In a previous post about the theory of optimum currency areas (OCA), asymmetric shocks, structural problems and the intrinsic need that this creates for the institution of a fiscal union, I argued that incomplete by monetary unions (i.e.: lacking a fiscal union) expose their members to the dispersion of wealth accross the union, creating a divergent trend where a convergent one may have existed before. In plain English, I made the point that countries in the Euro-Zone had been converging in terms of a large number of economic variables before the crisis hit. As it did, it benefited some at the detriment of other.
In this post I briefly illustrate this point by way of reference to a number of such economic variables. I begin by describing some well known divergences, before moving into a review some less well known facts. I conclude with an illustration of the theoretically predicted divergent trends in GDP, inflation and unemployment. The simple point is clearly that by any measurable yardstick, it’s better to be in the core than in the periphery.
European Sovereign Crisis: Famous Economic Divergences
A lot has been written about the sovereign debt crisis. As a result, new terms that were previously confined to the niche word of finance have migrated from their jargon to everyday parlance. Thus, every one knows about sovereign bond yields rising in the periphery and falling in the core.
Most people are now also familiar with GDP growth and the paces of economic growth among Euro-Zone countries
Most people will, clever and self-satisfyingly, also point to their knowledge of the fact that this is due to the fact that the core is more competitive than the periphery, as measured by Unit Labour Costs…
… or to real exchange rates.
Few however will be aware of how misleading the above indicators are. This is because both measurements, be it unit labour costs or the real exchange rate, depend on the deflator/rate of inflation, which grew quickly as a result of catching up, consistent with the familiar Balassa-Samuelson effect. As Felipe and Kumar 2011 point out, unit labout costs (ULC) “can be rewritten as the labour share in total output (value added) multiplied by the price deflator”. Using the figures below, they go on to show that most of the rise in ULCs was due to a rise in the deflator/inflation, since much of the labour share remained stable or declined.
The same authors go on to show that a comparison between peripheral countries and Germany is highly inappropriate due to the nature of export specialisation. Indeed, as the figure below shows, Germany specialises in much more sophisticated exports than the rest, probably a historical as much as educational and geographical fact.
Similarly, many people will be surprised to know that the Euro-Zone has a lower level of public debt to GDP than the USA.
Most people would also agree that the problem stems from fiscal profligacy in the periphery. However, this is only true for Greece, who misled its citizens and EU partners for several years about the state of its finances, publishing first a public deficit figure of 2% of GDP, before it was revised to 3.7%, 12.7% and 12.9%, finally settling at 13.6% in April of 2010.
Ireland and Spain ran deficits consistently below the €Z average until their respective real estate markets went belly up, ensuring a similar fate to their banks and to their governments, to whom the debt migrated eventually.
Portugal on the other hand has suffered from the endemically low levels of growth described previously. This put at risk their ability to collect the necessary levels of taxation to remain on a sustainable fiscal path.
As a result, only Greece and Italy fit the mould of fiscal profligacy. Portugal only has slighly higher levels of debt than the Euro average and Spain and Ireland were fine until the sovereign debt crisis hit. Indeed, Spain has a lower level of debt than France or Germany.
Beyond these facts, macroeconomic theory identifies other developments arising from this type of crisis. I like to point this out because economics has gotten a bad name these days, so it’s important to highlight when it gets things right. As described in that prior discussion of OCA theory and its applications to the Euro-Zone in the context of the effects of asymmetric shocks in incomplete monetary unions lacking a fiscal counterpart, GDP shold diverge with countries affected by the asymmetric shock experiencing negative growth and those imune from it experiencing positive growth(exactly the same figure as before)
Divergence also arises in the labour market with unemployment exploding in the countries affected by the shock, as the collapse in aggregate demand (consumption, investment, government spending or money stock) leads to lay-offs, while rising demand in non-affected countries leads to a need to increase employment to expand production.
Finally, as the AD-AS model also implies, as GDP falls/rises, so does inflation. As incomes have crashed and products are taken off the shelves, only those retailers that bring prices down keep afloat.
As for the differences between the countries, the model, as laid out in that post is not quantitative, just qualitative/descriptive.
No matter what way you look at it the Euro-zone, is individually and collectively more fragile, because it is an incomplete economic union lacking a strong, united and centralised fiscal authority that can rebalance asymmetric shocks and coerce its central bank like the US President and his/her Treasury Secretary can coerce the Fed. As it stands, the Euro-Zone temporarily benefits the core at the detriment of the periphery. However, as the dominos fall one after another our interdependeces should come home to bite the hubris of Germany and the chauvinism of the French that are threatening European peace and prosperity.