bruegelpolicybrief ISSUE 2006/01 FEBRUARY 2006
THE EURO: ONLY FOR THE AGILE
by Alan Ahearne SUMMARY Contrary to often-heard concerns, the main question regarding the future of the Research Fellow at Bruegel European single currency is not who is going to leave, but who is going to join. Three of the new and Vice Dean at Cairnes School Nat. University of Ireland, Galway EU member states want to join Economic and Monetary Union (EMU) and adopt the euro [email protected] within the next year, and others are due to follow within the next decade. The experience of the and Jean Pisani-Ferry first seven years demonstrates that membership has its benefits, but that these benefits are Director of Bruegel not free. Being part of a currency union requires discipline, and the loss of the exchange rate [email protected] as an instrument for coping with economic shocks can be costly. Within the euro area some members, such as Ireland, are thriving; others, especially among the southern member sta- tes, are struggling and face painful adjustments in the future. As the chart below illustrates, economic divergences between existing members have been significant. Ireland and Portugal have experienced marked real exchange rate appreciation, but with very different consequen- ces for export growth. There has been real depreciation in both Germany and France, but only Germany’s exports have flourished.
EURO AREA DIVERGENCES: POLICY CHALLENGE A COMPARISON OF REAL EXCHANGE The policy discussion to date has almost exclusively RATES AND GROSS EXPORTS focused on the implementation of the Stability and Ireland and Portugal have had above average Growth Pact. Divergences in growth and inflation inflation - but Ireland combined it with strong exports. France and Germany have gained have not been given sufficient attention. At the price competitiveness, but only German exports national level, wage and price flexibility in response have flourished. to economic conditions is essential, and govern- % 15 ments must avoid fiscal policies that aggravate Portugal divergences. Enhanced surveillance by European 10 Ireland institutions of economic performance and policies 5 in euro area member states is also vital. As regards euro area enlargement, policymakers should be -20 -15 -10 -5 5 10 15 20 ready to apply more sophisticated entry criteria -5 than in the past, even if that entails the risk of being Germany France -10 portrayed as “unfair”. What is needed is a more refi- ned filter for deciding on membership than the Maastricht criteria. These have proven to be ill-des- CHANGE IN REALCHANGE EXCHANGE RATE igned to assess whether structural convergence is RELATIVE EXPORT GROWTH sufficient to make participation in EMU sustainable.
Source: Eurostat THE EURO: ONLY FOR THE AGILE
BY THE END of the decade the euro national and European policyma- criteria spelled out in the area may have expanded from the kers. The damaging effects of Maastricht treaty, the key ques- 02 current 12 members to 19 mem- divergences now call for both pain- tions, therefore, are to what extent bers. The new member states’ des- ful corrective policies in member the new member states are at risk ire to join EMU is understandable. economies that have been marred of being hit by severe asymmetric Membership has its advantages: a by a loss in competitiveness shocks, and whether they can brief monetary anchor, lower interest (Section 2), and for the introduc- adjust to such shocks through rates, no speculative attacks on tion of a stronger surveillance fra- internal flexibility. In deciding who the exchange rate, lower transac- mework to prevent similar pro- is fit for membership in the single tion costs, and closer integration blems arising in the future currency, the EU should avoid policy with current euro area members. (Section 3). hiding behind ill-designed nominal criteria and address these ques- But these benefits are not free. There are also lessons to draw for tions explicitly. Being part of a currency union the new member states (Section involves discipline, and for the 4). Given their level of develop- 1. PERFORMANCE bruegel export-dependent participants the ment, the economic structures MEASURES loss of the exchange rate as an and financial systems in the new instrument for coping with econo- member states will continue to Some countries have fared better mic shocks can be costly. change as they converge to than others under EMU. Table 1 income levels in the EU-15 coun- documents the differences in real In retrospect, a lesson from the tries. These changes may require GDP growth rates across the euro first seven years of EMU is that significant