Center and periphery in the eurozone - Integration Options

July 24th  2012

The euro benefited all eurozone members with low interest rates, increased financial flows and greater trade integration. This facilitated the rapid "sale" of the euro in spite of significant productivity differentials, fiscal asymmetries, differences in bank regulatory frameworks, and the loss of lenders of last resort. Gaps in competitiveness and different degrees of fiscal consolidation in the eurozone eventually condemned periphery countries to a sharp recession and contagion fears spread to center countries raising questions about the sustainability of the euro. After the failure of rescue programs in Greece and Portugal, and despite the massive injection of liquidity by the ECB (European Central Bank), the yield of government bonds from countries like Italy and Spain remains at unsustainable levels of 6 to 7 percent.

A comprehensive strategy for the euro should recognize significant competitiveness and fiscal asymmetries within the eurozone. It should also take into account the dynamic fiscal implications of divergent competitiveness trends. For example, productivity growth in Germany (with a fixed exchange rate vis-à-vis eurozone countries) is expansionary and tends to lower its fiscal deficit/GDP ratio and its debt/GDP ratio. The opposite occurs in countries with less dynamic competitiveness trends: a persistent increase in unit labor costs (wage increase per unit of output) in these countries makes them less competitive vis-à-vis Germany and therefore, their GDP and fiscal balance relative to GDP tends to deteriorate. This is indeed what happened in most periphery countries. The policy implication is that fiscal sustainability in the eurozone cannot be addressed in isolation from underlying competitiveness trends.

The four countries with lower productivity growth in the periphery are Greece, Portugal, Ireland and Spain. In 1995-2007, growth of unit labor costs in these countries was 40 percent higher than in Germany. These countries are also among the most indebted: in Portugal and Ireland, the debt/GDP ratio was over 100 percent and in Greece more than 160 percent in 2011. In a few periphery countries, fiscal dynamics may have been unaffected by divergent competitiveness trends. However, this was the case only while the credit boom lasted; as the housing credit bubble burst, sovereign debt rose sharply in Ireland, and more recently, in Spain.

Competitiveness differentials have been smaller in center countries; however, even within this group there are sizable differences. For example, over 1995-2007, German unit labor costs fell 3 percent and Austria’s increased 5 percent. In the subgroup of Belgium, Finland and France, unit labor costs increased 10/20 percent more than in Germany. In a third subgroup, Italy, Netherlands and Luxembourg, unit labor costs increased 25/33 percent more than in Germany. Within the center group, the most indebted is Italy (120 percent of GDP in 2011), which is also among the less competitive. The two other more heavily indebted countries, Belgium (99 percent of GDP) and France (86 percent of GDP), belong to the second less competitive subgroup.  

Based on the foregoing, the countries which are closest in terms of competitiveness and fiscal performance (Germany and Austria) should be well prepared to converge to a fiscal union and, to that extent, to issue Eurobonds and create a banking union (with unified intervention mechanisms, and consolidated financial supervision and regulation). Such countries could adopt a common budget in stages, thereby helping to gradually promote deeper integration and competitiveness convergence. Macroeconomic policy coordination could lead to adoption of a fiscal rule with a structural balance target (adjusted to for the economic cycle).  Long-term fiscal savings could be achieved through reforms of social programs that can also help to enhance labor mobility, for example, extension of pensionable age based on longevity trends can be complemented with institutional reforms to enhance pension portability.

The road towards a broader fiscal union should be an incremental one, allowing the incorporation of other countries as they progress in terms of fiscal and competitiveness convergence. The political cohesiveness behind the commitment to join the union would be of paramount importance. During the transition, as other countries join, the core fiscal union could extend the European Stabilization Fund to help the region's banking systems (as recently announced) thus limiting the potential for bank runs and contagion. It could also grant the right to issue Eurobonds to countries with a proven record of structural and fiscal reforms and with an equal commitment to undergo such reforms in order to join the fiscal union. Given their size (and potentially disruptive impact on the euro) and ongoing policy commitments, Italy and Spain could be good candidates to receive such help.

For countries like Greece, where the commitment to reform is looser, the best alternative may be an orderly exit from the euro. The re-introduction of sovereign currencies would – through exchange rate devaluation – help to jump-start the recovery buying valuable social and political time to adopt reforms. The exit from the euro entails costs (increased burden of foreign currency debt, currency mismatches in the financial system, falling real wages) and risks associated with terminating a contract and/or likely debt restructuring. However, in view of the high current uncertainty, most of these costs are already largely discounted by the markets. The countries’ central banks – with help from the ECB – can provide a financial safety net to banks and foreign currency borrowers while debts are being restructured.

Aside from recognizing diversity and fostering a fiscal union, the strategy for the euro should be systemic.  Raising the ECB´s annual inflation target range to 2/3 percent would ease recession pressures throughout the eurozone and take off pressure in periphery countries. The core fiscal union should invest in low productivity EU countries through social and structural transfers to smooth out the potential short-term costs of reforms during the transition. Such reforms ought to include policies to increase labor market efficiency and mobility, adoption of budget processes leading to fiscal harmonization, consolidation of competition frameworks, unified regulation and supervision of financial institutions, and single infrastructure and education policies.

Daniel Oks. Ph.D., University of Oxford. Formerly, Manager of Financial Analysis at the Central Bank and Lead Economist for Chile and Uruguay at the World Bank.