Thursday, April 28, 2011

Euro divergence

There has been quite a lot of discussion among academics ( but much less among policy makers) on whether the euro is irreversible.  Economists have discussed at length about the adjustments that the introduction of the single currency would require, in particular on labour mobility since exchange rates are fixed.  In fact, this problem has been ignored by European governments focusing only on nominal convergence.  But this is not compatible under current circumstances with real divergence and slow growth. 

After setting up the fund to tackle the debt crisis in Greece and Ireland, Germany has imposed a 'pact for competitiveness' to introduce wage moderation along with austerity in public finance.  The main reason is that the adoption of the euro by most European member States led to a period of low interests in southern Europe which triggered an inflationary boom accompanied by a financial bubble (in Spain and Ireland). But when the boom ended, these countries became uncompetitive with northern Europe. Now, the European central bank is adapting its monetary policy in order to address this competitiveness gap via deflation in the south and inflation in the north, especially in Germany.  

This phenomenon is well illustrated in the graph below* which shows unit labour costs, with 1999 =100. the red line is Germany, he black line is France; the green line is the ECB's 2 per cent inflation target; the blue line is southern Europe. 

This may sound unorthodox, but there is an urgent need to address the issue of real divergence, which means increasing real prosperity in the poorest areas of Europe to make it work better and in a more sustainable manner. This implies, above all,  mobilizing funds for large investment programmes in Europe, which will pay off and reduce deficits as a result of higher growth and trade integration. 

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