Daniel Gros assesses the likely consequences of a downturn in the fortunes of some eurozone members.
The past few years of slow growth have severely tested the fiscal framework of European Monetary Union (EMU) and the independence of the European Central Bank (ECB). Political pressures are increasing for the ECB to support economic activity in the short term.
However, slow growth is not the only risk factor for EMU. The next half decade should see the emergence of increasing growth differentials among EMU member countries, which so far have remained rather limited and at a stable level. Differences among the growth rates of eurozone members have barely changed between 1999 and now, as the big three tended to move broadly together. The two main laggards were Germany and Italy, with France falling between them and the more dynamic smaller countries. However, the similarity between developments in Italy and Germany has been superficial: it is becoming clear that a chasm has opened up between them.
Germany entered EMU with an overvalued exchange rate, but has regained competitiveness through a process that used to be called “competitive deflation”, that is, continuous concessions by trade unions on labour costs. By contrast, Italy has continuously lost competitiveness – since the start of EMU, its labour costs have increased by about 20% relative to those of Germany. This has also translated into large movements in export market shares.
Housing boom and overbuilding
These large relative movements in competitive positions and export performance did not translate earlier into different growth rates because of the offsetting tendencies in the housing markets. The low interest rate environment fostered by the ECB’s policy and the global ‘savings glut’ led to a housing boom in several countries, including France and Italy. This has sustained consumption in these countries, while in Germany, overbuilding led to persistent weakness in the real estate market and consumption.
An even more severe disequilibrium is building up in Spain, which so far has been regarded as a success story. In Spain the loss of competitiveness has been as severe as for Italy and the housing boom has been even stronger. The construction boom – now accounting for 17% of gross domestic product (GDP), against a normal ratio of about 9%-10% – has been a key factor in Spain’s relatively strong growth of the past years. With so many houses being built, it is clear that at some point in the future the demand for new homes will decline drastically. Spain is thus likely to experience a protracted period of weak domestic demand. The only way to prevent unemployment from skyrocketing would then be to rely on increasing exports. But this would require a turnaround in competitiveness.
Trading places
The remainder of this decade is likely to see the north and south of Europe swap places: Germany is likely to emerge with the strongest growth once its real estate market has hit bottom; Italy and Spain are likely to experience a period of weak growth as their labour markets struggle with the problem of how to regain competitiveness through lower wages and concessions on working time.
The latest EC forecast implies that Italy and Spain will continue to lose competitiveness. The later the adjustment starts in these countries the more difficult it will become. The foreseeable period of weak growth is likely to lead to even greater budgetary difficulties, especially in Italy.
Could these tensions lead to a break-up of EMU? While this has been suggested by some Italian ministers, it is unlikely to materialise because the cost of breaking away would be prohibitive for a country with such a high public debt. The Italian public (and even its most populist politicians) know that leaving EMU, coupled with a devaluation to regain competitiveness, would have disastrous consequences for public finances. In the end, Italy (and Spain) will have little choice but to undergo their first full business cycle under a hard currency regime. EMU is likely to survive – but the sparks will fly for some time to come.
Daniel Gros is director of the Brussels-based Centre for European Policy Studies.
