Tuesday, January 26, 2010

Competitiveness Gaps Could Hurt Euro - No Really!

Reuters Jan Strupczewski gives more details of the EU Commission report first leaked by Der Spiegel. According to Strupczewski the "new European Commission report has expressed concern about gaps in competitiveness that could undermine confidence in the euro zone and point to tensions related to wage levels and capital flows in the 16-member club". The report was prepared for the finance ministers meeting on January 16.

Of particular interest the report acknowledges that the real effective exchange rate for Greece, Spain and Portugal is overvalued by more than 10 percent - I would put the Spanish figure at nearer 20%, but still, a start is a start - and this gives us an indication of how much either wages and prices in these countrieshave to fall, or productivity rise, to make them competitive again, given that they are locked into the euro.

The report also said that large and persistent differences in competitiveness across the zone are a serious concern and can undermine confidence in the single currency "Competitiveness divergences within the euro area may hamper the functioning of the Economic and Monetary Union, because of large trade and financial spillovers across Member States.......In particular, the persistence of large cross-country differences jeopardises confidence in the euro and threatens the cohesiveness of the euro area,"

The report, which runs to 172 pages, was requisitioned by the Commission to examine the competitiveness problem in the 16 countries using the single currency, such differences in competitiveness are reflected, for example, in the size of the respective current account deficits or surpluses in the eurozone.

To put things in perspective, the Commission estimates Greece had a current account gap of 8.8 percent of GDP last year, Spain 5.4 and Portugal 10.2 percent. Cyprus had a current account gap of 11.6 percent while Germany had a surplus of 4 percent, Luxembourg 9.4 percent, the Netherlands 3.1 and Finland 1.1 percent. These numbers are well down from 2008 in the cases of Greece, Spain and Portugal, where the deficits were more like 15%, 10% and 9%. As Krugman says, its all about "numbers, numbers, numbers".

The note said that the accumulation of large current account deficits could not be sustained forever and that they entailed a build-up of external and private sector debt. "If [these imbalances] remain unaddressed, the eventual correction can be abrupt and highly disruptive not only for the countries concerned but also for the rest of the euro area," it said.

"The combination of competitiveness losses and the excessive accumulation of public debt in some Member States are worrying in that context," the note said. Rigidities in labour and product markets may make regaining lost competitiveness a long and painful process , but the longer the adjustment is postponed the higher the ultimate cost will be, the Commission said.

"The divergence trend observed in the early years of euro reflects a worrying build-up of a range of domestic imbalances in some Member States," according to the Commission.

More controversially, the report suggests that while the real effective exchange rate for Greece, Spain and Portugal is overvalued, Germany's was 5.1 to 3.1 percent undervalued last year, indicating that companies have scope for wage increases without losing competitiveness. This is controversial, because naturally this rise in wages would bring Germany back into trade equilibrium, GDP growth would turn negative, since as a high median age society Germany is now completely dependent on its trade surplus for growth.

In addition the report said that most indicators of price and cost competitiveness pointed to a further divergence in competitiveness in the many euro zone countries during the financial crisis and in the early stages of the recovery. This is not good news, and the only clear signs of rebalancing come from Ireland gaining in competitiveness in 2008 and 2009.

"A smooth adjustment of intra-euro area competitiveness divergence and macroeconomic rebalancing is key for the recovery and, more generally, for the economic resilience and a smooth functioning of EMU in the long term.......It is therefore essential that Member States put in place an ambitious and comprehensive policy response geared at speeding up and improving intra-area adjustment mechanisms......The successful adjustment of intra-euro area competitiveness divergence and macroeconomic imbalances is of vital importance for the long-term functioning of EMU.

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