For a long time, Germany went unrivalled. Looking beyond the improvements in non-cost competitiveness and its strategic positioning, since reunification the German economy has focused on wage moderation, thanks notably to the decentralisation of wage negotiations. In the early 2000s, wage moderation was coupled with greater job market flexibility. These trends enabled Germany’s manufacturing industry to restore its competitiveness and helped fuel a significant improvement in the current account (+9 points of GDP since 1999, to about 8% in 2017). In the Netherlands, which also reported strong growth and a high current account surplus (more than 10% of GDP in 2017, a 7-point increase compared to 1999), the average increase in ULC was about 2% before the crisis (similar to France), while labour productivity gains were comparable to those in Germany.
During this period, unit labour costs rose sharply in the peripheral countries. In Italy, Portugal and Spain, the pre-crisis increase in ULC was mainly concentrated in the non-tradeable goods and services sectors[13]. As inputs in the production process, ULC growth in the sheltered sector hindered the competitiveness of sectors exposed to international competition. Different ULC dynamics between eurozone members contributed to the gap between countries with current account deficits and those with current account surpluses (see chart 8). During the euro’s first decade, the current account for the eurozone as a whole was generally well balanced, but it rose constantly thereafter, due largely to the impact of Germany’s swelling surplus. In the “deficit” countries, in contrast, their current account deficits widened sharply prior to 2008, but narrowed thereafter at a time of sluggish domestic demand.
Interpreting the chart: The “deficit” countries, represented by the black dotted line, are those that have reported a current account deficit on average since 1999. They include Italy, Greece, Spain and Portugal.
Since 2008, wage growth in Germany has tended to be stronger than the eurozone average (German ULC has increased by about 2% on average since the crisis, compared to 1.3% in the eurozone). Other countries experienced abrupt adjustments in their unit labour costs. In Greece and Spain, ULC rose at an average annual rate of more than 3% between 1999 and 2007, but has stagnated ever since. If these new trends persist, they would reduce the gap in cost competitiveness and could even correct some of the macroeconomic imbalances that have been accumulated within the eurozone.
Much-needed institutional advances
During asymmetric shocks, it is possible to make macroeconomic adjustments, notably via the moderation of unit labour costs. Yet these adjustments can have a lasting negative impact on demand. Seen in this light, risk sharing seems to be essential, especially within a monetary union, in order to smooth consumption over time and to improve wellbeing in general. By definition, a common monetary policy limits autonomy at the national level, which implies that risk sharing is necessary to absorb the impact of asymmetric shocks[14]. There are several different types of risk sharing mechanisms, which can be either private (via the capital markets or credit channels) or public (intergenerational transfers via public debt), national or cross border (transfer system between member states).
Unlike the United States, which is a federal republic, the eurozone has experienced very little risk sharing since the creation of EMU, 80% of the shocks affecting a given economy have not been smoothed[15]. Risk sharing also tends to weaken during periods of economic hardship. Cross-border lending was hard hit by the 2008 crisis, by the upsurge in risk aversion among economic agents and by greater differentiation between borrower risks.
To strengthen risk-sharing mechanisms within the eurozone, greater capital market integration is needed along with a cross-border credit market that is less sensitive to cyclical downturns. For many observers, the eurozone’s brief history has also revealed the need to reinforce institutional convergence.
First steps…
The slow and painful response to the sovereign debt crisis, especially in Greece (whose economy now accounts for only a little over 2% of the eurozone’s nominal GDP), highlighted major divergences between the hard-line proponents of “no bailouts” (in compliance with the European treaties) and the partisans of a more interventionist approach. These divergent points of view weakened the eurozone and aggravated tensions in the sovereign bond markets.
The creation of the European Stability Mechanism (ESM), which replaced the European Financial Stability Fund (EFSF)[16], was a first step toward risk sharing. These structures are designed to lend to member states encountering financial difficulties in exchange for “strict conditionality”. By stepping in for private lenders in the hardest hit countries, they made it possible to better absorb shocks in the eurozone during the crisis[17]. Yet these mechanisms act more as ex-post emergency measures. Although they are credible tools for fighting negative shocks in the short term, an upstream instrument could absorb part of the shock, which would help limit the negative effects on economic growth and employment.
