in some cases dramatically. No similar effect was found in countries that had kept their national currencies.
This divergence between perception and statistical fact has only recently narrowed, disappearing altogether in some eurozone countries. If that trend is confirmed that would be good news for the European economy as a whole. People rely on inflation data to guide many of their everyday economic decisions. It helps consumers to make choices over how much to spend, which items to buy and how much to save. It also influences commercial decision-making, such as setting retail prices for goods and services, and of course it guides management and labour wage negotiations. Wrong perceptions misguide individuals’ choices. If they think inflation is high, some may decide to consume less and save more, dampening economic growth unnecessarily. Convergence between perceived and actual inflation clearly reduces these risks.
But even if perceived inflation is now realigning with the facts, the discrepancy of earlier years still demands an explanation. Why did so many Europeans identify price hikes that went unrecorded by specialised economic institutions using state-of-the-art observations and well-established statistical techniques? This phenomenon is particularly puzzling given that it happened when annual price rises were so low in many countries that economic policymakers there were generally more worried about deflation than inflation.
Answering this riddle is far more than an academic exercise. Citizens and policymakers alike need to be confident that the harmonised index of consumer prices used to calculate European inflation is utterly reliable. It would be irresponsible to let conflicting opinions about price changes generate suspicion toward EU statistical offices and the organisations that base vital economic and monetary decisions on the accuracy of their figures. These statistics are crucial for wages, pensions and rents, as well as general economic policies. Mistrust could make them vulnerable to political bargaining and even coercion from lobby groups.
I should therefore make it very clear that the credibility of official euro inflation statistics remains unblemished by the variance between perceptions and reality that Europe experienced after the euro’s inauguration. Certainly, there are well-publicised questions over the composition of official consumer price indices, but these are no more pertinent to the eurozone than to countries elsewhere.
There is for example no evidence to support the popular myth that housing costs particularly affected official calculations of eurozone inflation. After the euro’s introduction, many people complained that inflation had been underestimated because of the way rampant house prices were measured in national indices. In fact, actual and perceived inflation diverged substantially in nations where house prices remained stable as well as those experiencing a bubble. Germans have been especially vocal critics of the euro’s alleged impact on prices, despite their relatively stable housing market. So housing cost calculations certainly don’t hold the solution to this puzzle.
Surveys nevertheless clearly showed that many Europeans were convinced that prices rose significantly from the start of 2002. So there must be some good reasons for the discrepancy between public perceptions and official data. Having read a number of studies that attempt to explain this conundrum, I think a consensus is emerging. The answer comprises various elements, mostly boiling down to human psychology.
When consumers form their opinions about average price movements, they tend to focus on the purchases they make most frequently. People naturally remember the cost of the goods and services they buy daily or weekly, not quarterly or even yearly. They also tend to remember price hikes more than price cuts.
During 2001-2003 there was a noticeable asymmetry in price rises. The cost of the sort of goods and services that are bought most frequently went up faster than those purchased less often. In many eurozone countries, restaurant meals, entertainment, hair dressing and dry cleaning all became substantially more expensive. Food prices fluctuated, chiefly in response to outbreaks of various animal diseases and adverse weather. The cost of durable goods increased more slowly. People therefore tended to remember the sharpest price rises when assessing the rate of inflation during the euro switch, rather than overall costs measured by consumer price indices.
Other misconceptions apparently played a role in these inflation perceptions. The changeover from national currencies to the euro meant that householders faced a steep learning curve. At the beginning, it was natural to compare prices in euros with prices in defunct national currencies – a complex enough task in itself, especially in countries where the conversion rate was complicated. People remembered how much things cost in “old money” at the end of 2001, but over time this comparison became increasingly invalid: even in 2005 euro prices were still being compared with their 2001 levels.
The habit of comparing euro and national currency prices is bound to banish over time. As people acquire larger memories of prices in euros, it becomes more natural to compare changes year-on-year, rather than going all the way back to 2002 or 2001. This consideration could in part explain why the divergence between actual and perceived inflation has of late been declining across the eurozone.
Studies of inflation survey data have also identified another interesting psychological trend. Individuals who said that prices increased “a lot” tended to have prior expectations that prices would increase “a lot”. They saw what they wanted to see. Of course, some individuals may simply dislike the euro or distrust economic institutions in general, although this can hardly be generalised into a full-scale explanation for eurozone-wide misconceptions about inflation. As it happens, surveys offer no evidence to support the suggestion that people with below-average trust in officialdom are more likely to exaggerate inflation.
The consensus view, therefore, suggests there is little to worry about. The arrival of the euro never boosted inflation; mistakes in popular perceptions were understandable and have been corrected with the passage of time. But perhaps economists can suggest another possibility, albeit one that has yet to be tested. Inflation is generally understood to mean the difference in the cost of a basket of consumer goods and services over a set period − say the start and end of a year. But it could also be seen as the increase in income that would make consumers able to afford the same range of goods and services over the course of a year. If consumers feel they can no longer afford all the goods they expected to be able to buy − or were able to buy the year before, their experience of “inflation” is greater than actual changes in price levels.
Such feelings of being less wealthy may have been experienced by many eurozone consumers in recent years, given the combination of weak economic activity since 2002 and widespread forecasts that annual growth will continue to slug at around 2%. This scenario cannot be applied across the board – only some eurozone countries have suffered rapid economic slowdowns, yet inflation misperceptions have occurred throughout the monetary union. It would seem reasonable, though, to assume that certain sectors of society, such as workers hit by soaring housing prices or by uncertainties over income and pensions, were more affected after the euro arrived by a sense of lost purchasing power.
If this conjecture is correct, it would add another piece to the economic and psychological jigsaw that is helping to explain why, in a low inflation environment, so many people have been so mistaken over inflation in the eurozone - and so keen to complain to their governments about it.