Foros de la Plataforma por una Vivienda Digna

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Will EMU survive 2010?

Will EMU survive 2010?

The challenge so far: Slow growth

What framework can ensure the stability of economic and monetary union? Before the final step was taken in 1998-99, many, including senior policy-makers, argued that monetary union would not be stable and could not survive in the long run if it were not accompanied by more economic flexibility and closer political union. The former was seen as necessary to allow better adjustment in the absence of country-specific interest and exchange rate changes; the latter was seen as necessary to establish democratic legitimisation for a stability-oriented monetary policy and the conditions for a fiscal policy consistent with this conduct of monetary policy. Without closer political union and the emergence of a European public will, it was feared that the European Central Bank could come under irresistible pressure from national governments to conduct a softer monetary policy and that fiscal policy would lack the necessary discipline to ensure price stability in the long-run. In other words, governments would pursue their narrow interests at the expense of the public good of price stability.

As preparations for EMU progressed and prospects for closer political union faded into the background, it was argued that the statutory independence of the ECB would shield it against political influence. Moreover, to ensure some fiscal policy discipline, the Stability and Growth Pact was agreed at the Amsterdam European Council meeting in 1997.

In the first few years of EMU, neither the degree of economic flexibility, nor the stability of the fiscal framework or the independence of the ECB was severely tested. However, as growth has faded, tensions have increased. Optimists hoped that economic tensions would eventually break the existing structural rigidities. Unfortunately, it seems that the rigidities are prevailing while fiscal policy discipline is giving way. Since this will not keep growth going, political pressure will increasingly be brought to bear on the ECB to support economic activity in the short-term. The fierce comments from finance ministers on the belated decision by the ECB in December 2005 to increase rates by a mere quarter point constitute a good illustration of this trend.

The forthcoming challenge: Intra-area divergences

Slow growth is not the only risk factor for EMU, however. The next half decade should see the emergence of another factor, namely increasing growth differentials among EMU member countries, which so far had remained rather limited and at a stable level. The weighted standard deviation of the growth rates of the euro area members has barely moved between 1999 and now as the large three euro area members tended to move broadly together. The two main laggards in the eurozone were Germany and Italy, with France falling somewhere in between them and the more dynamic smaller countries. However, the apparent similarity between developments in Italy and Germany has been superficial. It is now becoming clear that a chasm has opened up between them under the surface.

Germany entered EMU with an overvalued exchange rate, but it has regained competitiveness through a process that used to be called ‘competitive deflation’, i.e. extracting continuous concessions from trade unions on labour costs. By contrast, Italy has continuously lost competitiveness, and the French performance has again been ‘middling’. Figure 1 shows that Italy’s labour costs have increased by about 20 % relative to those of Germany since the start of EMU. This loss of competitiveness has also translated in large movements in market shares as illustrated in Figure 2, with the difference between Italy and Germany again being around 20%. Somewhat surprisingly, the export performance of France is even worse than that of Italy, suggesting a corresponding lack of structural reforms.

These large relative movements in competitive positions and export performance did not translate earlier into different growth rates because of the offsetting tendencies in the housing markets. The low interest rate environment fostered by the ECB’s policy and the global ‘savings glut’ led to a housing boom in a number of countries, including France and Italy. This has so far sustained consumption in these countries, while overbuilding especially in the eastern part of Germany during the early 1990s led to persistent weakness in the real estate market and consumption in that country. However, the cumulated loss in Italian competitiveness has become so severe that its negative effects can no longer be offset by the housing boom.

Unnoticed by many, an even more severe disequilibrium is building up in the case of Spain, which so far has been regarded as a success story. The relatively strong growth of Spanish exports until about 2003 – despite an also rather strong increase in relative labour costs – suggests that indeed some reforms have made Spain more competitive. However, the continuing loss of competitiveness has now impacted on export growth and, even more importantly, the housing boom has been so strong in Spain that is has translated not only in a consumption boom, but a degree of overbuilding much worse than even that experienced by Germany in the wake of unification. Figure 3 shows that a construction boom has been a key factor in the relative strong growth performance of Spain over the last few years. Construction now accounts for over 17% of GDP in Spain, much more than the 14% it accounted for in Germany in the wake of unification. With so many houses being built, it is clear that at some point in the future the demand for new houses in Spain will decline drastically. Spain is likely to experience a protracted period of weak domestic demand to an even greater extent than has Germany in recent years. The only way to prevent unemployment from skyrocketing would then be to rely on increasing exports. But this would require a turnaround in competitiveness, just like in Italy.

The remainder of this decade is thus likely to see the North and the South of Europe trading places: Germany is likely to emerge with the strongest growth once its real estate market has bottomed out, whereas Italy and Spain are likely to experience a period of weak growth as their labour markets struggle with the problem of how to regain competitiveness through lower wages and extracting concessions on working time.

Unfortunately, however, the divergent trends in place since the start of EMU show no sign of changing soon. The latest forecast of the Commission implies that Italy and Spain will continue to lose competitiveness. The later the adjustment starts in these two countries, the more difficult it will become. The foreseeable period of weak growth in these countries is likely to lead to even greater budgetary difficulties, especially in Italy.

The real test for the EMU framework is thus likely to arise over the remainder of this decade. Once Germany has brought its public finances under control (probably around 2007), the pressure will mount on Italy whose relative position is likely to have deteriorated further. Over time, the global savings glut is likely to end and global interest rates are likely to return to more normal levels. The ‘one size fits all’ policy of the ECB is then likely to become very difficult to bear for countries like Spain and Italy, which will then have to enter a period of very low increases, or even declining, domestic price levels. A combination of slow growth, rising real interest rates and increasing pressures from Brussels to reduce spending will make EMU unpopular in these countries.

Conclusion: A test the weakest cannot afford to fail

Could these tensions lead to a break-up of EMU? While this scenario has already been suggested by some ministers in Italy, it is unlikely to materialise for the simple reason that the cost of breaking away would be prohibitive for a country with such a high public debt. The Italian public (and even the most populist politicians) know that leaving EMU, coupled with a devaluation to regain competitiveness, would increase by one stroke the debt/GDP ratio as all existing public debt would have to be serviced in euro. Moreover, interest rates on the new lira are likely to be much higher than within the euro area, thus increasing the cost of servicing public debt easily by several percentage points of GDP. In the end, Italy (and Spain) will thus have little choice but to bite the bullet and undergo their first full business cycle under a hard currency regime. EMU is thus likely to survive, but the sparks will fly for some time to come.

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