real exchange rate area since 1999. Growth in those disciplines and potential adjustment if the new member Ireland, Greece and Spain has costs have been underestimated. states are to maintain internatio- significantly outpaced average The policy discussion has almost nal competitiveness and prevent euro area growth, while Germany, exclusively focused on the imple- deep recessions and bouts of high Italy and Portugal have underper- mentation of the Stability and inflation. Within EMU, real formed. Strong growth in Spain Growth Pact. Persistent divergen- exchange rate adjustment can and Greece has been driven by ces in growth and inflation, which only be brought about through robust domestic demand, whereas we examine in Section 1, have not changes in domestic prices and their export performance has been been given sufficient attention by wages. Beyond the nominal entry mediocre. Weak net exports have
TABLE 1. REAL GDP GROWTH CHART 1 (Annual avg. 1999-2005) PORTUGAL 115 REAL EXCHANGE RATES1 CONTRIBUTIONS FROM: IRELAND Real Domestic Net 110 Demand GDP Exports SPAIN Ireland 6.3 4.4 1.9 NETHERLANDS Greece 4.1 4.5 -0.4 105 Spain 3.6 4.6 -1.0 BELGIUM ITALY Finland 2.7 1.9 0.8 FINLAND France 2.2 2.6 -0.4 1999 Q1= 100 100 Belgium 2.0 1.7 0.3 AUSTRIA Austria 2.0 1.4 0.6 DEPRECIATION Netherlands 1.6 1.2 0.4 FRANCE 95 GREECE Portugal 1.5 1.8 -0.3 GERMANY 1Intra euro area real Italy 1.3 1.5 -0.2 trade-weighted exchange rates, Germany 1.2 0.4 0.8 90 based on Consumer 19992000 2001 2002 2003 2004 2005 Price Indices. Euro Area 1.9 1.8 0.1 Source: Eurostat Source: OECD THE EURO: ONLY FOR THE AGILE
also depressed growth in Italy and The changes in competitiveness 2. PROBLEM COUNTRIES Portugal, along with sluggish resulting from these movements domestic demand. Remarkably, in real exchange rates appear to It is important to note that growth 03 German domestic demand has have played a role in bringing and inflation differentials are not barely grown since 1999, and the about large swings in current undesirable per se. Whether the moderate growth that Germany account balances in several coun- observed differences are desirable brief has registered has been entirely tries. Portugal and Spain are now or undesirable depends in large due to net exports. running large current part on the nature of the shocks account deficits, that are causing the divergences. The dispersion of while Germany and In a currency union with different policy growth rates across “Savings and several other economies and asymmetric euro area countries investments higher-income shocks, some divergence between is not especially countries are run- members is to be expected and is large, being similar have become ning large surpluses. even necessary. Distinguishing in size to the disper- As savings and welcome from unwelcome diffe- sion across the US2. increasingly investment have rentials requires case-by-case bruegel Unlike in the US, decoupled in become increasingly economic analysis of initial condi- however, growth dif- decoupled in EMU tions and underlying factors. ferentials in the EMU countries.” countries, the disper- euro area are persis- sion of current The two countries with the highest tent, and evidence account balances inflation rates, Ireland and shows that it is the has trended up Portugal, are a case in point. In trend rate of growth that drives over the last 15 years (Chart 3). Ireland, real exchange rate appre- these differentials, rather than countries simply being at different stages in the output cycle. In fact, CHART 2 business cycles have become REAL EXCHANGE RATE AND DOMESTIC DEMAND (1999-2005) strongly synchronised in the euro area3. 12 PORTUGAL IRELAND Persistent differences in inflation 8 SPAIN rates across countries are another 4 feature of the euro area. Here also, NETHERLANDS BELGIUM GREECE at any point in time the dispersion ITALY of inflation across the euro area is AUSTRIA FINLAND not unusually large; but, as a -10 1 2 3 4 result of prolonged differences in FRANCE GERMANY -4 inflation rates, euro area econo- Domestic Demand mies have experienced very sizea- Ex. Rate Real % Change -8 (Avg. annual growth less avg. euro area growth) ble swings in their real exchange rates vis-à-vis their peers, as Source: OECD shown in Chart 1. These inflation CHART 3 % GDP differentials largely reflect domes- tic factors, especially growth in CURRENT ACCOUNT DISPERSION 5 wages, and are highest in the non- traded goods sector. 4 3 Generally speaking, countries with 2See Angeloni and the strongest growth in domestic TREND 2 Ehrmann (2004) and Gonzalez- demand also registered the Paramo (2005). highest rates of inflation (Chart 1 2). Portugal is the only notable 3See Lane (2006) exception. 