Since 2012-13, the eurozone has also engaged in banking union with three objectives:
1) risk prevention, through a single supervisory mechanism assigned to the European Central Bank (ECB),
2) the disassociation of sovereign and banking risks, via a single resolution mechanism comprised notably of a single resolution fund financed by the banks themselves, and
3) the mutualisation of risks via the European bank deposit insurance scheme, which is still incomplete.
Fostering real convergence would require: 1) strengthening the supply conditions of eurozone member countries (especially their competitiveness) to forge a sustainable convergence in terms of productivity and income levels, as discussed above, and 2) to set up mechanisms to limit the lasting negative effects of shocks on GDP and employment. In the rest of this article, we will focus on this second point.
…to be confirmed
The completion of banking union or a capital markets union would be a first step, but this still leaves the risk of capital flight during periods of financial stress. Moreover, the clean-up of macroeconomic and financial fundamentals – which Germany often sees as a precondition for exploring any form of in-depth mutualisation – seems to be a long-term objective, a necessary one but that is not sufficient on its own. As a result, some authors argue that the EMU is still vulnerable [18].
One way to strengthen the eurozone would be to empower it with a supranational fiscal capacity (European Commission, 2017[19]). Honed for macroeconomic stabilisation, this counter-cyclical tool would help partially or fully absorb shocks, and would prevent the divergence process from being triggered. It would also favour the implementation of better balanced policy mixes than those observed during the sovereign debt crisis[20]. A supranational fiscal policy would be even more pertinent today since monetary policy is restricted by very low interest rates.
To be effective, this supranational fiscal capacity would need to be based on a simple mechanism, one that is triggered as soon as the cyclical environment deteriorates. One indicator that could serve as a trigger would be the unemployment rate’s deviation from its long-term average[21]. This would be preferable to the output gap (the spread between effective and potential GDP growth), the measurement of which is regularly the subject of debate and can be called into question ex-post.
This fiscal capacity would be mobilised, temporarily and proportionally, in favour of one or more countries hit by an increase in cyclical unemployment following an asymmetric shock, resulting in a deterioration in their fiscal situation (due to a shortfall of revenues and higher social welfare payouts). Such an intervention would also offer the advantage of easing the negative effects of the deterioration of public finances on the bond markets (higher sovereign spreads). It would also limit the ex-post activation of the European Stability Mechanism.
The implementation of such a mechanism raises several major issues. Guarantees would also be necessary[22]. This fiscal mechanism could be financed through annual contributions by each country, which would require the transfer of some national resources to the federal level. The bigger the eurozone’s fiscal capacity, the higher the amount of transfers. This also raises the question of whether it would be politically or socially acceptable. In this respect, guarantees would be needed to facilitate the project’s implementation. The question of morale hazard also needs to be addressed. How can we guard against the risk of budget overruns at the national level in the presence of this “supranational” insurance mechanism? According to the IMF, net transfers to distressed countries should depend on their compliance with fiscal rules in past years. In case of non-compliance, transfers would not be completely cancelled, but would be digressive instead. This fiscal capacity should not be considered as a permanent mechanism and should not substitute for the sometimes necessary adjustment of national economic policies. When supranational transfers are used too frequently, penalties should be imposed on the delinquent countries (via an extra annual contribution, for example).
For the political acceptance and smoothing functioning of this system, eurozone member countries would have to adopt fiscal policies that rebuild fiscal manoeuvring room during cyclical upturns. This would facilitate the dialogue between countries with a structural surplus and those with structural deficits, ensuring the “smooth” functioning of the supranational fiscal capacity.
Crisis after crisis, the EMU has been strengthened through trial by fire. Stabilisation mechanisms have been created that were not part of the original project. The European Central Bank has played a much bigger role by increasing the size of its balance sheet and by directly supervising the main banks via a single supervisory mechanism. A capital markets union has been launched. Yet the centrifugal forces that fuelled divergence in the EMU in the past are still operational. European construction still requires special attention, at least in two respects.
Productivity seems to be a core issue. Even before the Great Financial Crisis of 2008, Total Factor Productivity (TFP) between countries varied widely, hampering convergence. Consequently, national policies are needed to raise productivity, which in turn will boost long-term growth potential.
Incomplete institutional advances led to abrupt macroeconomic adjustments that prolonged the crises’ negative impact on domestic demand. The eurozone now needs a veritable supranational stabilisation mechanism to make sure that the impact of localised shocks are not amplified and do not widen the gaps between countries.