The eurozone faces a grave risk of divergent economic growth patterns in the next 10 years, according to a recent analysis by Martin Wolf1 in the Financial Times. Although the whole of the euro area's current account is in broad balance with the rest of the world, the differences in the external position of single countries within the area are larger than those between China and the United States, commonly referred to as one of the main imbalances behind the global crisis.
In the euro area, Spain, Greece, and Ireland have very weak external positions. They have to sell bonds abroad to finance an excess of internal demand over domestic savings. At a time of financial instability, this imbalance may turn out to be more unsettling and much more costly to address. If interest rate premiums rise, it becomes doubtful whether external debts are sustainable. In an area in which the classical instrument of currency devaluation is barred, what adjustments will be necessary?
The conventional textbook answer is spelled simply: domestic demand in the deficit countries must decrease, allowing domestic savings to rise and compensate for the deficit. This is the deflationary way out of the imbalances. Ireland is following this path and Greece will have to do it as well, under pressure from the other member states.
I question whether this path is the only one available, even within the limited political integration in the Euro area.
The political discipline exerted by the Euro area can be looked at in three ways:
- Political pressure is more powerful and effective in persuading countries to adopt austerity measures than many assume. Distressed countries are eager to receive help from other partners in whatsoever form possible, even in the kind of informal or behind-the-scene coordination within the euro group. There are obvious limits to political pressure, but the sovereignty issue can be more easily wiped off the European table than normally assumed when dealing with fiscal interdependence in the eurozone.
- Fiscal coordination in the eurozone has been limited by an overly simplistic view of economic adjustment. Drawing on the experience of the last 10 years and on the logic typical of rating agencies, the weaknesses of member states are identified by their public finance or current account deficits. Reducing the deficits is required by the logic of every country taking responsibility for its own adjustment.
- As stated in a report of the European Commission, a large part of the divergences in the current accounts of the member states derive from domestic demand. But these differences cannot be explained by "traditional" medium-term determinants, such as fiscal policy and demographic factors. Since the late 1990s, only part of the divergence of the real effective exchange rate within the euro area—the value of the euro discounted by national price levels—can be explained by "benign drivers" like the Balassa-Samuelson effect, price convergence or the lack of cyclical homogeneity. The explanation lies much more in the area's limited wage equalization and in the large differences among firms' market power as shaped by national protective regulations.
In fact, country divergences in price development—affecting the current account balance—often reflect inappropriate wage responses to changes in productivity, or excessive wage growth in the public sector, or different sensitivity of wage policy to economic and political cycles. Analogous "rigidities" are common in the service sector and are generally a feature of protection of national firms (not limited to "national champions").
Addressing the level of domestic savings or consumption does not necessarily change the structural determinants of current account imbalances. Actually public deficits have been converging in all the euro countries between the mid 1990s and the beginning of the current crisis, while current account imbalances have steadily increased. In fact the latter are related to the national protection of firms and workers, which has the effect of fragmenting the single market. These factors also lead to the insufficient price adjustment among euro area member states. The single market has to be developed further, especially in the local service sector and in distribution services, in order to facilitate the restructuring of the European economy, reallocating supply and demand across the tradable and non-tradable sector and exposing firms and workers to international competition. Political responsibility on the real determinants of the divergences have to be shared more effectively at the European level.
It is very easy to understand why governments in the euro area prefer to focus on the public finance position of a weak partner rather than on that country's structural weaknesses. Taking into account the structure of external imbalances in the euro area would require scrutiny also of the surplus countries' policies toward labor and capital. Such scrutiny would touch the core of national politics—highlighting the different capacities and political ideologies that lead to protection of local firms and local workers.
1.M. Wolf: The eurozone's next decade will be tough. (Financial Times, January 5, 2010)