Consumer price and asset price inflation: Looking the wrong way

Recent readings of the harmonized index of consumer prices (HICP) suggest a nontrivial risk of dipping into deflation in the euro area. While ECB's Draghi sticks to his "subdued price pressures" line, the IMF's Madame Lagarde has already called central bankers to arms to fight the "ogre" of deflation.  This post argues that asset price inflation--in particular housing--is driving an overlooked wedge between the HICP and the cost of living, which ECB and commentators should take into account.

As shown below, asset prices have risen markably throughout Europe and Germany, much more than harmonized consumer prices. Stock and bond prices have advanced since 2011, albeit from depressed levels in some cases. Real estate prices are rising in Germany, among other euro area countries.

The HICP is largely aloof of asset price inflation. One perennially controversial item is the cost of housing. Currently, Eurostat's HIPC assigns small weight to housing--about 10 percent--as it excludes the implied cost of owner occupied housing given these are seen as capital expenditures. Eurostat is set to include owner-occupied housing cost in the HICP in a few years. This will significantly lift the weight of housing cost in the HICP, and lead to an increase in HICP measured inflation. Deflation no more.

House prices could and should also affect inflation expectation as the method for housing cost reflect average rather than marginal house prices. An example: Expectations of housing cost inflation of a young (and economics-literate) couple are less likely based on the constant rent they are currently paying for their current small student flat. Rather, the couple's expectations should be driven by run-away prices for family-size apartments in job-rich cities, such as Munich or Hamburg.

But there are more reasons for the ECB to take into account asset prices. Asset price inflation can stoke risks to financial stability. Juergen Stark once warned that "doing too much for too long" inhibits healthy balance sheet adjustments and leads to distortions. While financial stability is not at the core of ECB's mandate, ECB will increasingly become responsible for prudential and supervisory policies as well.

It is not deflation, it is the incapacitated transmission channels that ECB needs to fix. To achieve that, unconventional (and un-German) measures may be needed to avoid fueling unhealthy asset price inflation.

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The $9 trillion sale: Keep dreaming!

In its current edition, The Economist calls once again for privatization to help fund the high deficits of many Western governments. At first glance, this sounds reasonable given governments own indeed a lot of  assets. But that's about it. While privatization has played a significant role in the transition of Eastern Europe, in the aftermath of the Asia crisis, and in World Bank/IMF programs generally, privatization programs in the euro crisis often lagged more ambitious plans. Most notably, Greece's privatization program of EUR50 billion by 2015 has been a complete illusion. Also, sales were canceled in Spain and Ireland.

Why is that so? Key obstacles are:

• The price is too low. Buy low, sell high! Selling assets in a downturn is usually bad investment advice. It is when times are good that assets should be placed for sale.

• State companies enjoy implicit guarantees. In some cases, state owned enterprises and their staff may be understood to enjoy implicit guarantees or benefits, such as job guarantees or pensions. Withdrawing those could be costly and stir unrest. Paced reform is more appropriate, and takes longer.

• Public service must remain guaranteed. State enterprises often also serve a public good, such as servicing train lines in less densely populated regions. In many cases, private ownership makes service more efficient and customer oriented, however, at the cost of phasing out less profitable niche services. In such cases, the benefit of privatization may get offset by the loss in public good.

• Privatization may not increase net investment. Rather than increase investment, privatization may divert investive funds to the government, for instance when private assets of the same kind (such as land) are offered alongside government assets.

Privatization is not a quick snap to solve the debt issues of Western economies. Privatization is no panacea, again. Governments are better advised to ignore the wisdom of The Economist.  

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Why Germans should stop mowing their own lawn

Mowing the lawn appears to be a common pastime for Germans. Washing the car or ironing even makes it into a listing of ways to burn calories in a recent issue of the news magazine Focus. Does this make sense, economically?

Home production, i.e. productive non-market activities, are not captured in the national accounts. Time use surveys, such as the one carried out in Germany in 2001/02, show that adult Germans spend 25 hours per week on "unpaid" work, more than paid work on average.

Macroeconomic indicators may be reminiscent of the extent of home production in Germany. Labor participation, particularly among women, is low, possibly on the account of home keepers and stay-home mothers. Work hours have traditionally been lower, providing at least more opportunity to engage in home production also for those in jobs. These indicators distinguish Germany in particular from the US, where consumers are perceived to rather pay than doing stuff themselves. (For disclosure, Cliff uses dry cleaners, car washing, but doesn't have a lawn to mow.)

Home production may be a popular or cultural preference, economically sensible it is not. If home production would be outsourced and thus count as market activity, per capita GDP in Germany could be about 40 percent higher, possibly closing the gap to the US. Buying services instead of doing it yourself bears economic benefits: Mothers with higher education are more productive in paid work of their profession. Other home activities requiring low skills, such as mowing the lawn, could provide work for the less qualified. Economies of scale allow dry cleaners to be more efficient than ironing shirts at home can ever be.

Also from a policy perspective, home production is a blight. By remaining outside the "paid for" economy, home production escapes taxation. With the extent of public services and social safety net the same, higher home production means paid-for economic activities have to be taxed higher. This results in a coarse and inefficient redistributive effect and fosters black market activities, to the detriment of those seeking work in the formal economy. Also, home production largely escapes the scope of regulation, such as professional standards in home improvement. In contrast, regulations for paid-for services (such as by German's craft professions) often are excessive and deprive customers of the choice of less-quality but more affordable services. (Yet, environmental laws have put an end to Cliff's most favorite Saturday activity: washing his car on public streets.)

Overall, the mindset with regard to home production has to change. Many paid-for services that substitute home production are taxed and regulated in ways that make them unattractive alternatives. Instead, it is home production which should be viewed as an unregulated, subsidized, and usually inefficient form of economic activity, and the bar for paid-for services that replace them should be set accordingly. 

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