0 and de Bandt, 1985 1990 1995 2000 2005 Herrmann and Parigi (Standard deviation across 11 euro area members exc. Luxembourg) (2006). Source: Eurostat 04 bruegelpolicybrief THE EURO:ONLY FOR THEAGILE nerable to international competition and Portugal’s exports left them vul- growth and the composition of Italy’s Importantly, slow productivity demand and weak exports. Portugal, with sluggish domestic Italy bears astrong resemblance to also had above-average inflation. the other EMUmembers that have Chart 4illustrates the situations of x nate. titiveness eventually began to domi- was short-lived asthe loss of compe- agents. However, the honeymoon were entirely passed on to private from areduced interest debt burden the expansion because the benefits rapidly. Budgetary policy added to credit to households expanded more than 6percentage points and as real interest rates declined by sector around the time of EMUentry, tic demand and inthe construction enjoyed aspurt ingrowth indomes- has depressed exports. Portugal Portugal’s competitiveness, which has led to amarked deterioration in In contrast, above-average inflation in exports (Chart 4). suffered, aswitnessed by the boom Ireland’s competitiveness has not ded-goods sector. aresult, As ments up the value chain inthe tra- advances inproductivity and move- ciation has been offset by rapid Source: UNCTAD CHART 5a CHART % Share of World Exports CLOTHING ANDFOOTWEAR TEXTILES, 10 15 20 25 ls 0 5 1996 CHINA 1998 2000 ITALY Source: Eurostat 2002 to the external shocks that have buffeted both economies. competitiveness and narrowed the policy options for responding Member surged. products atthe same time asChina’s share of these markets has countries have suffered declines inmarket share of key export directly inChina’s line of fire. shown As inthe charts below, both Portugal entered EMUwith industrial structures that placed them cers, especially China and the new EU member states. Italy and left both countries vulnerable to competition from low-cost produ- Italy and Portugal isthe lack of structural transformation that has An important factor behind the current economic BOX 1:THE“CHINASHOCK” TO ITALY ANDPORTUGAL CHART 4 CHART REAL EXCHANGE RATE ANDGROSSREAL EXPORTS -20
Change in Real Exchange Rate % GREECE 1 -10 -15 2004 ITALY 9 0 1 2 3 4 5 6 7 8 10 FRANCE PORTUGAL ship of EMUhas both exacerbated the loss of Source: UNCTAD CHART 5b CHART TEXTILES, CLOTHING ANDFOOTWEAR TEXTILES, SPAIN
% Share of World Exports BELGIUM 10 15 20 25 0 5 NETHERLANDS 520 -5 1996 -10 15 10 -5 0 5 CHINA 1998 (Cumulative change 1999) since (Excess over euro area avg.) Export GrowthExport 5 FINLAND 2000 AUSTRIA PORTUGAL 10 problems in problems 2002 GERMANY 15 2004 IRELAND 2 2.5 0 0.5 1 1.5 THE EURO: ONLY FOR THE AGILE
from low-cost producers, especially China (see Box 1). Adjustment to BOX 2: REAL INTEREST RATES IN GERMANY global shocks would have required 05 real exchange rate depreciation in Real interest rates in Germany have declined from their Italy and Portugal, not the real appreciations that both countries peaks in 2000, as the ECB cut nominal interest rates experienced. In both countries, and as German inflation picked up a little from very low brief restoring competitiveness will rates. However, we estimate that the German “equili- require a prolonged period of brium” real interest rate—that is, the real interest rate below-euro-area-average growth in unit labour costs.Greece and that would provide enough stimulus to demand to use policy Spain have also perforccmed rela- up spare capacity in the economy—has also declined tively poorly when measured by over recent years, so that the level of real interest rates exports. To date, robust domestic has remained restrictive (see Chart 6 below). Given the demand, driven in part by activity in the construction sector, has large amount of economic slack at present, we estimate bruegel more than outweighed weak that, other things being equal, negative real interest exports. Our concern is that when rates in Germany would be needed to close the output the temporary boost from the 4 EMU-induced drop in real interest gap over the next few years. rates and rising property prices eventually fades, they may well be The calculations above are based on German Consumer- facing similar problems to those Price-Index (CPI) data. Domestic consumer prices are Portugal is facing today. clearly relevant for households’ consumption and At the other end of the scale is savings decisions, but less relevant for exporting firms’ Germany, where persistent excess investment