ECFIN in action
The 2006 EU Economy Review: adjustment dynamics in the euro area
 © Paul Tobeck |
A key question for the designers of Economic and Monetary Union (EMU) was whether the euro area, with exchange rates irrevocably fixed between the currencies of participating Member States and a one-size-fits-all monetary policy, would allow sufficient freedom for the economies to adjust to economic shocks that could hit individual countries differently. A particular point of contention among economists was whether EMU would lead to convergence or divergence of the economic structures in euro-area countries.
Convergence, argued some, might be inherent in EMU, generating the conditions necessary for harmonised economic structures and business cycles between its members – so economic shocks would be felt in the same way and adjusting to them would follow similar paths. Divergence, on the other hand, might arise from industrial diversification as members sought competitive advantage – but in this case economic shocks might affect some industrial sectors more than others, so they would be more country-specific, and the necessary adjustments would be different.
Channels for change
The 2006 Review takes a close look at how adjustment mechanisms have functioned in the euro area since its creation. Before participating in the euro area, a country had at its disposal a range of adjustment mechanisms that could be used to mitigate the effects of economic shocks like a rise in energy prices. Significantly, two of these are now unavailable: exchange rate policy and monetary policy. Monetary policy is now decided at the euro-area level for the benefit of the area as a whole, and an individual euro-area Member State can no longer devalue its currency or influence interest rates to stimulate economic activity. However, there are economic tools that remain at the disposal of or under the control of Member State governments and the Review’s authors take a close look at the more important ones, namely:
• Market adjustment channels, such as changes in relative competitiveness and (expected) real interest rates in the euro-area Member States; and
• Policy-based adjustment channels, such as taxation, public spending and structural policies in labour, product and financial markets.
To study these ‘adjustment channels’ in action, the Review first gives an overview of them and related indicators for the euro area as a whole. It then considers several types of economic shock that individual or groups of euro-area Member States experienced during their preparations for the euro and subsequently in the first seven years of the euro area. Examples include German unification, the large falls in interest rates experienced by some countries as they approached euro adoption, and the impact of tourism and migration on housing markets in certain countries. Some of these shocks led individual economies to diverge from the euro-area average. The Review then investigates how the various economic adjustment channels, in particular the market channels, operated to bring the economy back into line with the rest of the euro area. Some examples from the Review’s work are provided below.
The competitiveness channel
Changes in a country’s competitiveness are a key adjustment channel for bringing an economy back into line when monetary policy is determined centrally, as in the euro area. So, if an economy enters a boom phase relative to the euro area then the pressures on resources cause costs to rise, including wages. This raises the ‘real effective exchange rate’ (REER) – which measures price differences between countries (with respect to a base year). This in turn makes the country’s production and exports more expensive, which leads to a slowdown in economic activity until the economy falls back in line with the euro-area average.
Figure 1: Real effective exchange rate developments (index: 2002=100).  |
| Note: The real effective exchange rate index is based onunit labour costs. |
To study these effects, the Review compares competitiveness indicators that provide information about relative prices, which reflect input costs such as wages and energy. One example is the REER based on unit labour costs. Such indicators reveal that, while some Member States have seen an increase in competitiveness, others have observed a loss. For example, comparing REER developments between Germany, France and Italy in figure 1 shows that, while French competitiveness has remained stable since the euro was introduced, Germany has seen important gains and Italy important losses in their relative competitive positions.
Sticky costs
The authors then go further and look at the relative rigidity of labour costs by rating the hiring and firing restrictions of the different countries and then comparing these to the changes in growth rates of unit labour costs. This complicated comparison is seen in figure 2, which essentially shows the ability of an economy, in particular its labour costs, to adjust quickly to upward and downward movements in the economic cycle.
Figure 2 suggests that in Italy, Portugal, Greece and Finland, the rigidity of unit labour costs delays adjustments to swings in growth. What’s more, relative unit labour costs respond asymmetrically in Italy, Portugal and Greece – rising more in an upturn than they fall in a downturn – so there is a trend towards higher relative labour costs which reduce competitiveness further.
Figure 2: Growth rates of unit labour costs and their rigidity – euro-area countries.
|
| Note: ‘Rigidity’ is the difference between the elasticity of ULC growth with respect to positive and negatives output gaps,respectively. |
In Germany and Austria unit labour costs are less rigid – they adjust more quickly to economic swings and, although asymmetric, strengthen competitiveness because there is a bias towards labour-cost moderation during downswings. This interpretation of figure 2 links well with the REER developments shown in figure 1, where the moderate wage demands seen in the German economy have improved its competitive position, while higher costs in Italy, not matched by improved productivity gains, have eroded competitiveness.
Challenges to competitiveness
In the conclusions on the operation of the competitiveness channel, the authors point to this heterogeneity across countries as an important feature. Before the creation of the euro area, wage demands were the main cause of loss of competitiveness. Since 1999, nominal wages have converged but these have not always been matched by productivity gains – which has harmed some countries’ competitiveness.
