Eurozone Imbalances Weaken Trust in The Euro and Undermine Euro Area Cohesion

This is the conclusion drawn – rather surprisingly – not by some bank analyst, or by a Credit Ratings Agency, but by the European Commission itself, according to the contents of a report “leaked” to the German magazine Der Spiegel at the end of last week. “(The imbalances) weaken trust in the euro and endanger the cohesion of the monetary union,”.

Here is a rough translation of the Der Spiegel report:

The EU Commission Sees Monetary Union At Risk

The EU Commission is concerned about the survival of monetary union. The differences in competitiveness between member countries and the resulting imbalances give “cause for serious concern for the eurozone as a whole”, according to a presentation given by the Directorate General for Economy and Finance to the finance ministers of the Eurogroup.

The experts who advise the Finnish Commissioner-designate Olli Rehn fear that the differential development of the economies in the various Member States undermine confidence in the euro and may ultimately threaten the cohesiveness of the monetary union. Of particular concern to the Brussels officials is the economic condition of those countries who in the past ran huge deficits in their current account balances, because they lived for many years thanks to ample credit which was avaialable due to the low interest rates prevailing. Now these countries are suffering, especially Spain, Greece and Ireland, under the weight of escalating government deficits. “The combination of declining competitiveness and excessive accumulation of public debt worrying in this context,” the experts say.

As a way out of trouble, the EU officials first propose that the countries concerned put their own houses in order and introduce the necessary reforms. Wage levels need to be set with due consideration to falling productivity and the loss of competitiveness. In plain language: workers ambitions should be modest, with low wage settlements. “The adjustment will be accompanied by a marked increase in unemployment.”

The Commission officials also recommend that the deficit countries employ a strategy which was used by Germany in its recent efforts to exit from many years of weak growth. At the same time the German federal government does not escape criticism in the report, since Germany and other relatively successful countries such as Austria and the Netherlands need to tackle the chronic weakness in their domestic demand.

To achieve this the Brussels experts recommend enabling more competition in the services sector, the intriduction of tax reforms and the elimination of credit hurdles. The longer the countries concerned delay introducing the necessary measures, the higher the social costs which will be incurred. The Commission believes the euro countries have no choice: “These adjustments are vital for the long-term functioning of monetary union.”

As far as can be seen from this Spiegel report, while it is the case that some of the wording used is similar to things we have seen before, there would seem to be an underlying transition going on here, one which in EU terms is quite rapid. The EU’s own analysis of the problems in the Eurozone is coming nearer and nearer to that of both the IMF and the credit rating agencies. We are moving beyond short term fiscal deficit issues, and immediate liquidity issues, towards problems like competitiveness, and what was previously a taboo subject – the issue of Eurozone imbalances. These were, in fact, supposed to disappear with the passage of time, so it was expected that they would have diminished rather than increased. In that sense there is now an implicit admission that the institutional environment in which the common currency has been operated was severely deficient and badly needs to be improved. In my view this change in approach is already a big improvement, as is the fact that people are begining to face up to the reality that the Euro has exacerbated the imbalances, rather than reducing them.

In particular the Commission seem to be starting recognising that countries like Spain whose main export became pieces of paper (or IOUs on their future) which were securitised against assets which we can now see didn’t have the value they were thought to have (the housing stock, or should I say glut) entered a dynamic which was seriously unstable. Now we need to see the measures which can be applied for correcting these distortions.

Juergen Stark, member of the Executive Council of the ECB was out with another interview more or less along the same lines on Saturday:

Stark told the Welt am Sonntag newspaper that Greece, which is battling to get its budget under control, must make comprehensive consolidation a priority but also reform its economy to stop producing deficits. “Countries like Greece must not only bring their deficits under control, but also enact a fundamental reorientation of their economic policy,” Stark said. “Some countries have even managed to accept falling wages — there is no alternative for economies in a difficult situation,” he added in the interview, which had been held on Thursday.

The reference in the Spiegel report to the earlier German expience is to the earlier “internal devaluation” Germany carried out between 2001 and 2005 in an attempt to restore competitiveness after having entered the common currency at an exchange rate which was later discovered to have been too high. The thing is, the German devaluation was quite limited and quite slow. Greece and Spain have large devaluations to carry out, and the time scale is likely to need to be short, since it is urgentto restore growth to these economies to avoid the debt to GDP percentages snowballing upwards.

Another aspect to this whole problem is the new emphasis on correcting the imbalances as a shared process, one which, as Mr Zapatero would have it, involves “solidarity”, and joint responsibility. That is to say the surplus countries are going to be expected to play their part: no wonder the German economy minister became so angry with Mr Zapatero’s 2020 strategy initiative.

Of course, it is not really posible to present the problem in quite this way, since one set of economies are competitive, and another set are not, so it is hard for the Greeks and the Spanish to really blame the Germans and the Dutch for their present situation, although everyone, both centre and periphery, will have to play a part in the search for solutions. I tend to put it this way: the South must make sacrifices, and then the centre must help. Thus talk of no “financial bailout being possible”, or, as M Trichet would have it, simply stating that the “external surpluses of some member countries (in the balance of payments) finance the external deficits of some others” without recognising that the presence of these very same surpluses form a problematic part of the internal Eurozone imbalances is hardly helpful at this point.