decisions. In Chart 6 we plot an alternative capacity in the economy, because of weak domestic demand, has measure of the German real interest rate based on a kept inflation below the euro area weighted combination of domestic and foreign prices, average. With a common nominal where the weights reflect the size of exporters’ invest- interest rate across the euro area, ment spending in aggregate expenditure. The closeness below-average inflation has resul- ted in above-average (ex-post) real of the two measures suggests that, contrary to some interest rates in Germany, which claims, using domestic price indices can result in accu- has further depressed domestic rate calculations in real interest rates. demand and inflation (see Box 2). Below-average inflation has set in motion an economic force that CHART 6 works to offset the drag from high real interest rates: German expor- GERMAN REAL INTEREST RATES % ters have become more competi- 5 tive—the so-called “competitive- Real Interest Rate ness channel” of adjustment—and 4 Adjusted Real Rate German exports have surged. Over 3 time, the competitiveness channel Equilibrium Real Rate may come to dominate the depres- 2 sing effect of high real interest rates, but the German case shows 1 that this adjustment process 0 takes a damagingly long time, 2000 2001 2002 2003 2004 2005 even in a highly open economy. -1 The announced 2007 tax hike 4The output gap is -2 the difference bet- should further delay the revival of ween actual and domestic demand. Source: IMF, UNCTAD, own calculations. potential GDP. THE EURO: ONLY FOR THE AGILE
3. POLICY IMPLICATIONS important for Spain and Greece, Finally, the euro area should avoid FOR CURRENT MEMBERS given the concerns we have mentio- putting itself in a situation where its 06 ned about these economies. In the members pursue inconsistent goals. Economic problems in EMU member medium run, these reforms matter In this respect, further depreciation states are not only a matter for for all euro area members. of Germany’s real exchange rate vis- à-vis the rest of the euro area would
brief national governments. Even putting aside the risk of an eventual break- First, the “competitiveness channel” be inconsistent with the need to res- up, they are a common concern for through which a loss of price compe- tore price competitiveness in several the whole euro area. Difficulties in titiveness generates economic slack other countries. individual euro area countries spill that eventually corrects the real policy over and affect other EMU member appreciation needs to be strengthe- B. INSTITUTIONAL DIMENSIONS. states via two channels. ned. Particularly important in this As well as changes in polices at the regard is a wage formation process national level, changes at the Financial linkages. EMU member that makes wages respond swiftly to Community level in how problems in states are exposed to developments economic conditions. Increased individual member states are approached are also needed. bruegel in the rest of the euro area through competition in product markets large and growing cross-border hol- should also increase the responsive- Enhanced surveillance by European dings of assets. For example, recent ness of domestic prices to shocks. institutions of economic perfor- data show that other euro area mem- The completion of the single market mance and policies in euro area ber states hold about €70 billion in for services would help member states is vital. Such monito- Portuguese assets and thus would in this regard. ring would aim to suffer significant negative wealth “The European identify problems in effects should the value of these Second, it is clear that individual member assets decline markedly. built-in fiscal stabilizers Commission states that could should be allowed to spill over into the Monetary policy. Very low infla- work fully and that should use its rest of the euro area. tion, or even deflation, in one EMU national governments member country undergoing disin- should avoid pro-cycli- right of alert to Currently, multilate- flationary adjustment pulls down cal fiscal policies that single out pro- ral surveillance in average euro area inflation. In res- aggravate divergences. the euro area has ponse, the European Central Bank Portugal’s experience blem countries.” two arms: a relati- would run a more expansionary suggests that the fiscal vely strong one, the monetary policy than would other- discipline in place Stability and Growth wise be the case. The resulting looser during the pre-EMU years can easily Pact (SGP); and a relatively weak monetary conditions would push up be thrown aside once the