Eurozone Watch

In this week’s business cycle outlook from Deutsche Bank Global Markets ("Konjunktur und Märkte", June 23, www.db-rbf.de for DB customers), Thomas Mayer warns that some countries might have fallen in what he calls an "EMU Trap": According to his analysis, countries which have strong labour cost increases might fall into a position in which growth is slowing because competitiveness has badly deteriorated. With growth slowing, tax revenues are falling and outlays for unemployment are increasing, leading to a bigger budget deficit. In this position, a country cannot do much anymore: Cutting the deficit further would lead to even slower growth while there is no possibility to improve competitiveness quickly.

Thomas Mayer sees Portugal and Italy already in the EMU trap and Greece and Spain in imminent danger of falling into this trap. Thomas portraits three possible consequences from the EMU trap: First, a country could cut its production costs. Second, it could leave EMU. Third, it could pressure the ECB to allow for a higher rate of inflation in the whole union.

According to Thomas, it is highly unlikely that a single country would leave EMU in order to improve its competitiveness, given that a depreciation would increase the debt burden. However, he believes that countries in the EMU trap could pressure the ECB to accommodate a higher rate of inflation. This, he argues, might lead to stability-oriented countries to leave EMU at some future date.

One might question whether really the southern Europeans will manage to push Trichet, Stark and their team into allowing higher inflation in the Euro-zone as much as whether Germany would really leave EMU and accept a strong appreciation of a newly introduced German Mark just because inflation is running slightly above two percent. However, it is interesting that after Joachim Fels from Morgan Stanley and Véronique Riches-Flores from the Société Générale now Deutsche Bank is also thinking about scenarios of an unravelling of EMU.

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