As Martin Wolf said recently:

What people do not seem to understand is that peripheral European countries cannot escape from their trap because they are caught in a game of competitive deflation with Germany (and the Netherlands). So long as the eurozone has an external balance (roughly) and Germany has a vast surplus, the rest of the zone MUST be running aggregate deficits. That is a subtraction from their domestic demand. This then means that either the private sector runs deficits (spends more than its income) or the public sector does. If the latter is pushed towards balance, by eurozone pressure, GDP must contract enough to force the private sector finally back into deficit and so towards bankruptcy. Ultimately, the only way out of the trap is for nominal wages and costs in peripheral Europe to fall so much that it forces core Europe into depression . That also means a depression in peripheral Europe. No advanced polity can cope with a permanent depression. Anything can then happen. I have always feared that the euro could break the EU. I believe this is quite possible.

“Alternatively, demand must start to rise substantially in core Europe. Is that possible? The other alternative would be for the eurozone as a whole to move into surplus – but how, given the weakness of external demand and the strong euro?”

No easy answers yet awhile, but lots of interesting problems to talk about, and plenty of food for thought.

This entry was posted in A Fistful Of Euros, Economics and demography, Economics: Country briefings, Economics: Currencies by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

28 thoughts on “Eurozone Imbalances Weaken Trust in The Euro and Undermine Euro Area Cohesion

  1. The German-dominated EC makes here some serious errors. First, Ireland can not be blamed for “türming” – i.e. long term accumulating sovereign debt, because Ireland’s debt has been very low always and in some years even decreased. Ireland has been hit by a banking crisis (like Iceland and Latvia) AND the EC destructive policy “no bank to fail in the EU”. Of course, no small country can afford this policy financially. For the overblowing of the Ireland’s banking sector the EU is to blame at least so much as the Ireland itself, because of the all bla bla bla free competition coming from Bruxelles.

    The EC consolidation strategy itself is very instable issue. If main trading partners will avoid consolidation strategies and the EUR will become more expensive, EU will be just uncompetitive on global markets. At the moment there is no evidence that the EC strategy arising from German Sparbuch mentality has even the smallest chances to succeed. The problem lies in the fact that EC policy is too much influenced by German internal politics.

    Generally it must be questioned if the new German-influenced paradigm of zero inflation, falling wages and extreme surpluses in trade with other EU countries is so very sustainable? For countries with enough children and aging costs significantly reduced by generation agreement this Zero policy is not sustainable. And it is not sustainable because of expected enormous growth in unemployment due to this Zero strategy. Interesting thing – the new EU2020 strategy is created with an immanent axiom of extreme unemployment as long-term trait of the whole EU economy. That means, the aging costs will be exaggerated by costs of long-term unemployment. Must be this sustainable? Must be this sustainable on the global scale?

  2. Really the fault lies on EU.EU will be just uncompetitive on global markets as EC policy is too much influenced by German internal politics as we all knew.

  3. So, Edward, are you worried about euro accounts at banks in España? A couple of months ago you thought that there was no way Spain would leave the euro. Now, you don’t seem so sure. After reading your piece, I’m not either (and I live in Spain, like you)

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  5. Hello Mark,

    “A couple of months ago you thought that there was no way Spain would leave the euro. Now, you don’t seem so sure.”

    Sorry, my opinion hasn’t changed on this. I have been saying I thought there was no way Spain would chose to leave the Euro, and I still think this. But this doesn’t mean – if, for example these imbalances aren’t corrected – that an “accident” might not happen, and everyone might have to leave (or whatever, I have no crystal ball as far as financial crises goes).

    But what I am saying here is that the Eurogroup countries are trying to take giant steps to correct the institutional deficiencies that have given rise to these problems, including taking more or less control of the economies of given Eurogroup countries.

    Whether the changes will go far enough, or come fast enough, is what remains to be seen.

  6. Dear Mark,

    others leaving the EUR zone is a solution by far not favoured also by big influential EUR countries as Germany and France. Because their large surpluses from trade in EU are directly dependent on others inability to regain competitiviness by currency depreciation. Germany’s surplus has started to grow again at the end of 2009 (contrary to the 1st half of 2009 where it decreased), and all the Germany’s prospects are based on that.

    A much better solution will be to step away from senile German politics and push very consequently for ECB 2% target even in short run. No matter how many trillions -1,2, or 20 -are thrown into markets, prices must grow at 2%.

  7. Interesting answers from both. Thank you. I genuinely appreciate it.

    As for, “the Eurogroup countries are trying to take giant steps to correct the institutional deficiencies that have given rise to these problems, including taking more or less control of the economies of given Eurogroup countries.” Surely you jest. So far it’s been carte blanche for everyone to bust the stability pact, AND bail out their banks, with ex post facto approval /silience afterwards from the EU. Now, Spain late to the party with the FROB, is rather unfairly undergoing more scrutiny in this regard.