Further, the ‘stickiness’ of labour costs, their inability to respond to economic swings quickly enough, and their asymmetry, means that persistent differences in cost competitiveness are building in some euro-area Member States, paid for in higher unemployment and more volatile trade performance. This, the authors suggest, is the result of wage-bargaining structures and regulations that protect employment in the firm rather than workers in the market, and that these need to be adapted to reflect the need for more efficient economic adjustment.
The real-interest-rate channel
A lower real interest rate makes investment and consumption more attractive, thereby stimulating economic activity. This linkage has raised concern that in a monetary union, the cyclically more advanced countries experience above-average inflation rates and thus below-average real interest rates which provide an additional unwarranted growth stimulus. The Review looks at the experiences in the euro area in this context.
Figure 3: Real interest rates in the euro-area Member States
|
Figure 3 shows that real interest rates declined substantially in the run-up to the third stage of EMU, suggesting considerable differences in the monetary impetus to demand across economies. The results are similar for ex-post and ex-ante measures, i.e. real interest rates calculated using inflation expectations. Persistent inflation differentials are sustaining real-interest-rate differentials. However, the Review presents several reasons why national real interest rates are becoming less important over time as citizens adapt to life under the single currency.
Overall adjustment is stable
Empirical analysis combining model simulations and country case studies provide evidence of several channels of adjustment that interact with each other in determining the pattern of inter-country adjustment. Some emerging features deserve particular attention in terms of resolving puzzles about recent experience as well as highlighting issues with relevance for the future European policy agenda:
• The adjustment process is dynamically stable. The competitiveness channel emerges as strongly dominant over the medium term, despite evidence of perverse real-interest-rate effects. But the latter are less powerful than suggested in some earlier assessments.
• Country-specific developments play an important role. Country-specific “shocks” disturb factors that affect output and prices and contribute to the explanation of protracted differences in economic growth. Disturbances can be mutually reinforcing and spillover effects are found to be potentially important. Moreover, the dynamics of catching-up have varied considerably across countries.
• Several factors are crucial for the pace of adjustment. There can be wide variations in the responsiveness of wages and unit labour costs to changes in national output gaps – and in some cases, there was a weak response to the emergence of cyclical slack, which retarded adjustment. The role of financial markets has been more prominent than expected and financial integration has unlocked potentially large gains in formerly credit-constrained economies. Marked differences exist in the way that policy and market developments in euro-area economies interacted to dampen or amplify fluctuations in output and prices.
These findings raise a number of policy issues that deserve further exploration with a view to improving adjustment efficiency in the euro area. These concern the scope for enhancing adjustment through structural reforms in labour and product markets; the role of fiscal policy in helping to assure efficient adjustment outcomes; and the ways in which financial flows interact with real sector adjustment in a setting of ever-closer market integration. In presenting over 250 pages of research and analysis, the Review takes an in-depth look at macroeconomic differences and adjustment in the euro area and how these have arisen. But the aim is not only to look backwards; it is also to identify the lessons for the future in this complicated field of ‘real world’ economics.
Improving adjustment dynamics
 |
The experience of the first eight years in the euro area shows that many countries have not yet fully adapted to life with the single currency. It is true that the euro has established itself as a strong and stable currency, and that the euro area, as a whole, has responded well to common economic shocks, such as the rise in oil prices and the financial market volatility of the dotcom crash. It is also true that interest rates and inflation rates have been at historically low levels for a prolonged period of time – allowing companies and citizens to benefit from favourable credit conditions for investment and consumption. However, concludes the Review, the euro area remains sub-optimal in some aspects – in particular, the ability of individual member economies to adjust to changing economic challenges, as shown by persistent differences in economic growth and inflation rates.
In response, the Review points to well-functioning market adjustment channels as important elements marking the way forward, particularly improved competitiveness, but also policy channels. The quality of public spending should be reviewed to ensure it supports growth-enhancing investments in R&D, innovation and education, it suggests.
More progress on the integrated financial market would help smooth economic shocks where they hit the hardest, and implementation of the recent Services Directive will help increase competition in this important sector and improve productivity and competitiveness. The authors also look briefly at the lessons for catching-up economies, such as those of the recently acceded Member States preparing for the euro. The credit expansion seen in some current euro-area members might also be expected in these Member States as they adjust their economies for euro adoption.
Further, for the economy to remain competitive, say the authors, it is important for wage-price developments to reflect productivity gains – and economic actors, such as governments, businesses and trade unions, need to take this into account in wage bargaining and look to long-term competitiveness as a common aim. Lastly, it is essential that politicians explain clearly the overwhelming benefits of the euro to citizens, such that they are fully behind efforts to equip the euro area to face the challenges and opportunities of globalisation.
