Eurozone Watch

Yesterday, we had our long-time announced conference on EMU divergences in Berlin, sponsored by Nouriel Roubini's RGE monitor , the Stiftung Wissenschaft and Politik and the Arbeitskreis Europäische Integration.

From early morning until the evening, the day was packed with presentations and discussions whether certain economic developments in the euro area since its start have been pathological (see the programme and papers here). For us from Eurozone Watch, it was especially interesting to see how many serious economists, political scientists and policy makers are now interested in the topic of cyclical divergences, the discussion on which Eurozone Watch has been pushing since its launch a year ago.

The day started out with a keynote speech by ECB board member Lorenzo Bini Smaghi who was unexpectedly frank about the problems of divergences within EMU (read his speech here). While he argued that Europe has become more of an optimum currency area since the launch of the euro, he admitted that wage developments in some countries are a reason of concern:

"[Some of the changes of competitveness] suggest[s] that in several member countries the mechanism for determinig wage development are not optimal in a monetary union. In Italy, Spain, Greece and – to a lesser extent – France, where wage growth has not been consistent with productivity, competitiveness has deteriorated significantly. To regain the lost competitiveness, these countries will have to undertake a similarly painful adjustment to the one conducted in Germany over the last years."

Overall, there was a broad consensus among the particants of the conference that some of the divergences in EMU might indeed be economically harmful or even politically dangerous. This is a shift in perceptions. Roughly two years ago, the interest in these issues was much less developed. While you can of course argue, that those economists who do not see a problem in EMU divergences probably do not attend conferences on the issue, we noticed the following: upon our call for papers we had three times as many high quality submissions than we could accept for presentations at the conference, which reflects that research has intensified on this topic. In addition to academic research, relevant institutions such as the ECB or the European Commission, are increasingly concerned with this issue, despite the current upswing in the Eurozone which may temporarily hide the degree of underlying divergence.

There was broad agreement that divergences stem from different sources. Most panellists and discussants attributed an important role to the development of real estate markets and the construction sector. Daniel Gros even argued that the largest part of the divergences in competitiveness since 1999 has been due to exogenous shocks to the real estate market. In his eyes, the slow German growth performance and real depreciation was mainly due to a correction of (fiscally induced) overinvestment in construction after German reunification while Spanish loss in competitiveness was a result from the enormous construction boom on the Iberian peninsula.

In addition to the construction sector, most discussants pointed to labour market institutions as a main reason for divergences. The interaction of exogenous shocks to the construction sector, wage increases, a following real appreciation and an endogenous feed-back on the real estate due to the expectations of growing nominal incomes is surely one of the fields which will need (and hopefully see) more research over the coming years.

Coming to fiscal policies, the papers presented at the conference hinted that governments have actually contributed to the divergences rather than cushioning them. Evidence presented by several researchers suggests that fiscal policy in EMU has been rather pro-cyclical than anti-cyclical over the past years.

There was less disagreement on both consequences and cures of the divergences. While most discussants saw a period of extremely weak growth ahead for countries like Portugal, Spain or Italy, some even feared outright financial crisis due to an excessive increase in private debt over the past years.

Coming to cures, a whole number of issues were controversally discussed. Even though there was agreement on the point that wage setting institutions are important for the divergences, the discussants did not agree on whether nationally centralized wage setting is a good or bad thing in EMU. While some argued that a centralized wage setting gives an extra lever to influence the national exchange rate, others argued that it would jeopardize flexibility.

With regard to monetary policy, Adam Posen presented a paper (authored jointly with Kenneth Kuttner) which showed that the strain from the ECB's policy making is bigger the further an individual country differs in its structure from the average of EMU. They argue that each individual country experiences a welfare loss bigger than the average in the EMU. In the discussion, it was proposed that the ECB might hence have to take outliners more into account than they have done so far.

Coming to fiscal policy, there was a long debate on the question how the procyclicality could be tackled. While Paul de Grauwe proposed a political union of Europe (even though he was pretty sceptical about its feasibility), we presented a proposal consisting of three elements: First, to reform both the traditional revenues and expenditures of the EU budget so that they take more account of cyclical fluctuations. Second, we proposed a scheme of an unemployment insurance for European Monetary Union. We will outline these proposals in a further post on Eurozone Watch in the weeks to come.

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