goal of one, the monitoring of economic poli- inflation in other EMU member sta- EMU entry has been achieved. In the cies under Article 99 of the Treaty. tes, leading to greater divergence. countries that need to undergo a real Budgetary surveillance under the exchange rate adjustment, fiscal SGP aims at containing fiscal imba- A. WHAT TO DO AT THE NATIONAL LEVEL. policy should be geared towards lances that are a source of harmful For the countries in EMU with the supporting it. divergence. However, monitoring severest problems, i.e. Portugal and member states’ fiscal positions is Italy, there can be no solution other Third, there may be a role for enhan- not sufficient. After all, Spain is cur- than the long, hard slog of structural ced prudential and regulatory poli- rently running a small fiscal surplus. adjustment. The first priority should cies to help avoid asset price booms Moreover, Portugal made significant be to make sure that divergence and busts in individual member policy mistakes during the period does not become any worse. This countries. In particular, tighter regu- 1995-1999 at a time when its head- calls for wage moderation and lations on household borrowing line budget deficit was declining increased competition in goods and might be desirable in some countries from 5 per cent to below 3 per cent. services markets to bring inflation experiencing credit booms. At the down below the euro area average. very least, careful monitoring of cre- There is therefore a need to streng- dit expansion is essential to prevent then the “weak” arm. First, the Other members of the euro area an overshooting of domestic prices, European Commission should speak should also implement policies to especially for those members who up and use its so called “right of have to adjust to lower interest rates alert” to single out problem coun- 5 improve the functioning of adjust- In his speech on the ment mechanisms. In the short run, than they have historically been tries. Bank of England Governor future of the IMF of 20 5 February 2006. these reforms may be especially accustomed to. Mervyn King recently reminded us THE EURO: ONLY FOR THE AGILE
that Keynes placed faith in “ruthless though they have more flexible eco- pear once in the euro area, espe- truth-telling” and this should apply nomies than the current members. cially if budgetary accounting tricks to the Commission. Second, the were used to satisfy the criteria on 07 Eurogroup should have frank discus- Second, the Maastricht criteria government deficits and debt. sions on potential problems and based on inflation, long-term inte- remedies and make sure that their rest rates, exchange rate stability Third, real convergence matters. conclusions are brought to the atten- and public finances are neither Here, the new member states’ record brief tion of the relevant governments. necessary nor sufficient to deter- is more mixed. Trade and foreign The treaty-based community instru- mine suitability for EMU member- direct investment (FDI) integration ment, the so-called Broad Economic ship. They are not necessary with current EMU members has pro- Policy Guidelines (or the newly adop- because higher inflation can be a gressed quickly in recent years and ted Integrated Guidelines) is too consequence of rapid economic is now fairly advanced. However, out- weak to be relied upon, and plays vir- catch-up. They are not sufficient put per capita remains far below the tually no role in the national policy because satisfying the price stabi- average euro-area level, and conver- debates. Therefore, whenever nee- lity criterion in the run-up to EMU gence in output specialisation to EU ded, the President of the Eurogroup entry does not guarantee that infla- norms has been slow: significantly, bruegelpolicy should be given the mandate to tion will remain low once member- agriculture and manufacturing still engage in direct discussions with ship has been achieved. In a similar weight more than in the current EMU national governments. Finally, the vein, the fiscal discipline displayed members, and services are relatively specific euro-area dimension of prior to EMU entry can easily disap- underdeveloped. As convergence structural surveillance – which is associated with the Lisbon Agenda – CHART 7 should be strengthened. At least, the REAL EXCHANGE RATE AND DOMESTIC DEMAND(1999-2005) list of reform priorities should expli- 60 citly include measures that are nee- SLOVAKIA ded to improve the functioning of 50 EMU. 40 HUNGARY 4. POLICY IMPLICATIONS FOR 30 CZECH REPUBLIC POLAND LITHUANIA NEW EMU APPLICANTS 20 ESTONIA MALTA 10 CYPRUS Our analysis also throws light on the SLOVENIA LATVIA issue of euro area enlargement. As shown in Charts 7 and 8, many of the GERMANY -10 1 2 3 4 new EU member states have expe- Domestic Demand rienced solid growth in domestic Ex. Rate Real % Change (Avg. annual growth less avg. euro area growth) demand as well as considerable real Source: OECD exchange rate appreciation vis-à-vis current euro area members and a CHART 8 boom in exports. On these dimen- sions, they have more in common REAL EXCHANGE RATE AND GROSS EXPORTS with Ireland than with Portugal. 