Divergences within the euro area: threat and opportunity

Protests like this one in Athens could spread across Europe unless we act now to reduce competitive imbalances.

Divergences in the competitive positions and current-account balances of euro area Member States have been building up over the past decade. The divergences may threaten both the economic stability of individual countries and the cohesiveness of the euro area. Addressing the divergences will require significant price and cost adjustments in current-account deficit countries and removing the structural factors that hinder domestic demand in surplus countries. Nonetheless, the euro area and the EU as a whole now have the chance to improve economic surveillance and policy coordination.

The recent financial and economic turmoil in Greece has exposed weaknesses in the euro area. The problems in Greece, however, are only the most visible manifestation of a situation that has been brewing for years, as the Commission has been pointing out for some time.¹See for example the 2006 EU Economy Review, European Economy 6/2006, and EMU@10: successes and challenges after 10 years of economic and monetary union, European Economy 2/2008. Over the past decade, the euro area has experienced a steady divergence in the competitive positions and current account balances of Member States. Countries such as Germany, Finland and Austria gained in price/cost competitiveness while others such as Ireland, Greece, Spain, the Netherlands and Portugal lost competitiveness. These divergences are reflected in the important divergence in real effective exchange rates among Member States.²Quarterly Report on the Euro Area, Volume 8 N° 1 (2009), Special report: Competitiveness developments within the euro area.

Divergences in competitiveness have been associated with the steady widening of differences in current account positions. Germany, Luxembourg, the Netherlands, Austria and Finland have accumulated significant surpluses while Greece, Spain, Portugal and Cyprus have accumulated very large deficits. While the crisis has prompted a convergence in current account positions across Member States, the improvement is partly temporary and not backed by the necessary changes in relative prices except in Ireland. Key drivers of the convergence, such as the collapse in global demand for the exports of surplus countries or the substitution of imports in some deficit countries, are purely cyclical factors. The pre-crisis divergence trend is likely to continue once the recovery takes hold.

Is divergence a problem?

Divergence is not necessarily bad in a monetary union. Catching-up countries, for instance, need inflows of foreign capital for investment purposes. It may be normal for them to run current account deficits for a period of time.

‘There are “good” divergences and “bad” divergences,’ according to Reinhard Felke, head of the unit dealing with the economy of the euro area and EMU. ‘Unfortunately, capital inflows in many of the deficit countries fuelled asset price bubbles rather than productive investment.’

The divergence trend has been driven primarily by domestic economic imbalances, including the poor adjustment of wages to a slowdown in productivity, excessive credit growth and housing bubbles. Surplus countries have experienced an entrenched weakness in domestic demand, while in current account deficit countries, the large capital inflows led to an unsustainable accumulation of household and corporate debt. Moreover, in some deficit countries the situation has been exacerbated by inappropriate fiscal policies.

Current-account positions, euro-area Member States (in % of GDP)

Intra-area real effective exchange rate developments, based on GDP deflator, euro-area Member States (1998-2010, 1998=100)

Threat to the euro area?

Persistent divergences in competitiveness and macroeconomic imbalances are a cause for serious concern. They increase the economic and financial vulnerability of individual countries, may jeopardise confidence in the euro and weigh on the cohesiveness of the euro area. The situation, if not addressed, will eventually lead to a correction that may be abrupt and potentially disruptive, both for the countries concerned and for the euro area as a whole.

Unfortunately, most euro-area countries suffer from a relatively low adjustment capacity. Due to rigidities in labour and product markets, regaining competitiveness and unwinding macroeconomic imbalances is likely to be a painful and protracted process.

Structural recession and a persistent rise in unemployment are the likely outcomes of poorly managed adjustment processes. Moreover, the longer adjustment is postponed, the higher its ultimate social cost is likely to be.

The impact of the economic crisis

The economic crisis has added further pressure to an already volatile situation. The global financial crisis has demonstrated the vulnerability of euro-area countries to cross-border financial spillovers both via bank linkages and in terms of the widening of risk premiums on sovereign debt. Furthermore, Member States with large competitiveness problems face reduced growth potential. And due to pre-crisis profligacy, the costs of bank bailouts and economic stimulus, many countries’ public finances are also constrained.

The policy response

The smooth adjustment of intra-euro-area competitiveness and macroeconomic rebalancing are key for economic recovery and for the successful and sustainable functioning of EMU in the long term. Tackling divergences in competitiveness and current account imbalances will require action across Member States, both deficit and surplus countries. While policies must be tailored to the specific competitive situation of each country, coordinated efforts would reduce the amount of adjustment to be done in any given Member State.

Policies should address four key areas: macroeconomic policies, credit markets, labour markets, and product and service markets. Large price and cost adjustments will be needed in deficit countries to enhance their export competitiveness, but non-price competitiveness factors, such as technology-intensity, quality of services and the dynamics of export destinations, also have a role to play. The need for action is less pressing in surplus countries, but they need to address structural weaknesses in private domestic demand. This would make them better off and also facilitate adjustment in deficit countries by raising their exports.

Longer-term, mechanisms need to be put in place to improve the surveillance of external imbalances, and prevent them or tackle them if they emerge. It could be beneficial to put in place structural changes that reduce the occurrence of credit and asset price bubbles, for example.

The Eurogroup should play a key role in the coordination process by identifying adjustment needs and fostering a common diagnosis. Its work could eventually inform other efforts to strengthen the EU economy such as the Stability and Convergence Programmes and the emerging Europe 2020 strategy.

The opportunity

Ironically, the economic crisis may turn out to be an opportunity for the euro area and the EU as a whole. It has shown the strengths of the euro and has also revealed that there is unfinished business that needs to be addressed.

Without the euro, countries would have gone through exchange rate crises and the adjustment shocks would have been bigger. On the other hand, membership of the euro area has allowed some countries to delay taking action.

Nonetheless, there are reasons to be optimistic. The Commission has been looking into these divergences for quite some time now, but a policy consensus is finally emerging among Member States on the diagnosis of the problem and how to tackle it.