    As for competitive devaluation within the euro via wages,do you see that in Spain with Candido Mendez being the fourth vicepresident, as they say?

  8. Well if you are right Mark, and everyone continues to get Carte Blanche (although Greece surely isn’t, nor will Spain, nor will Portugal, nor is Hungary, nor is Latvia, all this is going on right now, and wasn’t two years ago) then we are all simply in for a very very long depression here in Europe (see Martin Wolf comment I have just appended).

    And if Spain doesn’t change its ways, people will ssimply start to leave – remember we have 5 million recently arrived – and the housing market will never clear. So it is another slow death, with no rosy pensions future. This is the price which will be paid for inaction.

    “Now, Spain late to the party with the FROB, is rather unfairly undergoing more scrutiny in this regard.”

    I don’t accept this interpretation. It is Spain’s banks who denied they had a problem and tried to hide their loses who have produced this mess. And the FROB is in breach of the EU Competitiveness rules (which the Bank of Spain should have understood but didn’t, see my recent Frobbing post here). They are trying to find a back door solution which doesn’t involve direct intervention and they will steadily slide into an ever deeper mess. I really find it hard to blame the EU or the ECB for this.

  9. Incidentally, Mark, if we still have a Carte Blanche approach, why are they even bothering to write this report, which is bound to cause controversy. Better just to leave people to their old ways until the whole thing blows up if the priority is to do nothing. I don’t believe that for a minute, and think that the change from Almunia, who was totally incompetent, to Rehn is very significant.

  10. I think the carte blanche approach was not so much an “approach” as probably finding out on the news the bailouts member countries were enacting, preferring to ask for forigveness rather than permission.

  11. Carte blanche for bailouts has gone, but what will happen with Ireland debt after ECB will revoke extraordinary measures? Not to ask what will happen when it will start to rise the rates.

  12. I think that the slow decline route is the most likely outcome in Spain. I have not seen any sign of Spanish politicians facing up to the problems the country faces. Which of the main parties will dare break the silence? I fear neither will.

  13. Well, sooner or later, Spain, like greece is going to be forced to take the medicine. and if neither party has the courage to implement changes, then a euro exist must be a possibility. Edward makes a very good point about the regions talking a lot of control out of central govts’ hands in terms of reducing the budget. This is a huge problem, especially when you’ve got the mayor who is currently the head of the muncipalities organization in Spain saying: “Do the right thing, and owe what you must”. This mass denial of reality does not augur well. As Orwell said: “To see what is in front of one’s nose needs a constant struggle.”

  14. Whether it is deliberate or not I think the opportunity to discuss the reality of Spains situation is being denied to the Spanish people. As to whether Spain would ever leave the Euro , I think it impossible that any party would propose it.. I think all concerned, including the ECB, are much more likely to follow the path of least resistence and go from crises to crises.I cant see any “good news” for Spain right now.

  15. I think some things:
    The Commision can not decide the future of the euro. This corresponds to the member countries.
    So, the question is whether any country is thinking of leaving it, or any country is considering that another should leave.
    I do not think that leaving the euro would solve the problems of countries with structural deficit.
    And I say more: I do not really believe in theories such as the optimal currency area.
    Another thing, if we can devalue a national currency, why not the euro itself?

  16. Carlos,

    You raise an interesting question:

    “The Commision can not decide the future of the euro. This corresponds to the member countries.”

    This is more or less the case. The Commission looks (in theory) to the interests of the whole, while the member states look to their own individual interests. Now what if the interest of the whole does not coincide with the sum of the individual interests?

    That is, if each country pursuing its own best interests produces a far from optimal – nay very unstable – outcome. This is where we are. So either the common interest prevails (over and above the national ones) or the whole thing goes to the dogs, with very unpleasant consequences for all concerned.

    “Another thing, if we can devalue a national currency, why not the euro itself?”

    The Euro is in fact devaluing (Greek problems are producing this result), and this will help, since Germany can run a larger ex EU27 surplus, and the less competitive countries can sell to Germany (keeping things simple) – the problem is, the way things are set up, this means an increase in the relative value of the dollar, which means the US economy will slow, since the US current account deficit will slow again.

    A complex, and interconnected world.

  17. Selling to Germany will not work. For instance, in Latvia PPI started to grow in December. Others are not better.

    Fully agree that countries with large intra-EU imbalances are playing a big mutual chicken game.

  18. “others leaving the EUR zone is a solution by far not favoured also by big influential EUR countries as Germany and France. Because their large surpluses from trade in EU are directly dependent on others inability to regain competitiviness by currency depreciation.”

    But they won’t export much to countries in a long depression either.

    why do you favor devaluation for the Baltic states, yet advice Spain and Greece to stay in the currency union? Indeed for Spain and Greece the problem of debt in a foreign currency wouldn’t arise.

    And furthermore, how is a repetition of the current situation to be avoided while a common interest rate will have to be misadjusted?

  19. That is not true. If you look on the actual German imports to Latvia, there will be cookies, cofee, milk powder, and very few cars. Actually Latvia is a net car exporter because of repossessed cars sold to Germany.

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