60 (Cumulative change since 1999) SLOVAKIA At first glance, therefore, our data 50 deliver an optimistic assessment. In judging whether EMU membership is 40 right for the new EU member states, HUNGARY however, there are other dimensions 30 that need to be considered. CZECH REP. 20 LITHUANIA First, compared with current EMU POLAND members, the potential benefits for 10 ESTONIA the new EU member states of joining MALTA SLOVENIA EMU are greater, but so too are the -30 -20 -10 0 10 20 30 40 50 60 70 potential costs. The new EU member CYPRUS LATVIA -10 Export Growth states probably face larger asymme- Appreciation Ex. Rate % Real tric shocks, and this matters, even (Excess over euro area avg.) Source: Eurostat THE EURO: ONLY FOR THE AGILE
proceeds further, real exchange deficits. In large part, deficits reflect asymmetric shocks. However, this rates may have to adjust, especially high prospective returns on invest- process takes considerable time. 08 in the context of changing world ment in these countries as a result of Prudent macroeconomic polices and trade patters as a consequence of their low capital-labour ratios. microeconomic reforms will be nee- the rise of China. Tellingly, much of the capital inflow ded to facilitate these advances. But has taken the form of FDI, which may convergence is rarely smooth, and brief It is frequently argued that the new limit vulnerability and has facilitated substantial real exchange rate EU member states technology trans- adjustments may be required along should be judged solely fer. However, the way. on the basis of the convergence policy Maastricht criteria towards a steady The question, therefore, is not whe- because these were the state where exter- ther EMU is suitable only for rich yardsticks applied to “EMU is a learning nal liabilities countries. The level of per-capita real the current members. represent a GDP in itself should not be a criterion But EMU is a learning process; nominal constant propor- for entry into EMU. The deciding process, and we have tion of GDP would question should be whether coun- bruegel learnt that nominal convergence is not imply for some tries for which the potential for diver- convergence is not enough to ensure countries an gence is significant have taken the enough to ensure that a adjustment in the necessary measures to minimise country is fit for the that a country is fit trade balance of this risk. euro. Furthermore, the order of mag- Article 121 of the Treaty for the euro.” nitude of 5 per It is illusory to believe that a well- explicitly mentions that cent of GDP or functioning single currency area can “a high degree of sustai- more6. This again emerge spontaneously; members nable convergence” is a raises the issue of have to work hard to make it happen. condition for member- the corresponding A reformed and enlarged EMU offers ship. This should be real exchange rate the potential of enormous benefits, taken as a basis for a broad assess- adjustment. but only for those countries that are ment of a country’s effective and willing to get into shape. lasting ability to participate in the To be sure, EMU entry should accele- single currency. rate the process of real integration. We thank Narcissa Balta for her In turn, increased trade integration assistance in preparing this Policy One feature of the recent perfor- with greater intra-industry trade Brief. mance of the new member states should lead to increased synchroni- has been their large current-account sation of business cycles with fewer
REFERENCES I. Angeloni and M. Ehrmann, “Euro Area Inflation Differentials”, European Central Bank Working Paper 388, 2004. J.M. Gonzalez-Paramo, “Regional Divergence in the Euro Area”, speech at the International Conference on the Role of Government in Regional Economic Development at University of Vigo, 2005,
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The Bruegel Policy Brief series is published under the editorial responsibility of Jean Pisani-Ferry, Director. Opinions expressed in this publication are those of the author(s) alone.
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